Corporate Restructuring of British Telecom

University Degree Business and Administrative studies

The De-Merger at British Telecom

The Spin-Off of the Wireless Division

Corporate Restructuring

Coursework

Submitted to Dr. Maria Carapeto

GROUP MEMBERS

Syed Gilani (Reg No: 070003409)
Rohan Segal (Reg No: 070024420)

Introduction:

Corporate restructuring can take a number of different forms varying from split ups to equity carve outs, however in this project we will be focusing on the spin off form of corporate restructuring. We will be looking at the telecommunications industry and analysing the company British Telecom. We have chosen this industry because in the last few years there have been major changes in the way this industry operates and BT seems to be at the centre of all this.

British Telecom has undertaken many corporate restructurings time but we will be looking specifically at the spin off of mmO2 on the 19th of November 2001. Strictly speaking though, it is a split up as two entities emerged after the restructuring, rather than a new entity with an existing one, as is seen in spin-offs. However, we will discuss this case as being one of a spin-off because the one of the resulting entities assumed most of the characteristics of the previous company.

We have tried to take a step-by-step approach by first analysing the industry environment and the specific conditions under which BT operates. Thus we attempt to take a well-rounded view in determining the causes, impact and post-performance of the restructuring

Previous studies show that share prices tend to react favourably to spin off announcements (especially when it is a focus increasing spin- off, as is the case of BT). We therefore also expect to see our results to be similar to previous studies on focus increasing spin offs.

Company Description:

Telephone services in almost all of the UK were, until 1981, provided by the Post Office, which was a government department until 1969 when it was established as a state public corporation. In 1981, the postal and telecommunications services of the Post Office became the responsibility of two separate corporations, with British Telecommunications – under the trading name of British Telecom – taking over the telecommunications business. As a result of the Telecommunications Act 1984, British Telecommunications plc was incorporated in England and Wales under the Companies Acts 1948 to 1981, on 1 April 1984, as a public limited company wholly owned by the UK Government. The transfer of property, rights and liabilities of the corporation to British Telecommunications plc was made on 6 August 1984.

BT Group plc is the listed holding company for the BT group of companies and was formed when the mmO2 business (comprising what had been British Telecommunications plc’s mobile activities) was demerged on 19 November 2001. It is listed on the London and New York stock exchanges. It is one of Europe's leading providers of telecommunications services. Its principal activities include local, national and international telecommunications services, higher-value broadband and internet products and services, and IT solutions. In the UK, BT serves over 20 million business and residential customers with more than 29 million exchange lines, as well as providing network services to other licensed operators.

As a global communications provider, BT offers a full range of services, including local, national and international telecommunications services, high-value broadband and internet products and services, IT solutions and customer support.

There are three main parts to BT’s strategy. First is its customer-oriented approach. Second, they have broadband focus at the heart of BT as they want to decrease their level of dependence on their fixed landline segment. Third; they strive towards having rigorous financial discipline. BT seeks to deliver the highest levels of customer satisfaction performance and reduce the number of dissatisfied customers each year while achieve organic profitable revenue growth, while carefully controlling capital expenditure. They seek to be cost leaders while transforming their network for the 21st century.

BT’s business is affected by a number of factors, ...

This is a preview of the whole essay

BT’s business is affected by a number of factors, not all of which are wholly within BT’s control e.g. occurrence of a natural calamity. Although many of the factors influencing BT’s performance are macro economic and likely to affect the performance of businesses generally, some aspects of BT’s business make it particularly sensitive to certain areas of business risk. If BT’s activities are subjected to significant price controls, its market share, competitive position and future profitability may be affected. It also faces strong competition in UK fixed network services, as regulators have promoted competition in this area by allowing BT’s competitors to site equipment in or adjacent to its exchanges to make it easier for BT’s customers to route some or all of their calls over competitors’ networks.

Deal Rationale:

BT demerged its Wireless business, which included its mobile operator division BT Cellnet, in a major restructuring move with effect from 19th November 2001. The step was taken under the direction of the CEO Sir Peter Bonfield, amid a concerning rise in debt levels of the group and widening divergence of interests with the BT wireless division headed by Peter Erskine. There seemed to be a conflict in the strategy of the BT group, whose core business is in fixed landlines, and its Wireless division operating in technologies like the mobile phones which are increasingly a substitute for the formers product. By this move, the shareholders of the BT group received 1 share in the newly listed mmO2 (previously the BT mobile phone business) for every share held in the existing BT Plc. Based on the first day's dealings on the London Stock Exchange, BT Group represented approximately 78% of the equity value of the former BT group and mmO2 represented approximately 22%.

