Mergers and Acquisitions: What are Honeywell International Inc.’s options?

Trautwein (1990) offers several theories of merger motives including efficiency, monopoly, raider valuation, empire building, and process and disturbance theory. Berkovitch and Narayanan (1993) suggest three major motives for the takeovers: synergy, agency and hubris.  Other motives include diversification, tax considerations, management incentives, purchase of assets below their replacement cost, and breakup value (Mukherjee, Kiymaz and Baker, 2004). Although the rationale may differ from one merger or acquisition to another, a common measure of success of a merger is the increased value of the combined firm (Bruner, 2004).

Mergers can be classified into three categories:

• Horizontal mergers – when two companies that are engaged in similar lines of activity are combined.
• Vertical mergers – when firms from different stages of the production chain amalgamate. 
• Conglomerates – the combining of two firms which operate in unrelated business areas. 

On the 6^th March 2015, Bloomberg announced that Honeywell International Inc., the $80 billion maker of industrial products including refrigerators and thermostats, was “warming to big acquisitions after largely sitting out on last year’s surge in deals”. This blog will identify the motives behind this announcement and potential targets.

So what were the main reasons behind Honeywell’s search? Firstly, dimming growth prospects are encouraging industrial companies to put their cash into takeovers. Secondly, with $9.1 billion in the bank, and the ability to add approximately $7 billion to its current debt load, (whilst maintaining its current credit rating), demonstrates that Honeywell has adequate cash reserves to acquire (Bloomberg, 2015). With such large cash reserves, I believe Honeywell should be looking for investment opportunities, to prevent investors becoming frustrated. Finally, this could be a potential way to help speed sales growth, as analysts have identified that Honeywell have had its worst year for sales growth since 2009 (Bloomberg, 2015).

On the other hand, Arnold (2013) suggests that managerial motives may be another reason behind mergers and acquisitions activity, rather than focusing on maximising shareholder wealth.  Honeywell is no stranger acquisitions, with the latest one being of Datamax-O’Neil in December 2014 for $185 million.  Perhaps this suggests that David Cotes (CEO) may just enjoy creating an empire as it provides them with a sense of accomplishment and satisfaction (Arnold, 2013). In addition, the increase in responsibility of controlling a larger enterprise means more money in his back pocket! However, Cotes has recently announced a profit forecast of $1.23 to $1.27 a share, which should reassure investors.  

So what are Honeywell options? Aerospace and security are Honeywell’s “sweet spots” and those are among the areas it looks for acquisitions (Bloomberg, 2015). Analysts have identified the following as potential takeovers:

• Brady Corp., a $1.3 billion company, which manufactures identification, tools such as employee badges. A potential horizontal merger, as this would complement Honeywell’s safety products.
• Woodward Inc., the $3.1 billion airplane-parts maker. Another horizontal merger opportunity, as this would complement Honeywell’s aerospace offerings.
• Yokogawa, the Japanese industrial company. As a vertical merger, Honeywell could buy the company just for the company’s field-instrumentation operations and then shut down the control-systems business since Honeywell already excelled in that area.

By combining any of these companies with Honeywell would increase the value of the combined firm. This is also known as a ‘synergy’. Sirower (1997) defines synergy as increases in competitiveness and resulting cash flows beyond what the two companies are expected to accomplish independently. By acquiring a company that engages in similar activities as Honeywell (horizontal merger), the company should be able to exploit economies of scale and enhancement of market power as a result of the reduction in competition (Eckbo, 1983). Internally, shared know-how, shared tangible resources, pooled negotiation power, coordinated strategies, and combined business creation will be created (Goold and Campbell, 1998). In contrast, a vertical merger with Yokogawa could increase the certainty of product supply and market outlets (Chen, 2001). There is also an opportunity to reduce costs of research, advertising and co-ordination of production (Arnold, 2013). Analysts have also suggested that a conglomerate could be on the table. The biggest opportunity for Honeywell may lie within the oil and gas industry, as prices of oil have slumped which could mean a potential discount (Bloomberg, 2015).

