2. INTRINSIC VALUE AT ENTRY

The following part will apply the three step valuation approach described in the book “Value Investing” by B. Greenwald et al. (2001) to determine DT’s intrinsic value that might have been the foundation for Blackstone’s investment decision. First, DT’s assets will be valued with Graham & Dood’s net-net, book value and reproduction value approaches. Second, the earnings power value will be calculated. The third step deals with the potential value of DT’s growth.

2.1. Asset valuation

2.1.1. Graham & Dood net-net

The Graham & Dood net-net approach proposes to subtract all liabilities from current assets to determine the asset value. ⁸ As per Table 1, in DT’s case this approach would result in strongly negative asset values for the last three fiscal years and for Blackstone’s entry on 24 April 2006. ⁹ In addition, these net-net asset values show no connection to the respective market values of equity. Hence, Graham & Dood’s approach does not seem feasible for determining DT’s intrinsic value.

Table 1: Asset value according to Graham & Dood net-net 10

2.1.2. Book value

Table 2 lists the book values of shareholder equity for 2003 to 2005 and for Blackstone’s entry date and compares them with the market value of the equity. ⁹ Interestingly, the market to book ratio declined by 25% to 1.19 from December 2004 to April 2006 although liabilities were almost stable at €78-79bn. This development indicates that capital markets have must have grown increasingly skeptical with regards to DT’s performance.

Table 2: Asset value according to book value approach 11

⁸  B. Greenwald et al. (2001), Value Investing, (Hoboken, NJ: John Wiley & Sons, 2001), p. 36.  

⁹  Note: DT published its Q1 2006 results two weeks after Blackstone acquired its shares. For this reason, all  book values for assets and liabilities are identical for 12/2005 and 04/2006.  

¹⁰  Deutsche Telekom, 2005 Annual Report, p. 105, http://envgdtag05.sul.t‐

online.de/gb05/backstage_04/documentpool/en/en.pdf, accessed April 2011 and J. Golob, N. Raithatha, S.  Weeden and J. Sawtell, “Upgrade to In‐Line as KfW sells 4.6% of DT to Blackstone”, Goldman Sachs, April 24,  2006, p. 1. 

¹¹  Ibid.  Page  2   

2.1.3. Asset reproduction cost

The reproduction cost approach tries to estimate how much it would cost a potential competitor to replicate the company to be valued. ¹² To do so, the asset side of the company’s balance sheet was taken as a starting base and then adjusted for several positions. As shown in Table 3, four adjustments were made to DT’s asset book values in order to arrive at the total reproduction value of assets of €171.8bn.

Table 3: Reproduction value of assets 13

First, €0.787bn of impairment losses on loans and receivables ¹⁴ were added to trade and other receivables because any new entrant would face similar or even higher allowances for bad debt on his receivables account. Second, current recoverable income taxes were expected to be cashed in within one year and hence discounted to present value. ¹⁵ Third, non-current deferred tax assets were discounted to present value. Almost all of these tax credits were to expire after five years or later. ¹⁶ Earnings before taxes in 2005 amounted to €6.2bn. ¹⁷ As the combined income tax rate for DT accounted for 39%, without tax credits DT would have had to pay taxes of €2.4bn in 2005. ¹⁸ For the present value calculation of deferred tax assets it was hence assumed that DT would make use of 1/3 of its total tax credits of €7.552bn in each of the next three years, which after a corresponding present value calculation resulted in a total discount to book value of €0.846bn. Fourth, according to B. Greenwald et al. (2001) new entrants would have to establish or buy customer relationships that are not accounted for on balance sheets. For this reason, the authors suggest adding one to three times annual selling, general and

¹²  B. Greenwald et al. (2001), Value Investing, (Hoboken, NJ: John Wiley & Sons, 2001), p. 55.  

¹³  Deutsche Telekom, 2005 Annual Report, p. 105, http://envgdtag05.sul.t‐ online.de/gb05/backstage_04/documentpool/en/en.pdf, accessed April 2011. 

¹⁴  Ibid., p. 143. 

¹⁵  The discount rate of 6.2% will be derived in the following earnings power section. 

¹⁶  Ibid., p. 138. 

¹⁷  Ibid., p. 104. 