Pre Spin-off performance:

The BT group had been witnessing a dissipation of its return on equity which fell from 18.69% for year ended 31st march 1997 to 13% for ended 31st march 2000, before turning negative in year ended 2001 at -12.87%. This was mainly due to rising competition from substitute mobile networks like Vodafone and Orange, dilution of market share as a result of pressure from the UK telecom regulatory body Ofcom, as well as increased leverage in the capital structure and the high capital expenditures connected with the procurement of the 3G mobile licenses. The following table provides some key ratios for BT and its competitors for years 1997-2003.

Although BT’s revenues during this period were rising at an increasing rate, its asset turnover was falling significantly mainly due to the increase in non-income generating assets on account of the goodwill paid on acquisitions (mostly overseas) and expensive telecom licenses. However the asset turnover levels remained competitive on average with the industry comparables.

Its interest coverage ratio was also becoming worse due to mounting debts. The group debt-equity ratio rose to 2.197 for year ended 31st march 2001, up from 0.442 year ending 31st march 1998. The increase in borrowings between 31st march 2000 and 31st march 2001 itself was nearly £19.2 bn.

Considering the flux BT was in, its management undertook a wide restructuring plan to reduce debt and spin-off divisions that were not ‘non-core activities’ and in the management’s opinion, unreliable for cash flows and concentrate its focus on the broadband business in the fixed line division. In its annual report, it stated a goal of reducing its debt by atleast £10 bn by 31st December 2001 and ‘create a new holding company to enhance corporate flexibility, and provide scope for further subsidiary floatation’s where advantageous to shareholders’.

The decision to demerge BT Wireless was taken in view of the tough competition in this segment from other Mobile operators. There was also an increasing threat of new entrants resulting from sale or additional issue of licenses and available spectrum. Fast changing technology environment and high levels of required investment also contributed in making the business more unreliable. Other factors included – continuing downward trends in prices, reduction in switching costs resulting in more power in the hands of the customer, difficulty in keeping high retention rates and slicing up of the market share. In short, the management were not very confident about the future of BT Wireless and wanted to keep any future adverse impact of the division off its Balance sheet and Income statement. Already the group was feeling the pinch of the high payment for the 3G telecom licenses. The management also had some concerns over health studies showing harmful radiation to users of mobile phones that they thought might affect consumer demand and increase chances of legal compensation suits.

Besides the spin-off, the comprehensive restructuring plan included:

Reduction of net debt by approximately £10 billion and Rights Issue of approximately £5.9 billion.

Separating the UK fixed network business into two businesses (wholesale and retail).
Create a new holding company called Future BT (this was actually named BT Group Plc.) for corporate flexibility and to facilitate other potential acquisitions, demergers, disposals and IPOs. This was to be created at the same time as the demerger of BT Wireless.
Future BT would comprise mainly of four separately managed businesses, namely BT Retail, BT OpenWorld, BT Wholesale and BT Ignite. The goal for Future BT was to focus on the European network and retail business concentrating on voice and data services and also to develop and market higher value broadband and internet products and services.
Sell off holdings in various other companies e.g. Japan Telecom, J-Phone, Airtel etc. to finance the debt reduction program.
Halt dividends for the time being.

Market reaction to spin-off:

The announcement of the demerger along with a massive rights issue was made on 10th of may 2001. In our analysis, we have carried out an event study to observe the impact of announcement of BT’s spin-off on its share prices. . We have used the FTSE 100 as our benchmark index. The daily share prices and FTSE 100 data for the period -241 to +40 have been obtained through datastream. We have then used this daily share price and the FTSE 100 to compute the return on share prices (Rt) and the return on market (RMt). The abnormal return has been calculated by first calculating the Expected return E(Rt) by using β (beta) equal to 1 and α (alpha) equal to 0. The difference between the return on share price (Rt) and expected return E(Rt) is the abnormal return (ARt). The abnormal return is now used to compute the T-test. The results for period -2 to +2 is shown below:

Before we actually go on to analyse these results it is important to mention at this point that on the announcement date T0 (10/05/2001), BT also made another announcement regarding a rights issue. The reason behind the rights issue was to provide greater financial stability and to help cut debt. The expectation was to cut debt by £ 5.9 billion. The record offer made in the Rights Issue was 3 for 10; that is, an offer of 3 new BT shares for every 10 BT shares held at the close of business on 9th May 2001. The Issue Price represented a 47 percent discount to the closing middle market price of 568.5 pence per BT share, which was 300 pence.