I believe that there is huge synergy potential for Honeywell. If they allow cash reserves to continue to grow, investors will become frustrated that they are not looking for ways to expand the business which could potentially cause investors to sell their shares, thus damaging market value. A synergy as a merger motive will allow the combined entity to have a value greater than the sum of its parts. Due to the combining of the companies, it will increase value from the boost to revenue and cost base. Companies engaging in the same activities will have complementary skills enabling the combined firm to sell more goods (Arnold, 2013).

Honeywell are in a very promising position. Without acquisitions, sales are projected to rise to as much as $51 billion in 2018. The company expects to generate free cash flow of as much as $28 billion during the next five years, outpacing the $19 billion from 2010 to 2014 (Bloomberg, 2015). I am sure we will hear a lot from Honeywell over the next five years regarding their expansion.

References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson.O’Brien

Berkovitch, E., & Narayanan, M. P. (1993). Motives for takeovers: An empirical investigation. Journal of Financial and Quantitative analysis, 28(03), 347-362.

Bloomberg (2015). Honeywell ramps up deal hunt armed with $10 billion: Real M&A. Retrieved from http://www.bloomberg.com/news/articles/2015-03-06/honeywell-ramps-up-deal-hunt-armed-with-10-billion-real-m-a

Bloomberg (2015) Honeywell plans to spend $10 billion on deals by 2018. Retrieved from http://www.bloomberg.com/news/articles/2014-03-05/honeywell-plans-to-spend-10-billion-on-deals-by-2018-correct-

Bruner, R. F. (2004). Applied mergers and acquisitions (Vol. 173). John Wiley & Sons.

Chen, Y. (2001). On vertical mergers and their competitive effects. RAND Journal of Economics, 667-685.

Eckbo, B. E. (1983). Horizontal mergers, collusion, and stockholder wealth.Journal of financial Economics, 11(1), 241-273.

Goold, M., & Campbell, A. (1998). Desperately seeking synergy. Harvard Business Review, 76(5), 131-143.

Honeywell (2013) Press Releases. Retrieved from http://honeywell.com/News/Pages/press-releases.aspx

Mukherjee, T. K., Kiymaz, H., & Baker, H. K. (2004). Merger Motives and Target Valuation: A Survey of Evidence from CFOs. Journal Of Applied Finance, 14(2), 7-24.

Sirower, M. L. (1997). The synergy trap: How companies lose the acquisition game. Simon and Schuster.

Trautwein, F. (1990). Merger motives and merger prescriptions. Strategic management journal, 11(4), 283-295.

Dividend Policy Theories: applicable to today's culture?

Dividend policy is “the determination of the proportion of profits paid out to shareholders – usually periodically” (Arnold, 2013). According to Portfield (1965) the aim of the dividend policy is to maximise shareholder wealth. To do so, the new share price should be equal to, or be greater than the previous share price. In comparison, Modigliani and Miller (1961) (M&M) argued that dividend policy is irrelevant to share value (with the assumptions that were mentioned in my previous blog). Their theory suggests that the determination of value is determined by future earning potential; and the pattern of dividends makes no difference to the acceptance of these. This indicates that the share price of a company would not change if the company declared a zero dividend policy or a policy of high near-term dividends (Baker, Powell and Veit, 2002).

Lets look at an example to illustrate this theory:

If this theory were to be true, then Morrisons share price would show no change when the Chairman announced on the 6^th March 2015 that the supermarket was cutting its dividends to help fund the turn around plan (The Telegraph, 2015). Figure 1 which I have created, shows that the share price was uneffected by this announcement. Although the market is not ‘perfect’ how M&M (1961) assumed, what this example does demonstrate it that when investors are aware that the cash retained will be going into a postive NPV project which will generate future dividend increases for shareholders, the share price is uneffected. However, some shareholders require dividends as a source of regular income, therefore Morrisons may see a decrease in a certain clientelle of shareholders (Watson and Head, 2013). Shareholders could sell a proportion of their shares to create ‘homemade dividend’ confident in the knowledge that a fair price would be obtained in this ‘perfect world’, which takes into account the additional value from the project (Arnold, 2013). Of course, as addressed in a previous blog, a perfect capital market does not exists, as transaction costs and taxes are very much real, therefore this theory is arguable inaccurate.    

