Oddo Securities-ESG Integration In January of 2009, John Keyes, portfolio manager for a medium-sized UK fund,...

  
 
 
   
 
 
 
 
 
 
 
 
 
 
 
 
 

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Oddo Securities-ESG Integration In January of 2009, John Keyes, portfolio manager for a medium-sized UK fund, reviewed the analyst report on the telecommunications industry he had just received from the French brokerage firm Oddo Securities (Oddo). Keyes was intrigued by Oddo's research, which provided two ratings of stocks covered, a financial rating and an environmental, social and governance (PSG) rating. Keyes was particularly struck by the returns generated by Oddo's ESG recommendations, which had outperformed most major stocks indices over the last five years. He reviewed the recommendations and analysis for two telecom stocks he was considering adding to his portfolio, British Telecom (BT) and France Telecom (FT). The Oddo analysis assigned BT its highest PSC rating (a Strong Opportunity) but rated the company as a "Reduce" in the financial recommendation. In contrast, FT was rated as a Moderate Risk under the ESC rating and a "Buy" for the financial rating, Keyes wondered how he should interpret these conflicting ratings, and which deserved more of his attention. Background on Oddo Securities Oddo Securities was owned by Oddo & Cie- an independent investment services firm that in 2010 had 900 employees, offices in Paris, Dubai, Madrid, and New York, and over €17 billion in assets under management. The firm was 80% owned by management, employees, and the Oddo family, and 20% by German-based insurer Allianz. It was headed by Philippe Oddo, whose family had been in the stockbroker business for five generations. In addition to its brokerage business, Oddo & Cie owned an investment bank, a financial advisory business, options and commodity businesses, a private bank, and an asset management unit. Oddo Securities was one of France's top brokers. The unit catered to an international institutional clientele providing brokerage services and research on a broad product range, including shares, futures, options and fixed income/credit. The research team, with 60 analysts, economists, and strategists, focused on the French and European market-equities, corporate bonds, and derivatives. The 5.momber prodit vocesuch term fomured on five incom and covered more than 120 1 capitalization of the France CAC 40 index, 89% of the DJ STOXX Euro 50 index and 60% of the DJ STOXX 600 index. ESG Investing and Analysis The use of ESC criteria for investing was a relatively recent innovation in the investment management industry and fell under the umbrella of socially responsible investing (SRI). SRI strategies could be broadly classified into five categories: negative screening, positive screening, integration, thematic, and engagement. Under negative screening, companies were excluded from investment portfolios based on ethical concerns about the safety of their products (e.g. tobacco, weapons, etc.) and their ethical standards of behavior. Positive screening identified companies with best-in-class ESG performance as investment candidates. Integration strategies focused on relations between ESG data, cash flows and/or cost of capital, and then embedded those relationships into valuation models. Thematic strategies followed either a multi-theme approach focusing on a broad range of long-term environmental or social issues (e.g. ageing societies, sustainable nutrition, clean energy, low-income solutions, urbanization, health, sustainable resources), or a hybrid approach. combining a large cap "best in class" universe with a thematic overlay. Finally, engagement represented a form of shareholder activism where investors sought to influence how companies addressed material ESG issues to protect and enhance the value of their investments. SRI investing experienced dramatic growth in the 1990s and 2000s. Between 2001 and 2007 assets under management of socially responsible investors grew by $400 billion in the US, $600 billion in the U.K, and $400 billion in Canada. In 2007, mutual funds that invested in socially conscious firms had assets under management of more than $2.5 trillion in the United States, $2 trillion in Europe, $500 billion in Canada, $100 billion in Japan and 564 billion in Australia. ESG Analysis at Oddo D ESG Analysis at Oddo In June 2005, Oddo hired Jean-Phillippe Desmartin to head its SRI initiative. Desmartin, who had started his career in financial engineering at Credit du Nord, a subsidiary of Societe Generale, and subsequently worked for several social and environmental rating agencies, was charged with developing a systematic methodology for SRI analysis at Oddo. He subsequently hired Sebastien Thevoux-Chabuel as a senior analyst in the initiative. Thevoux-Chabuel had been with Oddo since 2005 as a sell-side analyst on the European Technology sector and he had experience at Deutsche Bank and BFT, a subsidiary of Credit Agricole, as a buy-side analyst. ESG research at Oddo was divided into three broad areas, Environmental, Social and Governance (Exhibit 1). Environmental factors included environmental management, risks and opportunities. Social factors covered regulatory risks, the management of the firm's human resources, its reputational capital and brands, and its supplier and partner relationships. Governance factors included the firm's commitment to sustainable development (Le. using resources to meet human The CAC 40 was an index of 40 stocks traded on the Paris Stock Exchange. The Dow Jones STOXX Euro 50 Index represented 50 super sector market leaders in the 12 Eurosone countries Austria, Belgium, Finland, France, Germany Greece, Ireland. Italy, Luxemburg, the Netherlands, Portugal and Spain. The Dow Jones STOXX 600 Index was comprised of 600 highly capitalized and actively traded stocks listed and traded on stock exchanges from 17 European countries The authors calculated these numbers from information provided by national and international organizations that track socially conscious funds, such as Eurosif, Social Investment Forum, Responsible Investment Association Australasia, Social Responsible Organization, and SRI funds in Asia needs while also preserving the environment), adherence to corporate governance best practices, and business ethics. The Oddo SRI Research team, working in collaboration with the firm's sector analysts, used a multi-step approach to build separate ESG models for each sector. Under the first step, the analyst team assessed which ESG factors were likely to be relevant and material for firms in the sector. Once these constructs were identified, the team developed quantitative and qualitative metrics for each material factor. Finally, the analyst team determined appropriate sector-specific weightings for the metrics, enabling them to be aggregated into separate environmental, social and governance performance scores, and into a total ESG score. In explaining how the weightings were created, Desmartin noted that they are "intended to reflect the degree to which our ESG performance factors correlate with returns." Weights were estimated using historical relations between the sector's metrics/factors and its stock returns. The time horizon over which the historical relations were estimated ranged between 1 and 5 years depending on the availability of data. The ESG analysts at Oddo then used the sector metrics and weightings generated from this process to construct ESG scores for individual companies within the sector. Based on a company's aggregate score, Oddo issued one of four ESG recommendations (Strong Opportunity, Opportunity, Moderate Risk, or High Risk). Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the ESG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysts who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESC analysis and do not have control over the analysis." ddo's ESG approach was designed to provide investors with insights into a firm's management ilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial aj d ESG Integration 100% & Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the RSG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that: "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysis who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESG analysis and do not have control over the analysis. Oddo's ESG approach was designed to provide investors with insights into a firm's management capabilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial performance. The goal of the ESG analysis, therefore, was to allow clients to optimize the ratio of returns to risk. Desmartin explained the firm's approach and the type of clients it sought to attract: In practice we are very far from some of the ethical approaches used in the U.S. We do not exclude companies, we do not exclude activities, and we do not say what is good and what is bad. Ours is not a religious or moral approach. We simply want to find the best investment opportunities for our clients in the long-term.... We want 80% of our SRI research business to come from mainstream investors, not explicitly socially-conscious investors. Already, 50% of our business is coming from mainstream investors. SRI research was targeted to large institutional investors with long-term time horizons such as pension funds and insurance companies. However, Desmartin observed "we have seen some recent interest in SRI from hedge funds. I would not say it is a trend, yet it is very interesting because their focus is exclusively on making money." Oddo's ESG recommendations reflected the expected performance of each stock over a long-term horizon (i.e., beyond 12 months). As reported in Exhibit 2. the stocks included in Oddo's SRI Strong Opportunity portfolio had outperformed the market for both the five-year and one-year horizons. 1+ *** addo Securities-ESG Integration 4/21 100% & Oddo calculated that from 2005 to 2010, its Strong Opportunity portfolio beat market indices by between 1,476 and 2,401 basis points (bps), depending on the index. For 2010, the portfolio beat the market by 181 to 970 bps, again depending on the index. Oddo's Telecom Sector Report Oddo's study of the telecom sector covered major equipment makers and service providers in the U.S. and Europe. ESG Model Desmartin and Thevoux-Chabuel created a model to evaluate and score telecommunication companies based on the three ESC factors. The environmental factor was labeled Health, Safety and Environment and covered whether the firm had an environmental management system, the environmental impact of telecom products and services, and the safety of products and services. Social factors included regulatory risks and opportunities, and intellectual capital (reflecting customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG I scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom ➜ customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential i electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom operators, the most important social factors identified were regulatory risks, and intellectual capital generated from the management of human resources and customer, supplier, and partner relationships (termed social ecosystem). On the human resources side the Oddo analysis attempted to identify companies characterized by a workforce that was productive and economically efficient but at the same time paid well. On the social ecosystem side the analysts assessed the innovation capacity, brand value, supply chain efficiency, the quality, durability, growth potential and diversification of distribution networks, product and service quality, and customer satisfaction. The criteria used to generate scores for human resource and social ecosystem factors are I shown in Exhibits 4 and 5. Governance The sustainable development and corporate governance criteria used in the ESG model are shown in Exhibits 6 and 7. The sustainable development criteria distinguished between companies that factored corporate social responsibility (CSR) and sustainable development into their internal and external communications and those that integrated CSR and sustainable development into their strategies and business models. The weightings used for corporate governance criteria differed for large-cap and mid to small sized firms, for firms with a controlling interest and for those with diversified owners, and for family-owned businesses. Exhibit 8 shows the scores that BT and FT received by Oddo analysts in each of the factors. BT scored higher by more than 20 points and outperformed FT in all three categories. Industry Drivers Oddo's SRI analysis of the telecom industry identified five long-term performance drivers: sustainable development, regulation, sector consolidation, emerging countries, and technological advances or breakthroughs. Sustainable Development. The analysts rated the sector highly for sustainable development, primarily because they assessed that it was well-positioned to create dematerialized growth (defined as making more products using fewer resources), facilitate entrepreneurial activities, open new markets, and help other organizations and industries become more sustainable. Regulation. Because the telecom operator sector was viewed as a natural monopoly, it had been subject to regulation. Oddo analysts perceived this to be a key industry risk, particularly for many European telecom operators as regulators focused on increasing competition to lower prices and offer more services options for retail consumers. Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with technological change were likely to face product obsolescence and financial failure. Operators also relied on technology so they needed to ensure that their offerings delivered the newest services, which often required heavy investment. Results and Recommendations Using the latest iteration of its ESG model, SRI Research analyzed 25 companies, assigning each an ESG score, rank, recommendation and outlook (see Exhibit 9). A summary of the findings is presented in Exhibit 10. Of those companies that were covered by Oddo's financial analysts and given a recommendation, only three-Iliad, Telefonica, and Vivendi-had ESG recommendations that matched the financial recommendation. Desmartin explained: The first reason there may be a difference is because we are looking at different time horizons. The SRI team looks at long-term prospects, usually between 12 to 60 months, while the financial analysts typically are looking more short-term. The other reason for differences is when there is a mismatch between the SRI team and the financial analyst covering the sector or the company, about what is material for the sector or the company. Our aim is not to cover all ESG indicators but those that are most relevant and the most material from a financial standpoint. Our goal is to be right 50% of the time or more. In looking at the past performance of the 25 stocks, those that SRI Research identified as strong opportunity or opportunity outperformed the DJ Stoxx Telecommunications index by 171%; while those companies SRI Research identified as having moderate to high risk, underperformed the same index by 32% (Exhibit 11). Keyes' Decision John Keyes reflected on the Oddo SRI Telecom report. The ESG and financial recommendations for British Telecom and France Telecom led him to the opposite conclusions. He reviewed the recent financial performance (see Exhibit 12) and stock market performance (see Exhibit 13) of the two companies. The performance of BT was impressively strong in 2006 and 2007 where earnings-per- share increased significantly and the company proposed an increase in dividends. However, BT's performance was completely reversed as the financial crisis hit and investors' expectations adjusted. How should he proceed? Should he follow the ESG recommendation and buy BT stock, or the financial recommendation and take a position in FT? Exhibit 1 Integrating ESG into valuation models ESG Research Environment Management Risks Opportunities Social Regulation IC-Human Capital IC-License to Operate/Reputation IC-Ecosystem, Quality, non-compliance Governance Sustainable development strategy Corporate Governance Business Ethics Source: Company documents. Note: L O N G T E RM DR I V E R S Materiality Business Model Management Statements →→Measurement ESG KPI's ESG Events Monetary Value Vahation Model Opportunities ↓ Performance Cash flow Cost of Capital Risk Premium Volatility 1 Risks "Management"refers to "Management quality". "Statements" refers to "Financial statements". "IC" is "Intellectual Capital" Exhibit 2 One-Year and Five-Year Performance Comparison: Oddo SRI vs. Industry Indices as of December 2010 Index Oddo SRI List (non-weighted) France CAC 40 France SBF 120 DJ STOXX Euro 50 DJ STOXX 600 Since Dec 31-2009 7.96% -1.74 0.77 -0.85 6.15 Since Dec- 31-2005 1.69% -17.95 -13.96 -22.32 Source: Company documents. -13.07 CAC 40 Compagnie des Agents de Change 40 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 40 French companies listed on the Paris Stock Exchange that were also traded on the options market. Construction principle: Capitalization-weighted value ratio SBF 120 Société des Bourses Françaises 120 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 120 French companies listed on the Paris Stock Exchange Construction principle: Capitalization-weighted value ratio DI STOXX Euro 50 Index Europe's leading blue-chip index provided a representation of super sector leaders in Europe. The index covered 50 stocks from 18 European countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. DI STOXX 600 Index Derived from the STOXX Europe Total Market Index (TMI) and was a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represented large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. Oddo Securities-ESG Integration Exhibit 3 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Human resources Organizational Ecosystem Social Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. Equipment Makers 3% 6 2 5 16 1 5194 29 46 2333 10 25 38 100% Operators 1% NOK 2 14 15 6235 54 10 25 3 38 100% Exhibit 4 Human Resources Indicators and Criteria for the Telecom Sector Indicator Governance and HR profile Attractiveness and recruitment ||| Career integration and planning Motivation and satisfaction Operational HR management Total Criteria Growth model Age pyramid management HR representation on executive board HR transparency Size-related attractiveness International presence-related attractiveness Economic attractiveness Average wage costs Employee share of ownership Growth in headcount Integration, annual review rate, career planning Training quality and effectiveness Management of reorganizational/restructuring measures Departure/arrival of key personnel Staff tumover Absenteeism Workplace climate and dialogue Payroll management Quality of local management Operating margin per employee Social liabilities (pension funds, healthcare, class actions) Weighting 10% 6 4 2 5 4 2 2 5 2 4 2 10 5 3 10 3 2 5 5 9 100% Nature of Criterion Quantitative & qualitative Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative & qualitative Quantitative & qualitative Mainly Qualitative Qualitative Qui Ive Quantitative Mainly Qualitative Quantitative Qualitative Quantitative Quantitative Exhibit 5 Ecosystem Criteria for the Telecom Sector Criteria Corporate culture, Internal organization Innovation/R&D/patents Brand Supply chain, logistics, industrial partnerships Distribution network Product and service quality Customer satisfaction Total Source Company documents. Criteria Length of sustainable development track record and learning curve Sustainable development organization: Direct reporting: Director profile; Resources allocated; Interactions - across functions Sustainable development information systems Products and services with sustainable development added value Sustainable development objectives and results Total Equipment Makers 4.0% Source: Company documents. 11.0 2.0 4.0 2.0 3.0 99 3.0 2 Exhibit 6 Sustainable Development Strategy Criteria for the Telecom Sector Equipment Makers 1.0% 29.0% 1.0 2.0 3.0 3.0 Operators 2.0% 4.0 3.0 2.0 10.0% 5.0 3.0 4.0 23.0% Operators 1.0% 1.0 2.0 3.0 3.0 Nature of Criteria Qualitative Quantitative & qualitative Quantitative & qualitative Qualitative 10.0% Qualitative Quantitative & qualitative Quantitative & qualitative Nature of Criteria Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative & qualitative Quantitative & qualitative Exhibit 7 Corporate Governance Criteria for the Telecom Sector Criteria 1. Minority shareholder rights (1 share-1 vote; anti- takeover measures) 2. Separation of functions. (CEO-Chairman) 3. Separation of roles (executives/shareholders/ board members) 4. Executive succession planning 5. Transparency and cohesion of executive pay 6. Assessment of executive pay and long-term performance 7. Board effectiveness (composition, functioning) 8. Committees reporting to the board. 