UK Financial mis-selling at its worst

I am one of 20 or so people who made written representations to the FSA after the members of the Britannia Building Society had voted to approve the merger of the society with The Co-operative Bank Ltd.

Setting aside that the transaction is strategically wrong – why does the UK’s #2 building society by assets need help when it complies with the FSA’s capital requirements? – the transaction was mis-sold.

The bulk of documentation and all the publicity surrounding the “merger”, referred to a merger between the society and Co-operative Financial Services Ltd. This is incorrect and misleading. The CFS is the owner of the eponymous bank, but as anyone in business knows, a holding company is a separate legal entity from a subsidiary. The transaction was described as a merger with the holding company; the vote was for a merger with its subsidiary.

Merger implies that the parties merging are broadly equal and that shareholders in each party will end up with an ownership interest in the merged entity. This is not the case here as Britannia members will have no interest in the enlarged bank. Society members are being offered membership of the Co-op Group but this is the holding entity for CFS. Returns to society members will therefore be diversified and diluted not only by the Insurance business of CFS but also by the returns from Somerfield/Co-op supermarkets, housing development, undertakers and pharmacies, to name but a few.

The accounting for the transaction is a straightforward transfer of the net assets from the Society to the Co-op bank. At the end of December 2008, the net book value of the Society was GBP881 million – and this, in effect, is simply being given to the Co-op Bank’s shareholders. I am not expecting a windfall payment but for the Society’s board to imply that giving away the Society at a cost of over GBP200/member (assuming 4 million members) was the best deal they could get, is suspiciously mendacious.

Of course the representations to the FSA will be considered – but ignored. The documentation for the deal was passed to FSA for its prior approval. But just in case someone there has forgotten the definition of mis-selling, I attach the link to the FSA’s website.
http://www.fsa.gov.uk/Pages/Library/Communication/PR/2003/052.shtml

Should it still be signed off by the FSA, it will no doubt be discussed at a higher place. The Treasury Select Committee will bare its teeth and get to the bottom of the matter and then, led by its Chairman, John McFall MP, decide that apart from a couple of slapped wrists, it is all hunky-dory.

Did I mention the Co-op Party? Society members after years of no political donations will now find that the new owners of their assets are funding the Labour party. The Co-op Party has 29 MPs who stand as Labour Co-op members.

Labour Co-op is abbreviated to Labour even on official documentation. How do I know? The published list of members of the Treasury Select Committee describes the following:- Rt Hon John McFall MP (Chairman), West Dunbartonshire, Labour.

Society members are being undertaken to the cleaners.

British Airways gliding to oblivion

I came away from yesterday's BA AGM feeling that this company is headed the way of the old US carriers. Its cost base is simply too high. It is the airline equivalent of GM; its pension liabilities (but a relatively modest healthcare liability) prevents it from competing effectively with its Asian counterparts or domestic greenfield operations. And this focus on the pension deficit and wage cost is almost to the exclusion of everything else, including ways that revenues might be increased.

BA provides nothing in the way of segmental financial information other than revenues by regional source. At least the monthly operating statistics split the world into four geographic area. No further disclosure is provided in case it is of potential help to competitors. So when asked at the AGM about the relative profitablility of its european and international operations, there was some obfuscation. There was no clear answer according to management, due to the high level of transfer traffic, up to 60%, filling the long-haul flights.

However, when the relative profitablility of Calcutta and Hyderabad services was discussed or the reasons for reducing flights to Poland, the Board claimed to have the numbers to know that they were doing the right thing.

If the transfer traffic muddies the revenue picture then BA's costs are equally shrouded in cloud as the variable element of total is relatively small compared with other airlines. Allocating fixed costs to particular routes or services becomes an art.

One shareholder suggested that BA should price closer to its marginal costs in order to fill its aircraft and at least get some contribution towards its massive fixed costs. Perhaps the problem here is that Ryanair and Easyjet are already pricing at these levels and making a profit. BA cannot compete with the low-cost carriers.

