Europe's Treacherous Undertow

Falling bourses are dragging Corporate Europe down

Spin-offs. They've been a tried and true way for companies to raise cash for years now. That's why Deutsche Telekom (DT ), groaning under $67 billion in debt, decided two years ago to float a piece of T-Mobile International, its successful cell-phone division. But volatile stock markets meant that the time was never right. Now, following the latest slump in European shares, the German telecom giant has given up. "I don't rule out the possibility that the world will change," CEO Kai-Uwe Ricke said with disappointment. "But it would be wrong to expect we can solve our debt problems by listing T-Mobile on the stock exchange."

Indeed, the Continent's bourses have become the bane of Corporate Europe's existence. Germany's DAX stock index and France's CAC 40-stock index are down 69% and 60%, respectively, since global markets peaked in March, 2000, compared with a decline of 40% for the Standard & Poor's 500-stock index.

Deutsche Telekom is just one of scores of companies whose business strategies -- not to mention their profitability -- have been wounded by three years of tumbling share prices. And the list of casualties grows by the week. Companies are having to write down the value of acquisitions, reduce profits because of losses on stock they own in other companies, and shore up their stock-invested pension plans with billions of euros that a few years ago would have fallen to the bottom line. Fears of a war in Iraq, a litany of bad economic news from Europe and the U.S., and worries that the Netherlands' Royal Ahold may not be the only European company to have overstated its earnings have driven shares down to their lowest level in seven years.

Market watchers expect those prices to fall further. "That's bad news for the real economy as well as the financial sector," says Gwyn Hacche, a European economist at HSBC Investment Bank in London. "Companies as well as investors are being hurt by the market." For instance, DT is one of a dozen companies that would love to spin off divisions to raise cash, but cannot. Vivendi Universal had plans to pay down its $13.5 billion debt by selling shares in pay-TV subsidiary Canal+. Last month, Chairman & co-CEO Jean-René Fourtou said the scheme was "no longer on the agenda" because of market conditions. That heightens the pressure on Vivendi to dump its U.S. entertainment holdings, putting Fourtou in the unhappy position of being a distressed seller.

Hacche calculates that every 10% drop in share prices knocks 0.2 percentage points off European gross domestic product growth, due to the impact on consumer spending and companies' capital outlays. Although the retail equity culture is less developed in Europe than in the U.S., Old World companies tend to be more exposed to market gyrations. In part, that's because they own more stakes in other companies, often in the form of cross-shareholdings. For example, the past year's 76% slide in Vivendi (V ) shares has been bad news for Dutch giant Philips Electronics (PHG ), which holds about 3.6% of Vivendi's stock, and French building-materials manufacturer Saint-Gobain, which owns 1.1%. Last year, French Bank Société Générale took an $850 million charge to compensate for the shrinking value of its equity portfolio, which includes a 1.45% stake in Vivendi.

Likewise, the 76% slump in the share price of Munich insurance and banking leviathan Allianz (AZ ) has damaged the profitability of reinsurer Munich Re Group, its biggest shareholder. Partly as a result, Munich Re's stock has also taken a 74% dive over the past year, hurting the performance of its biggest shareholder, which just happens to be Allianz. "These cross-shareholdings produce a vicious-circle effect in which each company drags the other's earnings and share price down," says one Frankfurt banker. Munich Re also lost its coveted AAA credit rating.

For some companies, the market swoon is an invitation to a takeover. Take Roche Holding (RHHVF ). On Feb. 26, the Swiss drugmaker took a $3.8 billion write-down on its share portfolio, which sent it spiraling $3 billion into the red for 2002, even though the Basel company's core pharmaceutical business performed well. Its weakness could be fatal. Crosstown rival Novartis (NVS ) has been angling for a merger with Roche since taking a stake in the company in May, 2001, and is now increasing the pressure. Roche management is dead set against a merger, but shareholders -- dismayed by the 22% slump in Roche shares since the beginning of this year -- may have other ideas.

Meanwhile, falling equity prices coupled with declining bond yields are taking their toll on pension plans. Britain has been especially hard hit, since many companies there are still encumbered by old-style defined-benefit plans, in which the company pays a fixed monthly amount to the retiree for life. HSBC analysts reckon that the FTSE 100 companies have a deficit of as much as $150 billion in their pension portfolios because of the fall in the value of their equity holdings. That means that they have to scale back investment, cut dividends, and take money out of earnings to pay pensions. One of the hardest hit is BT Group PLC, which could see its pension shortfall rise to $8 billion this year -- up from $2.4 billion in 2002.

A growing number of Continental companies are also affected. Although fewer of them offer employee retirement plans that promise specific payouts after retirement, many do top up generous state-run pensions, often out of current cash flow. Those companies that thought they were safe investing their pension money in bonds are also hurting, with government bond yields slumping to record lows. In February, Deutsche Telekom issued a $2.5 billion mandatory convertible-bond issue just to fund its pensions.

In the meantime, rating agencies Standard & Poor's and Moody's Investors Service have downgraded their ratings of several European companies, including German steelmaker Thyssen-Krupp, because of their pension shortfalls. The lower credit ratings mean that the companies will pay more to borrow in the bond markets. Others have been put on credit watch. The situation could get worse. Karen Olney, an analyst with Dresdner Kleinwort Wasserstein in London, says that many companies are currently "sweeping the [pension] issue under the carpet by hiding behind unachievable assumptions" -- that is, they are overestimating market returns in the future to reduce anticipated losses.

As if that's not enough, market turmoil is bedeviling efforts to restructure. Credit Suisse Group (CSR ), the Swiss financial-services conglomerate, has found it much tougher to sell off noncore parts of its troubled Winterthur insurance operation because few buyers are willing to pay a reasonable price. Allianz has held onto most of its big industrial stakes for the same reason. The company, which has the largest portfolio of corporate holdings in Europe, had hoped to divest some of its shares. But Chief Financial Officer Paul Achleitner prefers to hold back. "It's better for our shareholders to wait until the capital markets are in better shape," he says.

If the bear market has turned retail investors away from equities, it has done the same for some corporations. Roche, for example, plans to reduce the proportion of stock in its investment portfolio to 10% from 24%. Zurich Financial Services has already reduced the stock proportion of its reserves to just 8%. That, of course, won't do anything to ease the pain. Indeed, it is likely to depress share prices further. This cycle is truly vicious.

By David Fairlamb in Frankfurt, with Carol Matlack in Paris, Kerry Capell in London, and Jack Ewing in Frankfurt

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