Blackstone's minority investment in Deutsche Telekom

Was Deutsche Telekom undervalued

when Blackstone acquired its minority stake?

Behavioral and Value Investing course paper by Robert Motzek

1. INTRODUCTION

On 24 April 2006, the private equity company Blackstone acquired 4.6% of the shares of publicly listed German telecom incumbent Deutsche Telekom (DT) at a share price of €14 for a total of €2.7bn.¹ According to Blackstone, DT was undervalued when compared to European peers.² This paper has three objectives:

1) To apply various established value investing valuation techniques to assess whether DT was indeed undervalued at Blackstone’s entry.
2) To explore which operational and share price performance Blackstone might have anticipated for DT in order to reach a typical private equity IRR of 25% over five years.
3) To review subsequent events and DT’s performance since Blackstone’s entry and to specify what would need to happen to at least recover Blackstone’s investment.

1.1. Company and shareholder overview

Deutsche Telekom is the German telecom incumbent and was Europe’s largest telecom operator with sales of €59.6bn in 2005. The company generated 57% of its sales in Germany, another 22% in other European countries (mainly the United Kingdom) and the remaining 20% in North America.³ In terms of business areas, mobile communications accounted for 48% of its revenues, broadband/fixed network made up 36% and business customers 15%.⁴

DT’s largest shareholder was the German government which held 15.2% of DT’s shares directly and controlled another 17.3% via the German state-owned bank Kreditanstalt für Wiederaufbau (KfW). The remaining 63% were held by a fragmented institutional and private investor base.⁵

1.2. Transaction details

Blackstone bought its stake directly from KfW at a 2.6% premium to DT shares’ trading price of €13.65, implying a total market capitalization of €58.8bn and an enterprise value of €97.4bn. In the fifth largest private equity investment ever observed in Germany, Blackstone agreed to a lock up period of two years to show its commitment as a long term investor. In return, it received one seat on DT´s supervisory board and KfW agreed not to sell any further DT shares within one year.⁶ 85% of Blackstone’s total investment was financed with a margin loan provided by Deutsche Bank.⁷

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

Abbildung in dieser Leseprobe nicht enthalten

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

Abbildung in dieser Leseprobe nicht enthalten

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

Abbildung in dieser Leseprobe nicht enthalten

First, €0.787bn of impairment losses on loans and receivables¹⁴ 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 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 €14.7bn²¹ 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.

[...]

¹ 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.

² P. Köhler and U. Sommer, “Flügel für die Phantasie“, Handelsblatt, April 25, 2006, p. 2.

³ Deutsche Telekom, 2005 Annual Report, p. IV, http://envgdtag05.sul.t- online.de/gb05/backstage_04/documentpool/en/en.pdf, accessed April 2011.

⁴ Ibid, p. 4.

⁵ “Blackstone-Einstieg zündet Kursfeuerwerk bei der Telekom“, B ö rsen-Zeitung, April 25, 2006.

⁶ J. Tartler, “Berlin erwartet steigenden Unternehmenswert“, Financial Times Deutschland, April 25, 2006.

⁷ A. Maier, “Vom Leid der Investoren“, Financial Times Deutschland, September 7, 2007.

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.

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.

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.