9. Audit processes; degree of accountability, legal and tax transparency and complexity 10. Quality of financial communication Total Source: Company documents. Non- Controlled Controlled 17% 12% 13 2 10 3 20 63 13 12 Large Cap 100% 10 10 10 20 13 12 100% Mid-Small Cap Non- Controlled 18% 13 2 15 3 20 11 100% Controlled 11% 10 10 15 21 11 100% Family- owned 12% S 13 20 03 16 12 100% Exhibit 8 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Social Human resources Organizational Ecosystem Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. British Telecom 1.0 2.0 0.0 5.0 8.0 9.0 8.8 1.5 15.5 34.8 10.0 18.8 2.5 31.3 74.1 PHONE France Telecom 0.5 1.5 0.0 2.0 4.0 8.4 0.5 15.4 28.3 5.5 14.0 2.0 21.5 53.8 Exhibit 9 Telecom Sector: Summary of ESG Scores, Rank, Recommendation, Outlook, Financial Recommendation, and Target Prices Company Equipment Makers Alcatel-Lucent Clavu Ericsson Gemalto Motorola Nokia Oberthur Tandberg Operators AT&T Belgacom Bouygues British Telecom Deutsche Telekom France Telecom Iliad KPN Maroc Telecom Mobistar OTE Sprint Telecom Italia Telefonica Verizon Vivendi Vodafone Averages Equipment Makers Operators Telecom Sector Maximum possible score 1-Strong opportunity ESG ESG ESG ESG Score Rank Recommendation" Outlook 2 Opportunity 3-Moderate risk A High risk 51.5 00.0 65.3 59.8 50.3 77.1 57.1 70.7 61.7 53.2 55.5 74.0 51.4 53.3 62.1 61.6 51.0 50.8 47.8 38.7 54.1 59.2 60.7 63.2 61.7 Source: Company documents. SEK Swedish Krona Recommendation 62.3 56.5 58.3 100.0 75458162 3 329191655467108 7 2 4 32223131 2 NNNNWAAW WNNWW3333 Positive THE Negative na na Stable na na na na Positive Stable Negative Positive Stable Stable na na na na Negative Stable na Positive Stable Pinancial Recommendation" 2 Nut fullumed Not followed 2 Accept the offer Not followed Not followed 2 2727 Not followed Not followed Target Price €3,5 118 SEK 65,0 €29.0 na €16.0 €6,7 na na €25.5 €51.0 €170.0 €14.0 €24.0 €79.0 €13.0 €16,5 €60.0 €24.0 na €1.0 €17,5 na €33.0 £115 Exhibit 12 Financial performance of France Telecom and British Telecom France Telecom, for year ended December 31 (in Emil) Total revenue Revenue growth NOPAT Margin Asset tumover ROA Spread Leverage Impact of leverage ROE Percent of revenues Grom profit Operating expenses Unusual income (expenses) Discontinued operations Valuation multiples Price-to-eamings Price-to-book value British Telecom, for the year ended March 31 (in Emillion) Total revence Revenue growth NOPAT Margin Asstturnover ROA Spread Leverage Impact of leverage ROE Percent of revences Gross profit Operating expenses Unusual income (expenses) Discontinued operations 2006 51,702 7.5% 20 10.3% 0.71 7.2% 4.8% 1.95 9.4% 16.6% 43.6% 23.6% -0.3% 1.3% 11.82 2.28 2007 20,223 3.6% 17.0% 173 29.3% 23,5% 6.54 153.8% 183.2% 61.9% 45.7% -1.3% 0.0% 1007 46,568 4.9% 30.48 7.47 18.4% 0.68 12.6% 7.3% 1.55 10.9% 23.5% 46.7% 23.0% -7.5% 6.9% 31.23 2.37 2008 20,704 2.4% 11.6% 1.71 19.8% 11.4% 1.87 21.2% 41.0% 61.8% 45.5% -2.9% 0.0% 2000 46,712 0.3% 8.32 4.02 12.3% 0.70 8.6% 41% 1.26 5.2% 13.8% 42.4% 19.7% 1.4% 0.4% 9.40 1.77 2009 21,390 3.3% 2.4% 1.43 3.4% LO% Valuation multiples Price-to-samnings Price-to-book value NOTAT is net operating profit after taxe NOPAT margin i NOPAT over Not Ants Asset turnover is total revenue over asets. Spread is NOPAT margn minus the interest on all interest paying abilities, Leverage in total debt minus cash over gulty Impact of s spread times leverage Sou Capulced July 2011. 1.77 -7.0% -30% 61.4% 55.9% -26% 0.0% 6.66 2.20 1. From a company valuation perspective, how should we include the elements of the ESG analysis in the process? Should we include the elements of ESG in the cash flows or in the discount rate, or in both? (Remember at the end we need to arrive to an intrinsic value). Any ideas on how to do it? 2. Should the financial elements dominate the analysis? Those of ESG? Do they complement each other? How can we better understand the situation? Please provide your perspective on this situation. Oddo Securities-ESG Integration In January of 2009, John Keyes, portfolio manager for a medium-sized UK fund, reviewed the analyst report on the telecommunications industry he had just received from the French brokerage firm Oddo Securities (Oddo). Keyes was intrigued by Oddo's research, which provided two ratings of stocks covered, a financial rating and an environmental, social and governance (PSG) rating. Keyes was particularly struck by the returns generated by Oddo's ESG recommendations, which had outperformed most major stocks indices over the last five years. He reviewed the recommendations and analysis for two telecom stocks he was considering adding to his portfolio, British Telecom (BT) and France Telecom (FT). The Oddo analysis assigned BT its highest PSC rating (a Strong Opportunity) but rated the company as a "Reduce" in the financial recommendation. In contrast, FT was rated as a Moderate Risk under the ESC rating and a "Buy" for the financial rating, Keyes wondered how he should interpret these conflicting ratings, and which deserved more of his attention. Background on Oddo Securities Oddo Securities was owned by Oddo & Cie- an independent investment services firm that in 2010 had 900 employees, offices in Paris, Dubai, Madrid, and New York, and over €17 billion in assets under management. The firm was 80% owned by management, employees, and the Oddo family, and 20% by German-based insurer Allianz. It was headed by Philippe Oddo, whose family had been in the stockbroker business for five generations. In addition to its brokerage business, Oddo & Cie owned an investment bank, a financial advisory business, options and commodity businesses, a private bank, and an asset management unit. Oddo Securities was one of France's top brokers. The unit catered to an international institutional clientele providing brokerage services and research on a broad product range, including shares, futures, options and fixed income/credit. The research team, with 60 analysts, economists, and strategists, focused on the French and European market-equities, corporate bonds, and derivatives. The 5.momber prodit vocesuch term fomured on five incom and covered more than 120 1 capitalization of the France CAC 40 index, 89% of the DJ STOXX Euro 50 index and 60% of the DJ STOXX 600 index. ESG Investing and Analysis The use of ESC criteria for investing was a relatively recent innovation in the investment management industry and fell under the umbrella of socially responsible investing (SRI). SRI strategies could be broadly classified into five categories: negative screening, positive screening, integration, thematic, and engagement. Under negative screening, companies were excluded from investment portfolios based on ethical concerns about the safety of their products (e.g. tobacco, weapons, etc.) and their ethical standards of behavior. Positive screening identified companies with best-in-class ESG performance as investment candidates. Integration strategies focused on relations between ESG data, cash flows and/or cost of capital, and then embedded those relationships into valuation models. Thematic strategies followed either a multi-theme approach focusing on a broad range of long-term environmental or social issues (e.g. ageing societies, sustainable nutrition, clean energy, low-income solutions, urbanization, health, sustainable resources), or a hybrid approach. combining a large cap "best in class" universe with a thematic overlay. Finally, engagement represented a form of shareholder activism where investors sought to influence how companies addressed material ESG issues to protect and enhance the value of their investments. SRI investing experienced dramatic growth in the 1990s and 2000s. Between 2001 and 2007 assets under management of socially responsible investors grew by $400 billion in the US, $600 billion in the U.K, and $400 billion in Canada. In 2007, mutual funds that invested in socially conscious firms had assets under management of more than $2.5 trillion in the United States, $2 trillion in Europe, $500 billion in Canada, $100 billion in Japan and 564 billion in Australia. ESG Analysis at Oddo D ESG Analysis at Oddo In June 2005, Oddo hired Jean-Phillippe Desmartin to head its SRI initiative. Desmartin, who had started his career in financial engineering at Credit du Nord, a subsidiary of Societe Generale, and subsequently worked for several social and environmental rating agencies, was charged with developing a systematic methodology for SRI analysis at Oddo. He subsequently hired Sebastien Thevoux-Chabuel as a senior analyst in the initiative. Thevoux-Chabuel had been with Oddo since 2005 as a sell-side analyst on the European Technology sector and he had experience at Deutsche Bank and BFT, a subsidiary of Credit Agricole, as a buy-side analyst. ESG research at Oddo was divided into three broad areas, Environmental, Social and Governance (Exhibit 1). Environmental factors included environmental management, risks and opportunities. Social factors covered regulatory risks, the management of the firm's human resources, its reputational capital and brands, and its supplier and partner relationships. Governance factors included the firm's commitment to sustainable development (Le. using resources to meet human The CAC 40 was an index of 40 stocks traded on the Paris Stock Exchange. The Dow Jones STOXX Euro 50 Index represented 50 super sector market leaders in the 12 Eurosone countries Austria, Belgium, Finland, France, Germany Greece, Ireland. Italy, Luxemburg, the Netherlands, Portugal and Spain. The Dow Jones STOXX 600 Index was comprised of 600 highly capitalized and actively traded stocks listed and traded on stock exchanges from 17 European countries The authors calculated these numbers from information provided by national and international organizations that track socially conscious funds, such as Eurosif, Social Investment Forum, Responsible Investment Association Australasia, Social Responsible Organization, and SRI funds in Asia needs while also preserving the environment), adherence to corporate governance best practices, and business ethics. The Oddo SRI Research team, working in collaboration with the firm's sector analysts, used a multi-step approach to build separate ESG models for each sector. Under the first step, the analyst team assessed which ESG factors were likely to be relevant and material for firms in the sector. Once these constructs were identified, the team developed quantitative and qualitative metrics for each material factor. Finally, the analyst team determined appropriate sector-specific weightings for the metrics, enabling them to be aggregated into separate environmental, social and governance performance scores, and into a total ESG score. In explaining how the weightings were created, Desmartin noted that they are "intended to reflect the degree to which our ESG performance factors correlate with returns." Weights were estimated using historical relations between the sector's metrics/factors and its stock returns. The time horizon over which the historical relations were estimated ranged between 1 and 5 years depending on the availability of data. The ESG analysts at Oddo then used the sector metrics and weightings generated from this process to construct ESG scores for individual companies within the sector. Based on a company's aggregate score, Oddo issued one of four ESG recommendations (Strong Opportunity, Opportunity, Moderate Risk, or High Risk). Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the ESG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysts who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESC analysis and do not have control over the analysis." ddo's ESG approach was designed to provide investors with insights into a firm's management ilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial aj d ESG Integration 100% & Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the RSG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that: "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysis who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESG analysis and do not have control over the analysis. Oddo's ESG approach was designed to provide investors with insights into a firm's management capabilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial performance. The goal of the ESG analysis, therefore, was to allow clients to optimize the ratio of returns to risk. Desmartin explained the firm's approach and the type of clients it sought to attract: In practice we are very far from some of the ethical approaches used in the U.S. We do not exclude companies, we do not exclude activities, and we do not say what is good and what is bad. Ours is not a religious or moral approach. We simply want to find the best investment opportunities for our clients in the long-term.... We want 80% of our SRI research business to come from mainstream investors, not explicitly socially-conscious investors. Already, 50% of our business is coming from mainstream investors. SRI research was targeted to large institutional investors with long-term time horizons such as pension funds and insurance companies. However, Desmartin observed "we have seen some recent interest in SRI from hedge funds. I would not say it is a trend, yet it is very interesting because their focus is exclusively on making money." Oddo's ESG recommendations reflected the expected performance of each stock over a long-term horizon (i.e., beyond 12 months). As reported in Exhibit 2. the stocks included in Oddo's SRI Strong Opportunity portfolio had outperformed the market for both the five-year and one-year horizons. 1+ *** addo Securities-ESG Integration 4/21 100% & Oddo calculated that from 2005 to 2010, its Strong Opportunity portfolio beat market indices by between 1,476 and 2,401 basis points (bps), depending on the index. For 2010, the portfolio beat the market by 181 to 970 bps, again depending on the index. Oddo's Telecom Sector Report Oddo's study of the telecom sector covered major equipment makers and service providers in the U.S. and Europe. ESG Model Desmartin and Thevoux-Chabuel created a model to evaluate and score telecommunication companies based on the three ESC factors. The environmental factor was labeled Health, Safety and Environment and covered whether the firm had an environmental management system, the environmental impact of telecom products and services, and the safety of products and services. Social factors included regulatory risks and opportunities, and intellectual capital (reflecting customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG I scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom ➜ customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential i electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom operators, the most important social factors identified were regulatory risks, and intellectual capital generated from the management of human resources and customer, supplier, and partner relationships (termed social ecosystem). On the human resources side the Oddo analysis attempted to identify companies characterized by a workforce that was productive and economically efficient but at the same time paid well. On the social ecosystem side the analysts assessed the innovation capacity, brand value, supply chain efficiency, the quality, durability, growth potential and diversification of distribution networks, product and service quality, and customer satisfaction. The criteria used to generate scores for human resource and social ecosystem factors are I shown in Exhibits 4 and 5. Governance The sustainable development and corporate governance criteria used in the ESG model are shown in Exhibits 6 and 7. The sustainable development criteria distinguished between companies that factored corporate social responsibility (CSR) and sustainable development into their internal and external communications and those that integrated CSR and sustainable development into their strategies and business models. The weightings used for corporate governance criteria differed for large-cap and mid to small sized firms, for firms with a controlling interest and for those with diversified owners, and for family-owned businesses. Exhibit 8 shows the scores that BT and FT received by Oddo analysts in each of the factors. BT scored higher by more than 20 points and outperformed FT in all three categories. Industry Drivers Oddo's SRI analysis of the telecom industry identified five long-term performance drivers: sustainable development, regulation, sector consolidation, emerging countries, and technological advances or breakthroughs. Sustainable Development. The analysts rated the sector highly for sustainable development, primarily because they assessed that it was well-positioned to create dematerialized growth (defined as making more products using fewer resources), facilitate entrepreneurial activities, open new markets, and help other organizations and industries become more sustainable. Regulation. Because the telecom operator sector was viewed as a natural monopoly, it had been subject to regulation. Oddo analysts perceived this to be a key industry risk, particularly for many European telecom operators as regulators focused on increasing competition to lower prices and offer more services options for retail consumers. Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with technological change were likely to face product obsolescence and financial failure. Operators also relied on technology so they needed to ensure that their offerings delivered the newest services, which often required heavy investment. Results and Recommendations Using the latest iteration of its ESG model, SRI Research analyzed 25 companies, assigning each an ESG score, rank, recommendation and outlook (see Exhibit 9). A summary of the findings is presented in Exhibit 10. Of those companies that were covered by Oddo's financial analysts and given a recommendation, only three-Iliad, Telefonica, and Vivendi-had ESG recommendations that matched the financial recommendation. Desmartin explained: The first reason there may be a difference is because we are looking at different time horizons. The SRI team looks at long-term prospects, usually between 12 to 60 months, while the financial analysts typically are looking more short-term. The other reason for differences is when there is a mismatch between the SRI team and the financial analyst covering the sector or the company, about what is material for the sector or the company. Our aim is not to cover all ESG indicators but those that are most relevant and the most material from a financial standpoint. Our goal is to be right 50% of the time or more. In looking at the past performance of the 25 stocks, those that SRI Research identified as strong opportunity or opportunity outperformed the DJ Stoxx Telecommunications index by 171%; while those companies SRI Research identified as having moderate to high risk, underperformed the same index by 32% (Exhibit 11). Keyes' Decision John Keyes reflected on the Oddo SRI Telecom report. The ESG and financial recommendations for British Telecom and France Telecom led him to the opposite conclusions. He reviewed the recent financial performance (see Exhibit 12) and stock market performance (see Exhibit 13) of the two companies. The performance of BT was impressively strong in 2006 and 2007 where earnings-per- share increased significantly and the company proposed an increase in dividends. However, BT's performance was completely reversed as the financial crisis hit and investors' expectations adjusted. How should he proceed? Should he follow the ESG recommendation and buy BT stock, or the financial recommendation and take a position in FT? Exhibit 1 Integrating ESG into valuation models ESG Research Environment Management Risks Opportunities Social Regulation IC-Human Capital IC-License to Operate/Reputation IC-Ecosystem, Quality, non-compliance Governance Sustainable development strategy Corporate Governance Business Ethics Source: Company documents. Note: L O N G T E RM DR I V E R S Materiality Business Model Management Statements →→Measurement ESG KPI's ESG Events Monetary Value Vahation Model Opportunities ↓ Performance Cash flow Cost of Capital Risk Premium Volatility 1 Risks "Management"refers to "Management quality". "Statements" refers to "Financial statements". "IC" is "Intellectual Capital" Exhibit 2 One-Year and Five-Year Performance Comparison: Oddo SRI vs. Industry Indices as of December 2010 Index Oddo SRI List (non-weighted) France CAC 40 France SBF 120 DJ STOXX Euro 50 DJ STOXX 600 Since Dec 31-2009 7.96% -1.74 0.77 -0.85 6.15 Since Dec- 31-2005 1.69% -17.95 -13.96 -22.32 Source: Company documents. -13.07 CAC 40 Compagnie des Agents de Change 40 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 40 French companies listed on the Paris Stock Exchange that were also traded on the options market. Construction principle: Capitalization-weighted value ratio SBF 120 Société des Bourses Françaises 120 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 120 French companies listed on the Paris Stock Exchange Construction principle: Capitalization-weighted value ratio DI STOXX Euro 50 Index Europe's leading blue-chip index provided a representation of super sector leaders in Europe. The index covered 50 stocks from 18 European countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. DI STOXX 600 Index Derived from the STOXX Europe Total Market Index (TMI) and was a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represented large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. Oddo Securities-ESG Integration Exhibit 3 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Human resources Organizational Ecosystem Social Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. Equipment Makers 3% 6 2 5 16 1 5194 29 46 2333 10 25 38 100% Operators 1% NOK 2 14 15 6235 54 10 25 3 38 100% Exhibit 4 Human Resources Indicators and Criteria for the Telecom Sector Indicator Governance and HR profile Attractiveness and recruitment ||| Career integration and planning Motivation and satisfaction Operational HR management Total Criteria Growth model Age pyramid management HR representation on executive board HR transparency Size-related attractiveness International presence-related attractiveness Economic attractiveness Average wage costs Employee share of ownership Growth in headcount Integration, annual review rate, career planning Training quality and effectiveness Management of reorganizational/restructuring measures Departure/arrival of key personnel Staff tumover Absenteeism Workplace climate and dialogue Payroll management Quality of local management Operating margin per employee Social liabilities (pension funds, healthcare, class actions) Weighting 10% 6 4 2 5 4 2 2 5 2 4 2 10 5 3 10 3 2 5 5 9 100% Nature of Criterion Quantitative & qualitative Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative & qualitative Quantitative & qualitative Mainly Qualitative Qualitative Qui Ive Quantitative Mainly Qualitative Quantitative Qualitative Quantitative Quantitative Exhibit 5 Ecosystem Criteria for the Telecom Sector Criteria Corporate culture, Internal organization Innovation/R&D/patents Brand Supply chain, logistics, industrial partnerships Distribution network Product and service quality Customer satisfaction Total Source Company documents. Criteria Length of sustainable development track record and learning curve Sustainable development organization: Direct reporting: Director profile; Resources allocated; Interactions - across functions Sustainable development information systems Products and services with sustainable development added value Sustainable development objectives and results Total Equipment Makers 4.0% Source: Company documents. 