Figure 1: Share Price of Morrisons. Figures from Yahoo Finance, 2015

M&M (1961) also argue that dividends represent a residual payment. Using the Morrisons example to illustrate, once Morrison's have provided funds for the turn around plan, investors should be given the residual. By receiving this cash, they can invest in other organisations of the same risk class which provide an expected return at least greater as the required return on equity capital (Arnold, 2013).

In this circumstance dividend policy becomes an important determinant of shareholder wealth:

•    If cash flow is retained and invested within Morrisons at less than the equity capital, shareholder wealth would be destroyed; therefore it would be better to raise the dividend payout rate
• If retained earnings are insufficient to fund the positive NPV turn around plan, shareholder value is lost, and it would be beneficial to lower the dividend.

In contrast, Gordon (1959) presented the “bird in the hand”argument which indicates that dividends are preferred to capital gains due to future uncertainty. As an investor, I would rather have my money now, than to leave it tied up in uncertain investments. With this in mind, it is clear to see that the dividend policy will influence the market value of a company.

Now lets look at an example to illustrate this opposing theory:

On February 6^th 2015, Norway’s Statoil announced that it would cut capital spending by $2 billion this year in preparation for an ‘extended period’ of low prices and volatility (Bloomberg, 2015). This announcement came after Statoil published that the net income for the quarter was $9 billion which was drastically lower than their estimations of $26 billion. However, the new CEO, Eldar Saetre ensured shareholders that the company is still “highly committed to the dividend policy”. The dividend rate will remain at a flat for the next 3 quarters, which he believes reflects the current market environment whilst remaining competitive (Bloomberg, 2015).

If Statoil are facing tough times, then why are they committed to their dividend policy? From a business point of view, the answer is simply. If Statoil had decided to pay a lower dividend, then their investors may sell their shares and invest in one of their competitors which are paying a higher dividend. This would result in a decrease in Statoil’s share price and therefore decrease the market value of the company (Watson and Head, 2013). What Statoil is doing is ‘signalling’ good news to their shareholders. The competitive dividend pay out is acting as an important conveyor of information (Arnold, 2013). Due to information asymmetry within the market, dividends are used as an indicator of a firm’s sustainable level of income. Even when faced with uncertainty regarding the price of oil, Statoil are indicating an optimistic view about their future, which should therefore not reduce investor’s confidence in the company. By looking at Figure 2, it is clear that this approach has been successful, as Statoil have been able to maintain a reasonable steady share price since the announcement.     

Figure 2: Statoil’s share price for the first quarter of 2015. Figures from Statoil, 2015

In comparison to M&M’s theory, as an investor I would be slightly concerned that by continuing to pay competitive dividends that Statoil may have limited positive NPV projects therefore may lower my future returns (Watson and Head, 2013). However, Saetre has clearly communicated that the company will continue to stay on track with its giant Johan Sverdrup field and other ongoing projects. I believe that by addressing shareholders’ concerns on Bloomberg Television’s “Countdown” demonstrates transparency therefore shareholders know exactly where they stand with Statoil’s future, which had also influenced the steady share price.     

   

In conclusion, although M&M’s (1961) theory is criticised due to assumptions that were made, I agree that in order for Morrison’s to make an effective turn around, dividends need to be reduced so there can be a concentration on investing in positive NPV projects. By thinking long term, this should increase shareholder wealth. However, if there is a residual once all projects have been covered, then I believe that the shareholders should receive that money. By illustrating this theory with the Morrison’s case, it demonstrates that when shareholders are aware of what the reduction in dividends are being invested in, then the share price remains relatively steady. Likewise, by effectively communicating what their plans are, Statoil have been able to maintain shareholder confidence which has resulted in a steady share price. Although they have not reduced their dividend policy, the recently published results could have affected the share price of the company, had they not effectively communicated their future plans and signalled a positive view for the future.       

