Verizon Wireless: who’s getting the better of the deal, Verizon (VZ) or Vodafone (VOD)?

I think it’s VZ.  The company says that even at a cost of $130 billion the buy-in of VOD’s 45% minority interest will add 10% to VZ’s earnings.  But VZ is also adding a significant amount of risk in leveraging itself financially.

a simplified history

In 1982 the federal government forced the breakup of the monopoly telephone service provider, ATT.  It separated the parts into a national long-distance provider, which retained the ATT name, and a bunch of regional local service providers, nicknamed the “Baby Bells.”  Each Baby Bell contained its area’s nascent mobile services.

Soon enough, the Baby Bells began to merge with one another, ultimately forming into a Western US group (which subsequently acquired “new” ATT and took on the ATT name) and an Eastern group, which subsequently renamed itself Verizon.  Proto-VZ wanted to keep its mobile assets.  Proto-ATT didn’t.  To keep the mobile assets out of the clutches of prot0-VZ, Airtouch, the proto-ATT mobile operation, sold itself to VOD in 2000.

VOD promptly struck a deal with VZ in which it merged Airtouch with the VZ mobile operations to form Verizon Wireless.  VZ had operating control and a 55% interest.  VOD had veto power over some decisions and held the other 45% of Verizon Wireless.

Got all that?

culture clash

VOD is a British company.  It apparently believed in the old-style colonial European way of doing business, according to which a firm with global pretensions could get more bang for a buck (or quid, in this case) of capital by taking large minority interests in important foreign  firms.  Through superior intellect/management technique, or force of will, or sheer European-ness, it would dominate the board of directors.  It would thereby get the benefits of 100% ownership without the capital outlay.   The resulting network of companies would move in lockstep with its European leader, buying the capital equipment suggested (getting discounts for all) and perhaps paying management fees to the European company for its advice.

VZ, an American firm, would have thought that no one in his right mind would accept a minority stake.  If would have figured that VOD would soon see the light and be persuaded to sell.

Or maybe that’s just how the two parties rationalized the unhappy partnership that they entered into.

what each party gets from the deal

Verizon

–when the deal closes early next year, VZ will have access to the cash flow from Verizon Wireless for the first time.  US tax law   requires that a parent have an 80% interest in a subsidiary before cash can flow tax-free from it to the parent

–VOD will no longer have an operational say in Verizon Wireless

–the very mature fixed-line telephone business will be a significantly smaller proportion of the whole

–the deal is accretive to earnings by 10%

Vodafone

–VOD extracts itself from its awkward minority position

–ir gets a big payday, even after distributing the bulk of the proceeds to shareholders, which it will presumably use for EU acquisitions

–VOD believes it can use a provision in UK tax law regarding transactions between conglomerates to pay only about $8 billion it taxes on this deal

Verizon (VZ), Vodafone (VOD) and flowback

VZ is buying the 45% of Verizon Wireless that VOD owns.

VZ, which owns 55$ of Verizon Wireless, recently agreed  to buy the other 45% from VOD for around $130 billion.

From what I can tell so far, the deal will be good for VZ.  And, at the very least, VOD gets a boatload of cash and stock.  In hindsight, VZ would have been a lot better off striking the same deal in March, before the Fed began hinting that it was thinking of ending the current post-recession period of extra-super-accommodative money policy in the US.  The interest rate VZ would have paid on newly issued bonds would have been lower.

More on this topic in future posts.

There may not be a great need to load up on VZ ( which I own) immediately, however–even if you think the deal is a spectacular coup for VZ (too enthusiastic for me).  The reason is flowback.

what flowback is

VZ is going to issue over a billion shares of new stock to VOD as part of the purchase price.  VOD has already announced it will distribute to its shareholders all of the VZ stock it receives.  That’s something like one VZ share for every 40 VOD shares held (the exact ratio isn’t important).