11.0 2.0 4.0 2.0 3.0 99 3.0 2 Exhibit 6 Sustainable Development Strategy Criteria for the Telecom Sector Equipment Makers 1.0% 29.0% 1.0 2.0 3.0 3.0 Operators 2.0% 4.0 3.0 2.0 10.0% 5.0 3.0 4.0 23.0% Operators 1.0% 1.0 2.0 3.0 3.0 Nature of Criteria Qualitative Quantitative & qualitative Quantitative & qualitative Qualitative 10.0% Qualitative Quantitative & qualitative Quantitative & qualitative Nature of Criteria Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative & qualitative Quantitative & qualitative Exhibit 7 Corporate Governance Criteria for the Telecom Sector Criteria 1. Minority shareholder rights (1 share-1 vote; anti- takeover measures) 2. Separation of functions. (CEO-Chairman) 3. Separation of roles (executives/shareholders/ board members) 4. Executive succession planning 5. Transparency and cohesion of executive pay 6. Assessment of executive pay and long-term performance 7. Board effectiveness (composition, functioning) 8. Committees reporting to the board. 9. Audit processes; degree of accountability, legal and tax transparency and complexity 10. Quality of financial communication Total Source: Company documents. Non- Controlled Controlled 17% 12% 13 2 10 3 20 63 13 12 Large Cap 100% 10 10 10 20 13 12 100% Mid-Small Cap Non- Controlled 18% 13 2 15 3 20 11 100% Controlled 11% 10 10 15 21 11 100% Family- owned 12% S 13 20 03 16 12 100% Exhibit 8 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Social Human resources Organizational Ecosystem Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. British Telecom 1.0 2.0 0.0 5.0 8.0 9.0 8.8 1.5 15.5 34.8 10.0 18.8 2.5 31.3 74.1 PHONE France Telecom 0.5 1.5 0.0 2.0 4.0 8.4 0.5 15.4 28.3 5.5 14.0 2.0 21.5 53.8 Exhibit 9 Telecom Sector: Summary of ESG Scores, Rank, Recommendation, Outlook, Financial Recommendation, and Target Prices Company Equipment Makers Alcatel-Lucent Clavu Ericsson Gemalto Motorola Nokia Oberthur Tandberg Operators AT&T Belgacom Bouygues British Telecom Deutsche Telekom France Telecom Iliad KPN Maroc Telecom Mobistar OTE Sprint Telecom Italia Telefonica Verizon Vivendi Vodafone Averages Equipment Makers Operators Telecom Sector Maximum possible score 1-Strong opportunity ESG ESG ESG ESG Score Rank Recommendation" Outlook 2 Opportunity 3-Moderate risk A High risk 51.5 00.0 65.3 59.8 50.3 77.1 57.1 70.7 61.7 53.2 55.5 74.0 51.4 53.3 62.1 61.6 51.0 50.8 47.8 38.7 54.1 59.2 60.7 63.2 61.7 Source: Company documents. SEK Swedish Krona Recommendation 62.3 56.5 58.3 100.0 75458162 3 329191655467108 7 2 4 32223131 2 NNNNWAAW WNNWW3333 Positive THE Negative na na Stable na na na na Positive Stable Negative Positive Stable Stable na na na na Negative Stable na Positive Stable Pinancial Recommendation" 2 Nut fullumed Not followed 2 Accept the offer Not followed Not followed 2 2727 Not followed Not followed Target Price €3,5 118 SEK 65,0 €29.0 na €16.0 €6,7 na na €25.5 €51.0 €170.0 €14.0 €24.0 €79.0 €13.0 €16,5 €60.0 €24.0 na €1.0 €17,5 na €33.0 £115 Exhibit 12 Financial performance of France Telecom and British Telecom France Telecom, for year ended December 31 (in Emil) Total revenue Revenue growth NOPAT Margin Asset tumover ROA Spread Leverage Impact of leverage ROE Percent of revenues Grom profit Operating expenses Unusual income (expenses) Discontinued operations Valuation multiples Price-to-eamings Price-to-book value British Telecom, for the year ended March 31 (in Emillion) Total revence Revenue growth NOPAT Margin Asstturnover ROA Spread Leverage Impact of leverage ROE Percent of revences Gross profit Operating expenses Unusual income (expenses) Discontinued operations 2006 51,702 7.5% 20 10.3% 0.71 7.2% 4.8% 1.95 9.4% 16.6% 43.6% 23.6% -0.3% 1.3% 11.82 2.28 2007 20,223 3.6% 17.0% 173 29.3% 23,5% 6.54 153.8% 183.2% 61.9% 45.7% -1.3% 0.0% 1007 46,568 4.9% 30.48 7.47 18.4% 0.68 12.6% 7.3% 1.55 10.9% 23.5% 46.7% 23.0% -7.5% 6.9% 31.23 2.37 2008 20,704 2.4% 11.6% 1.71 19.8% 11.4% 1.87 21.2% 41.0% 61.8% 45.5% -2.9% 0.0% 2000 46,712 0.3% 8.32 4.02 12.3% 0.70 8.6% 41% 1.26 5.2% 13.8% 42.4% 19.7% 1.4% 0.4% 9.40 1.77 2009 21,390 3.3% 2.4% 1.43 3.4% LO% Valuation multiples Price-to-samnings Price-to-book value NOTAT is net operating profit after taxe NOPAT margin i NOPAT over Not Ants Asset turnover is total revenue over asets. Spread is NOPAT margn minus the interest on all interest paying abilities, Leverage in total debt minus cash over gulty Impact of s spread times leverage Sou Capulced July 2011. 1.77 -7.0% -30% 61.4% 55.9% -26% 0.0% 6.66 2.20 1. From a company valuation perspective, how should we include the elements of the ESG analysis in the process? Should we include the elements of ESG in the cash flows or in the discount rate, or in both? (Remember at the end we need to arrive to an intrinsic value). Any ideas on how to do it? 2. Should the financial elements dominate the analysis? Those of ESG? Do they complement each other? How can we better understand the situation? Please provide your perspective on this situation. Oddo Securities-ESG Integration In January of 2009, John Keyes, portfolio manager for a medium-sized UK fund, reviewed the analyst report on the telecommunications industry he had just received from the French brokerage firm Oddo Securities (Oddo). Keyes was intrigued by Oddo's research, which provided two ratings of stocks covered, a financial rating and an environmental, social and governance (PSG) rating. Keyes was particularly struck by the returns generated by Oddo's ESG recommendations, which had outperformed most major stocks indices over the last five years. He reviewed the recommendations and analysis for two telecom stocks he was considering adding to his portfolio, British Telecom (BT) and France Telecom (FT). The Oddo analysis assigned BT its highest PSC rating (a Strong Opportunity) but rated the company as a "Reduce" in the financial recommendation. In contrast, FT was rated as a Moderate Risk under the ESC rating and a "Buy" for the financial rating, Keyes wondered how he should interpret these conflicting ratings, and which deserved more of his attention. Background on Oddo Securities Oddo Securities was owned by Oddo & Cie- an independent investment services firm that in 2010 had 900 employees, offices in Paris, Dubai, Madrid, and New York, and over €17 billion in assets under management. The firm was 80% owned by management, employees, and the Oddo family, and 20% by German-based insurer Allianz. It was headed by Philippe Oddo, whose family had been in the stockbroker business for five generations. In addition to its brokerage business, Oddo & Cie owned an investment bank, a financial advisory business, options and commodity businesses, a private bank, and an asset management unit. Oddo Securities was one of France's top brokers. The unit catered to an international institutional clientele providing brokerage services and research on a broad product range, including shares, futures, options and fixed income/credit. The research team, with 60 analysts, economists, and strategists, focused on the French and European market-equities, corporate bonds, and derivatives. The 5.momber prodit vocesuch term fomured on five incom and covered more than 120 1 capitalization of the France CAC 40 index, 89% of the DJ STOXX Euro 50 index and 60% of the DJ STOXX 600 index. ESG Investing and Analysis The use of ESC criteria for investing was a relatively recent innovation in the investment management industry and fell under the umbrella of socially responsible investing (SRI). SRI strategies could be broadly classified into five categories: negative screening, positive screening, integration, thematic, and engagement. Under negative screening, companies were excluded from investment portfolios based on ethical concerns about the safety of their products (e.g. tobacco, weapons, etc.) and their ethical standards of behavior. Positive screening identified companies with best-in-class ESG performance as investment candidates. Integration strategies focused on relations between ESG data, cash flows and/or cost of capital, and then embedded those relationships into valuation models. Thematic strategies followed either a multi-theme approach focusing on a broad range of long-term environmental or social issues (e.g. ageing societies, sustainable nutrition, clean energy, low-income solutions, urbanization, health, sustainable resources), or a hybrid approach. combining a large cap "best in class" universe with a thematic overlay. Finally, engagement represented a form of shareholder activism where investors sought to influence how companies addressed material ESG issues to protect and enhance the value of their investments. SRI investing experienced dramatic growth in the 1990s and 2000s. Between 2001 and 2007 assets under management of socially responsible investors grew by $400 billion in the US, $600 billion in the U.K, and $400 billion in Canada. In 2007, mutual funds that invested in socially conscious firms had assets under management of more than $2.5 trillion in the United States, $2 trillion in Europe, $500 billion in Canada, $100 billion in Japan and 564 billion in Australia. ESG Analysis at Oddo D ESG Analysis at Oddo In June 2005, Oddo hired Jean-Phillippe Desmartin to head its SRI initiative. Desmartin, who had started his career in financial engineering at Credit du Nord, a subsidiary of Societe Generale, and subsequently worked for several social and environmental rating agencies, was charged with developing a systematic methodology for SRI analysis at Oddo. He subsequently hired Sebastien Thevoux-Chabuel as a senior analyst in the initiative. Thevoux-Chabuel had been with Oddo since 2005 as a sell-side analyst on the European Technology sector and he had experience at Deutsche Bank and BFT, a subsidiary of Credit Agricole, as a buy-side analyst. ESG research at Oddo was divided into three broad areas, Environmental, Social and Governance (Exhibit 1). Environmental factors included environmental management, risks and opportunities. Social factors covered regulatory risks, the management of the firm's human resources, its reputational capital and brands, and its supplier and partner relationships. Governance factors included the firm's commitment to sustainable development (Le. using resources to meet human The CAC 40 was an index of 40 stocks traded on the Paris Stock Exchange. The Dow Jones STOXX Euro 50 Index represented 50 super sector market leaders in the 12 Eurosone countries Austria, Belgium, Finland, France, Germany Greece, Ireland. Italy, Luxemburg, the Netherlands, Portugal and Spain. The Dow Jones STOXX 600 Index was comprised of 600 highly capitalized and actively traded stocks listed and traded on stock exchanges from 17 European countries The authors calculated these numbers from information provided by national and international organizations that track socially conscious funds, such as Eurosif, Social Investment Forum, Responsible Investment Association Australasia, Social Responsible Organization, and SRI funds in Asia needs while also preserving the environment), adherence to corporate governance best practices, and business ethics. The Oddo SRI Research team, working in collaboration with the firm's sector analysts, used a multi-step approach to build separate ESG models for each sector. Under the first step, the analyst team assessed which ESG factors were likely to be relevant and material for firms in the sector. Once these constructs were identified, the team developed quantitative and qualitative metrics for each material factor. Finally, the analyst team determined appropriate sector-specific weightings for the metrics, enabling them to be aggregated into separate environmental, social and governance performance scores, and into a total ESG score. In explaining how the weightings were created, Desmartin noted that they are "intended to reflect the degree to which our ESG performance factors correlate with returns." Weights were estimated using historical relations between the sector's metrics/factors and its stock returns. The time horizon over which the historical relations were estimated ranged between 1 and 5 years depending on the availability of data. The ESG analysts at Oddo then used the sector metrics and weightings generated from this process to construct ESG scores for individual companies within the sector. Based on a company's aggregate score, Oddo issued one of four ESG recommendations (Strong Opportunity, Opportunity, Moderate Risk, or High Risk). Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the ESG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysts who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESC analysis and do not have control over the analysis." ddo's ESG approach was designed to provide investors with insights into a firm's management ilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial aj d ESG Integration 100% & Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the RSG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that: "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysis who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESG analysis and do not have control over the analysis. Oddo's ESG approach was designed to provide investors with insights into a firm's management capabilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial performance. The goal of the ESG analysis, therefore, was to allow clients to optimize the ratio of returns to risk. Desmartin explained the firm's approach and the type of clients it sought to attract: In practice we are very far from some of the ethical approaches used in the U.S. We do not exclude companies, we do not exclude activities, and we do not say what is good and what is bad. Ours is not a religious or moral approach. We simply want to find the best investment opportunities for our clients in the long-term.... We want 80% of our SRI research business to come from mainstream investors, not explicitly socially-conscious investors. Already, 50% of our business is coming from mainstream investors. SRI research was targeted to large institutional investors with long-term time horizons such as pension funds and insurance companies. However, Desmartin observed "we have seen some recent interest in SRI from hedge funds. I would not say it is a trend, yet it is very interesting because their focus is exclusively on making money." Oddo's ESG recommendations reflected the expected performance of each stock over a long-term horizon (i.e., beyond 12 months). As reported in Exhibit 2. the stocks included in Oddo's SRI Strong Opportunity portfolio had outperformed the market for both the five-year and one-year horizons. 1+ *** addo Securities-ESG Integration 4/21 100% & Oddo calculated that from 2005 to 2010, its Strong Opportunity portfolio beat market indices by between 1,476 and 2,401 basis points (bps), depending on the index. For 2010, the portfolio beat the market by 181 to 970 bps, again depending on the index. Oddo's Telecom Sector Report Oddo's study of the telecom sector covered major equipment makers and service providers in the U.S. and Europe. ESG Model Desmartin and Thevoux-Chabuel created a model to evaluate and score telecommunication companies based on the three ESC factors. The environmental factor was labeled Health, Safety and Environment and covered whether the firm had an environmental management system, the environmental impact of telecom products and services, and the safety of products and services. Social factors included regulatory risks and opportunities, and intellectual capital (reflecting customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG I scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom ➜ customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential i electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom operators, the most important social factors identified were regulatory risks, and intellectual capital generated from the management of human resources and customer, supplier, and partner relationships (termed social ecosystem). On the human resources side the Oddo analysis attempted to identify companies characterized by a workforce that was productive and economically efficient but at the same time paid well. On the social ecosystem side the analysts assessed the innovation capacity, brand value, supply chain efficiency, the quality, durability, growth potential and diversification of distribution networks, product and service quality, and customer satisfaction. The criteria used to generate scores for human resource and social ecosystem factors are I shown in Exhibits 4 and 5. Governance The sustainable development and corporate governance criteria used in the ESG model are shown in Exhibits 6 and 7. The sustainable development criteria distinguished between companies that factored corporate social responsibility (CSR) and sustainable development into their internal and external communications and those that integrated CSR and sustainable development into their strategies and business models. The weightings used for corporate governance criteria differed for large-cap and mid to small sized firms, for firms with a controlling interest and for those with diversified owners, and for family-owned businesses. Exhibit 8 shows the scores that BT and FT received by Oddo analysts in each of the factors. BT scored higher by more than 20 points and outperformed FT in all three categories. Industry Drivers Oddo's SRI analysis of the telecom industry identified five long-term performance drivers: sustainable development, regulation, sector consolidation, emerging countries, and technological advances or breakthroughs. Sustainable Development. The analysts rated the sector highly for sustainable development, primarily because they assessed that it was well-positioned to create dematerialized growth (defined as making more products using fewer resources), facilitate entrepreneurial activities, open new markets, and help other organizations and industries become more sustainable. Regulation. Because the telecom operator sector was viewed as a natural monopoly, it had been subject to regulation. Oddo analysts perceived this to be a key industry risk, particularly for many European telecom operators as regulators focused on increasing competition to lower prices and offer more services options for retail consumers. Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with technological change were likely to face product obsolescence and financial failure. Operators also relied on technology so they needed to ensure that their offerings delivered the newest services, which often required heavy investment. Results and Recommendations Using the latest iteration of its ESG model, SRI Research analyzed 25 companies, assigning each an ESG score, rank, recommendation and outlook (see Exhibit 9). A summary of the findings is presented in Exhibit 10. Of those companies that were covered by Oddo's financial analysts and given a recommendation, only three-Iliad, Telefonica, and Vivendi-had ESG recommendations that matched the financial recommendation. Desmartin explained: The first reason there may be a difference is because we are looking at different time horizons. The SRI team looks at long-term prospects, usually between 12 to 60 months, while the financial analysts typically are looking more short-term. The other reason for differences is when there is a mismatch between the SRI team and the financial analyst covering the sector or the company, about what is material for the sector or the company. Our aim is not to cover all ESG indicators but those that are most relevant and the most material from a financial standpoint. Our goal is to be right 50% of the time or more. In looking at the past performance of the 25 stocks, those that SRI Research identified as strong opportunity or opportunity outperformed the DJ Stoxx Telecommunications index by 171%; while those companies SRI Research identified as having moderate to high risk, underperformed the same index by 32% (Exhibit 11). Keyes' Decision John Keyes reflected on the Oddo SRI Telecom report. The ESG and financial recommendations for British Telecom and France Telecom led him to the opposite conclusions. He reviewed the recent financial performance (see Exhibit 12) and stock market performance (see Exhibit 13) of the two companies. The performance of BT was impressively strong in 2006 and 2007 where earnings-per- share increased significantly and the company proposed an increase in dividends. However, BT's performance was completely reversed as the financial crisis hit and investors' expectations adjusted. How should he proceed? Should he follow the ESG recommendation and buy BT stock, or the financial recommendation and take a position in FT? Exhibit 1 Integrating ESG into valuation models ESG Research Environment Management Risks Opportunities Social Regulation IC-Human Capital IC-License to Operate/Reputation IC-Ecosystem, Quality, non-compliance Governance Sustainable development strategy Corporate Governance Business Ethics Source: Company documents. Note: L O N G T E RM DR I V E R S Materiality Business Model Management Statements →→Measurement ESG KPI's ESG Events Monetary Value Vahation Model Opportunities ↓ Performance Cash flow Cost of Capital Risk Premium Volatility 1 Risks "Management"refers to "Management quality". "Statements" refers to "Financial statements". "IC" is "Intellectual Capital" Exhibit 2 One-Year and Five-Year Performance Comparison: Oddo SRI vs. Industry Indices as of December 2010 Index Oddo SRI List (non-weighted) France CAC 40 France SBF 120 DJ STOXX Euro 50 DJ STOXX 600 Since Dec 31-2009 7.96% -1.74 0.77 -0.85 6.15 Since Dec- 31-2005 1.69% -17.95 -13.96 -22.32 Source: Company documents. -13.07 CAC 40 Compagnie des Agents de Change 40 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 40 French companies listed on the Paris Stock Exchange that were also traded on the options market. Construction principle: Capitalization-weighted value ratio SBF 120 Société des Bourses Françaises 120 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 120 French companies listed on the Paris Stock Exchange Construction principle: Capitalization-weighted value ratio DI STOXX Euro 50 Index Europe's leading blue-chip index provided a representation of super sector leaders in Europe. The index covered 50 stocks from 18 European countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. DI STOXX 600 Index Derived from the STOXX Europe Total Market Index (TMI) and was a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represented large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. Oddo Securities-ESG Integration Exhibit 3 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Human resources Organizational Ecosystem Social Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. Equipment Makers 3% 6 2 5 16 1 5194 29 46 2333 10 25 38 100% Operators 1% NOK 2 14 15 6235 54 10 25 3 38 100% Exhibit 4 Human Resources Indicators and Criteria for the Telecom Sector Indicator Governance and HR profile Attractiveness and recruitment ||| Career integration and planning Motivation and satisfaction Operational HR management Total Criteria Growth model Age pyramid management HR representation on executive board HR transparency Size-related attractiveness International presence-related attractiveness Economic attractiveness Average wage costs Employee share of ownership Growth in headcount Integration, annual review rate, career planning Training quality and effectiveness Management of reorganizational/restructuring measures Departure/arrival of key personnel Staff tumover Absenteeism Workplace climate and dialogue Payroll management Quality of local management Operating margin per employee Social liabilities (pension funds, healthcare, class actions) Weighting 10% 6 4 2 5 4 2 2 5 2 4 2 10 5 3 10 3 2 5 5 9 100% Nature of Criterion Quantitative & qualitative Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative & qualitative Quantitative & qualitative Mainly Qualitative Qualitative Qui Ive Quantitative Mainly Qualitative Quantitative Qualitative Quantitative Quantitative Exhibit 5 Ecosystem Criteria for the Telecom Sector Criteria Corporate culture, Internal organization Innovation/R&D/patents Brand Supply chain, logistics, industrial partnerships Distribution network Product and service quality Customer satisfaction Total Source Company documents. Criteria Length of sustainable development track record and learning curve Sustainable development organization: Direct reporting: Director profile; Resources allocated; Interactions - across functions Sustainable development information systems Products and services with sustainable development added value Sustainable development objectives and results Total Equipment Makers 4.0% Source: Company documents. 