¹⁸  Ibid., p. 138.  Page  3   

administrative expenses to the reproduction costs of the assets. ¹⁹ At the end of 2005, DT had customer relationships with 8.5m broadband, 41.2m narrowband and 86.6m mobile phone subscribers. ²⁰ Due this broad subscriber base and DT’s incumbent position in Germany, three times the 2005 expense for marketing and selling of €14.7bn ²¹ was added to the adjusted asset value. Due to the commodity nature of the telecom business, no further adjustments were made for research & development costs.

In order to make the resulting reproduction value of assets of €171.8m comparable to the current market capitalization, three different categories of adjusted liabilities as well as excess cash needed to be deducted as displayed in Table 4. 22

Table 4: Equity required for reproduction 23

The first category are so called spontaneous liabilities such as trade and other payables which stem from normal conduct of business and incur no interest expenses. DT’s spontaneous liabilities were adjusted for €1.207bn current and €0.484bn non-current investment, litigation, reimbursement and other provisions. ²⁴ The sum of these two positions of €1.691bn can instead be found in the second category of circumstantial liabilities because it was caused by circumstances special to DT that could be avoided by new entrants. The third category of liabilities that needed to be deducted was current and non-current financial liabilities amounting to €46.7bn. Finally, in line with the

¹⁹  B. Greenwald et al. (2001), Value Investing, (Hoboken, NJ: John Wiley & Sons, 2001), pp. 61‐62.  

²⁰  Deutsche Telekom, 2005 Annual Report, p. 29 and p. 36, http://envgdtag05.sul.t‐ online.de/gb05/backstage_04/documentpool/en/en.pdf, accessed April 2011. 

²¹  Ibid., p. 104. 

²²  B. Greenwald et al. (2001), Value Investing, (Hoboken, NJ: John Wiley & Sons, 2001), pp. 63‐64.  

²³  Deutsche Telekom, 2005 Annual Report, p. 105, http://envgdtag05.sul.t‐ online.de/gb05/backstage_04/documentpool/en/en.pdf, accessed April 2011. 

²⁴  Ibid., p. 166.  Page  4   

assumption of B. Greenwald et al. (2001) that most businesses only require a cash balance of 1% of sales for their operations, €5.6bn of excess cash were deducted.

The resulting equity required for reproduction of €88bn is comparable to DT’s current market value of equity of €58.8bn. The fact that the market to reproduction equity value ratio amounts to only 0.67 indicates that from a reproduction of assets perspective DT was trading at a discount of 33% and hence could indeed be considered undervalued.

2.1.4. Conclusion

In this section on asset valuation, it was found that DT’s market to book value of equity ratio stood at 1.19 at Blackstone’s entry and had decreased by 25% over the last 15 months. In addition, DT’s current market capitalization amounted to only 67% of the equity required for its reproduction of assets. Combined, these two observations indicate that DT was trading at a significant discount to its reproduction asset value and that this discount had increased over time. The next section will explore potential reasons for this development.

2.2. Earnings power value

According to B. Greenwald et al. (2001), the earnings power value (EPV) is designed to estimate the value of a company’s current earnings properly adjusted. ²⁵ First, a cash flow adjusted earnings number representing a sustainable level of future cash flows excluding growth has to be derived. Second, multiplying this cash flow adjusted earnings number by the factor of (1 / cost of capital) yields the earnings power value.

2.2.1. Cash flow adjusted earnings

As shown in Table 5 below, the starting point for deriving cash flow adjusted earnings was DT’s 2005 reported profit from operation of €7.622bn. 26

Table 5: DT’s cash flow adjusted earnings

However, the reported EBIT includes negative one-time effects amounting €0.610bn from staff-related measures which were only partially offset by reversal of provisions. ²⁷ In addition, the reported EBIT includes an impairment loss on goodwill at T-Mobile UK of

²⁵  B. Greenwald et al. (2001), Value Investing, (Hoboken, NJ: John Wiley & Sons, 2001), p. 39.  

²⁶  Deutsche Telekom, 2005 Annual Report, p. 104, http://envgdtag05.sul.t‐ online.de/gb05/backstage_04/documentpool/en/en.pdf, accessed April 2011. 

²⁷  Ibid., p. 74.  Page  5