Apple pays a dividend at last but is it a good thing?

Should we pay a dividend?  What rate will please the shareholders?  Will this dividend attract new investors? What does this dividend level say about our performance?  What does it say about our future prospects?  There are so many factors for managers to consider when making decisions about the payment of dividends.  As a result dividends are a tough balancing act for corporate managers.

Apple serves as a curious case when looking at dividend policy.  The company has not paid a dividend since 1995 instead preferring to plough money back into the business.  Any surplus cash in this period has been used to help grow the business through research and development, acquisitions, new retail store openings and improvement of infrastructure.  This has proved very successful and Apple is now the world’s most valuable company being worth more than $500bn.  Yet despite all this success the company has not paid a dividend for close to twenty years.

However this changed recently when Apple announced on the 19^th March that it would pay a dividend of $2.65 per share later this year.  This came after it emerged at the end of last year that the company was sitting on $97.6bn worth of cash.  In theory the decision to pay a dividend should be a good thing.  It sends a positive message to the marketplace highlighting that the company is performing well which should in turn entice a new wave of investors attracted by the proposition of regular dividend payments.  But will shareholders and potential investors see it that way?

Although the payment of a dividend shows the company is performing well it can also show that they have ran out of things to spend their money on so is making the easy decision to simply give it back to the shareholders.  It could be argued that it displays a lack of creativity, lack of new ideas and a lack of attractive new investments which could undermine the future growth of the company.  Coincidentally it is worth noting that Apple hasn’t released a revolutionary new product since the launch of the ipad over two years ago and there doesn’t appear to be one on the near horizon.  Tim Cook (CEO) revealed that the board had been discussing what they were going to do with the pileup of cash for some time.  This seems alarming to me that they were struggling to decide what to do with it and sparks images of the Apple board sitting round scratching their heads saying “hmmmm what on earth are we going to do with all this money?”.

Ten years ago shares in Apple could be purchased for a mere $10.  The same shares are now worth over $600.  As the graph highlights, the shares have almost doubled in value the last year alone.  This represents an overwhelming increase in shareholder wealth which, in the absence of dividends, has been achieved solely through extensive capital gains.  However April looks set to be the first month that Apple shares haven’t gone up since November 2011.  This is coincidentally the first full month since the announcement that dividends were to be reintroduced and may serve to outline the decisions potential to limit future capital gains.  What shareholders must be thinking is; as my shares have already increased in value by $198 per share this year why would I be bothered about getting a small dividend of $2.65 a share which may get in the way of my capital gains.

It could be argued that the dividend will provide some obvious tax benefits to shareholders.  The split of income across capital gains and dividends allows shareholders to take advantage of two tax free allowances as oppose to one.  However the US tax system is set to change in 2013 so that dividends are taxed at the same rate as standard income tax whereas capital gains will continue to carry a preferential lower rate.  This could lead to some angry Apple shareholders who in a years’ time may find their capital gains stagnating and meanwhile will be getting taxed heavily on their new dividend payments.

There is some past precedence to say that changing policy to start paying a dividend is not such a good idea.  Apple themselves previously paid a dividend between 1987 and 1995, a time in which the company struggled financially and came dangerously close to bankruptcy.  Close rival Microsoft experienced extensive capital gains, not unlike Apple currently, when not paying a dividend between 1986 and 2002 but the capital gains have been minimal since the reintroduction of dividends in 2003.

Overall I am surprised that Apple has decided to change a winning formula and bring back dividends.  Perhaps it is Tim Cook’s idea to put his stamp on a company that is still heavily influenced by its late founder Steve Jobs.  The success of Apple is unlikely to waiver in the near future however this decision has the potential to do more harm than good to shareholder wealth.

Economic uncertainty blows the airline industry off course

When you think of the credit crunch you naturally think of the banking crisis.  The UK government has spent a colossal £1.5 trillion to date bailing out its banks since 2008.  To put this into perspective; in the UK £500bn was spent on the banking rescue plan in the year following the 2008 crisis compared to a measly £193bn spent on health and education.  Credit crunch is a term used to describe “a severe shortage of money or credit” and this is certainly not a problem that is confined to the banking sector alone.

The financial crisis meant banks were much less inclined to lend to their customers and the cost of borrowing increased dramatically.  House prices and share prices also plummeted.  The upshot of this for everyday people is a severe impact on market confidence and a reduction in their disposable incomes.  People who have less money to spend are forced to focus their income on essential spending rather than luxury goods.  The impact of this on many businesses has been monumental.  This is the point at which a crisis confined to the banking industry becomes a wider social issue, the consequences of which continue to be felt today.