11.0 2.0 4.0 2.0 3.0 99 3.0 2 Exhibit 6 Sustainable Development Strategy Criteria for the Telecom Sector Equipment Makers 1.0% 29.0% 1.0 2.0 3.0 3.0 Operators 2.0% 4.0 3.0 2.0 10.0% 5.0 3.0 4.0 23.0% Operators 1.0% 1.0 2.0 3.0 3.0 Nature of Criteria Qualitative Quantitative & qualitative Quantitative & qualitative Qualitative 10.0% Qualitative Quantitative & qualitative Quantitative & qualitative Nature of Criteria Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative & qualitative Quantitative & qualitative Exhibit 7 Corporate Governance Criteria for the Telecom Sector Criteria 1. Minority shareholder rights (1 share-1 vote; anti- takeover measures) 2. Separation of functions. (CEO-Chairman) 3. Separation of roles (executives/shareholders/ board members) 4. Executive succession planning 5. Transparency and cohesion of executive pay 6. Assessment of executive pay and long-term performance 7. Board effectiveness (composition, functioning) 8. Committees reporting to the board. 9. Audit processes; degree of accountability, legal and tax transparency and complexity 10. Quality of financial communication Total Source: Company documents. Non- Controlled Controlled 17% 12% 13 2 10 3 20 63 13 12 Large Cap 100% 10 10 10 20 13 12 100% Mid-Small Cap Non- Controlled 18% 13 2 15 3 20 11 100% Controlled 11% 10 10 15 21 11 100% Family- owned 12% S 13 20 03 16 12 100% Exhibit 8 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Social Human resources Organizational Ecosystem Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. British Telecom 1.0 2.0 0.0 5.0 8.0 9.0 8.8 1.5 15.5 34.8 10.0 18.8 2.5 31.3 74.1 PHONE France Telecom 0.5 1.5 0.0 2.0 4.0 8.4 0.5 15.4 28.3 5.5 14.0 2.0 21.5 53.8 Exhibit 9 Telecom Sector: Summary of ESG Scores, Rank, Recommendation, Outlook, Financial Recommendation, and Target Prices Company Equipment Makers Alcatel-Lucent Clavu Ericsson Gemalto Motorola Nokia Oberthur Tandberg Operators AT&T Belgacom Bouygues British Telecom Deutsche Telekom France Telecom Iliad KPN Maroc Telecom Mobistar OTE Sprint Telecom Italia Telefonica Verizon Vivendi Vodafone Averages Equipment Makers Operators Telecom Sector Maximum possible score 1-Strong opportunity ESG ESG ESG ESG Score Rank Recommendation" Outlook 2 Opportunity 3-Moderate risk A High risk 51.5 00.0 65.3 59.8 50.3 77.1 57.1 70.7 61.7 53.2 55.5 74.0 51.4 53.3 62.1 61.6 51.0 50.8 47.8 38.7 54.1 59.2 60.7 63.2 61.7 Source: Company documents. SEK Swedish Krona Recommendation 62.3 56.5 58.3 100.0 75458162 3 329191655467108 7 2 4 32223131 2 NNNNWAAW WNNWW3333 Positive THE Negative na na Stable na na na na Positive Stable Negative Positive Stable Stable na na na na Negative Stable na Positive Stable Pinancial Recommendation" 2 Nut fullumed Not followed 2 Accept the offer Not followed Not followed 2 2727 Not followed Not followed Target Price €3,5 118 SEK 65,0 €29.0 na €16.0 €6,7 na na €25.5 €51.0 €170.0 €14.0 €24.0 €79.0 €13.0 €16,5 €60.0 €24.0 na €1.0 €17,5 na €33.0 £115 Exhibit 12 Financial performance of France Telecom and British Telecom France Telecom, for year ended December 31 (in Emil) Total revenue Revenue growth NOPAT Margin Asset tumover ROA Spread Leverage Impact of leverage ROE Percent of revenues Grom profit Operating expenses Unusual income (expenses) Discontinued operations Valuation multiples Price-to-eamings Price-to-book value British Telecom, for the year ended March 31 (in Emillion) Total revence Revenue growth NOPAT Margin Asstturnover ROA Spread Leverage Impact of leverage ROE Percent of revences Gross profit Operating expenses Unusual income (expenses) Discontinued operations 2006 51,702 7.5% 20 10.3% 0.71 7.2% 4.8% 1.95 9.4% 16.6% 43.6% 23.6% -0.3% 1.3% 11.82 2.28 2007 20,223 3.6% 17.0% 173 29.3% 23,5% 6.54 153.8% 183.2% 61.9% 45.7% -1.3% 0.0% 1007 46,568 4.9% 30.48 7.47 18.4% 0.68 12.6% 7.3% 1.55 10.9% 23.5% 46.7% 23.0% -7.5% 6.9% 31.23 2.37 2008 20,704 2.4% 11.6% 1.71 19.8% 11.4% 1.87 21.2% 41.0% 61.8% 45.5% -2.9% 0.0% 2000 46,712 0.3% 8.32 4.02 12.3% 0.70 8.6% 41% 1.26 5.2% 13.8% 42.4% 19.7% 1.4% 0.4% 9.40 1.77 2009 21,390 3.3% 2.4% 1.43 3.4% LO% Valuation multiples Price-to-samnings Price-to-book value NOTAT is net operating profit after taxe NOPAT margin i NOPAT over Not Ants Asset turnover is total revenue over asets. Spread is NOPAT margn minus the interest on all interest paying abilities, Leverage in total debt minus cash over gulty Impact of s spread times leverage Sou Capulced July 2011. 1.77 -7.0% -30% 61.4% 55.9% -26% 0.0% 6.66 2.20 1. From a company valuation perspective, how should we include the elements of the ESG analysis in the process? Should we include the elements of ESG in the cash flows or in the discount rate, or in both? (Remember at the end we need to arrive to an intrinsic value). Any ideas on how to do it? 2. Should the financial elements dominate the analysis? Those of ESG? Do they complement each other? How can we better understand the situation? Please provide your perspective on this situation. Oddo Securities-ESG Integration In January of 2009, John Keyes, portfolio manager for a medium-sized UK fund, reviewed the analyst report on the telecommunications industry he had just received from the French brokerage firm Oddo Securities (Oddo). Keyes was intrigued by Oddo's research, which provided two ratings of stocks covered, a financial rating and an environmental, social and governance (PSG) rating. Keyes was particularly struck by the returns generated by Oddo's ESG recommendations, which had outperformed most major stocks indices over the last five years. He reviewed the recommendations and analysis for two telecom stocks he was considering adding to his portfolio, British Telecom (BT) and France Telecom (FT). The Oddo analysis assigned BT its highest PSC rating (a Strong Opportunity) but rated the company as a "Reduce" in the financial recommendation. In contrast, FT was rated as a Moderate Risk under the ESC rating and a "Buy" for the financial rating, Keyes wondered how he should interpret these conflicting ratings, and which deserved more of his attention. Background on Oddo Securities Oddo Securities was owned by Oddo & Cie- an independent investment services firm that in 2010 had 900 employees, offices in Paris, Dubai, Madrid, and New York, and over €17 billion in assets under management. The firm was 80% owned by management, employees, and the Oddo family, and 20% by German-based insurer Allianz. It was headed by Philippe Oddo, whose family had been in the stockbroker business for five generations. In addition to its brokerage business, Oddo & Cie owned an investment bank, a financial advisory business, options and commodity businesses, a private bank, and an asset management unit. Oddo Securities was one of France's top brokers. The unit catered to an international institutional clientele providing brokerage services and research on a broad product range, including shares, futures, options and fixed income/credit. The research team, with 60 analysts, economists, and strategists, focused on the French and European market-equities, corporate bonds, and derivatives. The 5.momber prodit vocesuch term fomured on five incom and covered more than 120 1 capitalization of the France CAC 40 index, 89% of the DJ STOXX Euro 50 index and 60% of the DJ STOXX 600 index. ESG Investing and Analysis The use of ESC criteria for investing was a relatively recent innovation in the investment management industry and fell under the umbrella of socially responsible investing (SRI). SRI strategies could be broadly classified into five categories: negative screening, positive screening, integration, thematic, and engagement. Under negative screening, companies were excluded from investment portfolios based on ethical concerns about the safety of their products (e.g. tobacco, weapons, etc.) and their ethical standards of behavior. Positive screening identified companies with best-in-class ESG performance as investment candidates. Integration strategies focused on relations between ESG data, cash flows and/or cost of capital, and then embedded those relationships into valuation models. Thematic strategies followed either a multi-theme approach focusing on a broad range of long-term environmental or social issues (e.g. ageing societies, sustainable nutrition, clean energy, low-income solutions, urbanization, health, sustainable resources), or a hybrid approach. combining a large cap "best in class" universe with a thematic overlay. Finally, engagement represented a form of shareholder activism where investors sought to influence how companies addressed material ESG issues to protect and enhance the value of their investments. SRI investing experienced dramatic growth in the 1990s and 2000s. Between 2001 and 2007 assets under management of socially responsible investors grew by $400 billion in the US, $600 billion in the U.K, and $400 billion in Canada. In 2007, mutual funds that invested in socially conscious firms had assets under management of more than $2.5 trillion in the United States, $2 trillion in Europe, $500 billion in Canada, $100 billion in Japan and 564 billion in Australia. ESG Analysis at Oddo D ESG Analysis at Oddo In June 2005, Oddo hired Jean-Phillippe Desmartin to head its SRI initiative. Desmartin, who had started his career in financial engineering at Credit du Nord, a subsidiary of Societe Generale, and subsequently worked for several social and environmental rating agencies, was charged with developing a systematic methodology for SRI analysis at Oddo. He subsequently hired Sebastien Thevoux-Chabuel as a senior analyst in the initiative. Thevoux-Chabuel had been with Oddo since 2005 as a sell-side analyst on the European Technology sector and he had experience at Deutsche Bank and BFT, a subsidiary of Credit Agricole, as a buy-side analyst. ESG research at Oddo was divided into three broad areas, Environmental, Social and Governance (Exhibit 1). Environmental factors included environmental management, risks and opportunities. Social factors covered regulatory risks, the management of the firm's human resources, its reputational capital and brands, and its supplier and partner relationships. Governance factors included the firm's commitment to sustainable development (Le. using resources to meet human The CAC 40 was an index of 40 stocks traded on the Paris Stock Exchange. The Dow Jones STOXX Euro 50 Index represented 50 super sector market leaders in the 12 Eurosone countries Austria, Belgium, Finland, France, Germany Greece, Ireland. Italy, Luxemburg, the Netherlands, Portugal and Spain. The Dow Jones STOXX 600 Index was comprised of 600 highly capitalized and actively traded stocks listed and traded on stock exchanges from 17 European countries The authors calculated these numbers from information provided by national and international organizations that track socially conscious funds, such as Eurosif, Social Investment Forum, Responsible Investment Association Australasia, Social Responsible Organization, and SRI funds in Asia needs while also preserving the environment), adherence to corporate governance best practices, and business ethics. The Oddo SRI Research team, working in collaboration with the firm's sector analysts, used a multi-step approach to build separate ESG models for each sector. Under the first step, the analyst team assessed which ESG factors were likely to be relevant and material for firms in the sector. Once these constructs were identified, the team developed quantitative and qualitative metrics for each material factor. Finally, the analyst team determined appropriate sector-specific weightings for the metrics, enabling them to be aggregated into separate environmental, social and governance performance scores, and into a total ESG score. In explaining how the weightings were created, Desmartin noted that they are "intended to reflect the degree to which our ESG performance factors correlate with returns." Weights were estimated using historical relations between the sector's metrics/factors and its stock returns. The time horizon over which the historical relations were estimated ranged between 1 and 5 years depending on the availability of data. The ESG analysts at Oddo then used the sector metrics and weightings generated from this process to construct ESG scores for individual companies within the sector. Based on a company's aggregate score, Oddo issued one of four ESG recommendations (Strong Opportunity, Opportunity, Moderate Risk, or High Risk). Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the ESG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysts who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESC analysis and do not have control over the analysis." ddo's ESG approach was designed to provide investors with insights into a firm's management ilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial aj d ESG Integration 100% & Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the RSG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that: "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysis who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESG analysis and do not have control over the analysis. Oddo's ESG approach was designed to provide investors with insights into a firm's management capabilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial performance. The goal of the ESG analysis, therefore, was to allow clients to optimize the ratio of returns to risk. Desmartin explained the firm's approach and the type of clients it sought to attract: In practice we are very far from some of the ethical approaches used in the U.S. We do not exclude companies, we do not exclude activities, and we do not say what is good and what is bad. Ours is not a religious or moral approach. We simply want to find the best investment opportunities for our clients in the long-term.... We want 80% of our SRI research business to come from mainstream investors, not explicitly socially-conscious investors. Already, 50% of our business is coming from mainstream investors. SRI research was targeted to large institutional investors with long-term time horizons such as pension funds and insurance companies. However, Desmartin observed "we have seen some recent interest in SRI from hedge funds. I would not say it is a trend, yet it is very interesting because their focus is exclusively on making money." Oddo's ESG recommendations reflected the expected performance of each stock over a long-term horizon (i.e., beyond 12 months). As reported in Exhibit 2. the stocks included in Oddo's SRI Strong Opportunity portfolio had outperformed the market for both the five-year and one-year horizons. 1+ *** addo Securities-ESG Integration 4/21 100% & Oddo calculated that from 2005 to 2010, its Strong Opportunity portfolio beat market indices by between 1,476 and 2,401 basis points (bps), depending on the index. For 2010, the portfolio beat the market by 181 to 970 bps, again depending on the index. Oddo's Telecom Sector Report Oddo's study of the telecom sector covered major equipment makers and service providers in the U.S. and Europe. ESG Model Desmartin and Thevoux-Chabuel created a model to evaluate and score telecommunication companies based on the three ESC factors. The environmental factor was labeled Health, Safety and Environment and covered whether the firm had an environmental management system, the environmental impact of telecom products and services, and the safety of products and services. Social factors included regulatory risks and opportunities, and intellectual capital (reflecting customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG I scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom ➜ customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential i electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom operators, the most important social factors identified were regulatory risks, and intellectual capital generated from the management of human resources and customer, supplier, and partner relationships (termed social ecosystem). On the human resources side the Oddo analysis attempted to identify companies characterized by a workforce that was productive and economically efficient but at the same time paid well. On the social ecosystem side the analysts assessed the innovation capacity, brand value, supply chain efficiency, the quality, durability, growth potential and diversification of distribution networks, product and service quality, and customer satisfaction. The criteria used to generate scores for human resource and social ecosystem factors are I shown in Exhibits 4 and 5. Governance The sustainable development and corporate governance criteria used in the ESG model are shown in Exhibits 6 and 7. The sustainable development criteria distinguished between companies that factored corporate social responsibility (CSR) and sustainable development into their internal and external communications and those that integrated CSR and sustainable development into their strategies and business models. The weightings used for corporate governance criteria differed for large-cap and mid to small sized firms, for firms with a controlling interest and for those with diversified owners, and for family-owned businesses. Exhibit 8 shows the scores that BT and FT received by Oddo analysts in each of the factors. BT scored higher by more than 20 points and outperformed FT in all three categories. Industry Drivers Oddo's SRI analysis of the telecom industry identified five long-term performance drivers: sustainable development, regulation, sector consolidation, emerging countries, and technological advances or breakthroughs. Sustainable Development. The analysts rated the sector highly for sustainable development, primarily because they assessed that it was well-positioned to create dematerialized growth (defined as making more products using fewer resources), facilitate entrepreneurial activities, open new markets, and help other organizations and industries become more sustainable. Regulation. Because the telecom operator sector was viewed as a natural monopoly, it had been subject to regulation. Oddo analysts perceived this to be a key industry risk, particularly for many European telecom operators as regulators focused on increasing competition to lower prices and offer more services options for retail consumers. Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with technological change were likely to face product obsolescence and financial failure. Operators also relied on technology so they needed to ensure that their offerings delivered the newest services, which often required heavy investment. Results and Recommendations Using the latest iteration of its ESG model, SRI Research analyzed 25 companies, assigning each an ESG score, rank, recommendation and outlook (see Exhibit 9). A summary of the findings is presented in Exhibit 10. Of those companies that were covered by Oddo's financial analysts and given a recommendation, only three-Iliad, Telefonica, and Vivendi-had ESG recommendations that matched the financial recommendation. Desmartin explained: The first reason there may be a difference is because we are looking at different time horizons. The SRI team looks at long-term prospects, usually between 12 to 60 months, while the financial analysts typically are looking more short-term. The other reason for differences is when there is a mismatch between the SRI team and the financial analyst covering the sector or the company, about what is material for the sector or the company. Our aim is not to cover all ESG indicators but those that are most relevant and the most material from a financial standpoint. Our goal is to be right 50% of the time or more. In looking at the past performance of the 25 stocks, those that SRI Research identified as strong opportunity or opportunity outperformed the DJ Stoxx Telecommunications index by 171%; while those companies SRI Research identified as having moderate to high risk, underperformed the same index by 32% (Exhibit 11). Keyes' Decision John Keyes reflected on the Oddo SRI Telecom report. The ESG and financial recommendations for British Telecom and France Telecom led him to the opposite conclusions. He reviewed the recent financial performance (see Exhibit 12) and stock market performance (see Exhibit 13) of the two companies. The performance of BT was impressively strong in 2006 and 2007 where earnings-per- share increased significantly and the company proposed an increase in dividends. However, BT's performance was completely reversed as the financial crisis hit and investors' expectations adjusted. How should he proceed? Should he follow the ESG recommendation and buy BT stock, or the financial recommendation and take a position in FT? Exhibit 1 Integrating ESG into valuation models ESG Research Environment Management Risks Opportunities Social Regulation IC-Human Capital IC-License to Operate/Reputation IC-Ecosystem, Quality, non-compliance Governance Sustainable development strategy Corporate Governance Business Ethics Source: Company documents. Note: L O N G T E RM DR I V E R S Materiality Business Model Management Statements →→Measurement ESG KPI's ESG Events Monetary Value Vahation Model Opportunities ↓ Performance Cash flow Cost of Capital Risk Premium Volatility 1 Risks "Management"refers to "Management quality". "Statements" refers to "Financial statements". "IC" is "Intellectual Capital" Exhibit 2 One-Year and Five-Year Performance Comparison: Oddo SRI vs. Industry Indices as of December 2010 Index Oddo SRI List (non-weighted) France CAC 40 France SBF 120 DJ STOXX Euro 50 DJ STOXX 600 Since Dec 31-2009 7.96% -1.74 0.77 -0.85 6.15 Since Dec- 31-2005 1.69% -17.95 -13.96 -22.32 Source: Company documents. -13.07 CAC 40 Compagnie des Agents de Change 40 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 40 French companies listed on the Paris Stock Exchange that were also traded on the options market. Construction principle: Capitalization-weighted value ratio SBF 120 Société des Bourses Françaises 120 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 120 French companies listed on the Paris Stock Exchange Construction principle: Capitalization-weighted value ratio DI STOXX Euro 50 Index Europe's leading blue-chip index provided a representation of super sector leaders in Europe. The index covered 50 stocks from 18 European countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. DI STOXX 600 Index Derived from the STOXX Europe Total Market Index (TMI) and was a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represented large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. Oddo Securities-ESG Integration Exhibit 3 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Human resources Organizational Ecosystem Social Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. Equipment Makers 3% 6 2 5 16 1 5194 29 46 2333 10 25 38 100% Operators 1% NOK 2 14 15 6235 54 10 25 3 38 100% Exhibit 4 Human Resources Indicators and Criteria for the Telecom Sector Indicator Governance and HR profile Attractiveness and recruitment ||| Career integration and planning Motivation and satisfaction Operational HR management Total Criteria Growth model Age pyramid management HR representation on executive board HR transparency Size-related attractiveness International presence-related attractiveness Economic attractiveness Average wage costs Employee share of ownership Growth in headcount Integration, annual review rate, career planning Training quality and effectiveness Management of reorganizational/restructuring measures Departure/arrival of key personnel Staff tumover Absenteeism Workplace climate and dialogue Payroll management Quality of local management Operating margin per employee Social liabilities (pension funds, healthcare, class actions) Weighting 10% 6 4 2 5 4 2 2 5 2 4 2 10 5 3 10 3 2 5 5 9 100% Nature of Criterion Quantitative & qualitative Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative & qualitative Quantitative & qualitative Mainly Qualitative Qualitative Qui Ive Quantitative Mainly Qualitative Quantitative Qualitative Quantitative Quantitative Exhibit 5 Ecosystem Criteria for the Telecom Sector Criteria Corporate culture, Internal organization Innovation/R&D/patents Brand Supply chain, logistics, industrial partnerships Distribution network Product and service quality Customer satisfaction Total Source Company documents. Criteria Length of sustainable development track record and learning curve Sustainable development organization: Direct reporting: Director profile; Resources allocated; Interactions - across functions Sustainable development information systems Products and services with sustainable development added value Sustainable development objectives and results Total Equipment Makers 4.0% Source: Company documents. 11.0 2.0 4.0 2.0 3.0 99 3.0 2 Exhibit 6 Sustainable Development Strategy Criteria for the Telecom Sector Equipment Makers 1.0% 29.0% 1.0 2.0 3.0 3.0 Operators 2.0% 4.0 3.0 2.0 10.0% 5.0 3.0 4.0 23.0% Operators 1.0% 1.0 2.0 3.0 3.0 Nature of Criteria Qualitative Quantitative & qualitative Quantitative & qualitative Qualitative 10.0% Qualitative Quantitative & qualitative Quantitative & qualitative Nature of Criteria Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative & qualitative Quantitative & qualitative Exhibit 7 Corporate Governance Criteria for the Telecom Sector Criteria 1. Minority shareholder rights (1 share-1 vote; anti- takeover measures) 2. Separation of functions. (CEO-Chairman) 3. Separation of roles (executives/shareholders/ board members) 4. Executive succession planning 5. Transparency and cohesion of executive pay 6. Assessment of executive pay and long-term performance 7. Board effectiveness (composition, functioning) 8. Committees reporting to the board. 9. Audit processes; degree of accountability, legal and tax transparency and complexity 10. Quality of financial communication Total Source: Company documents. Non- Controlled Controlled 17% 12% 13 2 10 3 20 63 13 12 Large Cap 100% 10 10 10 20 13 12 100% Mid-Small Cap Non- Controlled 18% 13 2 15 3 20 11 100% Controlled 11% 10 10 15 21 11 100% Family- owned 12% S 13 20 03 16 12 100% Exhibit 8 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Social Human resources Organizational Ecosystem Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. British Telecom 1.0 2.0 0.0 5.0 8.0 9.0 8.8 1.5 15.5 34.8 10.0 18.8 2.5 31.3 74.1 PHONE France Telecom 0.5 1.5 0.0 2.0 4.0 8.4 0.5 15.4 28.3 5.5 14.0 2.0 21.5 53.8 Exhibit 9 Telecom Sector: Summary of ESG Scores, Rank, Recommendation, Outlook, Financial Recommendation, and Target Prices Company Equipment Makers Alcatel-Lucent Clavu Ericsson Gemalto Motorola Nokia Oberthur Tandberg Operators AT&T Belgacom Bouygues British Telecom Deutsche Telekom France Telecom Iliad KPN Maroc Telecom Mobistar OTE Sprint Telecom Italia Telefonica Verizon Vivendi Vodafone Averages Equipment Makers Operators Telecom Sector Maximum possible score 1-Strong opportunity ESG ESG ESG ESG Score Rank Recommendation" Outlook 2 Opportunity 3-Moderate risk A High risk 51.5 00.0 65.3 59.8 50.3 77.1 57.1 70.7 61.7 53.2 55.5 74.0 51.4 53.3 62.1 61.6 51.0 50.8 47.8 38.7 54.1 59.2 60.7 63.2 61.7 Source: Company documents. SEK Swedish Krona Recommendation 62.3 56.5 58.3 100.0 75458162 3 329191655467108 7 2 4 32223131 2 NNNNWAAW WNNWW3333 Positive THE Negative na na Stable na na na na Positive Stable Negative Positive Stable Stable na na na na Negative Stable na Positive Stable Pinancial Recommendation" 2 Nut fullumed Not followed 2 Accept the offer Not followed Not followed 2 2727 Not followed Not followed Target Price €3,5 118 SEK 65,0 €29.0 na €16.0 €6,7 na na €25.5 €51.0 €170.0 €14.0 €24.0 €79.0 €13.0 €16,5 €60.0 €24.0 na €1.0 €17,5 na €33.0 £115 Exhibit 12 Financial performance of France Telecom and British Telecom France Telecom, for year ended December 31 (in Emil) Total revenue Revenue growth NOPAT Margin Asset tumover ROA Spread Leverage Impact of leverage ROE Percent of revenues Grom profit Operating expenses Unusual income (expenses) Discontinued operations Valuation multiples Price-to-eamings Price-to-book value British Telecom, for the year ended March 31 (in Emillion) Total revence Revenue growth NOPAT Margin Asstturnover ROA Spread Leverage Impact of leverage ROE Percent of revences Gross profit Operating expenses Unusual income (expenses) Discontinued operations 2006 51,702 7.5% 20 10.3% 0.71 7.2% 4.8% 1.95 9.4% 16.6% 43.6% 23.6% -0.3% 1.3% 11.82 2.28 2007 20,223 3.6% 17.0% 173 29.3% 23,5% 6.54 153.8% 183.2% 61.9% 45.7% -1.3% 0.0% 1007 46,568 4.9% 30.48 7.47 18.4% 0.68 12.6% 7.3% 1.55 10.9% 23.5% 46.7% 23.0% -7.5% 6.9% 31.23 2.37 2008 20,704 2.4% 11.6% 1.71 19.8% 11.4% 1.87 21.2% 41.0% 61.8% 45.5% -2.9% 0.0% 2000 46,712 0.3% 8.32 4.02 12.3% 0.70 8.6% 41% 1.26 5.2% 13.8% 42.4% 19.7% 1.4% 0.4% 9.40 1.77 2009 21,390 3.3% 2.4% 1.43 3.4% LO% Valuation multiples Price-to-samnings Price-to-book value NOTAT is net operating profit after taxe NOPAT margin i NOPAT over Not Ants Asset turnover is total revenue over asets. Spread is NOPAT margn minus the interest on all interest paying abilities, Leverage in total debt minus cash over gulty Impact of s spread times leverage Sou Capulced July 2011. 1.77 -7.0% -30% 61.4% 55.9% -26% 0.0% 6.66 2.20 1. From a company valuation perspective, how should we include the elements of the ESG analysis in the process? Should we include the elements of ESG in the cash flows or in the discount rate, or in both? (Remember at the end we need to arrive to an intrinsic value). Any ideas on how to do it? 2. Should the financial elements dominate the analysis? Those of ESG? Do they complement each other? How can we better understand the situation? Please provide your perspective on this situation. Oddo Securities-ESG Integration In January of 2009, John Keyes, portfolio manager for a medium-sized UK fund, reviewed the analyst report on the telecommunications industry he had just received from the French brokerage firm Oddo Securities (Oddo). Keyes was intrigued by Oddo's research, which provided two ratings of stocks covered, a financial rating and an environmental, social and governance (PSG) rating. Keyes was particularly struck by the returns generated by Oddo's ESG recommendations, which had outperformed most major stocks indices over the last five years. He reviewed the recommendations and analysis for two telecom stocks he was considering adding to his portfolio, British Telecom (BT) and France Telecom (FT). The Oddo analysis assigned BT its highest PSC rating (a Strong Opportunity) but rated the company as a "Reduce" in the financial recommendation. In contrast, FT was rated as a Moderate Risk under the ESC rating and a "Buy" for the financial rating, Keyes wondered how he should interpret these conflicting ratings, and which deserved more of his attention. Background on Oddo Securities Oddo Securities was owned by Oddo & Cie- an independent investment services firm that in 2010 had 900 employees, offices in Paris, Dubai, Madrid, and New York, and over €17 billion in assets under management. The firm was 80% owned by management, employees, and the Oddo family, and 20% by German-based insurer Allianz. It was headed by Philippe Oddo, whose family had been in the stockbroker business for five generations. In addition to its brokerage business, Oddo & Cie owned an investment bank, a financial advisory business, options and commodity businesses, a private bank, and an asset management unit. Oddo Securities was one of France's top brokers. The unit catered to an international institutional clientele providing brokerage services and research on a broad product range, including shares, futures, options and fixed income/credit. The research team, with 60 analysts, economists, and strategists, focused on the French and European market-equities, corporate bonds, and derivatives. The 5.momber prodit vocesuch term fomured on five incom and covered more than 120 1 capitalization of the France CAC 40 index, 89% of the DJ STOXX Euro 50 index and 60% of the DJ STOXX 600 index. ESG Investing and Analysis The use of ESC criteria for investing was a relatively recent innovation in the investment management industry and fell under the umbrella of socially responsible investing (SRI). SRI strategies could be broadly classified into five categories: negative screening, positive screening, integration, thematic, and engagement. Under negative screening, companies were excluded from investment portfolios based on ethical concerns about the safety of their products (e.g. tobacco, weapons, etc.) and their ethical standards of behavior. Positive screening identified companies with best-in-class ESG performance as investment candidates. Integration strategies focused on relations between ESG data, cash flows and/or cost of capital, and then embedded those relationships into valuation models. Thematic strategies followed either a multi-theme approach focusing on a broad range of long-term environmental or social issues (e.g. ageing societies, sustainable nutrition, clean energy, low-income solutions, urbanization, health, sustainable resources), or a hybrid approach. combining a large cap "best in class" universe with a thematic overlay. Finally, engagement represented a form of shareholder activism where investors sought to influence how companies addressed material ESG issues to protect and enhance the value of their investments. SRI investing experienced dramatic growth in the 1990s and 2000s. Between 2001 and 2007 assets under management of socially responsible investors grew by $400 billion in the US, $600 billion in the U.K, and $400 billion in Canada. In 2007, mutual funds that invested in socially conscious firms had assets under management of more than $2.5 trillion in the United States, $2 trillion in Europe, $500 billion in Canada, $100 billion in Japan and 564 billion in Australia. ESG Analysis at Oddo D ESG Analysis at Oddo In June 2005, Oddo hired Jean-Phillippe Desmartin to head its SRI initiative. Desmartin, who had started his career in financial engineering at Credit du Nord, a subsidiary of Societe Generale, and subsequently worked for several social and environmental rating agencies, was charged with developing a systematic methodology for SRI analysis at Oddo. He subsequently hired Sebastien Thevoux-Chabuel as a senior analyst in the initiative. Thevoux-Chabuel had been with Oddo since 2005 as a sell-side analyst on the European Technology sector and he had experience at Deutsche Bank and BFT, a subsidiary of Credit Agricole, as a buy-side analyst. ESG research at Oddo was divided into three broad areas, Environmental, Social and Governance (Exhibit 1). Environmental factors included environmental management, risks and opportunities. Social factors covered regulatory risks, the management of the firm's human resources, its reputational capital and brands, and its supplier and partner relationships. Governance factors included the firm's commitment to sustainable development (Le. using resources to meet human The CAC 40 was an index of 40 stocks traded on the Paris Stock Exchange. The Dow Jones STOXX Euro 50 Index represented 50 super sector market leaders in the 12 Eurosone countries Austria, Belgium, Finland, France, Germany Greece, Ireland. Italy, Luxemburg, the Netherlands, Portugal and Spain. The Dow Jones STOXX 600 Index was comprised of 600 highly capitalized and actively traded stocks listed and traded on stock exchanges from 17 European countries The authors calculated these numbers from information provided by national and international organizations that track socially conscious funds, such as Eurosif, Social Investment Forum, Responsible Investment Association Australasia, Social Responsible Organization, and SRI funds in Asia needs while also preserving the environment), adherence to corporate governance best practices, and business ethics. The Oddo SRI Research team, working in collaboration with the firm's sector analysts, used a multi-step approach to build separate ESG models for each sector. Under the first step, the analyst team assessed which ESG factors were likely to be relevant and material for firms in the sector. Once these constructs were identified, the team developed quantitative and qualitative metrics for each material factor. Finally, the analyst team determined appropriate sector-specific weightings for the metrics, enabling them to be aggregated into separate environmental, social and governance performance scores, and into a total ESG score. In explaining how the weightings were created, Desmartin noted that they are "intended to reflect the degree to which our ESG performance factors correlate with returns." Weights were estimated using historical relations between the sector's metrics/factors and its stock returns. The time horizon over which the historical relations were estimated ranged between 1 and 5 years depending on the availability of data. The ESG analysts at Oddo then used the sector metrics and weightings generated from this process to construct ESG scores for individual companies within the sector. Based on a company's aggregate score, Oddo issued one of four ESG recommendations (Strong Opportunity, Opportunity, Moderate Risk, or High Risk). Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the ESG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysts who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESC analysis and do not have control over the analysis." ddo's ESG approach was designed to provide investors with insights into a firm's management ilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial aj d ESG Integration 100% & Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the RSG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that: "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysis who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESG analysis and do not have control over the analysis. Oddo's ESG approach was designed to provide investors with insights into a firm's management capabilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial performance. The goal of the ESG analysis, therefore, was to allow clients to optimize the ratio of returns to risk. Desmartin explained the firm's approach and the type of clients it sought to attract: In practice we are very far from some of the ethical approaches used in the U.S. We do not exclude companies, we do not exclude activities, and we do not say what is good and what is bad. Ours is not a religious or moral approach. We simply want to find the best investment opportunities for our clients in the long-term.... We want 80% of our SRI research business to come from mainstream investors, not explicitly socially-conscious investors. Already, 50% of our business is coming from mainstream investors. SRI research was targeted to large institutional investors with long-term time horizons such as pension funds and insurance companies. However, Desmartin observed "we have seen some recent interest in SRI from hedge funds. I would not say it is a trend, yet it is very interesting because their focus is exclusively on making money." Oddo's ESG recommendations reflected the expected performance of each stock over a long-term horizon (i.e., beyond 12 months). As reported in Exhibit 2. the stocks included in Oddo's SRI Strong Opportunity portfolio had outperformed the market for both the five-year and one-year horizons. 