- Elliott Advisors is actually right in its critique of SSE – financing costs don’t go away in a conglomerate
- This doesn’t mean that SSE is right, or even wrong, it’s just a fact that needs to be understood
- If a business has a high financing cost then that business has a high financing cost
Something that we all need to understand about investing. Actually, about the world as a whole – prices are information. This information doesn’t go away nor is it refuted by changing who is paying the price.
This is the background to the argument between SSE PLC (LON: SSE) and Elliott Advisors. Leave aside all the details here and just think instead of the basic structure.
SSE consists of two divisions. There’s the retail power supply business which – assuming it has hedged properly against gas prices this winter – produces steady if not terribly exciting profits. Then there’s the growing renewables business. This is – at one level of accuracy – a build out of vast North Sea wind farms.
OK, so the wind farms need substantial investment, money comes back in at some point in the future. This is fine. We do need to invest in order to be able to make a future profit.
The SSE case is – again, stripped right down – that the profits of the retail business should be used to finance the building of the wind farms. This is conglomerate thinking, that money earned in one area should be used to finance another. The clinching argument is that if the wind farms had to raise money directly on the market then they’d face a very high cost of capital.
The Elliott point is that if the windfarms had to raise money directly on the market then they’d face a very high cost of capital. They do at least agree upon that.
The reality here being that prices are information. The price for capital for the wind farms is high. That’s just reality. So, whoever pays it – and changing who does, doesn’t change how much – the cost of that capital is high.
At which point, well, we could do this one of two ways. The shareholders could forgo those profits from the retail arm so that the wind farms are financed. Or, the company could be split. At which point the retail arm profits are paid to shareholders and they – or perhaps other investors – provide the capital to build the windfarms at that higher price.
Essentially, SSE is saying keep it within the one company, make the shareholders subsidise building the windfarms through lower returns. Elliott is saying no, don’t do that, pull it apart and make it all obvious without subsidy.
To the economist which path to follow depends upon the cost of raising capital. Not the price that must be paid for it, but the friction costs of how to raise it. These costs are currently rather low so probably the economically efficient way is to follow Elliott Advisors.
However, that’s not conclusive, what should happen is up to the shareholders, of course it is. The point being made here is that those high costs of capital for the wind farms don’t go away because of that financing from the retail side. We’ve just changed who pays them – current shareholders or future ones in the windfarms alone.
This being something we’ve got to remember when investing. If there are costs then someone, somewhere, is going to be paying them. Switching who it is doesn’t change the existence of those costs. This is the very argument driving this campaign by Elliott Advisors over SSE. Disguising the costs in the conglomerate is just disguising them, not changing them.
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