The airline industry is clearly feeling the effects.  Cathay Pacific, a Hong Kong based worldwide airline, this week announced a dramatic fall in profits.  The airline made only 5.5bn Hong Kong dollars in 2011 in comparison to 14bn the previous year; a decrease of 61%.  Although rising fuel costs and unexpected weather conditions were drivers behind the drop in profits the principal reason provided by Cathay Pacific was “global economic uncertainty” which had hit passenger numbers.  The problem is that in a recessionary climate everyday people are less likely to spend what little money they do have on travel. The problem is not confined to Cathay Pacific alone; their announcement follows similar tales of woe from Air France-KLM, Malaysia Airlines, Air Berlin and Air Asia in the last month.  The problem is clearly a worldwide one and one that is probably here to stay.

Economic confidence is at an all-time low especially in Europe where the on-going Euro crisis is damaging people’s disposable income and will limit spending, on non essential items such as flights for the foreseeable future.  Widespread unemployment and in particular youth unemployment adds to the problem.  Young people are a significant part of that sector that spends their money on flights in order to go on holidays around the world.  When you throw these confidence damaging issues together the prospects for the airline industry and the wider business world don’t look good.

The early signals are that the airlines themselves don’t expect the situation to improve.  Ryanair, KLM and Qantas have all recently announced they are to cut staff in response to declining passenger numbers.  But this is symptomatic of the underlying problems  I believe lie ahead for the worldwide economy as a whole; people have less money to spend, so they spend less, so businesses profits fall,  in response they cut staff numbers, so more people are out of work with less money to spend.  And so the dangerous cycle continues. When a similar situation arose in America in the 1930’s after the Wall Street Crash, President Roosevelt increased government spending on a range of measures including building new schools, roads, dams and agricultural regeneration schemes such as the Tennessee Valley Authority to kick start the economy and get people back to work. Even then his measures only reduced unemployment by approximately 50%. A return to full employment in Europe and the USA only came after the start of World War 2 with its subsequent demands on manpower and war materials.

The roots of today’s problems lie with the financial crisis. The result has been significant damage to people’s ability and willingness to spend. Businesses of all kinds will continue to pay the price.



RBS acquisition of ABN Amro: bad decision, bad timing or the Fred effect?

In October 2007 the Royal Bank of Scotland Group (RBS) led a consortium in acquiring Dutch bank ABN Amro in a deal worth £50bn.  However, a year later the company had endured a £5.9bn write-down of its asset book value, a £12bn rights issue to raise necessary capital and eventually had to be supported by HM Treasury in a well-publicised bail out of UK banks.  The question is; what went wrong?

First of all the motivations for the acquisition have to be seriously called into question.  The £50bn deal represented a hefty chunk of capital but this seems even pricier when you consider that RBS paid a whopping 70% premium over the actual value of ABN Amros’ shares.  This was evidently a boom time in the banking industry and sacrifices have to be made, many argued.  During mergers and acquisitions companies usually expect to pay a 20-30% premium on the value of the target companies shares but looking back, boom or no boom, this price seems ridiculous.  In addition there was growing uncertainty in capital markets and it was being questioned whether growth could be sustained in the banking sector.

Nevertheless the acquisition promised to provide RBS with €1.8bn synergy gains and would enhance the group’s international capabilities.  What part did management play in the failures of this takeover?

RBS’ acquisition of ABN Amro was a hostile break up bid and it was virtually unprecedented to break up a company which operated on such a worldwide stage, in particular a bank.  Since 2000 ABN Amro had experienced rapid expansion into the foreign markets of Europe, South America and the USA.  At one point it had been seen as a potential rival to some of the banking sector’s leading world players.  However the company had experienced recent poor performance leading to deterioration in the share price and calls from its own shareholders for the company to be broken up.  Considering the growing concerns over the viability of the banking sector surely RBS would have been best served by refining and improving the existing services of the bank.  ABN Amro quite obviously had the ability to be successful, they just needed the guidance of RBS to realise this once again.

However RBS were fully intent on a major overhaul of the business involving extensive staff cutting and cost saving measures.  This was represented early on by the dismissal of ABN Amro’s current CEO Rijkman Groenink for a costly final severance package of just over €30m.  This, and other strategic decisions, was questionable, however RBS quite clearly wanted to firmly plant their own stamp on affairs.  Commentators at the time drew distinct similarities with RBS’ extremely successful takeover and implementation of the National Westminster (Natwest) bank in 2000.  RBS were quite fairly attempting to follow a similar process.  But what went wrong this time around?