1+ *** addo Securities-ESG Integration 4/21 100% & Oddo calculated that from 2005 to 2010, its Strong Opportunity portfolio beat market indices by between 1,476 and 2,401 basis points (bps), depending on the index. For 2010, the portfolio beat the market by 181 to 970 bps, again depending on the index. Oddo's Telecom Sector Report Oddo's study of the telecom sector covered major equipment makers and service providers in the U.S. and Europe. ESG Model Desmartin and Thevoux-Chabuel created a model to evaluate and score telecommunication companies based on the three ESC factors. The environmental factor was labeled Health, Safety and Environment and covered whether the firm had an environmental management system, the environmental impact of telecom products and services, and the safety of products and services. Social factors included regulatory risks and opportunities, and intellectual capital (reflecting customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG I scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom ➜ customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential i electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom operators, the most important social factors identified were regulatory risks, and intellectual capital generated from the management of human resources and customer, supplier, and partner relationships (termed social ecosystem). On the human resources side the Oddo analysis attempted to identify companies characterized by a workforce that was productive and economically efficient but at the same time paid well. On the social ecosystem side the analysts assessed the innovation capacity, brand value, supply chain efficiency, the quality, durability, growth potential and diversification of distribution networks, product and service quality, and customer satisfaction. The criteria used to generate scores for human resource and social ecosystem factors are I shown in Exhibits 4 and 5. Governance The sustainable development and corporate governance criteria used in the ESG model are shown in Exhibits 6 and 7. The sustainable development criteria distinguished between companies that factored corporate social responsibility (CSR) and sustainable development into their internal and external communications and those that integrated CSR and sustainable development into their strategies and business models. The weightings used for corporate governance criteria differed for large-cap and mid to small sized firms, for firms with a controlling interest and for those with diversified owners, and for family-owned businesses. Exhibit 8 shows the scores that BT and FT received by Oddo analysts in each of the factors. BT scored higher by more than 20 points and outperformed FT in all three categories. Industry Drivers Oddo's SRI analysis of the telecom industry identified five long-term performance drivers: sustainable development, regulation, sector consolidation, emerging countries, and technological advances or breakthroughs. Sustainable Development. The analysts rated the sector highly for sustainable development, primarily because they assessed that it was well-positioned to create dematerialized growth (defined as making more products using fewer resources), facilitate entrepreneurial activities, open new markets, and help other organizations and industries become more sustainable. Regulation. Because the telecom operator sector was viewed as a natural monopoly, it had been subject to regulation. Oddo analysts perceived this to be a key industry risk, particularly for many European telecom operators as regulators focused on increasing competition to lower prices and offer more services options for retail consumers. Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with technological change were likely to face product obsolescence and financial failure. Operators also relied on technology so they needed to ensure that their offerings delivered the newest services, which often required heavy investment. Results and Recommendations Using the latest iteration of its ESG model, SRI Research analyzed 25 companies, assigning each an ESG score, rank, recommendation and outlook (see Exhibit 9). A summary of the findings is presented in Exhibit 10. Of those companies that were covered by Oddo's financial analysts and given a recommendation, only three-Iliad, Telefonica, and Vivendi-had ESG recommendations that matched the financial recommendation. Desmartin explained: The first reason there may be a difference is because we are looking at different time horizons. The SRI team looks at long-term prospects, usually between 12 to 60 months, while the financial analysts typically are looking more short-term. The other reason for differences is when there is a mismatch between the SRI team and the financial analyst covering the sector or the company, about what is material for the sector or the company. Our aim is not to cover all ESG indicators but those that are most relevant and the most material from a financial standpoint. Our goal is to be right 50% of the time or more. In looking at the past performance of the 25 stocks, those that SRI Research identified as strong opportunity or opportunity outperformed the DJ Stoxx Telecommunications index by 171%; while those companies SRI Research identified as having moderate to high risk, underperformed the same index by 32% (Exhibit 11). Keyes' Decision John Keyes reflected on the Oddo SRI Telecom report. The ESG and financial recommendations for British Telecom and France Telecom led him to the opposite conclusions. He reviewed the recent financial performance (see Exhibit 12) and stock market performance (see Exhibit 13) of the two companies. The performance of BT was impressively strong in 2006 and 2007 where earnings-per- share increased significantly and the company proposed an increase in dividends. However, BT's performance was completely reversed as the financial crisis hit and investors' expectations adjusted. How should he proceed? Should he follow the ESG recommendation and buy BT stock, or the financial recommendation and take a position in FT? Exhibit 1 Integrating ESG into valuation models ESG Research Environment Management Risks Opportunities Social Regulation IC-Human Capital IC-License to Operate/Reputation IC-Ecosystem, Quality, non-compliance Governance Sustainable development strategy Corporate Governance Business Ethics Source: Company documents. Note: L O N G T E RM DR I V E R S Materiality Business Model Management Statements →→Measurement ESG KPI's ESG Events Monetary Value Vahation Model Opportunities ↓ Performance Cash flow Cost of Capital Risk Premium Volatility 1 Risks "Management"refers to "Management quality". "Statements" refers to "Financial statements". "IC" is "Intellectual Capital" Exhibit 2 One-Year and Five-Year Performance Comparison: Oddo SRI vs. Industry Indices as of December 2010 Index Oddo SRI List (non-weighted) France CAC 40 France SBF 120 DJ STOXX Euro 50 DJ STOXX 600 Since Dec 31-2009 7.96% -1.74 0.77 -0.85 6.15 Since Dec- 31-2005 1.69% -17.95 -13.96 -22.32 Source: Company documents. -13.07 CAC 40 Compagnie des Agents de Change 40 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 40 French companies listed on the Paris Stock Exchange that were also traded on the options market. Construction principle: Capitalization-weighted value ratio SBF 120 Société des Bourses Françaises 120 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 120 French companies listed on the Paris Stock Exchange Construction principle: Capitalization-weighted value ratio DI STOXX Euro 50 Index Europe's leading blue-chip index provided a representation of super sector leaders in Europe. The index covered 50 stocks from 18 European countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. DI STOXX 600 Index Derived from the STOXX Europe Total Market Index (TMI) and was a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represented large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. Oddo Securities-ESG Integration Exhibit 3 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Human resources Organizational Ecosystem Social Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. Equipment Makers 3% 6 2 5 16 1 5194 29 46 2333 10 25 38 100% Operators 1% NOK 2 14 15 6235 54 10 25 3 38 100% Exhibit 4 Human Resources Indicators and Criteria for the Telecom Sector Indicator Governance and HR profile Attractiveness and recruitment ||| Career integration and planning Motivation and satisfaction Operational HR management Total Criteria Growth model Age pyramid management HR representation on executive board HR transparency Size-related attractiveness International presence-related attractiveness Economic attractiveness Average wage costs Employee share of ownership Growth in headcount Integration, annual review rate, career planning Training quality and effectiveness Management of reorganizational/restructuring measures Departure/arrival of key personnel Staff tumover Absenteeism Workplace climate and dialogue Payroll management Quality of local management Operating margin per employee Social liabilities (pension funds, healthcare, class actions) Weighting 10% 6 4 2 5 4 2 2 5 2 4 2 10 5 3 10 3 2 5 5 9 100% Nature of Criterion Quantitative & qualitative Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative & qualitative Quantitative & qualitative Mainly Qualitative Qualitative Qui Ive Quantitative Mainly Qualitative Quantitative Qualitative Quantitative Quantitative Exhibit 5 Ecosystem Criteria for the Telecom Sector Criteria Corporate culture, Internal organization Innovation/R&D/patents Brand Supply chain, logistics, industrial partnerships Distribution network Product and service quality Customer satisfaction Total Source Company documents. Criteria Length of sustainable development track record and learning curve Sustainable development organization: Direct reporting: Director profile; Resources allocated; Interactions - across functions Sustainable development information systems Products and services with sustainable development added value Sustainable development objectives and results Total Equipment Makers 4.0% Source: Company documents. 11.0 2.0 4.0 2.0 3.0 99 3.0 2 Exhibit 6 Sustainable Development Strategy Criteria for the Telecom Sector Equipment Makers 1.0% 29.0% 1.0 2.0 3.0 3.0 Operators 2.0% 4.0 3.0 2.0 10.0% 5.0 3.0 4.0 23.0% Operators 1.0% 1.0 2.0 3.0 3.0 Nature of Criteria Qualitative Quantitative & qualitative Quantitative & qualitative Qualitative 10.0% Qualitative Quantitative & qualitative Quantitative & qualitative Nature of Criteria Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative & qualitative Quantitative & qualitative Exhibit 7 Corporate Governance Criteria for the Telecom Sector Criteria 1. Minority shareholder rights (1 share-1 vote; anti- takeover measures) 2. Separation of functions. (CEO-Chairman) 3. Separation of roles (executives/shareholders/ board members) 4. Executive succession planning 5. Transparency and cohesion of executive pay 6. Assessment of executive pay and long-term performance 7. Board effectiveness (composition, functioning) 8. Committees reporting to the board. 9. Audit processes; degree of accountability, legal and tax transparency and complexity 10. Quality of financial communication Total Source: Company documents. Non- Controlled Controlled 17% 12% 13 2 10 3 20 63 13 12 Large Cap 100% 10 10 10 20 13 12 100% Mid-Small Cap Non- Controlled 18% 13 2 15 3 20 11 100% Controlled 11% 10 10 15 21 11 100% Family- owned 12% S 13 20 03 16 12 100% Exhibit 8 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Social Human resources Organizational Ecosystem Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. British Telecom 1.0 2.0 0.0 5.0 8.0 9.0 8.8 1.5 15.5 34.8 10.0 18.8 2.5 31.3 74.1 PHONE France Telecom 0.5 1.5 0.0 2.0 4.0 8.4 0.5 15.4 28.3 5.5 14.0 2.0 21.5 53.8 Exhibit 9 Telecom Sector: Summary of ESG Scores, Rank, Recommendation, Outlook, Financial Recommendation, and Target Prices Company Equipment Makers Alcatel-Lucent Clavu Ericsson Gemalto Motorola Nokia Oberthur Tandberg Operators AT&T Belgacom Bouygues British Telecom Deutsche Telekom France Telecom Iliad KPN Maroc Telecom Mobistar OTE Sprint Telecom Italia Telefonica Verizon Vivendi Vodafone Averages Equipment Makers Operators Telecom Sector Maximum possible score 1-Strong opportunity ESG ESG ESG ESG Score Rank Recommendation" Outlook 2 Opportunity 3-Moderate risk A High risk 51.5 00.0 65.3 59.8 50.3 77.1 57.1 70.7 61.7 53.2 55.5 74.0 51.4 53.3 62.1 61.6 51.0 50.8 47.8 38.7 54.1 59.2 60.7 63.2 61.7 Source: Company documents. SEK Swedish Krona Recommendation 62.3 56.5 58.3 100.0 75458162 3 329191655467108 7 2 4 32223131 2 NNNNWAAW WNNWW3333 Positive THE Negative na na Stable na na na na Positive Stable Negative Positive Stable Stable na na na na Negative Stable na Positive Stable Pinancial Recommendation" 2 Nut fullumed Not followed 2 Accept the offer Not followed Not followed 2 2727 Not followed Not followed Target Price €3,5 118 SEK 65,0 €29.0 na €16.0 €6,7 na na €25.5 €51.0 €170.0 €14.0 €24.0 €79.0 €13.0 €16,5 €60.0 €24.0 na €1.0 €17,5 na €33.0 £115 Exhibit 12 Financial performance of France Telecom and British Telecom France Telecom, for year ended December 31 (in Emil) Total revenue Revenue growth NOPAT Margin Asset tumover ROA Spread Leverage Impact of leverage ROE Percent of revenues Grom profit Operating expenses Unusual income (expenses) Discontinued operations Valuation multiples Price-to-eamings Price-to-book value British Telecom, for the year ended March 31 (in Emillion) Total revence Revenue growth NOPAT Margin Asstturnover ROA Spread Leverage Impact of leverage ROE Percent of revences Gross profit Operating expenses Unusual income (expenses) Discontinued operations 2006 51,702 7.5% 20 10.3% 0.71 7.2% 4.8% 1.95 9.4% 16.6% 43.6% 23.6% -0.3% 1.3% 11.82 2.28 2007 20,223 3.6% 17.0% 173 29.3% 23,5% 6.54 153.8% 183.2% 61.9% 45.7% -1.3% 0.0% 1007 46,568 4.9% 30.48 7.47 18.4% 0.68 12.6% 7.3% 1.55 10.9% 23.5% 46.7% 23.0% -7.5% 6.9% 31.23 2.37 2008 20,704 2.4% 11.6% 1.71 19.8% 11.4% 1.87 21.2% 41.0% 61.8% 45.5% -2.9% 0.0% 2000 46,712 0.3% 8.32 4.02 12.3% 0.70 8.6% 41% 1.26 5.2% 13.8% 42.4% 19.7% 1.4% 0.4% 9.40 1.77 2009 21,390 3.3% 2.4% 1.43 3.4% LO% Valuation multiples Price-to-samnings Price-to-book value NOTAT is net operating profit after taxe NOPAT margin i NOPAT over Not Ants Asset turnover is total revenue over asets. Spread is NOPAT margn minus the interest on all interest paying abilities, Leverage in total debt minus cash over gulty Impact of s spread times leverage Sou Capulced July 2011. 1.77 -7.0% -30% 61.4% 55.9% -26% 0.0% 6.66 2.20 1. From a company valuation perspective, how should we include the elements of the ESG analysis in the process? Should we include the elements of ESG in the cash flows or in the discount rate, or in both? (Remember at the end we need to arrive to an intrinsic value). Any ideas on how to do it? 2. Should the financial elements dominate the analysis? Those of ESG? Do they complement each other? How can we better understand the situation? Please provide your perspective on this situation. Oddo Securities-ESG Integration In January of 2009, John Keyes, portfolio manager for a medium-sized UK fund, reviewed the analyst report on the telecommunications industry he had just received from the French brokerage firm Oddo Securities (Oddo). Keyes was intrigued by Oddo's research, which provided two ratings of stocks covered, a financial rating and an environmental, social and governance (PSG) rating. Keyes was particularly struck by the returns generated by Oddo's ESG recommendations, which had outperformed most major stocks indices over the last five years. He reviewed the recommendations and analysis for two telecom stocks he was considering adding to his portfolio, British Telecom (BT) and France Telecom (FT). The Oddo analysis assigned BT its highest PSC rating (a Strong Opportunity) but rated the company as a "Reduce" in the financial recommendation. In contrast, FT was rated as a Moderate Risk under the ESC rating and a "Buy" for the financial rating, Keyes wondered how he should interpret these conflicting ratings, and which deserved more of his attention. Background on Oddo Securities Oddo Securities was owned by Oddo & Cie- an independent investment services firm that in 2010 had 900 employees, offices in Paris, Dubai, Madrid, and New York, and over €17 billion in assets under management. The firm was 80% owned by management, employees, and the Oddo family, and 20% by German-based insurer Allianz. It was headed by Philippe Oddo, whose family had been in the stockbroker business for five generations. In addition to its brokerage business, Oddo & Cie owned an investment bank, a financial advisory business, options and commodity businesses, a private bank, and an asset management unit. Oddo Securities was one of France's top brokers. The unit catered to an international institutional clientele providing brokerage services and research on a broad product range, including shares, futures, options and fixed income/credit. The research team, with 60 analysts, economists, and strategists, focused on the French and European market-equities, corporate bonds, and derivatives. The 5.momber prodit vocesuch term fomured on five incom and covered more than 120 1 capitalization of the France CAC 40 index, 89% of the DJ STOXX Euro 50 index and 60% of the DJ STOXX 600 index. ESG Investing and Analysis The use of ESC criteria for investing was a relatively recent innovation in the investment management industry and fell under the umbrella of socially responsible investing (SRI). SRI strategies could be broadly classified into five categories: negative screening, positive screening, integration, thematic, and engagement. Under negative screening, companies were excluded from investment portfolios based on ethical concerns about the safety of their products (e.g. tobacco, weapons, etc.) and their ethical standards of behavior. Positive screening identified companies with best-in-class ESG performance as investment candidates. Integration strategies focused on relations between ESG data, cash flows and/or cost of capital, and then embedded those relationships into valuation models. Thematic strategies followed either a multi-theme approach focusing on a broad range of long-term environmental or social issues (e.g. ageing societies, sustainable nutrition, clean energy, low-income solutions, urbanization, health, sustainable resources), or a hybrid approach. combining a large cap "best in class" universe with a thematic overlay. Finally, engagement represented a form of shareholder activism where investors sought to influence how companies addressed material ESG issues to protect and enhance the value of their investments. SRI investing experienced dramatic growth in the 1990s and 2000s. Between 2001 and 2007 assets under management of socially responsible investors grew by $400 billion in the US, $600 billion in the U.K, and $400 billion in Canada. In 2007, mutual funds that invested in socially conscious firms had assets under management of more than $2.5 trillion in the United States, $2 trillion in Europe, $500 billion in Canada, $100 billion in Japan and 564 billion in Australia. ESG Analysis at Oddo D ESG Analysis at Oddo In June 2005, Oddo hired Jean-Phillippe Desmartin to head its SRI initiative. Desmartin, who had started his career in financial engineering at Credit du Nord, a subsidiary of Societe Generale, and subsequently worked for several social and environmental rating agencies, was charged with developing a systematic methodology for SRI analysis at Oddo. He subsequently hired Sebastien Thevoux-Chabuel as a senior analyst in the initiative. Thevoux-Chabuel had been with Oddo since 2005 as a sell-side analyst on the European Technology sector and he had experience at Deutsche Bank and BFT, a subsidiary of Credit Agricole, as a buy-side analyst. ESG research at Oddo was divided into three broad areas, Environmental, Social and Governance (Exhibit 1). Environmental factors included environmental management, risks and opportunities. Social factors covered regulatory risks, the management of the firm's human resources, its reputational capital and brands, and its supplier and partner relationships. Governance factors included the firm's commitment to sustainable development (Le. using resources to meet human The CAC 40 was an index of 40 stocks traded on the Paris Stock Exchange. The Dow Jones STOXX Euro 50 Index represented 50 super sector market leaders in the 12 Eurosone countries Austria, Belgium, Finland, France, Germany Greece, Ireland. Italy, Luxemburg, the Netherlands, Portugal and Spain. The Dow Jones STOXX 600 Index was comprised of 600 highly capitalized and actively traded stocks listed and traded on stock exchanges from 17 European countries The authors calculated these numbers from information provided by national and international organizations that track socially conscious funds, such as Eurosif, Social Investment Forum, Responsible Investment Association Australasia, Social Responsible Organization, and SRI funds in Asia needs while also preserving the environment), adherence to corporate governance best practices, and business ethics. The Oddo SRI Research team, working in collaboration with the firm's sector analysts, used a multi-step approach to build separate ESG models for each sector. Under the first step, the analyst team assessed which ESG factors were likely to be relevant and material for firms in the sector. Once these constructs were identified, the team developed quantitative and qualitative metrics for each material factor. Finally, the analyst team determined appropriate sector-specific weightings for the metrics, enabling them to be aggregated into separate environmental, social and governance performance scores, and into a total ESG score. In explaining how the weightings were created, Desmartin noted that they are "intended to reflect the degree to which our ESG performance factors correlate with returns." Weights were estimated using historical relations between the sector's metrics/factors and its stock returns. The time horizon over which the historical relations were estimated ranged between 1 and 5 years depending on the availability of data. The ESG analysts at Oddo then used the sector metrics and weightings generated from this process to construct ESG scores for individual companies within the sector. Based on a company's aggregate score, Oddo issued one of four ESG recommendations (Strong Opportunity, Opportunity, Moderate Risk, or High Risk). Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the ESG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysts who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESC analysis and do not have control over the analysis." ddo's ESG approach was designed to provide investors with insights into a firm's management ilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial aj d ESG Integration 100% & Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the RSG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that: "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysis who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESG analysis and do not have control over the analysis. Oddo's ESG approach was designed to provide investors with insights into a firm's management capabilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial performance. The goal of the ESG analysis, therefore, was to allow clients to optimize the ratio of returns to risk. Desmartin explained the firm's approach and the type of clients it sought to attract: In practice we are very far from some of the ethical approaches used in the U.S. We do not exclude companies, we do not exclude activities, and we do not say what is good and what is bad. Ours is not a religious or moral approach. We simply want to find the best investment opportunities for our clients in the long-term.... We want 80% of our SRI research business to come from mainstream investors, not explicitly socially-conscious investors. Already, 50% of our business is coming from mainstream investors. SRI research was targeted to large institutional investors with long-term time horizons such as pension funds and insurance companies. However, Desmartin observed "we have seen some recent interest in SRI from hedge funds. I would not say it is a trend, yet it is very interesting because their focus is exclusively on making money." Oddo's ESG recommendations reflected the expected performance of each stock over a long-term horizon (i.e., beyond 12 months). As reported in Exhibit 2. the stocks included in Oddo's SRI Strong Opportunity portfolio had outperformed the market for both the five-year and one-year horizons. 