Excess capital and negative spread

Geoffrey Colvin, the star of our last post, is once again delivering basic finance concepts to the masses in his all-too-short article on the AT&T- BellSouth merger. Believe us, basic is the level that many corporate finance & management teams are working at, so Colvin is doing shareholders a favor (we can assume a broad overlap of share owners with Fortune readership).

Colvin adds up the invested capital of the two businesses (a total of $280 billion) and uses their WACCs to calculate the weighted capital cost for the combined entity. Unfortunately for shareholders, he calculates that cost to be $25.5 billion a year. (NB: Colvin uses NOPAT, and in a future post, Mike Princi will comment on the differences for this analysis between using NOPAT, as Colvin does, and NOPLAT, which ThoughtStorm typically uses.)

More simple math follows, which has apparently escaped everyone whose bonus doesn’t rely on the completion of this deal. Since both AT&T and BellSouth are woefully underperforming, there’s little evidence that the combined company can get a 200% improvement in operating performance (currently $8.5 billion) out of the merger. We’d have to do a lot of digging, but if anyone can find a large company merger that produced anywhere this kind of operating synergy, please drop us a line.

It may be obvious and “simple” analysis, but Colvin’s matter-of-fact approach has impressed us in this article. These truths are apparently not self-evident, and he does a great service to the investing community.

Speaking of investments, what might an equity investor (long or short) do in the face of this analysis? Well, classic merger arbitrage strategy says short the buyer (AT&T) and go long on the seller (BellSouth). In fact, Colvin notes that AT&T’s share price is down since the announcement. Merger arbitrage, in spite of its one commandment, seems to be pretty successful: we’ve come across more than one fund using this strategy that has been able to convince investors to pay hedge fund rates for this advice.

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