Firstly, and most importantly, post deal there was a serious decline in credit market conditions and a quickly worsening economic outlook in what has since been coined the ‘financial crisis’.  For RBS this meant the capital required to fund the ABN Amro deal was placing a huge strain on the company’s assets.  This, coupled with the exposure to the housing market crash, led to the write down of £5.9bn of the company’s assets and a £12bn rights issue in April 2008 to help shore up the company’s finances.   At the time this represented the largest rights issue in UK corporate history and the deal allowed shareholders to purchase shares at an incredible 46% discounted price of only 200p per share (the actual share price at the time was 372.5p!).  The turmoil was quite clear to see and the capital straining ABN Amro deal was being pinpointed as the root of the problems.

The situation did not ease and the UK government famously intervened in October 2008 to help recapitalise UK banks.  RBS was one of the main beneficiaries of an initial £37bn bailout aimed at stabilising the situation; providing short term liquidity and facilitating future lending.  What I cannot understand is if there was uncertainty surrounding the UK economy, and in particular the banking sector, then why participate in such a daring, capital intensive takeover of ABN Amro.  Perhaps the motives of a certain individual could help explain this?

The acquisition of ABN Amro represents the world’s biggest ever bank takeover and the then CEO, Fred Goodwin, would have taken immense personal pride in being at the centre of such a prestigious deal.  John Varley, CEO of rival bidder Barclays, commented at the time that Goodwin was willing to pay any price for ABN Amro - to win at any cost!  Goodwin appeared to take the attitude that he had done it before with Natwest, why couldn’t he do it all over again.  His overriding desire was to enhance the bank’s worldwide power as opposed to protecting the welfare of the company and, in particular, the shareholders.  In the year from the takeover to the government bailout RBS shareholders lost an astonishing 440.5p (86%) off the value of their shares - and the situation is still no better:

The ABN Amro acquisition was an immense failure, but it could be argued this was largely due to it being a victim of circumstances.  The credit crisis put too large a strain on RBS resources and ultimately the ABN Amro deal went down with it.  But the cost of the deal reached dizzy heights at a time of uncertainty and I would describe it as a silly deal at the end of a simmering debt-fuelled boom in the UK economy. A bank like RBS, the epitome of safety to many, should have known better and Goodwin not only should but probably did know better.

Volkswagen leads the way in the FDI decision race

Foreign Direct Investment (FDI) is ‘The purchase of physical assets or a significant amount of ownership of a company in another country to gain a measure of management control’ (Wild, Wild & Han, 2004).  There are commonly two types of FDI which can be categorised as Greenfield investment or International mergers and acquisitions activity.  Greenfield investment is when a company solely enters a market and invests in offices, buildings or other physical assets.  Conversely International mergers and acquisitions is when a company joins forces with an international business or businesses.

FDI has been the biggest flow of resources into developing countries in the last 20 years.  Much of this has been driven by the growth in international technology advancements and the desire of large domestic companies to make the step to become multinational.  It could be argued we are part of a ‘multinational era’ where almost all large firms have operations all around the world which originated from significant FDI.  In recent years the most rapidly increasing inflow area for FDI has been south-east Asia.  But why do firms decide to employ FDI in the first place?

·         Market – firms may be facing domestic saturation or could see an international market as a growing source of demand.

·         Raw materials – international regions may have high levels of natural resources that are essential to a firms output and hence it makes sense to get closer to them.

·         Product efficiency – a business may employ FDI to make their business more efficient.  This could be by seeking technology or, more commonly, lower labour costs.

·         Knowledge – it may be that international countries have specific knowledge bases that could be exploited to aid the growth of a business.

The reasons outlined to explain FDI are generic principals often outlined in academic texts.  In reality the reason depends entirely on the motive of the firm in question.  For example fast food chain McDonald’s expansion into the Asian market in the late 70’s and 80’s was largely driven by the rapidly expanding market for fast food in the region.  Conversely UK and US service sector industries often locate their call centres in countries like India and the Philippines to take advantage primarily of the cheap labour force that is available.  However I would expect that within any motivation the overriding desire is to maximise growth and ultimately increase profits.

