THE MARKETS Jacques Magliolo
CORPORATE raiders are generally a detested lot. They invoke fear in company directors, desperation in owners who lose their organisations to them and drive shareholders into a frenzy of greed as share prices are driven skywards.
However, there is one aspect of corporate raiders worth learning: their ability to raise seemingly unlimited funds to conduct hostile takeovers and to rid themselves of this burden after the takeover battle.
In addition to the host of due diligence assessments, indepth analyses of market, economic and political trends, business development research and accounting proposals conducted prior to making a bid for a targeted company, the raider has to determine how much the takeover battle will cost, what its final offer will be and how to raise the necessary cash.
In nearly all successful United States takeover battles, funds are raised through debt. This can take the form of bank loans, issuing bonds, or a combination of the two. But never, say the raiders, obtain the funds by issuing shares.
Why not? After all, Amic chairman Leslie Boyd is on record as saying that raising cash through capitalisation issues “is a cheap way of giving effect to a rights issue”. In this manner, the company offers its shareholders new shares in place of a dividend payment.
Most analysts do not agree. “It is usually cheaper to raise funds through debt than to issue shares,” says EW Balderson industrial analyst Brian Feldtman, adding that the “interest payable on loans is tax deductible, which makes it even cheaper”.
Says another analyst: “Investors expect a return which is greater than the relatively risk-free long- bond rate, otherwise they will sell their shares.” These rates are now nearly 17 percent.
This is best highlighted in a fictitious takeover bid, where a company has determined that R10-million is needed to fully fund a bid. In the following three scenarios, the same tax rate (35 percent), prime rate (15,25 percent), preference or debenture bond rate (10 percent), dividend cover (two times) and number of shares in issue (one million ordinary shares) is used. To simplify the examples, all cases assume a turnover of R100-million, a profit before tax of R30- million and no abnormal or extraordinary items, which makes profit after tax also attributable profit.
* In the first case study, the directors decide to raise the R10-million through long-term loans. Without using compound interest, the company’s interest bill for the year would be R1,5-million, which leaves the company with a pre-tax profit of R28,5-million and an after-tax profit of R18,5- million.
Based on its ordinary shares in issue, earnings per share (eps) would thus be 1 850 cents and, on a two- times cover, dividend per share (dps) would be 925 cents.
* The second scenario involves a company issuing debentures or preference shares to raise the funds. The company would not have an interest bill, thus its operating profit would also be its pre-tax profit. After deducting tax, the company would have an attributable profit of R19,5-million.
Company law orders that preference shareholders always get paid before ordinary shareholders, and thus the interest of R1-million paid to them would be deducted. This reduces bottom-line earnings to R18,5- million, or an eps of 1 850 cents and dps of 925 cents.
A decision to convert these preference shares into ordinary shares or to redeem them — turn them into long-term loans — would affect the financial status of the firm at some future date. If the shares are redeemed, the previous case study would be followed. If the directors decide to convert the shares, the effect would be the same as in the third example.
* The third example assesses the influence of issuing two million shares to obtain the required funds. The company’s financial statements will have the same attributable profit (before a deduction for preference dividend) as in the case where preference shares are issued. However, the three million ordinary shares in issue reduce eps to 650 cents and dps to 325 cents.
In addition to the obvious effect the dilution of earnings will have on the existing shareholders, the increase in the volume of shares hails loss of control for major shareholders, loss of investor confidence and ultimately a decline in the share price.