BT shares tumbled 7% in morning trading as investors digested the news but had recovered to 544p - to be 4.3% down on the day - by 1335 GMT.

It is reasonable to say that the market took the huge rights issue as an indication that something was really wrong in BT’s position and this would explain the powerful negative reaction. It could be speculated that the management deliberately timed the announcement of the demerger to mitigate the powerful negative impact of the rights issue. The joint announcement of the demerger could be interpreted as a signal to the market that BT’s management was taking major steps by undertaking restructurings to tackle the problems effectively. However, the dramatic drop in BT share price suggests that the market remained sceptical of BT’s future and strategy.

Post Spin-off performance:

After the spin-off and the other restructurings, BT saw a substantial improvement in their financial performance, with across-the-board improvements in key indicators such as return on capital employed, asset turnover, interest coverage and dividend coverage. In the year ended March 2003, their return on equity ballooned to a whopping 101%, compared to its nadir of -12.65% in 2001. By the financial year end 2002, it had also managed to it reduce its net debt to £13.701bn from £27.942bn in the previous year, even though they were able to transfer only £500m of their debts to mm02, as opposed to the previously planned £2bn.

In 2002, it also restarted its dividend payments, paying out 2 pence per share. The dividend payout has been increasing thereafter, amounting to 6.5 pence for the financial year 2002/03. BT has also announced that it expects to increase its dividend payout for the following years. For 2003/04 it expects to payout 50% of it earnings as dividends, and anticipates that by 2005/06 it will increase the payout to 60%.

BT Group vs. Telecommunications Sector (event study period) :

As we have shown previously through our event study, the restructuring announcements were met by scepticism which led to a negative price reaction. Although the price performance for BT was better than that of the telecommunications sector and some of its competitors in the fixed line business, in the long run BT has tended to under-perform against the whole telecommunication sector. This may be because of the stronger performance and relative dominance of the mno wayobile phone business in the telecoms sector, since compared to some of its competitors, BTs performance in the long run remains strong. Significantly though, BT continues to under perform against the FTSE 100 from the announcement day to date.

Looking at BT, we propose that BTs poor performance against the FTSE 100 may be explained by the following:

BTs high dividend payout policy for the immediate future signifies that although it is making profits and generates sufficient cash, the fact that the cash is being distributed to the shareholders reflects low growth opportunities; and

Due to the increasingly competitive nature of the business and increasing deregulation of the telecom sector by Ofcom as it continues to dismantle BT’s monopoly, as shown in our industry analysis. BTs profitability is under considerable threat because of the potential for loss of market share and wholesale fixed line revenues.

The above would also explain why BT shares are currently traded at a P/E multiple of 10.9, below the industry average of 23.30

Conclusion:

The spin-off was a good idea - as observed in our report earlier by BTs moderate financial recovery - after the restructuring BT decided that rather than diversify its businesses, it would reinforce the fixed line segment. That is why implementing a broadband network is a key element of its strategy. This makes more strategic sense since broadband, or fibre-optic networks, support both voice and data content, which therefore makes telephony and internet access natural by-products of each other without incurring high incremental capital expenditure. BT believes that this will create operational synergies that will add value for the shareholders.

Spinning-off the wireless segment has not spelt the end of troubles for BT. There are still quite a lot of potential pitfalls ahead, not least of which are rumours in telecom circles that the media to telecoms regulatory authority Ofcom might split up BTs wholesale operations from its retail operations. Still more, the directive from Ofcom on local loop unbundling, i.e., to cut tariffs on exchanges for wholesale customers, threatens to result in further declines in BTs revenues. Moreover, industry deregulation and substitutes such as Wi-fi, which allows users wireless internet access, and Voice over Internet Protocol (VoIP), which lets users make telephone calls through the internet, thereby by-passing the traditional exchange system (which some experts believe to be the “next big thing” in IT) are a threat to both BTs internet and telephony business. However, because of the spin-off, a leaner and more focused BT may be in a better position to face the challenges ahead.