BA cannot sensibly compete with other premium operators. On page 21 of the latest annual report and accounts, there is a picture of an Airbus A380 in BA livery. The report notes that three airlines are operating this aircraft into Heathrow and that "the aircraft offers them the chance to enhance their products". But the picture is misleading; BA is not operating the A380. It is in fact delaying the entry into service by at least 5 months. When it eventually enters service in 2012, that will be a mere 4 years later than its key competitors on eastern long-haul routes.

So if the A380 is so good and BA wants to be a leader in premium traffic, why defer it? Why not instead sell some of the mothballed B747 and try and get some earlier slots on the A380 delivery schedule? It is a good passenger aircraft compared with the B747; in economy the seats are wider, legroom can be longer and cabin pressure higher (about 5,000ft equivalent vs 8,000ft). If the A380 is not as profitable as a B777-ER, for example, as may well be the case in the current market environment when bigger means harder to fill, then cancel the orders. If it is a viable proposition, buy it sooner rather than later. Even Singapore Airlines is now finding use for them on sub-four hour regional sectors in competition with LCCs.

In the current quest for revenue, as several shareholders pointed out, BA does a good job of scaring customers away. If it's not the unions threatening some action then it's Mr Walsh suggesting that the business might fail (make sure you buy tickets with credit cards if you have no trip insurance).

So what supports the great company. It doesn't believe in government subsidies but it is quite happy for other barriers to entry to persist such as landing rights or for others to build infrastructure on its behalf. BA are rightfully delighted with Heathrow Terminal 5 and the improvements in service levels are palpable according to their statisitcs. (I've not used T5. Since SQ introduced the A380 and coupled with a change in occupation, I've not flown with BA since 2006. Anyway pressure on T3 seems to have abated with the opening of T5). Furthermore, it is probably only BA that wants the third runway at Heathrow.

Nevertheless, BA's western long-haul business is also under the cosh. Following the end of the cosy foursome arrangement on the UK-US routes in March 2008, rival airlines are considering new point to point transatlantic routes or even new hub opportunities. Perhaps it is fortunate that the EU-US open skies agreement happened at a time of declining air traffic, making it more challenging for new players to start a new route, but it is once again forcing BA to look for a partner(s) such as American and Iberia.

As for the financials. For some reason shareholders were asked to approve special resolution 7, the allotment of new shares by placing or rights issue before special resolution 8 which created the headroom in authorised capital - cart before horse? Never mind, all resolutions were passed.

And the rights issue. The Board insisted that a rights issue was not planned and that a convertible bond was being considered instead with institutional investors. It seeks to maintain liquidity equivalent to 15% of revenues and it is already above this level. (1.38bn cash and equivalents at FYEMar09 vs revenue of GBP9.0bn.) However, the CB - diluting existing equity by no more than 7.5% if a shareholder meeting is to be avoided, would help to cover any further deterioration in operating conditions.

But 7.5% of the shares in issue is only 86.5million new shares. Based on a current share price of 128p, the conversion premium would need to be very large just to raise GBP200m. The issue of 9.75% convertible capital bonds (2005) in FY1990 raised GBP320m and represented a potential 18.3% of the then issued share capital. It looks like the proposed CB may need to be on a rights basis in order to raise a sensible amount of money at a sensible price.

But all is not well; we are still in a period of rising unemployment, rising oil prices and with BA's unions fighting to minimise job losses (3,700 further losses in the current FY). On top of that, there is the result of the triennial pension funds valuation after which the company's contribution level will be reassessed. The rating agencies are on top of the situation for once - both coming down a notch in the last few months to Ba1/BB. The company thinks the rating downgrades will have limited impact on its access to funds; it has committed facilities and adequate cash for 12 months of operations. However, the cost of hedging will now reflect a higher counterparty risk.

The company is in a stall but it is trying to regain control simply by pushing the cost stick forward. A stall can be recovered this way, but having a few revenue generating ideas to power the recovery might make the difference between meeting the ground hard and scraping the paint on the belly. Time to ring the broker and make sure that I'm not permitted to attend next year's AGM.