Investors watching the takeover boom and wondering whether it is the start or the end of a period of high investment returns may want to have a look at Shell’s proposed takeover of BG.
Megadeals often tell us that the buyer is far more challenged than we know or he admits. Companies with good, reliable prospects almost never take such risks. Prospects for a dividend may play a large role in this deal.
When looking at the proposed purchase of BG, I note a striking similarity with RBS’s purchase of ABN Amro (ABN) in 2007.
RBS bought ABN just as the global financial crisis was taking hold, forcing firms like Northern Rock to seek government help, and amid a growing realisation that the world would never quite be the same again.
Shell announced its bid for BG in April 2015, after oil prices had halved in the second half of 2014.
When Shell made its move, oil and mining companies were competing to cut costs and capital expenditures. Shell almost alone went looking for ways to increase substantially the capital invested in its business.
This is not surprising. Shell’s tendency to grow its capital employed is remarkable, doubling it between 2000-15.
The BG deal would give it another huge fillip, increasing the total from $220bn (£150bn) to around $300bn. At current prices the return would be just over 4pc.
Shell’s record of poor returns on an ever-rising capital base makes the BG deal in our view even less appealing.
It is a matter of dispute what assumptions Shell was making about oil prices in April.
Some larger investors believe Shell expected a quick recovery to around $90. Over time, vast amounts of money will be seen to have been blown on the assumption of permanently high energy prices.
In a decade in which capital poured into commodities (such as oil), almost no one admits that they were assuming a permanent change in prices. It is often better to watch what the money is actually doing rather than what is being said.
Prices may recover and certainly need to. The value of the deal is now $70bn including BG’s debt. BG is forecast to produce an operating profit of just over $2.8bn in 2015 on consensus forecasts.
For the deal to stack up, profits need to get towards $10bn, three times the expected 2015 outcome. There will doubtless be cost saving benefits. Shell was initially targeting $2.5bn and the number keeps rising.
Back in April, the CEO said the move provided a springboard for “a higher rate of portfolio…” Growth? No. Return? No. Cash generation? No, just “portfolio change”.
This odd notion might suggest internal expectations for the financial dynamics of the deal are not high.
It is quite possible to rebalance a portfolio by more aggressive selling, reducing capital employed without the costs and risks of a big deal. Shell’s strategy might be seen as “grow in order to shrink”.
Hugely expensive moves whose main purpose is to rebalance portfolios have a grim history. ICI’s purchase of assets from Unilever was aimed at boosting group-wide margins and was a disaster for them.
The story for Shell is of poor returns on capital. Between 2000-2015 capital employed doubled to $220bn while production declined around 15pc. They are responding to this by a massive further hike in capital employed by acquiring BG.
Still, we should not be alarmed. The company tells us “there is no prima facie need to keep worrying about the value of the deal on a day-to-day basis”.
Telling your shareholders what they should and should not worry about is typical of large companies like Shell; when you are so big that a single shareholder is never going to have a big enough holding to apply pressure, it is easy for a company to adopt a dismissive attitude to its investors.
They are part of the social fabric and immune from hostile takeover.
We might agree not to worry “day-to-day”, but I believe there is plenty to worry about with the big premium that is being paid.
On April 7 BG was valued at $43bn. The bid the next day was worth $70bn: a premium of $27bn. Since then, a basket of comparable companies has fallen an average of 26pc.
On a similar move, BG’s value would now be $32bn. As the share component of the offer has fallen along with Shell’s share price, the value of the deal is currently $62bn and the notional premium now $30bn.
This is the value Shell now needs to create. Shell is capitalised at over $200bn. This deal is not big enough to do to Shell what ABN did to RBS, but I think it is still highly material.
The non-executives on the board are in a tricky position. They cannot feasibly disclaim responsibility for the vast sums that are spent. But the spending of companies like Shell is so big, technically complex and long term that non-executives cannot really oversee it properly, in my view.
Unlike RBS and ABN, in this case the taxpayer can rest easy. If it goes wrong, the shareholder takes the hit. The board will move on. The CEO may have already lost shareholder confidence through this deal but will likely be around for a while before he can decently do likewise.
We do not yet have the date for the vote, but in my view shareholders should think hard about this deal and be prepared to show Shell that they care greatly how their money is being spent.
Source: The Telegraph
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