References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson.O’Brien

Baker, H. K., Powell, G. E., & Veit, E. T. (2002). Revisiting the dividend puzzle: Do all of the pieces now fit?. Review of Financial Economics, 11(4), 241-261.

Bloomberg (2015) Statoil CEO Says `Highly Committed' to Dividend Policy. Retrieved from http://bloomberg.com 

Gordon M (1959), “Dividends, Earnings and Stock Prices”, Review of Economics and Statistics, 41, 99- 105.

Miller, M. H., & Modigliani, F. (1961). Dividend policy, growth, and the valuation of shares. the Journal of Business, 34(4), 411-433.

Porterfield, J. T. (1967). Dividend Policy and Shareholders' Wealth. Financial Research and Management Decisions, hg. von Alexander A. Robichek, New York, London, Sydney, 54-67.

The Telegraph (2015) Morrisons to slash dividend to fund rescue plan. Retrieved from

 http://www.telegraph.co.uk/finance/newsbysector/retailandconsumer/11455839/Morrisons-to-slash-dividend-to-fund-rescue-plan.html 

Watson, D. & Head, A. (2013). Corporate Finance: Principles and Practice. (6^TH ed.), Harlow: Pearson. 

Figure 1 - Figures from Yahoo Finance. Retrieved from https://uk.finance.yahoo.com/echarts?s=MRW.L#symbol=MRW.L;range=1d 

Figure 2 – Figures from StatoIl. Retrieved from  http://www.statoil.com/en/investorcentre/share/pages/historicshareprices.aspx

How much debt is too much debt?

The capital structure of a company refers to the mixture of equity and debt finance used by the company to finance its assets. The decision on what mixture to use is called the financing decision. (ACCA, 2009).

On February 25 2014, Bloomberg announced that Det Norske Oljeselskap ASA, the oil producer, was reviewing its funding options and looking to cut costs as a plunge in crude oil prices caps the cash flow it needs for new projects. A financial decision has been made that the company will increase their debt finance and may also be able to issue new shares. In essence, the company is trying to create the optimal capital structure, at the lowest possible cost to their shareholders (Bloomberg, 2015).

At this stage in my studies, I understand that financing a business through borrowing is cheaper and less risky than using equity; therefore it is unsurprising that companies, such as Det Norske, are increasing their debt levels. The benefits that companies can obtain through debt finance are as follows (Arnold, 2013):

•  lenders require a lower rate of return than ordinary shareholders
•  debt financing securities present a lower risk than shares because they have prior claims on annual income and in liquidation.
• a profitable business effectively pays less for debt capital than equity, as debt interest can be offset against pre-tax profits before the calculation of the corporation tax bill, thus reducing the tax paid.
• issuing and transaction costs associated with raising and servicing debt are generally less than for ordinary shares.

The traditional view implies that the market value is very much dependent on a company’s capital structure. It suggests that by increasing their debt finance, Det Norske would be financed to a greater extent by cheaper borrowed funds; therefore the weighted average cost of capital (WACC) would decrease (Arnold, 2013). A lower WACC, would result in a higher market value of the company, thus increasing shareholders wealth.

But is there such a thing as too much debt?

 

Put simply, yes. As debt begins to increase, Det Norkse will increase their chances of financial distress which could ultimately result in liquidation (Arnold, 2013). Although a successful company, if Det Norske is faced with a prolonged period of declining profits, the interest on the debt will still need to be paid, which may affect the company’s ability to pay dividends (ACCA, 2009). This increase in dividend volatility is a financial risk to shareholders. As a result, shareholders will require greater returns to compensate them for this risk, thus the cost of equity will increase, which will lead to an increase in the WACC. Furthermore, if profits are low, the company’s shareholders will find their returns declining to an exaggerated amount (Arnold, 2013). This research demonstrates that debt really is a ‘ball and chain’ for a company – there is no way to avoid payments, especially during a bad year.