What is important is that VOD is a UK corporation whose stock is traded in London.  The bulk of its shares are held either by UK or Continental European institutions.  US institutions hold only about 15%.

Put another way, early next year almost everyone who owns VOD will receive shares in a foreign stock, VZ.

What will they do with it?

For index funds, the answer is clear.  If it’s not in the index, it has to be sold.

For institutional managers in the EU, the answer depends, in the first instance, on what their contracts with customers say.  They’ve presumably been hired for their expertise in EU equities.  Management agreements probably stipulate that they’re not allowed to hold non-European securities.

Even if they are permitted to hold VZ, why do it?  Why take the risk of holding a stock that’s outside your area of competence–and which will require considerable research effort to get a firm grasp on.  Selling is a much safer option.

For individuals, if form runs true, the first they’ll hear of the deal will be when their broker calls to tell them that shares of VZ have plopped into their accounts–and to urge them to get rid of this weird thing.

That’s flowback.

It happens in all cross-border deals that involve stock.  When shares of the issuing company leave the home country, some portion will be sold immediately by investors who are unable or unwilling to hold what is for them a foreign stock.

Where do these sales take place?   …ultimately in the home market of the issuer.

the VZ case

For VZ, average daily trading volume is around 10 million – 12 million shares.   Occasionally, volume can get as high as 30 million- 40 million shares without moving the stock too much.

Let’s make up a number and say that flowback will be 300 million shares.  That’s easily an entire month’s trading volume.  So this could be a serious issue for VZ’s price.

mitigating factors

There are three that I see:

–Verizon Wireless is the largest and most important asset for both VZ and for VOD.  Non-index investors in the EU must have wanted exposure to Verizon Wireless to be holding VOD shares.  Arguably, they will want to continue to have that exposure and will therefore be less inclined than normal to want to sell.  So maybe some will be able to wangle exceptions from their clients.

–trading volume in VZ over the past seven trading days (not including today) has averaged about 25 million, or–let’s say–12 million shares above normal.  If this is all merger-related short-selling, which it probably is, then this trading has already created demand for 80+ million shares of VZ when the shorts are covered.

–the stock has a current dividend yield of 4.6%.  At some point, this and other VZ fundamentals should provide price support.

my take

Worries about flowback are one reason large cross-world acquisitions involving stock aren’t that common.  This one was clearly too big for VZ to do any other way.

My guess is that anticipatory selling in advance of the acquisition will make it hard for VZ to go up for a while.  I also think, however, that downward pressure from potential flowback will abate long before the deal actually occurs.

At some point, an excellent buying opportunity for VZ will emerge from acquisition-related stock activity.  The trick is deciding exactly when.  The most prudent strategy, I think, is to establish a small position and await further developments.

 

 

Moffett Research, Vodafone’s financials, Wall Street’s security analysts

The “Heard on the Street” column of today’s Wall Street Journal talks about the purchase commitment Verizon Wireless had to make to Apple in order to be able to offer the iPhone on its network.

a footnote in the Vodafone financial statements

The information comes from newly-formed Moffett Research LLC, a venture headed by Craig Moffett, the truly excellent (former) telecoms analyst at Bernstein.  Mr. Moffett points to a footnote in the financial statements of  Vodafone plc, a Verizon Wireless co-owner, that implies Verizon Wireless has committed to buy a minimum of $44.7 billion worth of iPhones during 2011-2013.  The company spent only $18.5 billion on iPhones through the end of last year, however, and still had $2 billion worth (Mr. Moffett’s number) in inventory.

That leaves $26.2 billion worth of iPhones to be bought this year (my arithmetic–HotS says the shortfall is $23.5 billion).

I find three aspects of this story interesting:

1.  Neither Verizon Wireless nor Verizon disclose this information.  It took a sharp-eyed telecom specialist combing through the back pages of a UK company’s financials to spot the figures and realize their significance.