German company Volkswagen is the world’s second largest motor vehicle manufacturer and the biggest in Europe.  The group also owns well know automobile companies Audi, Seat and Skoda.  In 2011 the company’s profits more than doubled to €15.8bn as they delivered a record 8.2 million vehicles.  These impressive figures have been underpinned by their strong performance in the three biggest growth areas; China, Brazil and India.  Volkswagen is popular in these areas, and all around the world, due to their flexible strategy; they make cars to fit local tastes and needs and price the vehicles to suit the finances in the market place.  For example in China Volkswagen focus on small vehicles like the Polo to suit the busy roads and have been known to lower their prices to make them more available to the masses that have little disposable income.  But these cars are no longer being imported from factories in Germany; the growth has been supported by notable spurts of FDI.

Volkswagen targeted China over a quarter of a century ago with a joint venture in 1984, the Shanghai Volkswagen Automotive Company Ltd.  This was shortly followed by the Volkswagen Automotive Company Ltd in Changchun in 1990.  This was seen as incredibly risky by analysts as China was still in the throes of a cultural and economic revolution at the time and uncertainty still clouded the region.

China is now, and has been since 2008, the largest car producer in the world.  In 1990 China produced less than a million vehicles a year but now produces over 20 million annually.  Over 50% of this production is undertaken by foreign companies of which Volkswagen is the largest.  Volkswagen’s Chinese subsidiaries are now wholly independent of their German roots and control the entire value chain; from design and production right through to sales and service.  This is an example of an incredibly successful piece of FDI with the company taking advantage of a fast growing consumer market coupled with the country’s low cost labour and now highly advanced infrastructure.  What makes this all the more impressive is that the world’s leading motor vehicle manufacturer, General Motors, did not invest in China until as late as 1997 in a joint venture with Shanghai Motors.  This highlights Volkswagen’s notable foresight in investing so early and gaining a firm footing in the market before its main competitors.

However in December 2011 a joint announcement by the Ministry of Commerce and the National Reform and Development Commission in China stated it would ‘withdraw support for foreign investment in the country's car industry to encourage domestic carmakers’.  This is a fair decision in a struggling world economy as the government simply wants to support domestic businesses by stimulating local production.  But where does this leave Volkswagen? If they want to continue their worldwide expansion surely they will have to find somewhere new in which to invest?

The answer is that they already have - India.  Volkswagen has invested €580m in India since 2006; Volkswagen India Private Limited has a large production facility in the northern state of Punjab which produces 110,000 units annually.

India is currently the second fastest growing motor vehicle market and is likely to become the fastest growing in the next 20 years.  It is expected that domestic demand will outstrip that of the USA by 2035 and China by 2050.  Volkswagen sales in India were up 18% in 2011 and the head of the passenger car division of Volkswagen India, Neeraj Garg, told the BBC that he ‘expected the same compounded interest over the next four to five years’.  All in all this makes it an essential market to have an influence in.

Volkswagen has displayed their investment foresight once again and has taken advantage of the significant benefits of FDI in India.  Firstly, as discussed, it is a rapidly expanding market and it seems logical for cars destined for India to be produced within the country.  Also India has a vast, knowledgeable workforce which remains cheap to employ.  In the past the poor infrastructure in India has limited the extent of FDI flowing into the country.  However as the economy expands, currently the second fastest growing economy after China, the infrastructure is rapidly improving.  As time progresses more and more manufacturing and production companies will look to invest in India.

In the case of Volkswagen it looks like they have implemented FDI with seemingly perfect timing.  They entered China before the boom and then expanded abroad, to India, as the Chinese market seems to have reached saturation point and the Indian market is in the infancy of what is expected to be a rapid development.  Whatever the future holds for the car manufacturing industry it appears Volkswagen will be at the forefront.  Whether the next boom area is Russia, Brazil, Africa or somewhere different altogether it is likely Volkswagen will already be there ready and waiting.

Could a strong Yen seriously change the face of the worldwide consumer goods market?

International trade is a key driver in the demand for foreign currency as consumers and firms around the world need foreign currency to trade with one another.  The globalisation of the marketplace in the last fifty years has intensified this demand and it was reported that by the early part of the 21st century over $1.5 trillion in national currencies was traded daily to support the expanded levels of worldwide trade.  However in order to trade in this competitive environment firms must accept exposure to the risks associated with changes in currency.  These risks can be great as foreign currency changes daily and directly impacts on the price and demand for goods and services.