What this argument identifies is that an increase in debt reduces the WACC, but it also increases WACC due to equity holders wanting higher returns. This demonstrates the complex relationship between debt and a company’s capital structure. 

However, in 1958 Modigliani and Miller (M&M) proposed an alternative theory by making some assumptions. Given these assumptions they concluded that the value of a firm remains constant regardless of the debt level. The WACC is constant as the cost of equity increases this is offset by the cost of the cheaper debt, and therefore shareholder wealth is neither enhanced nor destroyed by changing the gearing level, thus capital structure is irrelevant (O’brien, Klein and Hilliard, 2007).

 

In 1963, M&M revised their theory to include corporate tax and their conclusion altered dramatically. As debt becomes cheaper (due to tax relief on interest payments), the cost of debt decreases significantly (Watson and Head, 2013). This would mean a decrease in WACC (due to the cheaper debt) is now greater than the increase in WACC (due to the increase in financial risk); thus WACC falls as gearing increases (ACCA, 2009). If this theory is correct, this implies that Det Norske should gear up as much as possible, if they wish to reduce their WACC.

 

In contrast to both theories, which attempt to find an optimal capital structure, in this approach there is no search for an optimal capital structure. Companies simply follow an established pecking order which enables them to raise finance in the simplest and most efficient manner (ACCA, 2009) The order is as follows:

(1) use all retained earnings available
(2) issue debt
(3) issue equity, as a last resort.

 

I believe that companies should build up cash reserves in case of any future unforeseen expenses, which would reduce the amount of time spent on raising external finance to peruse new projects. 

 

So what is the best course of action for Det Norske to take?

 

Although increasing debt levels has its benefits, a company with excessive levels of debt could face huge implications, as outlined above.  I would discourage Det Norske from following M&M’s theory as I believe it would result in instability, as they failed to take into account bankruptcy costs, agency costs and tax exhaustion. In addition, M&M also assumed perfect capital markets in their theory, and as I discussed in my previous blog, this not true as prosecutions for insider information have taken place. I believe an optimal capital structure does exist, but is hard to define as each structure is unique to each individual company. Det Norske should consider what a “reasonable” level of debt is; based on the industry it operates in.

Additionally, although I do not support the pecking order theory, as I believe Det Norske should retain cash reserves, the company should not ignore the fact that the theory places debt higher than equity. This somewhat supports the traditional theory, that Det Norske should gear up, but once again, to a “reasonable” level to finance new projects.

References

ACCA (2009) Optimal Capital Structure. Retrieved from http://www.accaglobal.com/content/dam/acca/global/PDF-students/2012s/sa_junjul09_lynch.pdf

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson.O’Brien

Bloomberg (2015).  Billionaire Roekke’s Det Norske Reviews Funding as Oil Drops. Retrieved from  http://www.bloomberg.com/news/articles/2015-02-25/billionaire-roekke-s-det-norske-reviews-funding-amid-oil-drop

O'Brien, T. J., Schmid Klein, L., & Hilliard, J. I. (2007). Capital structure swaps and shareholder wealth. European Financial Management, 13(5), 979-997
 

Watson, D. & Head, A. (2013). Corporate Finance: Principles and Practice. (6^TH ed.), Harlow: Pearson. 

Is the market always right?

Companies and investors do not need capital markets to be perfect; but to be efficient and to offer fair prices so they can make reasoned investment and financial decisions (Watson, 2013). In the recent past, there has been much debate questioning the notion that stock markets are efficient. To add to this debate, in 2013 two economists with completely opposing interpretations of the ways markets behave were jointly awarded the 2013 Nobel memorial prize for economics (BBC, 2014). How can two opposing theorists win the same prize?

Market efficiency research goes back to 1900 when Louis Bachelier published his idea that government bonds followed a random course. He understood that if it was obvious that a share would be worth more next week, then surely the price would already have risen in anticipation of that? Correct! Predictable moves have already happened, because the market is efficient – and all that is left are unpredictable surprises.

