What’s wrong with BEE?

Surely there must be something wrong with BEE? Right? Vodacom Group on Monday (June 11) unveiled the country’s biggest black economic empowerment telecoms deal.

Existing empowerment shareholders will be gifted R3 billion in an unencumbered special dividend and swapped into an ostensibly more liquid instrument, closer to the outside-of-South Africa action. Vodacom itself will nudge its BEE shareholding up to around 6% and begin sniffing at the Icasa (Independent Communications Authority of South Africa) prerequisites for winning a portion of South Africa’s delayed radio frequency high-speed internet spectrum when allocated on auction around March next year.

This should have been a value-positive signal to the market. Why then did Vodacom trade down 3% from its Friday close, drop another percent the day after and further on Wednesday? Does this mean that BEE is inherently value destructive? If the South African securities market is at all efficient, it certainly seems to imply so.

Shareholders not happy

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There is a lot of movement in the Rand Merchant Bank structure that delivers the circa 6% empowerment outcome. The more important facets are: purchase by Vodacom of R4.7 billion in non-operating preference shares; funding by third party financiers to the tune of R5.8 billion; and a special dividend payment of R3 billion to YeboYethu ordinary shareholders.

Proceeds of the preference share purchase by Vodacom are round-tripped through the YeboYethu BEE conduit. Some of it makes its way back into Vodacom’s bank accounts, against fresh issue of shares. Third party financier money is routed via YeboYethu to Vodacom, also by way of new share issue. And the special dividend is shed to YeboYethu BEE shareholders for their troubles and obedience.

The RMB structure elegantly maintains the YeboYethu milieu that was created for Vodacom to control its BEE moving parts, which alternately would have unwound on October 8. It keeps the status quo at a higher effective BEE shareholding, with no real operational impact on Vodacom.

So why the selloff?

New York-based financial consulting firm Stern Stewart & Co believes that the premium of enterprise value over total capital is a measure of the present value of all economic value added created (EVA™, or what economists call ‘residual income’). A fall in market value of Vodacom’s equity is therefore an indication of lower EVA™ expectations – but from what, given that the RMB structure has no impact on the company’s operations?

The short answer is that the value the market places on Vodacom is a measure of its management and their decisions made in the ordinary course of the mobile business. It’s these decisions that generate the 6% revenue growth, about 40% Ebitda  margin and nearly 20% earnings growth that engender shareholders to invest. That the company is placing R4.7 billion of shareholders’ money in third party preference shares that pay a return of 68% of prime (admittedly after tax) does not engender that confidence.

Forecast net reduced EVA™ off the higher capital base explains almost completely the 3% decline in share price on Monday.

This price change has nothing to do with BEE. If it did, there should have been an uptick through the value added expected from winning spectrum, for which BEE is a prerequisite. Because any outcome of the bidding process is too uncertain at this stage, the market has no basis on which to presume this value will be realised.

The sell off has everything to do with the structure proposed by RMB, as understood from Vodacom management. Although (a lot of) shareholders’ funds pass back into Vodacom accounts for its ordinary activities, there is still no reason why the company should use operating cash in an investment construct that earns less than preferred returns.

And why the payoff?

Why is there a special dividend of R3 billion being paid to YeboYethu ordinary shareholders? It equates to almost 64% of the funds placed in YeboYethu preference shares by Vodacom. It’s a material liquidity event that according to the CEO “amounts to 2.7 times the original capital … invested” (a decade ago), which is great for BEE. From a Vodacom perspective however, it’s not entirely necessary.

Third party financiers could just as easily have backed BEE investors to subscribe directly for new Vodacom shares and inject cash into the company’s operations. It made more sense for both Royal Bafokeng Holdings and Thebe Investment Corporation to invest directly in listed shares rather than a relatively illiquid leveraged conduit.

On the face of it, it seems that the existing BEE shareholders of YeboYethu are being paid to remain in the scheme controlled by Vodacom’s management. It’s perhaps otherwise not commercial to do so. Shareholders should question why the company needs to use shareholder money in YeboYethu to unlock the workaround (presumably encouraging third party funder involvement).

Is the value gone?

Ideally, if there’s no vendor investment in YeboYethu preference shares by Vodacom, there will have been no share devaluation. However, on the basis that this new YeboYethu BEE scheme is going ahead, the value lost may be recovered by further capital injection directly into the listed company for new shares. This cash may be used by management in the ordinary course of business: new spectrum infrastructure rollout, further acquisitions of African assets from the parent Vodafone and so forth.

From an EVA™ perspective, newly issued shares of a further 5% ex post will offset the economic value lost by rewrapping YeboYethu. From a shareholder valuation stand point, there is nothing wrong here with BEE. Value destruction comes from a company taking inefficient operational and investment decisions based on misaligned and adverse incentives and drivers.

Faizal Cader is an independent analyst, formerly in structured products at Deutsche Bank and Banking EVA™ at Stern Stewart (South Africa).

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