Japan, for example, is a high exporter of consumer goods, in particular electronics and automobiles (cars), to countries like the US.  In order for US consumers to purchase Japanese goods they generally have to purchase Japanese Yen with their US Dollars to make payment.  As a result Japan’s trading position places them at risk to adverse changes in the short or long term movements of exchange rates.  We call this Economic Exposure.

As the graph highlights the Yen has strengthened considerably, by 13.89%, in the last two years.  In terms of a trading position this means that it costs US consumers more US$ to purchase Japanese goods.  But why has this happened?  This trend in Japanese currency strengthening has been apparent for a number of years and is due to the simple fact that more Japanese Yen is demanded than what is supplied.  The primary reason behind this is that western consumers have continuously purchased cheap goods from Japan for over 20 years, demanding Japanese Yen as they do so.  Furthermore the recent economic recession, the effects of which have been more profound in US and European economies, have meant investors have seen the Yen as a safer investment during times of uncertainty, causing it to appreciate in value.  The question is whether this is a sustainable trend for the Japanese economy?

The simple answer would be a resounding NO based on recent announcements about the country's performance.  Firstly Japan announced on the 25th January that 2011 saw the country’s first annual trade deficit in 30 years, with a deficit of 2.9 trillion Yen ($32bn, £20bn).  This came as exports fell 2.7% and imports rose by 12%.  The situation seems to have worsened further in recent weeks as it emerged exports in January were down 9.3% compared to 2011.  Furthermore car manufacturers Honda and Toyota and electrical manufacturers Sony and Panasonic have all announced either slowing or declining 2011 profits since the new year.  These companies are key contributors to the Japanese economy.

What will all this mean for Japanese manufacturers who export to places like the US? The problem for Japanese manufacturers is that their primary market lies overseas, in particular in the US and Europe.  During the past few years of economic recession consumers have tightened their belts and spent less on imported goods from places like Japan.  The currency strength has compounded this problem as not only do consumers have less to spend but it now costs them more to purchase their goods.  This could mean that Japanese companies begin to locate their production facilities overseas to help mitigate the Economic Exposure they are experiencing at the moment.  Toyota, for example, have recently announced that they are looking to expand exports from their US plant by 20% in 2012 to mitigate the problem caused by the strong Yen.  Generally though I feel we are more likely to see Japanese manufacturers relocate within Asia to countries like China and Thailand or even stay in Japan.  This is because Asia still holds a significant advantage over their western counterparts in terms of labour and production costs.  The Yen and other Asian currencies would have to strengthen a colossal amount for manufacturers to begin to filter production back to the US and Europe.

Could the strong Yen benefit UK manufacturers?  There have been a limited number of examples where UK manufacturing has strengthened due to companies avoiding the strong Yen.  Japan based car manufacturer Nissan has a production plant at Washington, Sunderland which in 2011 experienced a 14% rise in production taking its output to 480,000 vehicles and created over 1,500 new jobs.  This is a positive sign for the UK manufacturing industry and UK employment which is grateful for any positive news it can get.  However, is this a genuine sign that Japan based manufacturers may look to the UK as a valid alternative?  In reality Sunderland volume of output is just a drop in the ocean in comparison to Japan’s firms; in 2011 Honda produced 2.9m cars and market leader Toyota produced over 7m!  I think a more logical explanation for the Sunderland figures is that this is an example of a growing worldwide company, Nissan, diversifying its operations to respond quickly to the market all across the world. 

I think that overall the only outcome of the strengthening of the Japanese Yen will be a small change in the pricing of consumer goods exported from Japan.  Consumers who have got used to cheap electronics may see a marginal increase in prices.  A shift in the location of the production facilities, on the back of the Yen strength, quite simply is not on the cards.  Lets face it; it seems ridiculous to describe the current exchange rate of $1/¥79 as strong anyway, so any radical change in the worldwide consumer goods market seems unlikely to say the least.

Morrisons unusual recent finance activities

When companies are looking to raise finance from external sources they are presented with two options; equity finance and debt finance.  Equity finance usually involves issuing new ordinary shares.  Investors purchase the new shares in the market and the company uses the finance raised from the sale for their own purposes.  Debt finance is commonly achieved by seeking loans or debt securities from financial institutions in return for regular repayments.

WM Morrison Supermarkets (Morrisons), the UK’s fourth largest supermarket, has recently engaged in some intriguing financing activities.  On the 8^th December Morrisons issued a £400m sterling bond jointly provided by Barclays, RBS and HSBC.  The bond will attract an interest rate of 4.625% payable semi-annually as well as a bullet repayment (a cool financey word for lump sum) that will be made on maturity in 2023. Why have Morrisons decided to do this?