In the 1960’s, Eugene Fama wasn’t satisfied with Bachelier’s theory as there wasn’t “an economical model behind it”. Fama’s theory established the prices of capital market securities and stated that the prices of securities fully and fairly reflect all relevant available information’. Market efficiency therefore refers to both the speed and the quality of the price adjustment to new information (Watson, 2013). If I was a new investor entering the market, the main consequence of the market being efficient, is that the market would always be one step ahead of me. If this is the case, I would be much better off investing broadly and diversifying my portfolio of shares, to increase my chances of higher returns. This is the concept that underpins Markowitz’s (1952) portfolio theory.

Fame (1970) identified three forms of efficiency:

Weak form efficiency: current share price reflects all past movements, which implies that if I carried out a ratio analysis on a company, it would immediately be out of date. Share prices will change as new information arrives on the market and, since new information arrives at random, share price movements will also be random (Samuelson, 1965). This supports the ‘Random Walk Hypothesis’ theory by Kendal (1953) that there is no systematic link between one price movement and subsequent ones, therefore a share prices at any one time reflects all known information. Because of the nature of the news, when it arrives it is unknown if it will be good or bad.

Semi-strong efficiency: share prices reflect all historic and publicly available information and react quickly and rationally to new information. This means that you can’t make abnormal returns by studying publicly available information, as the market has already adjusted to the news. 

I believe the UK stock market is semi-strong efficient. To support my statement I have created a graph to show Twitter’s share price during the first week of February 2015 (see diagram 1). On the 6^th February, Twitter’s Chief Executive announced that the social media company saw a 97% increase year on year for revenue growth. Based on Fama’s theory, this means that as soon as the news was released, share prices should have immediately reflected this new information. This is exactly what is illustrated by diagram 1.  

Diagram 1: Twitters share price during the first week of February 2015

Strong form efficiency: reflects all information, whether it is publically available or not. Investors cannot make abnormal returns from share dealing, not even investors who act on ‘insider information’. Capital markets clearly do not meet all the conditions for strong form efficiency as prosecutions for this offence has taken place.   

As an investor I might as well behave as though the market is efficient and that nothing is therefore underpriced. The market quickly and rationally integrates new information, as supported by the Twitter example, which therefore means that abnormally high returns can only be made where there is access to information that is not yet published (insider information) or by chance.    

So the market is always right. Or is it?

In 1981 Robert Shiller a challenger to the efficient market hypothesis arrived on the scene. His argument was ‘market volatility is too high for the efficient markets theory to be true’. He believed that investors’ behaviour cannot be fully based on rationality and must acknowledge the role played by psychology (Malkiel, 2003). In the 1980’s, he showed that stock prices tend to fluctuate more than corporate dividends. This should not happen if investors were fully rational, since stock prices forecast future dividends (Financial Times, 2013). His idea was that markets have a tendency to overreact to news, or to react to non-news. 

By using share price data, I have constructed a graph to show the change in Apple’s share price throughout February 2015 (see diagram 2). In two instances during the month, ‘rumours’ circulated within the news about potential new products and release dates. Although no official announcements had been made by Apple, share prices increased even though the news could potentially be ‘non-news’, demonstrating Shiller’s theory that the market overreacts, and in this case to ‘non-news’.

Diagram 2: Apple’s share price over February 2015

Shiller went on to write a best-selling book called Irrational Exuberance, and applied his insights to the US housing market, which he believed was overvalued. He claimed that behaviour of house prices was driven by excessive optimism over future valuations (Shiller, 2007). This finding was proven to be remarkably prescient when the market crashed in 2007.  

In his book, Shiller explained that stock analysts commonly look at how company profits, or earnings, compared to their share price. What Shiller and his colleague John Campbell investigated was the longer-term view of this price earnings ratio. They compared the share price to the average earnings for the past 10 years. This long-term price-earnings ratio showed a sharp peak in 1929, just before the great Wall Street crash. And the peak in the late 1990s was even bigger (The Economist, 2014). So why didn’t investor spot these irrational booms? Stiller compared it to the expression “no-one should shout fire in a crowded theatre”. Earnings were increasing and so were prices. Everything looked positive!

