Should BT now trash the MCI acquisition?

`How it was that BT's own due diligence and researches failed to reveal these things is one issue. It certainly beggars belief that the first BT directors knew about all this was when they attended an MCI board meeting last Wednesday'
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The Independent Online
When things go wrong for a company, they tend to do so in spades. Already hit by the windfall profit tax and the abolition of tax credits on dividends, BT now finds itself in dire straits over its yet to be consummated merger with MCI of the US. Sir Iain Vallance and his chief executive, Sir Peter Bonfield, will find it mighty hard to extricate themselves from this one without loss of value, as the precipitous fall in BT's share price already bluntly predicts.

The bottom line is that MCI's already high-risk plunge into the newly deregulated local US telecoms market is going to cost at least $1.2bn more over the next two years than everyone thought, this at a time when growth in MCI's core revenue earning long distance market is beginning to taper off with a speed nobody anticipated when the terms of this deal were struck.

How it was that BT's own due diligence and researches failed to reveal these things is one issue. It certainly beggars belief that the first BT directors knew about all this was when they attended an MCI board meeting last Wednesday. You might have thought they would have had their ears rather closer to the ground than that. The more important immediate question, however, is what they are going to do about it.

MCI seems already to have made up its mind to proceed with the extra investment, and for the time being BT is powerless to halt the process, even if it takes the view that the big push into local telecommunications has become uneconomic. BT would in any case be hard pressed to oppose MCI's plans, since they are so much a part of MCI's strategy for the future and formed such a key part of BT's sales pitch to the City.

This was a deal launched by BT on a gale of optimism and bravado, which I have to confess, I fully fell for at the time. The mindset of management in circumstances like these is to push ahead at all costs, even though the short to medium-term impact on their share price might be highly damaging. Powerful egos and ambitions depend on this deal going ahead. All the same, there is plainly no longer any question of this happening, as one seasoned institutional investor remarked yesterday, without a considerable downward renegotiation of the price.

The trouble is, MCI may not be prepared to play ball, and even if it is, it is no longer clear that MCI is the right acquisition for BT. Certainly a thorough process of re-evaluation is needed before proceeding any further. To go ahead after a warning like this one requires the most fundamental and searching of reappraisals. In a sense BT is lucky that US regulators have taken so long to approve the deal, because at least it now gets that chance.

Pulling out entirely, something which Sir Peter says has not yet even remotely crossed his mind, itself carries a considerable cost. MCI insisted when it signed the deal on one of those "heads we win, tails you lose" clauses beloved of Wall Street corporate financiers. In BT's case, it means paying MCI up to $450m in compensation should it wish to trash the deal.

The question BT's non executive directors must now address is whether this might none the less prove the cheaper option. There is a small, though quite vocal, minority in the City which has long taken the view that the MCI acquisition never did amount to anything more than an earnings-dilutive pig in a poke. How does buying into the increasingly competitive US domestic market further BT's aim of becoming a global business telecommunications service provider, it is asked. The money could be better spent on smaller bolt-on acquisitions in the business telecoms market, and on buy-backs and enhanced dividends. That view, though still not one I would wholly go along with, will have been much strengthened by yesterday's revelations.

It would be wrong to talk in terms of insurrection yet, but certainly the City is falling out of love with the new Government quite markedly at the moment. At City lunch tables, the talk is of "unravelling", a Budget that was bad for business and bad for the City, and of the Chancellor going a step too far in his reforming zeal.

Actually this new mood of hostility probably has more to do with the City reverting to its traditional, true blue, political colours than anything else. After a period when nobody really knew what to think about Labour's landslide victory, City people are beginning to find their tongues once more, and since, for a change, not everything seems to be going the Government's way right now, they are becoming increasingly bold about it. I kid you not, for many, the final straw was the Prime Minister saying he was going to vote against fox hunting.

It takes quite a leap to get from fox hunting and the problems of Northern Ireland to the Chancellor's handling of the economy, but that hasn't stopped some people making it. The Chancellor didn't do enough in the Budget to cool the consumer boom, is the general criticism. Furthermore, the abolition of tax credits on dividends was an ill thought out piece of vindictiveness, the argument goes, whose effect will be to impose a hidden tax on business and clobber the City.

On the latter point, the City is probably right. But the more general observation that the Chancellor is failing the economy is not really supported by the evidence.

It is important here to ignore what the City is saying, which often amounts to little more than self-interested waffle, and look instead at what it is actually doing. Since Labour came to power, the FTSE 100 share index has gone up more than10 per cent, and despite three rises in short-term interest rates, long gilt yields have gone down. That in itself is quite a vote of confidence in what Gordon Brown is doing.

But the most powerful evidence of improved international confidence in the British economy, and in Labour's ability to manage it, is the strength of sterling, which touched three German marks to the pound yesterday for the first time since the autumn of 1990. Admittedly, this has quite a lot to do with the fact that Britain is ahead of Germany in the business cycle. As a consequence, its interest rates are going up sharply at a time when Germany's are stuck at a near recessionary low point. The changing fortunes of European monetary union accentuate the position by making the pound an attractive hedge against a weak euro.

There's plainly more to it than that, however. International investors would not be piling into the pound unless they believed Britain's relative economic position had changed. So although Gordon Brown's first Budget was arguably a bad one for business in the sense that it disproportionately hit the corporate sector, the judgement of markets is that the broad fiscal and monetary framework being established by Labour is rather more healthy than what went before. It seems that the City backlash against the new Chancellor is rather more apparent than real. Tally ho!