Officially Morrisons stated that “The proceeds from the issue of the Bond will be used for the Group's general corporate purposes”.  Well… the company could not be any vaguer about the purpose of the finance, meaning we are left to read very carefully between the lines.  Looking at Morrisons most recent annual reports it becomes apparent that the company is looking to enhance its store portfolio in the near future.  The company may therefore have sought the finance to support any potential bids for relating companies that could help achieve this.  Since the issue of the bond Morrisons have been linked with bids for frozen foods company Iceland and internet retailer specialist Ocado.  Regarding Iceland firstly, Morrisons have eventually backed out due to concerns about the risk of acquiring such a large chain in the current climate.  As a result the bidding war has been narrowed down to private equity firms BC Partners and Bain Capital.  Readers will recognise some of Bain’s companies in particular as they include well-known Dominos, Burger King, Toys ‘R’ Us and Staples.  The takeover bid for internet retailer specialist Ocado is still at the speculative stage but it is a move that would certainly help support Morrisons desire to move into the online retail market.  Although as of yet no significant investment has materialised it seems clear that Morrisons will certainly use the capital to support some kind of acquisition in the weeks and months ahead.

Why though did Morrisons choose to issue a bond as opposed to borrowing from a bank?  Generally bank loans are seen as restrictive as they are usually accompanied by debt covenants.  For example banks can stop companies from issuing any more debt or acquiring any new companies until the loan is repaid.  This would have seriously constrained Morrisons.  Bonds give the issuer greater freedom as they are issued for a long period of time and the bond market is more forgiving in their terms.  This means Morrisons can confidently take their time in choosing their next investment.  Iceland did not work out, Ocado is still in the pipeline or it could even be another company altogether.  By using debt finance, and in particular a bond issue, it is up to them when and if they act? 

However, unusually since the debt issuance Morrisons has spent over £9m purchasing their own shares to cancel through the Bank of America Merrill Lynch.  On the 31^st January they purchased 1.2m shares at 285.2913p and then on the 1^st February purchased 1.99m shares at 287.9934p; the shares were subsequently cancelled from trading.  To everyday people this would seem bizarre; you wouldn’t buy a new car to intentionally write it off the next day, so why have Morrisons done this?

Morrisons may have done this due to a personal feeling that the market was undervaluing the company’s shares.  Prior to the intervention the shares were at their lowest value in around six months and from the start of January had dropped by an alarming 40.3p (12.35%).  The subsequent increase in share price, shown by the graph, would suggest that their actions have been vindicated.  But would Morrisons really fork out over £9m just to restore some shareholder value?

I feel that the actions are more a sign of Morrisons increasing lack of creativity.  A lacklustre Christmas and a subsequent loss of market share verified by Kantar on the 31^st January shows the company is experiencing a rocky period.  I have explored above the possibility that the raising of £400m could be to support an upcoming takeover, but perhaps the recent purchase and cancellation of their own shares shows the company really doesn’t know what to spend the money on.  The leading lights of the company may think that it’s a good idea to use some of the funds to prop up the share price to help restore some shareholder confidence.  But for me this is merely papering over the cracks.

The cancellation of their own shares is the polar opposite of equity finance; where shares are created to raise finance, a method employed to fund their £3bn landmark takeover of Safeway in 2004.  At the time Morrisons issued over one billion shares at 249p to raise the large majority of the capital required for the takeover.  So it would appear that in recent times Morrisons preference has changed to debt finance as they have issued a bond and cancelled their own shares all in the last three months.  However I feel the extensive equity financing of the Safeway takeover was more due to the magnitude of the deal and the resulting finance required.  After all the key advantage of equity finance is that the funds do not have to be repaid so when such a vast amount is needed it makes sense to do this.  Generally I would argue Morrisons are in a stronger position now to finance any upcoming deals by issuing further debt rather than issuing shares.  However it is difficult to say what the next move will be. Could it be Ocado?  Cancel more shares? Or something else altogether?   Watch this space…

Rolls-Royce: Profits up, Share price down?