So, is the market always right? As identified in this blog, I expressed that I believe that the U.K's stock market is semi-strong efficient, as demonstrated by the Twitter case when information is released, the market reacts appropriately. On the other hand, Shiller also has a strong argument as the Apple case illustrates that markets do overreact to news, or react to non-news. By applying the two opposing theories to real life events, it is understandable why both theorist were awarded the nobel prize. I believe that both methods will continue to be standard tools in academic research, and provide guidance for the development of theory as well as for investment practice. 

References 

BBC News (2013) Are markets ‘efficient’ or irrational? Retrieved from  http://www.bbc.co.uk/news/magazine-24579616

Malkiel, B. G. (2003). The efficient market hypothesis and its critics. Journal of economic perspectives, 59-82

Shiller, R. J. (1981). The Use of Volatility Measures in Assessing Market Efficiency*. The Journal of Finance, 36(2), 291-304.

Shiller, R. J. (2000). Irrational exuberance. Princeton University Press. 

The Economist (2014) Rational or not? Retreived from http://www.economist.com/blogs/buttonwood/2014/03/equity-markets

The Financial Times (2013) Fama, Hansen and Shiller win Nobel Prize for economics. Retrieved from http://www.ft.com/cms/s/0/6f949e8c-34c1-11e3-8148-00144feab7de.html

The Guardian (2015) Twitter shares soar after sharp revenue increase but growth still slowing. Retrieved from http://www.theguardian.com/technology/2015/feb/05/twitter-shares-soar-revenue-increase-growth-slowing

The Independent (2015) Apple could be planning virtual reality headset. Retrieved from  http://www.independent.co.uk/life-style/gadgets-and-tech/news/apple-could-be-planning-virtual-reality-headset-10053916.html?origin=internalSearch

The Independent (2015). New Apple watch expected to launch. http://www.independent.co.uk/life-style/gadgets-and-tech/news/apple-event-on-9-march-apple-watch-expected-to-launch-10073354.html?origin=internalSearch

Watson (2013) Corporate finance: principles and practice. 6^th Ed.

Diagram 1 - Yahoo Finance (2015) Apple share price figures. Retrieved from https://uk.finance.yahoo.com/q/hp?s=AAPL

Diagram 2 - Yahoo Finance (2015) Twitter share price figures. Retrieved from https://uk.finance.yahoo.com/q?s=TWTR

Will the Tesco turnaround plan create long term shareholder value?

Maximising shareholder value is fundamentally maximising shareholders purchasing power, which implies that the ultimate measure of a company’s success is the extent to which it enriches shareholders. This is seen by increasing a company’s share price over the long term and through paying out dividends. Jensen and Meckling (1973) argued that the singular goal of a company should be to maximise the return to shareholders. Similarly, Arnold (2013) states Value Based Management is a managerial approach in which the primary purpose is long term shareholder wealth maximisation. However, in comparison, Arnold (2013) brings together the way in which shares are valued by investors, with the strategy of the firm, its organisational capabilities and the finance function. Based on the recent revelations of Tesco’s poor performance, in this blog I will highlight the flaws in Tesco's previous strategy and how the concepts proposed by Arnold (2013) underpins the turnaround plans for Tesco. 

In my opinion, if investors are using indicators such as Earnings Per Share (EPS) to assess the performance of a company, and form expectations as to how the company is likely to perform in the future, it is by no surprise that management feel the need to focus their attentions on the future rather than what really matters; their current position and their stakeholders. With such an emphasis on EPS, unsurprisingly in 2009, Tesco announced in its annual reports ‘the best way of enhancing shareholder value is to grow earnings while maintaining a sustainable level of Return on Capital Employed’ (ROCE). The results on the other hand were very different (see Figure 1).

