Some see handing back cash to shareholders as an admission of defeat; a sign that the directors have run out of ideas. Others view it as tight balance sheet management. After all, if you don’t need the money then why go on paying to borrow it from shareholders?
There may have been a bit of both in British Energy’s return of value to shareholders announced in May of this year. But the privatized nuclear power generator’s deal deserves closer examination, not least because its terms are more complicated than your average buy-back. Since the announcement, British Energy has made a string of corporate moves, suggesting its directors aren’t short of ideas. Whether they’re good ideas remains to be seen.
Three degrees
The deal offered shareholders three options as part of a capital reorganization to reduce the number of British Energy’s (BE) existing ordinary shares in issue by 10.4 percent. First of all – subject to shareholders’ approval – on August 6 each ordinary share with a nominal value of £1 will be split into an ‘undesignated ordinary share’ and an ‘A share’ with nominal values of 40p and 60p respectively. This was followed by a ‘share capital consolidation’ where 43 new ordinary shares replaced 48 undesignated shares. This apparently odd proportion was worked with reference to a market price of the stock on May 7, 1999 of 576.5p per ordinary share, adjusted for a final dividend payment.
The three options for shareholders are:
- Repurchase offer – BE purchases shareholders’ A shares at 60p each. The purchased shares would then be cancelled.
- Initial A share dividend – the A shares are not purchased but a single, one-off dividend of 60p is payable to shareholders. The A shares themselves would then be converted to so-called ‘deferred shares’ which would not be listed, would carry very limited voting rights and be of ‘negligible monetary value.’
- A share continuing dividend – shareholders retain their A shares which receive a net non-cumulative dividend of 75 percent of twelve months Libor (the London Inter-Bank Offered Rate – the lending rate at which the most creditworthy banks lend money to each other in the London money markets).
Flexibility and choice
‘The key to understanding these options,’ explains Sonia Boggis of BE’s investors relations team, ‘is flexibility and choice. None of these options is novel in itself. But put together this is quite a novel deal.’
Jason Goddard, utilities analyst at HSBC Securities in London describes the deal as ‘well-structured. They’ve tried to balance the requirements of different shareholders and have not been biased toward one type of shareholder or another.’
The key to the various options is tax. As if to underline the importance of tax considerations in the structure, the comprehensive 40-page prospectus outlining the proposal to shareholders includes an appendix on UK taxation.
From a tax point of view, option one represents a capital gain. The shares, albeit the result of a share split, would be treated as a ‘chargeable gain.’ For approved pension funds there would not generally be any tax to pay on such a chargeable gain. Furthermore, as a capital gain it would not receive treatment as income for UK tax purposes which means that there would be no tax credit. In essence this option says, Goddard, is likely to appeal to the bulk of large funds which hold BE stock.
Robert Fleming Securities’ Edinburgh-based utilities analyst Adam Forsyth adds, ‘From an institution’s point of view it is just a share buy-back as most have the same tax situation.’ Furthermore, under option one the cash would be paid out by mid-August, enabling it to be quickly available for re-investment.
Outside edge
While those institutional investors who speak for most of BE’s stock are likely to be content to go with option one, it will not suit all shareholders. Hence the other two options. The second provides for the one-off dividend payment and share cancellation and is designed to suit those who would not wish to realize a capital gain.
The dividend is payable on October 6 this year and investors are likely to be high-net-worth individuals who are already at or above their capital gains tax ceiling. Clearly this option is rather transparently structured as the deferred shares merely perform the task of helping shareholders in their dealings with the tax authorities and nothing else.
The third option looks the least appealing of them all. The first dividend pay out will not take place until August 10, 2000. Furthermore, the interest rate of 75 percent of twelve month sterling Libor may not be the most effective way for an investor to deploy his or her funds. However, it does allow for a deferred income stream which may appeal to higher rate investors who wish to take their income into the next and future fiscal periods.
Although the dividend is floating rate it is a predictable income stream and may appeal to some investors. It also preserves investors’ rights to sell their A shares in the future as they will be listed on the London Stock Exchange.
But why would BE adopt this return of value strategy at all? One analyst says BE had been ‘coming under pressure from shareholders’ to do something more remunerative with their investment or repay it. The company did respond to this by saying it would do so if it didn’t make good use of it. BE’s disappointment at its failed bid for London Electricity has been much discussed and chairman Jon Robb mentioned the abortive deal in his May announcement of the cash-back deal. He adds: ‘In looking after shareholders’ interests it is important that we avoid overpaying for acquisitions. This was the reason why we did not acquire London Electricity.’
In being consistent the company has visibly stuck to its strategy pledge. This, says HSBC’s Goddard, has been well received. Robert Fleming’s Forsyth also praises BE’s general IR approach and views this pledge and its delivery as being consistent with earlier statements. ‘BE on the whole is pretty good at its IR. It’s nice that there have been no surprises… Everyone in the City expected a return to shareholders.’
Powder room
But there’s more. For example, why didn’t BE pay back more value to shareholders? The answer is that it wanted to keep some of its powder dry for future moves, retaining sufficient cash, as John Robb has said, to achieve its strategic objectives. And the company’s desire to buy a UK regional electricity company has long been flagged by analysts and commentators who note that BE was in discussions over a variety of possible acquisitions. No great surprise then when on June 23 it announced that it had agreed to acquire the gas and electricity businesses of Welsh utility group Hyder and sole rights to the Swalec brand for £105 mn.
BE’s global objectives are also relevant. As we go to press, Amergen, the company’s US joint venture with Peco Energy is awaiting regulatory clearance for its Three Mile Island One and Two and its Clinton nuclear plant acquisitions.
So while it may be returning capital to investors it’s not a question of BE having no prospects for further business development. The important thing is that it doesn’t necessarily need as large a block of relatively inflexible shareholder capital to fulfill its ambitions. And it has a few strong cards up its sleeve.
One is that it generates huge amounts of cash. Analysts reckon it has a net cash position to the order of a £0.25 bn to play with. And as with most utilities the cash keeps coming in – customers need ongoing supplies of the product over lengthy periods of time.
Cards on the table
A second card is that BE has very low gearing. It has great scope for borrowing keenly-priced debt, especially with all the existing and potential cash flow available to service it. Continuing shareholders may be more likely to complain that it is not leveraging up its capital sufficiently to maximize the return. But by distributing dividends between fewer shares, this seems to be an unlikely beef against the company.
Lastly, its trump card is its core skill. Analysts recognize that there are not that many companies in the world that can manage nuclear power plants. So they see that BE has quite a number of new opportunities it can pursue, especially internationally, to grow its business.
Overall analysts say that BE has achieved quite an investor relations coup with its return of value package. The big shareholders seem well pleased enough. But what about small shareholders?
At first glance the prospectus which thudded onto the hall carpet must have daunted a few of the 268,000 small shareholders who hold less than a thousand BE shares. BE’s Sonia Boggis explains, ‘We anticipated the what do I do? reaction we might get from our smaller shareholders.’
‘We set up a helpline for them after the stock exchange announcement…We provided prepared scripts and feedback loops so that we could answer the sort of questions which we were bound to be asked.’
It is too early in the day to know how successful this strategy has been. BE will not know how effective the helpline and, indeed, the overall offering has been until the votes have been counted.
But all in all there is something for everyone in this deal. It is viewed fairly positively by the investment community and press comment since it was announced has hardly mentioned the potentially negative connotation of a share buy-back. So far, at least, British Energy’s return of value looks to have been an IR success which remains well in tune with the interests of the company’s shareholders.
All they want now is to see the good ideas continue.