An efficient capital market is expected to display the following forms of efficiency; operational, allocational and, most importantly for this discussion, pricing efficiency.  Pricing efficiency means that share prices fully and fairly reflect all information whether past or future.  This idea was further developed by Fama (1970) who pioneered the concept of the Efficient Market Hypothesis (EMH).  EMH is a concept concerned with establishing share prices in a capital market and states that share prices reflect all relevant available information.  As a result it is expected that in an efficient capital market undervaluation and or overvaluation does not occur as current and past information is immediately reflected in the share price.  However this ideology is flawed as it relies on perfect market conditions.  This ‘perfect’ market quite simply cannot and will never exist.

The recent story of Rolls-Royce does little to support the theory of an efficient capital market.  On Thursday morning Rolls-Royce announced record profits of £1.16bn, an increase of 21% on the previous year.  This has been driven by increased demand for their civil aircraft engines; the order book upon announcement had reached £62bn as orders rose 5% from the previous year.  These are impressive figures for the company and it would be expected in an efficient market that the information would be reflected positively almost instantly in the share price.  This presumption seems logical and is what I would expect to happen.  However by mid-morning the shares had fallen over 3.5% in value; at 10.23am the share price was down by 32p to 753p.  This has left many scratching their heads.  How can an extremely positive announcement of record profits result in a fall in the share price?

So, why has this happened?  The graph shows that since the start of February Rolls-Royce shares have gone up by 49.5p, a notable short term increase in share value of 6.73%.  I believe it could be that these increases were the result of anticipatory trading activity from investors with insider knowledge.  Insiders and close followers of the company will have been well aware of the positive performance that had been achieved during 2011.  As a result they will have been trading up the price of the shares prior to Thursday’s announcement.  However when the news officially hit the market they will have been inclined to sell as the information was public knowledge and according to the EMH should have been immediately reflected in the share price.  I feel these investors selling their shares will have been a major factor in the share price falling immediately following the news announcement.

Is the Rolls-Royce case a supporter for the Random Walk theory? Random Walk (Kendall, 1953) theory suggests that the relationship between share prices across time periods is completely random.  This is because news, which affects share prices, is by definition rando making it impossible to predict future changes in share price.  Rolls-Royce share price has reacted in the opposite way to which theory and logic would suggest so maybe its share price is just following a random walk.  It is my opinion that generally, in periods of no relevant news, companies share prices do reflect a random walk or at least one which follows the general pattern of the entire market.  However I would expect when there is relevant news the market would react rationally in line with EMH theory.  To put this into context Diageo announced, also on Thursday morning, that its profits were up 15% to £1.86bn.  As a result shares rose steadily on the day by 13.81p, the kind of reaction expected on the back of a positive news announcement.  The puzzling thing about Rolls-Royce is that the opposite of what basic logic suggests should happen has happened.

Has the bombardment of positive news stories relating to Rolls-Royce played a part in this reaction?  Over the last year it seems there has been a constant stream of positive news stories relating to Rolls-Royce.  In the new year they announced that Rolls-Royce car sales were at a record high in the company’s 107 year history.  Also there have been many announcements in recent weeks detailing the company’s upcoming expansion plans in Asia.  Share prices over the last year have risen dramatically by 115p (17.49%) which could suggest that a lot of good news is already reflected in the Rolls-Royce share price.  It would be fair to expect that this uninterrupted increase cannot continue and at some point the share price will reach its optimum level.  I feel that perhaps Thursday’s announcement was one good news story too far and some investor’s immediate reaction was to get out while the going really was at its very best.  The remaining shareholders will be asking themselves; is now the time to sell up?

Tesco: Shareholder Wealth Maximisation

Shareholder wealth is maximised when the share price and dividends of a company are maximised over time.  Basic theory suggests that shareholders are the owners of the company and therefore deserve a share of any surplus wealth generated.  This seems logical, as shareholders are the highest risk bearers when it comes to corporate ownership.  They commit their own wealth and then generally the use of the funds is left to the discretion of the directors of the company.  Companies should seek to return capital to the shareholders as this should attract further investors and in turn provide additional capital to expand the business.