If Tesco truly believed in their strategy, then why do the results illustrate a decreasing ROCE and a rapidly increasing EPS? Research suggests that there was inadequate cash to both invest and pay out dividends; however this problem was covered by the proceeds of the sale of fixed assets.This example demonstrates that it is possible for a company to generate a rising EPS at the same time as it is employing increasing capital at inadequate rates of return. In other words, Tesco was destroying shareholder value as it was increasing its earnings (Financial Times, 2015).

Figure 1 – Tesco: the Leahy Years (Financial Times, 2014)

This unsustainable resource of cash led to Tesco borrowing the money, demonstrating that they lacked one of the main elements of shareholder value creation – finance. Furthermore, in 2014, the BBC News reported that Tesco had predicted profits of £1.1 billion for the first half of 2014. However, due to accounting errors there had been a £250 million overestimation in its forecasts. As this news hit the headlines in September 2014, shares plunged to an 11-year low, closing at 202.75p, and then continued to fall overnight hitting a trough of 191.08p - see figure 2. This rapid decrease in share price illustrates that the market was of semi-strong efficiency (Fama, 1970), as the news was rationally being integrated into the public domain as it hit the headlines. 

Figure 2 - Share Price of Tesco during September 2014

More recently, Denning (2012) argued that pursuing the goal of maximising shareholders value produces less shareholder value than a specific focus on delighting the customer. His research concluded that shareholder value is a result, not a strategy. Denning explained that in order to rescue companies from bad habits, a phase stage is required whereby it rethinks the very basis of a corporation and the way the business is conducted. If you take care of your customers, shareholders will be drawn. With a focus on customers, there is an opportunity to build a brand for the long term rather than to exploit short term opportunities. This theory was support by the research carried out by Hillman & Keim (2001), which concluded that stakeholder management leads to improved shareholder value creation. Working for customers produces focus and motivation for organisations – enter Dave Lewis!

In order to increase long term prospects, Dave Lewis has recently been appointed the new Chief Executive of Tesco, who is determined to give Tesco a ‘cultural cold bath’ by implementing back-to-basic strategies, which supports the research of Denning and Hillman. He plans to get Tesco back to what it does best: selling a wide range of items at low prices. The previous Chief Executive’s first error was promising investors that he could sustain an operating margin of 5.2% in the U.K (The Guardian, 2015). Lewis has made no medium-term financial pledges because restoring competitiveness is his top priority. He is also ensuring that short term profits associate with an increase in the long term value of the company. In creating a clear strategy to support long term prospects, he has planned to close 43 unprofitable stores, cut back on new store openings and seek to rationalise the business by cancelling dividends and ending the company’s defined benefit pension scheme, which has a deficit of £3.4 billion (The Guardian, 2015). In the past, Tesco’s product range has arguably become over diversified, resulting in a decline in profits. Lewis has planned to sell the Tesco Broadband and movie streaming service Blinkbox to TalkTalk for an undisclosed sum. In addition, to help implement the changes, a new UK Operations Director (arrival from Halfords) and Finance Director (M&S) have also been appointed. By employing three external candidates for top management roles, I believe this will introduce a fresh perspective into the business whilst also bringing much needed experience, knowledge and a wider skill set, which in turn will strengthen the organisations capabilities of fulfilling Lewis’ Tesco Turnaround vision.

Based on the new plans, Tesco is set to report a rise in profit next year of 2%, followed by an increase of 23% in the following financial year (Yahoo Finance, 2015). If achieved, this will demonstrate a strong growth, which should change the markets view on the company and lead to a higher share price over the medium term. The results published by The Financial Times on 8^th January 2015, illustrates that shareholders are feeling optimistic about the turnaround plan as share price has increased by 15% since December (The Guardian, 2015).

I believe this turnaround plan demonstrates the strong connection between the three elements of creating shareholder value. A clear strategy, implemented by the correct people can drive success, which in turn will increase shareholder value. The proposed plans by Dave Lewis already look to deliver strong results based on the recent increase in share price - see figure 3.