This example illustrates what security analysts do for a living, as well as the depth of information that traditionally has been at the fingertips of any professional investor who does business with the major brokerage firms who employ these analysts and furnish their research to customers.  In other words, no matter how dull-witted the pro and how smart we as individual investors are, the pro has a huge information advantage starting out.

2.  Mr. Moffett started up his new firm two months ago.  It may be that he’s decided he can make more money as an independent than as an employee of Bernstein.  More likely, if past Wall Street form follows true, is that Bernstein has started to dismantle its high-powered equity research effort.  Why do so?  Wall Street believes that research is a money losing business.

3.  What happens if/when Verizon Wireless falls short of its $44.7 billion purchase commitment?

HotS doesn’t say.

Using (very) round numbers, the shortfall will likely be $10 billion or so.  In contracts of this type that I’m familiar with, Verizon Wireless would have to pay that amount to Apple shortly after the end of the year.  Verizon Wireless would, however, get a credit against future purchases of a gradually declining percentage of the shortfall payment.

Given the popularity of the competing Samsung Galaxy phone line, I imagine the shortfall payment will be a prominent element in negotiations over supply arrangements in 2014.

On another note,  I wonder how Apple and Verizon have been accounting for the minimum purchase contract.   HotS says the minimums for 2011-13 are:  $13.7 billion, $14 billion, $17 billion, respectively.  The actual purchases have been $8.4 billion and $10.2 billion in 2011 and 2012.

Both firms are most likely using the actuals, not the contracted minimum amounts.  Might be a little awkward for Apple, though, if it isn’t.

emerging markets: political risk in India

the home field advantage

No company ever goes into a foreign country expecting a level playing field.  There are always going to be rules–written and unwritten–that favor the home team.  This is the flip side of the belief that you’re always going to have at least a slight advantage over a foreign company in your domestic market.

One exception–if you’re hoping that the foreigner will buy your domestic business.  Chances are he’d be willing to pay over the odds.  But it’s equally likely the government will force a sale to a domestic competitor.  Around the world, that’s just the way it is.

in sports

We see this all the time in sports.

Olympic judging.

Your favorite baseball team plays an away game.  You can be sure the field will be manicured to minimize the home team’s weaknesses and your strengths. The visitor’s dugout in San Francisco is, unusually, on the first-base side of the field?  Why?  It faces right into the frigid wind off the bay.

The home town timekeeper will make the game clock in basketball or hockey run fast or slow, as the home team requires.

Even the referees will exhibit a home-town bias, perhaps influenced by crowd noise.

what’s not cricket

Some actions are beyond the pale, however.  One such appears to be happening right now in India.

In 2004, when Vodafone was still intent on ruling the world, it entered the Indian cellphone market by buying an interest in an existing player from Hutchison Whampoa.  Aware that if the transaction were done in India it would trigger a capital gains tax of around $2.9 billion, the parties did the deal offshore.

The Indian Tax Department ruled that the tax was still due.  Vodafone refused to pay and lengthy litigation ensued.

Two months ago, the Indian Supreme Court ruled in Vodafone’s favor–that no tax was due.

proposed retroactive tax law change

On Saturday, the Financial Times reported that in its annual budget the Indian government proposes to change the tax law, retroactive to April 1962, to make offshore transactions involving multinationals and Indian subsidiaries subject to domestic capital gains tax.

Although the proposed change, if implemented, will have much wider implications than for Vodafone alone, it is being widely seen as aimed directly at the UK telecoms company.

The issue of course, is that Vodafone has played on the home field and won–but the losing side is trying to change the basic ground rules five years after the fact, in a way that turns victory into defeat.

I think it’s ironic that this situation is arising just as the Indian government has decided to try to woo foreign portfolio investors for the first time.  If the budget documents are not just bluster and parliament makes the retroactive tax law change, that would seem to me to dim substantially the appeal to foreign investors of India’s large domestic population.  The negative effect could last for many years.  For emerging markets investors, then, I think the Vodafone situation bears close watching.