Tesco is an example where, in recent weeks, there has been a substantial destruction in shareholder wealth.  On 12^th January 2012 Tesco shares fell by 61.6p, dropping in value by nearly 16%, and knocking almost £5bn off the market value of the company.  This came after Tesco announced poor Christmas trading figures with like for like sales falling by 2.3% aswell as forecasts that 2012 will see a definite slowdown in Tesco’s profitability.  Clearly, this severely dented investor confidence and led to the extensive devaluation of Tesco shares. Over the Christmas period Tesco reduced prices, in a pricing strategy which commentators have coined the ‘big price flop’, in order to match competitors who had engaged in similar activities.  However Tesco failed to offer any coupons to reward regular spending, unlike its competitors, meaning customers were not properly rewarded for their loyalty.  This mistake is likely to have cost Tesco many customers at the checkouts.  In my opinion as Tesco is the market leading supermarket they should represent the cornerstone of quality, value and choice.  However they have decided to get embroiled in a pricing war with competitors like Sainsbury’s, who have introduced their well marketed brand match policy.  Sainsbury’s was the market leader for much of the 20^th century but is now the third largest UK supermarket chain and has seen its shares fall steeply in value in the last ten years (-34.81%).  It could be seen as acceptable for them to go in a new direction and attempt a daring pricing strategy in order to get customers back through the tills, albeit at low margin.  However, Tesco should not have sacrificed their reputation for quality in order to compete on low prices.  As a result profits, and ultimately shareholder wealth has paid the price.

It recently emerged that a senior Tesco executive sold over £200,000 worth of shares.  Bob Robbins, Chief Operating Officer of the UK business, sold 50,000 shares at 404.5p 8 days prior to the profit announcement.  This compounded the problem for Tesco as the news will surely have damaged shareholder confidence and added to the already negative effect of the profit announcement.  In a statement Tesco stated that “Bob Robbins sold less than 5% of his substantial shareholding in Tesco for necessary family expenditure” and that it was “approved in the usual way”.  Robbins is paid a base salary by Tesco of £832,000 which, according to the companies’ annual report, makes up a maximum of 40% of his total remuneration.  Robbins can earn over £3m in any one year.  The question has to be poised; who is Robbins and the company trying to kid?  Stringent Tesco shareholders should have seen this as a warning sign that it was time to get out and if they didn’t they most definitely did when it emerged eight days later that the companies’ profits were struggling.  The move by Robbins saved him just over £30,000 in share value but what were the repercussions of his actions for the remaining shareholders wealth.

However Tesco shareholders cannot have too much to grumble about surely?  Despite the recent dip in share price, Tesco shares have risen by 74.91% since the turn of the millennium.  This is in stark contrast to the FTSE 100 which has declined by 13.3% over the same period.  Tesco also paid out over £1bn in dividends in 2011.  Shareholder wealth has certainly been maximised as the company has witnessed unprecedented growth, largely down to its ongoing strategy to increase market share.  Tesco controls over 30% of the UK supermarket industry and in 2007 one in every seven pounds spent in the UK was at Tesco.  However, I would argue that perhaps too much emphasis is placed on the desire to maintain this high level of market share within the Tesco board.  The festive pricing strategy was seen by many as a decision made simply to match up to competitors and maintain the status quo, with Tesco by far and away the market leader.  Shareholders have good reason to be dissatisfied as the poorly thought out pricing strategy has caused to some extent the new year profitability warning and resulting share price drop.

Tesco’s growth previously has been achieved through the mass construction of superstores all across the UK to provide customers with a one stop place for all of their consumer needs.  However, I feel that there is beginning to be a shift in the UK market from superstores to convenience.  Customers no longer want to visit out of town superstores, they still want quality, choice and value but in a more convenient location.  This provides a challenging outlook for Tesco. In his BBC blog Robert Peston summated that “Companies have an organic quality. They have a lifecycle. No business continues on a path of unbroken growth forever”.  Have Tesco reached the peak of their growth?  They certainly have to rethink their strategy to help the company and ultimately maintain their good track record as a shareholder wealth maximiser.    Philip Clarke, Tesco CEO, recognised the challenge they faced, stating that “what is at stake is whether the core of this huge global business, the UK stores, can regain their vitality or must become reconciled to long-term stagnation or even shrinkage.” They cannot afford to have too many more days like the 12^th January or the slope may start to become even slippier.

It is worth noting that the supermarket industry has struggled across the board so far in 2012.  UK traded competitors Sainsbury’s (-2.58%) and Morrisons (-9.5%) share price has also declined since the new year.  Why is this the case?  During the recession supermarkets have generally been regarded as a ‘safe haven’ having remained strong or at least maintained their value to shareholders.  This has reflected consumer trends to eat out less and purchase higher quality ingredients to produce home cooked meals.  It may be that the recent decline was just a blip due to a tight Christmas and the growth of more savvy customers.  But, more likely, the signs for the general economy are that alarming that customers are watching there pennies at the supermarket checkouts now just as much as the high street.  If so this could be a worrying time for supermarket shareholders.