1+ *** addo Securities-ESG Integration 4/21 100% & Oddo calculated that from 2005 to 2010, its Strong Opportunity portfolio beat market indices by between 1,476 and 2,401 basis points (bps), depending on the index. For 2010, the portfolio beat the market by 181 to 970 bps, again depending on the index. Oddo's Telecom Sector Report Oddo's study of the telecom sector covered major equipment makers and service providers in the U.S. and Europe. ESG Model Desmartin and Thevoux-Chabuel created a model to evaluate and score telecommunication companies based on the three ESC factors. The environmental factor was labeled Health, Safety and Environment and covered whether the firm had an environmental management system, the environmental impact of telecom products and services, and the safety of products and services. Social factors included regulatory risks and opportunities, and intellectual capital (reflecting customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG I scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom ➜ customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential i electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom operators, the most important social factors identified were regulatory risks, and intellectual capital generated from the management of human resources and customer, supplier, and partner relationships (termed social ecosystem). On the human resources side the Oddo analysis attempted to identify companies characterized by a workforce that was productive and economically efficient but at the same time paid well. On the social ecosystem side the analysts assessed the innovation capacity, brand value, supply chain efficiency, the quality, durability, growth potential and diversification of distribution networks, product and service quality, and customer satisfaction. The criteria used to generate scores for human resource and social ecosystem factors are I shown in Exhibits 4 and 5. Governance The sustainable development and corporate governance criteria used in the ESG model are shown in Exhibits 6 and 7. The sustainable development criteria distinguished between companies that factored corporate social responsibility (CSR) and sustainable development into their internal and external communications and those that integrated CSR and sustainable development into their strategies and business models. The weightings used for corporate governance criteria differed for large-cap and mid to small sized firms, for firms with a controlling interest and for those with diversified owners, and for family-owned businesses. Exhibit 8 shows the scores that BT and FT received by Oddo analysts in each of the factors. BT scored higher by more than 20 points and outperformed FT in all three categories. Industry Drivers Oddo's SRI analysis of the telecom industry identified five long-term performance drivers: sustainable development, regulation, sector consolidation, emerging countries, and technological advances or breakthroughs. Sustainable Development. The analysts rated the sector highly for sustainable development, primarily because they assessed that it was well-positioned to create dematerialized growth (defined as making more products using fewer resources), facilitate entrepreneurial activities, open new markets, and help other organizations and industries become more sustainable. Regulation. Because the telecom operator sector was viewed as a natural monopoly, it had been subject to regulation. Oddo analysts perceived this to be a key industry risk, particularly for many European telecom operators as regulators focused on increasing competition to lower prices and offer more services options for retail consumers. Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with technological change were likely to face product obsolescence and financial failure. Operators also relied on technology so they needed to ensure that their offerings delivered the newest services, which often required heavy investment. Results and Recommendations Using the latest iteration of its ESG model, SRI Research analyzed 25 companies, assigning each an ESG score, rank, recommendation and outlook (see Exhibit 9). A summary of the findings is presented in Exhibit 10. Of those companies that were covered by Oddo's financial analysts and given a recommendation, only three-Iliad, Telefonica, and Vivendi-had ESG recommendations that matched the financial recommendation. Desmartin explained: The first reason there may be a difference is because we are looking at different time horizons. The SRI team looks at long-term prospects, usually between 12 to 60 months, while the financial analysts typically are looking more short-term. The other reason for differences is when there is a mismatch between the SRI team and the financial analyst covering the sector or the company, about what is material for the sector or the company. Our aim is not to cover all ESG indicators but those that are most relevant and the most material from a financial standpoint. Our goal is to be right 50% of the time or more. In looking at the past performance of the 25 stocks, those that SRI Research identified as strong opportunity or opportunity outperformed the DJ Stoxx Telecommunications index by 171%; while those companies SRI Research identified as having moderate to high risk, underperformed the same index by 32% (Exhibit 11). Keyes' Decision John Keyes reflected on the Oddo SRI Telecom report. The ESG and financial recommendations for British Telecom and France Telecom led him to the opposite conclusions. He reviewed the recent financial performance (see Exhibit 12) and stock market performance (see Exhibit 13) of the two companies. The performance of BT was impressively strong in 2006 and 2007 where earnings-per- share increased significantly and the company proposed an increase in dividends. However, BT's performance was completely reversed as the financial crisis hit and investors' expectations adjusted. How should he proceed? Should he follow the ESG recommendation and buy BT stock, or the financial recommendation and take a position in FT? Exhibit 1 Integrating ESG into valuation models ESG Research Environment Management Risks Opportunities Social Regulation IC-Human Capital IC-License to Operate/Reputation IC-Ecosystem, Quality, non-compliance Governance Sustainable development strategy Corporate Governance Business Ethics Source: Company documents. Note: L O N G T E RM DR I V E R S Materiality Business Model Management Statements →→Measurement ESG KPI's ESG Events Monetary Value Vahation Model Opportunities ↓ Performance Cash flow Cost of Capital Risk Premium Volatility 1 Risks "Management"refers to "Management quality". "Statements" refers to "Financial statements". "IC" is "Intellectual Capital" Exhibit 2 One-Year and Five-Year Performance Comparison: Oddo SRI vs. Industry Indices as of December 2010 Index Oddo SRI List (non-weighted) France CAC 40 France SBF 120 DJ STOXX Euro 50 DJ STOXX 600 Since Dec 31-2009 7.96% -1.74 0.77 -0.85 6.15 Since Dec- 31-2005 1.69% -17.95 -13.96 -22.32 Source: Company documents. -13.07 CAC 40 Compagnie des Agents de Change 40 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 40 French companies listed on the Paris Stock Exchange that were also traded on the options market. Construction principle: Capitalization-weighted value ratio SBF 120 Société des Bourses Françaises 120 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 120 French companies listed on the Paris Stock Exchange Construction principle: Capitalization-weighted value ratio DI STOXX Euro 50 Index Europe's leading blue-chip index provided a representation of super sector leaders in Europe. The index covered 50 stocks from 18 European countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. DI STOXX 600 Index Derived from the STOXX Europe Total Market Index (TMI) and was a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represented large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. Oddo Securities-ESG Integration Exhibit 3 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Human resources Organizational Ecosystem Social Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. Equipment Makers 3% 6 2 5 16 1 5194 29 46 2333 10 25 38 100% Operators 1% NOK 2 14 15 6235 54 10 25 3 38 100% Exhibit 4 Human Resources Indicators and Criteria for the Telecom Sector Indicator Governance and HR profile Attractiveness and recruitment ||| Career integration and planning Motivation and satisfaction Operational HR management Total Criteria Growth model Age pyramid management HR representation on executive board HR transparency Size-related attractiveness International presence-related attractiveness Economic attractiveness Average wage costs Employee share of ownership Growth in headcount Integration, annual review rate, career planning Training quality and effectiveness Management of reorganizational/restructuring measures Departure/arrival of key personnel Staff tumover Absenteeism Workplace climate and dialogue Payroll management Quality of local management Operating margin per employee Social liabilities (pension funds, healthcare, class actions) Weighting 10% 6 4 2 5 4 2 2 5 2 4 2 10 5 3 10 3 2 5 5 9 100% Nature of Criterion Quantitative & qualitative Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative & qualitative Quantitative & qualitative Mainly Qualitative Qualitative Qui Ive Quantitative Mainly Qualitative Quantitative Qualitative Quantitative Quantitative Exhibit 5 Ecosystem Criteria for the Telecom Sector Criteria Corporate culture, Internal organization Innovation/R&D/patents Brand Supply chain, logistics, industrial partnerships Distribution network Product and service quality Customer satisfaction Total Source Company documents. Criteria Length of sustainable development track record and learning curve Sustainable development organization: Direct reporting: Director profile; Resources allocated; Interactions - across functions Sustainable development information systems Products and services with sustainable development added value Sustainable development objectives and results Total Equipment Makers 4.0% Source: Company documents. 11.0 2.0 4.0 2.0 3.0 99 3.0 2 Exhibit 6 Sustainable Development Strategy Criteria for the Telecom Sector Equipment Makers 1.0% 29.0% 1.0 2.0 3.0 3.0 Operators 2.0% 4.0 3.0 2.0 10.0% 5.0 3.0 4.0 23.0% Operators 1.0% 1.0 2.0 3.0 3.0 Nature of Criteria Qualitative Quantitative & qualitative Quantitative & qualitative Qualitative 10.0% Qualitative Quantitative & qualitative Quantitative & qualitative Nature of Criteria Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative & qualitative Quantitative & qualitative Exhibit 7 Corporate Governance Criteria for the Telecom Sector Criteria 1. Minority shareholder rights (1 share-1 vote; anti- takeover measures) 2. Separation of functions. (CEO-Chairman) 3. Separation of roles (executives/shareholders/ board members) 4. Executive succession planning 5. Transparency and cohesion of executive pay 6. Assessment of executive pay and long-term performance 7. Board effectiveness (composition, functioning) 8. Committees reporting to the board. 9. Audit processes; degree of accountability, legal and tax transparency and complexity 10. Quality of financial communication Total Source: Company documents. Non- Controlled Controlled 17% 12% 13 2 10 3 20 63 13 12 Large Cap 100% 10 10 10 20 13 12 100% Mid-Small Cap Non- Controlled 18% 13 2 15 3 20 11 100% Controlled 11% 10 10 15 21 11 100% Family- owned 12% S 13 20 03 16 12 100% Exhibit 8 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Social Human resources Organizational Ecosystem Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. British Telecom 1.0 2.0 0.0 5.0 8.0 9.0 8.8 1.5 15.5 34.8 10.0 18.8 2.5 31.3 74.1 PHONE France Telecom 0.5 1.5 0.0 2.0 4.0 8.4 0.5 15.4 28.3 5.5 14.0 2.0 21.5 53.8 Exhibit 9 Telecom Sector: Summary of ESG Scores, Rank, Recommendation, Outlook, Financial Recommendation, and Target Prices Company Equipment Makers Alcatel-Lucent Clavu Ericsson Gemalto Motorola Nokia Oberthur Tandberg Operators AT&T Belgacom Bouygues British Telecom Deutsche Telekom France Telecom Iliad KPN Maroc Telecom Mobistar OTE Sprint Telecom Italia Telefonica Verizon Vivendi Vodafone Averages Equipment Makers Operators Telecom Sector Maximum possible score 1-Strong opportunity ESG ESG ESG ESG Score Rank Recommendation" Outlook 2 Opportunity 3-Moderate risk A High risk 51.5 00.0 65.3 59.8 50.3 77.1 57.1 70.7 61.7 53.2 55.5 74.0 51.4 53.3 62.1 61.6 51.0 50.8 47.8 38.7 54.1 59.2 60.7 63.2 61.7 Source: Company documents. SEK Swedish Krona Recommendation 62.3 56.5 58.3 100.0 75458162 3 329191655467108 7 2 4 32223131 2 NNNNWAAW WNNWW3333 Positive THE Negative na na Stable na na na na Positive Stable Negative Positive Stable Stable na na na na Negative Stable na Positive Stable Pinancial Recommendation" 2 Nut fullumed Not followed 2 Accept the offer Not followed Not followed 2 2727 Not followed Not followed Target Price €3,5 118 SEK 65,0 €29.0 na €16.0 €6,7 na na €25.5 €51.0 €170.0 €14.0 €24.0 €79.0 €13.0 €16,5 €60.0 €24.0 na €1.0 €17,5 na €33.0 £115 Exhibit 12 Financial performance of France Telecom and British Telecom France Telecom, for year ended December 31 (in Emil) Total revenue Revenue growth NOPAT Margin Asset tumover ROA Spread Leverage Impact of leverage ROE Percent of revenues Grom profit Operating expenses Unusual income (expenses) Discontinued operations Valuation multiples Price-to-eamings Price-to-book value British Telecom, for the year ended March 31 (in Emillion) Total revence Revenue growth NOPAT Margin Asstturnover ROA Spread Leverage Impact of leverage ROE Percent of revences Gross profit Operating expenses Unusual income (expenses) Discontinued operations 2006 51,702 7.5% 20 10.3% 0.71 7.2% 4.8% 1.95 9.4% 16.6% 43.6% 23.6% -0.3% 1.3% 11.82 2.28 2007 20,223 3.6% 17.0% 173 29.3% 23,5% 6.54 153.8% 183.2% 61.9% 45.7% -1.3% 0.0% 1007 46,568 4.9% 30.48 7.47 18.4% 0.68 12.6% 7.3% 1.55 10.9% 23.5% 46.7% 23.0% -7.5% 6.9% 31.23 2.37 2008 20,704 2.4% 11.6% 1.71 19.8% 11.4% 1.87 21.2% 41.0% 61.8% 45.5% -2.9% 0.0% 2000 46,712 0.3% 8.32 4.02 12.3% 0.70 8.6% 41% 1.26 5.2% 13.8% 42.4% 19.7% 1.4% 0.4% 9.40 1.77 2009 21,390 3.3% 2.4% 1.43 3.4% LO% Valuation multiples Price-to-samnings Price-to-book value NOTAT is net operating profit after taxe NOPAT margin i NOPAT over Not Ants Asset turnover is total revenue over asets. Spread is NOPAT margn minus the interest on all interest paying abilities, Leverage in total debt minus cash over gulty Impact of s spread times leverage Sou Capulced July 2011. 1.77 -7.0% -30% 61.4% 55.9% -26% 0.0% 6.66 2.20 1. From a company valuation perspective, how should we include the elements of the ESG analysis in the process? Should we include the elements of ESG in the cash flows or in the discount rate, or in both? (Remember at the end we need to arrive to an intrinsic value). Any ideas on how to do it? 2. Should the financial elements dominate the analysis? Those of ESG? Do they complement each other? How can we better understand the situation? Please provide your perspective on this situation. Oddo Securities-ESG Integration In January of 2009, John Keyes, portfolio manager for a medium-sized UK fund, reviewed the analyst report on the telecommunications industry he had just received from the French brokerage firm Oddo Securities (Oddo). Keyes was intrigued by Oddo's research, which provided two ratings of stocks covered, a financial rating and an environmental, social and governance (PSG) rating. Keyes was particularly struck by the returns generated by Oddo's ESG recommendations, which had outperformed most major stocks indices over the last five years. He reviewed the recommendations and analysis for two telecom stocks he was considering adding to his portfolio, British Telecom (BT) and France Telecom (FT). The Oddo analysis assigned BT its highest PSC rating (a Strong Opportunity) but rated the company as a "Reduce" in the financial recommendation. In contrast, FT was rated as a Moderate Risk under the ESC rating and a "Buy" for the financial rating, Keyes wondered how he should interpret these conflicting ratings, and which deserved more of his attention. Background on Oddo Securities Oddo Securities was owned by Oddo & Cie- an independent investment services firm that in 2010 had 900 employees, offices in Paris, Dubai, Madrid, and New York, and over €17 billion in assets under management. The firm was 80% owned by management, employees, and the Oddo family, and 20% by German-based insurer Allianz. It was headed by Philippe Oddo, whose family had been in the stockbroker business for five generations. In addition to its brokerage business, Oddo & Cie owned an investment bank, a financial advisory business, options and commodity businesses, a private bank, and an asset management unit. Oddo Securities was one of France's top brokers. The unit catered to an international institutional clientele providing brokerage services and research on a broad product range, including shares, futures, options and fixed income/credit. The research team, with 60 analysts, economists, and strategists, focused on the French and European market-equities, corporate bonds, and derivatives. The 5.momber prodit vocesuch term fomured on five incom and covered more than 120 1 capitalization of the France CAC 40 index, 89% of the DJ STOXX Euro 50 index and 60% of the DJ STOXX 600 index. ESG Investing and Analysis The use of ESC criteria for investing was a relatively recent innovation in the investment management industry and fell under the umbrella of socially responsible investing (SRI). SRI strategies could be broadly classified into five categories: negative screening, positive screening, integration, thematic, and engagement. Under negative screening, companies were excluded from investment portfolios based on ethical concerns about the safety of their products (e.g. tobacco, weapons, etc.) and their ethical standards of behavior. Positive screening identified companies with best-in-class ESG performance as investment candidates. Integration strategies focused on relations between ESG data, cash flows and/or cost of capital, and then embedded those relationships into valuation models. Thematic strategies followed either a multi-theme approach focusing on a broad range of long-term environmental or social issues (e.g. ageing societies, sustainable nutrition, clean energy, low-income solutions, urbanization, health, sustainable resources), or a hybrid approach. combining a large cap "best in class" universe with a thematic overlay. Finally, engagement represented a form of shareholder activism where investors sought to influence how companies addressed material ESG issues to protect and enhance the value of their investments. SRI investing experienced dramatic growth in the 1990s and 2000s. Between 2001 and 2007 assets under management of socially responsible investors grew by $400 billion in the US, $600 billion in the U.K, and $400 billion in Canada. In 2007, mutual funds that invested in socially conscious firms had assets under management of more than $2.5 trillion in the United States, $2 trillion in Europe, $500 billion in Canada, $100 billion in Japan and 564 billion in Australia. ESG Analysis at Oddo D ESG Analysis at Oddo In June 2005, Oddo hired Jean-Phillippe Desmartin to head its SRI initiative. Desmartin, who had started his career in financial engineering at Credit du Nord, a subsidiary of Societe Generale, and subsequently worked for several social and environmental rating agencies, was charged with developing a systematic methodology for SRI analysis at Oddo. He subsequently hired Sebastien Thevoux-Chabuel as a senior analyst in the initiative. Thevoux-Chabuel had been with Oddo since 2005 as a sell-side analyst on the European Technology sector and he had experience at Deutsche Bank and BFT, a subsidiary of Credit Agricole, as a buy-side analyst. ESG research at Oddo was divided into three broad areas, Environmental, Social and Governance (Exhibit 1). Environmental factors included environmental management, risks and opportunities. Social factors covered regulatory risks, the management of the firm's human resources, its reputational capital and brands, and its supplier and partner relationships. Governance factors included the firm's commitment to sustainable development (Le. using resources to meet human The CAC 40 was an index of 40 stocks traded on the Paris Stock Exchange. The Dow Jones STOXX Euro 50 Index represented 50 super sector market leaders in the 12 Eurosone countries Austria, Belgium, Finland, France, Germany Greece, Ireland. Italy, Luxemburg, the Netherlands, Portugal and Spain. The Dow Jones STOXX 600 Index was comprised of 600 highly capitalized and actively traded stocks listed and traded on stock exchanges from 17 European countries The authors calculated these numbers from information provided by national and international organizations that track socially conscious funds, such as Eurosif, Social Investment Forum, Responsible Investment Association Australasia, Social Responsible Organization, and SRI funds in Asia needs while also preserving the environment), adherence to corporate governance best practices, and business ethics. The Oddo SRI Research team, working in collaboration with the firm's sector analysts, used a multi-step approach to build separate ESG models for each sector. Under the first step, the analyst team assessed which ESG factors were likely to be relevant and material for firms in the sector. Once these constructs were identified, the team developed quantitative and qualitative metrics for each material factor. Finally, the analyst team determined appropriate sector-specific weightings for the metrics, enabling them to be aggregated into separate environmental, social and governance performance scores, and into a total ESG score. In explaining how the weightings were created, Desmartin noted that they are "intended to reflect the degree to which our ESG performance factors correlate with returns." Weights were estimated using historical relations between the sector's metrics/factors and its stock returns. The time horizon over which the historical relations were estimated ranged between 1 and 5 years depending on the availability of data. The ESG analysts at Oddo then used the sector metrics and weightings generated from this process to construct ESG scores for individual companies within the sector. Based on a company's aggregate score, Oddo issued one of four ESG recommendations (Strong Opportunity, Opportunity, Moderate Risk, or High Risk). Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the ESG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysts who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESC analysis and do not have control over the analysis." ddo's ESG approach was designed to provide investors with insights into a firm's management ilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial aj d ESG Integration 100% & Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the RSG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that: "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysis who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESG analysis and do not have control over the analysis. Oddo's ESG approach was designed to provide investors with insights into a firm's management capabilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial performance. The goal of the ESG analysis, therefore, was to allow clients to optimize the ratio of returns to risk. Desmartin explained the firm's approach and the type of clients it sought to attract: In practice we are very far from some of the ethical approaches used in the U.S. We do not exclude companies, we do not exclude activities, and we do not say what is good and what is bad. Ours is not a religious or moral approach. We simply want to find the best investment opportunities for our clients in the long-term.... We want 80% of our SRI research business to come from mainstream investors, not explicitly socially-conscious investors. Already, 50% of our business is coming from mainstream investors. SRI research was targeted to large institutional investors with long-term time horizons such as pension funds and insurance companies. However, Desmartin observed "we have seen some recent interest in SRI from hedge funds. I would not say it is a trend, yet it is very interesting because their focus is exclusively on making money." Oddo's ESG recommendations reflected the expected performance of each stock over a long-term horizon (i.e., beyond 12 months). As reported in Exhibit 2. the stocks included in Oddo's SRI Strong Opportunity portfolio had outperformed the market for both the five-year and one-year horizons. 1+ *** addo Securities-ESG Integration 4/21 100% & Oddo calculated that from 2005 to 2010, its Strong Opportunity portfolio beat market indices by between 1,476 and 2,401 basis points (bps), depending on the index. For 2010, the portfolio beat the market by 181 to 970 bps, again depending on the index. Oddo's Telecom Sector Report Oddo's study of the telecom sector covered major equipment makers and service providers in the U.S. and Europe. ESG Model Desmartin and Thevoux-Chabuel created a model to evaluate and score telecommunication companies based on the three ESC factors. The environmental factor was labeled Health, Safety and Environment and covered whether the firm had an environmental management system, the environmental impact of telecom products and services, and the safety of products and services. Social factors included regulatory risks and opportunities, and intellectual capital (reflecting customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG I scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom ➜ customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential i electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom operators, the most important social factors identified were regulatory risks, and intellectual capital generated from the management of human resources and customer, supplier, and partner relationships (termed social ecosystem). On the human resources side the Oddo analysis attempted to identify companies characterized by a workforce that was productive and economically efficient but at the same time paid well. On the social ecosystem side the analysts assessed the innovation capacity, brand value, supply chain efficiency, the quality, durability, growth potential and diversification of distribution networks, product and service quality, and customer satisfaction. The criteria used to generate scores for human resource and social ecosystem factors are I shown in Exhibits 4 and 5. Governance The sustainable development and corporate governance criteria used in the ESG model are shown in Exhibits 6 and 7. The sustainable development criteria distinguished between companies that factored corporate social responsibility (CSR) and sustainable development into their internal and external communications and those that integrated CSR and sustainable development into their strategies and business models. The weightings used for corporate governance criteria differed for large-cap and mid to small sized firms, for firms with a controlling interest and for those with diversified owners, and for family-owned businesses. Exhibit 8 shows the scores that BT and FT received by Oddo analysts in each of the factors. BT scored higher by more than 20 points and outperformed FT in all three categories. Industry Drivers Oddo's SRI analysis of the telecom industry identified five long-term performance drivers: sustainable development, regulation, sector consolidation, emerging countries, and technological advances or breakthroughs. Sustainable Development. The analysts rated the sector highly for sustainable development, primarily because they assessed that it was well-positioned to create dematerialized growth (defined as making more products using fewer resources), facilitate entrepreneurial activities, open new markets, and help other organizations and industries become more sustainable. Regulation. Because the telecom operator sector was viewed as a natural monopoly, it had been subject to regulation. Oddo analysts perceived this to be a key industry risk, particularly for many European telecom operators as regulators focused on increasing competition to lower prices and offer more services options for retail consumers. Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with technological change were likely to face product obsolescence and financial failure. Operators also relied on technology so they needed to ensure that their offerings delivered the newest services, which often required heavy investment. Results and Recommendations Using the latest iteration of its ESG model, SRI Research analyzed 25 companies, assigning each an ESG score, rank, recommendation and outlook (see Exhibit 9). A summary of the findings is presented in Exhibit 10. Of those companies that were covered by Oddo's financial analysts and given a recommendation, only three-Iliad, Telefonica, and Vivendi-had ESG recommendations that matched the financial recommendation. Desmartin explained: The first reason there may be a difference is because we are looking at different time horizons. The SRI team looks at long-term prospects, usually between 12 to 60 months, while the financial analysts typically are looking more short-term. The other reason for differences is when there is a mismatch between the SRI team and the financial analyst covering the sector or the company, about what is material for the sector or the company. Our aim is not to cover all ESG indicators but those that are most relevant and the most material from a financial standpoint. Our goal is to be right 50% of the time or more. In looking at the past performance of the 25 stocks, those that SRI Research identified as strong opportunity or opportunity outperformed the DJ Stoxx Telecommunications index by 171%; while those companies SRI Research identified as having moderate to high risk, underperformed the same index by 32% (Exhibit 11). Keyes' Decision John Keyes reflected on the Oddo SRI Telecom report. The ESG and financial recommendations for British Telecom and France Telecom led him to the opposite conclusions. He reviewed the recent financial performance (see Exhibit 12) and stock market performance (see Exhibit 13) of the two companies. The performance of BT was impressively strong in 2006 and 2007 where earnings-per- share increased significantly and the company proposed an increase in dividends. However, BT's performance was completely reversed as the financial crisis hit and investors' expectations adjusted. How should he proceed? Should he follow the ESG recommendation and buy BT stock, or the financial recommendation and take a position in FT? Exhibit 1 Integrating ESG into valuation models ESG Research Environment Management Risks Opportunities Social Regulation IC-Human Capital IC-License to Operate/Reputation IC-Ecosystem, Quality, non-compliance Governance Sustainable development strategy Corporate Governance Business Ethics Source: Company documents. Note: L O N G T E RM DR I V E R S Materiality Business Model Management Statements →→Measurement ESG KPI's ESG Events Monetary Value Vahation Model Opportunities ↓ Performance Cash flow Cost of Capital Risk Premium Volatility 1 Risks "Management"refers to "Management quality". "Statements" refers to "Financial statements". "IC" is "Intellectual Capital" Exhibit 2 One-Year and Five-Year Performance Comparison: Oddo SRI vs. Industry Indices as of December 2010 Index Oddo SRI List (non-weighted) France CAC 40 France SBF 120 DJ STOXX Euro 50 DJ STOXX 600 Since Dec 31-2009 7.96% -1.74 0.77 -0.85 6.15 Since Dec- 31-2005 1.69% -17.95 -13.96 -22.32 Source: Company documents. -13.07 CAC 40 Compagnie des Agents de Change 40 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 40 French companies listed on the Paris Stock Exchange that were also traded on the options market. Construction principle: Capitalization-weighted value ratio SBF 120 Société des Bourses Françaises 120 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 120 French companies listed on the Paris Stock Exchange Construction principle: Capitalization-weighted value ratio DI STOXX Euro 50 Index Europe's leading blue-chip index provided a representation of super sector leaders in Europe. The index covered 50 stocks from 18 European countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. DI STOXX 600 Index Derived from the STOXX Europe Total Market Index (TMI) and was a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represented large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. Oddo Securities-ESG Integration Exhibit 3 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Human resources Organizational Ecosystem Social Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. Equipment Makers 3% 6 2 5 16 1 5194 29 46 2333 10 25 38 100% Operators 1% NOK 2 14 15 6235 54 10 25 3 38 100% Exhibit 4 Human Resources Indicators and Criteria for the Telecom Sector Indicator Governance and HR profile Attractiveness and recruitment ||| Career integration and planning Motivation and satisfaction Operational HR management Total Criteria Growth model Age pyramid management HR representation on executive board HR transparency Size-related attractiveness International presence-related attractiveness Economic attractiveness Average wage costs Employee share of ownership Growth in headcount Integration, annual review rate, career planning Training quality and effectiveness Management of reorganizational/restructuring measures Departure/arrival of key personnel Staff tumover Absenteeism Workplace climate and dialogue Payroll management Quality of local management Operating margin per employee Social liabilities (pension funds, healthcare, class actions) Weighting 10% 6 4 2 5 4 2 2 5 2 4 2 10 5 3 10 3 2 5 5 9 100% Nature of Criterion Quantitative & qualitative Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative & qualitative Quantitative & qualitative Mainly Qualitative Qualitative Qui Ive Quantitative Mainly Qualitative Quantitative Qualitative Quantitative Quantitative Exhibit 5 Ecosystem Criteria for the Telecom Sector Criteria Corporate culture, Internal organization Innovation/R&D/patents Brand Supply chain, logistics, industrial partnerships Distribution network Product and service quality Customer satisfaction Total Source Company documents. Criteria Length of sustainable development track record and learning curve Sustainable development organization: Direct reporting: Director profile; Resources allocated; Interactions - across functions Sustainable development information systems Products and services with sustainable development added value Sustainable development objectives and results Total Equipment Makers 4.0% Source: Company documents. 11.0 2.0 4.0 2.0 3.0 99 3.0 2 Exhibit 6 Sustainable Development Strategy Criteria for the Telecom Sector Equipment Makers 1.0% 29.0% 1.0 2.0 3.0 3.0 Operators 2.0% 4.0 3.0 2.0 10.0% 5.0 3.0 4.0 23.0% Operators 1.0% 1.0 2.0 3.0 3.0 Nature of Criteria Qualitative Quantitative & qualitative Quantitative & qualitative Qualitative 10.0% Qualitative Quantitative & qualitative Quantitative & qualitative Nature of Criteria Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative & qualitative Quantitative & qualitative Exhibit 7 Corporate Governance Criteria for the Telecom Sector Criteria 1. Minority shareholder rights (1 share-1 vote; anti- takeover measures) 2. Separation of functions. (CEO-Chairman) 3. Separation of roles (executives/shareholders/ board members) 4. Executive succession planning 5. Transparency and cohesion of executive pay 6. Assessment of executive pay and long-term performance 7. Board effectiveness (composition, functioning) 8. Committees reporting to the board. 9. Audit processes; degree of accountability, legal and tax transparency and complexity 10. Quality of financial communication Total Source: Company documents. Non- Controlled Controlled 17% 12% 13 2 10 3 20 63 13 12 Large Cap 100% 10 10 10 20 13 12 100% Mid-Small Cap Non- Controlled 18% 13 2 15 3 20 11 100% Controlled 11% 10 10 15 21 11 100% Family- owned 12% S 13 20 03 16 12 100% Exhibit 8 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Social Human resources Organizational Ecosystem Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. British Telecom 1.0 2.0 0.0 5.0 8.0 9.0 8.8 1.5 15.5 34.8 10.0 18.8 2.5 31.3 74.1 PHONE France Telecom 0.5 1.5 0.0 2.0 4.0 8.4 0.5 15.4 28.3 5.5 14.0 2.0 21.5 53.8 Exhibit 9 Telecom Sector: Summary of ESG Scores, Rank, Recommendation, Outlook, Financial Recommendation, and Target Prices Company Equipment Makers Alcatel-Lucent Clavu Ericsson Gemalto Motorola Nokia Oberthur Tandberg Operators AT&T Belgacom Bouygues British Telecom Deutsche Telekom France Telecom Iliad KPN Maroc Telecom Mobistar OTE Sprint Telecom Italia Telefonica Verizon Vivendi Vodafone Averages Equipment Makers Operators Telecom Sector Maximum possible score 1-Strong opportunity ESG ESG ESG ESG Score Rank Recommendation" Outlook 2 Opportunity 3-Moderate risk A High risk 51.5 00.0 65.3 59.8 50.3 77.1 57.1 70.7 61.7 53.2 55.5 74.0 51.4 53.3 62.1 61.6 51.0 50.8 47.8 38.7 54.1 59.2 60.7 63.2 61.7 Source: Company documents. SEK Swedish Krona Recommendation 62.3 56.5 58.3 100.0 75458162 3 329191655467108 7 2 4 32223131 2 NNNNWAAW WNNWW3333 Positive THE Negative na na Stable na na na na Positive Stable Negative Positive Stable Stable na na na na Negative Stable na Positive Stable Pinancial Recommendation" 2 Nut fullumed Not followed 2 Accept the offer Not followed Not followed 2 2727 Not followed Not followed Target Price €3,5 118 SEK 65,0 €29.0 na €16.0 €6,7 na na €25.5 €51.0 €170.0 €14.0 €24.0 €79.0 €13.0 €16,5 €60.0 €24.0 na €1.0 €17,5 na €33.0 £115 Exhibit 12 Financial performance of France Telecom and British Telecom France Telecom, for year ended December 31 (in Emil) Total revenue Revenue growth NOPAT Margin Asset tumover ROA Spread Leverage Impact of leverage ROE Percent of revenues Grom profit Operating expenses Unusual income (expenses) Discontinued operations Valuation multiples Price-to-eamings Price-to-book value British Telecom, for the year ended March 31 (in Emillion) Total revence Revenue growth NOPAT Margin Asstturnover ROA Spread Leverage Impact of leverage ROE Percent of revences Gross profit Operating expenses Unusual income (expenses) Discontinued operations 2006 51,702 7.5% 20 10.3% 0.71 7.2% 4.8% 1.95 9.4% 16.6% 43.6% 23.6% -0.3% 1.3% 11.82 2.28 2007 20,223 3.6% 17.0% 173 29.3% 23,5% 6.54 153.8% 183.2% 61.9% 45.7% -1.3% 0.0% 1007 46,568 4.9% 30.48 7.47 18.4% 0.68 12.6% 7.3% 1.55 10.9% 23.5% 46.7% 23.0% -7.5% 6.9% 31.23 2.37 2008 20,704 2.4% 11.6% 1.71 19.8% 11.4% 1.87 21.2% 41.0% 61.8% 45.5% -2.9% 0.0% 2000 46,712 0.3% 8.32 4.02 12.3% 0.70 8.6% 41% 1.26 5.2% 13.8% 42.4% 19.7% 1.4% 0.4% 9.40 1.77 2009 21,390 3.3% 2.4% 1.43 3.4% LO% Valuation multiples Price-to-samnings Price-to-book value NOTAT is net operating profit after taxe NOPAT margin i NOPAT over Not Ants Asset turnover is total revenue over asets. Spread is NOPAT margn minus the interest on all interest paying abilities, Leverage in total debt minus cash over gulty Impact of s spread times leverage Sou Capulced July 2011. 1.77 -7.0% -30% 61.4% 55.9% -26% 0.0% 6.66 2.20 1. From a company valuation perspective, how should we include the elements of the ESG analysis in the process? Should we include the elements of ESG in the cash flows or in the discount rate, or in both? (Remember at the end we need to arrive to an intrinsic value). Any ideas on how to do it? 2. Should the financial elements dominate the analysis? Those of ESG? Do they complement each other? How can we better understand the situation? Please provide your perspective on this situation. Oddo Securities-ESG Integration In January of 2009, John Keyes, portfolio manager for a medium-sized UK fund, reviewed the analyst report on the telecommunications industry he had just received from the French brokerage firm Oddo Securities (Oddo). Keyes was intrigued by Oddo's research, which provided two ratings of stocks covered, a financial rating and an environmental, social and governance (PSG) rating. Keyes was particularly struck by the returns generated by Oddo's ESG recommendations, which had outperformed most major stocks indices over the last five years. He reviewed the recommendations and analysis for two telecom stocks he was considering adding to his portfolio, British Telecom (BT) and France Telecom (FT). The Oddo analysis assigned BT its highest PSC rating (a Strong Opportunity) but rated the company as a "Reduce" in the financial recommendation. In contrast, FT was rated as a Moderate Risk under the ESC rating and a "Buy" for the financial rating, Keyes wondered how he should interpret these conflicting ratings, and which deserved more of his attention. Background on Oddo Securities Oddo Securities was owned by Oddo & Cie- an independent investment services firm that in 2010 had 900 employees, offices in Paris, Dubai, Madrid, and New York, and over €17 billion in assets under management. The firm was 80% owned by management, employees, and the Oddo family, and 20% by German-based insurer Allianz. It was headed by Philippe Oddo, whose family had been in the stockbroker business for five generations. In addition to its brokerage business, Oddo & Cie owned an investment bank, a financial advisory business, options and commodity businesses, a private bank, and an asset management unit. Oddo Securities was one of France's top brokers. The unit catered to an international institutional clientele providing brokerage services and research on a broad product range, including shares, futures, options and fixed income/credit. The research team, with 60 analysts, economists, and strategists, focused on the French and European market-equities, corporate bonds, and derivatives. The 5.momber prodit vocesuch term fomured on five incom and covered more than 120 1 capitalization of the France CAC 40 index, 89% of the DJ STOXX Euro 50 index and 60% of the DJ STOXX 600 index. ESG Investing and Analysis The use of ESC criteria for investing was a relatively recent innovation in the investment management industry and fell under the umbrella of socially responsible investing (SRI). SRI strategies could be broadly classified into five categories: negative screening, positive screening, integration, thematic, and engagement. Under negative screening, companies were excluded from investment portfolios based on ethical concerns about the safety of their products (e.g. tobacco, weapons, etc.) and their ethical standards of behavior. Positive screening identified companies with best-in-class ESG performance as investment candidates. Integration strategies focused on relations between ESG data, cash flows and/or cost of capital, and then embedded those relationships into valuation models. Thematic strategies followed either a multi-theme approach focusing on a broad range of long-term environmental or social issues (e.g. ageing societies, sustainable nutrition, clean energy, low-income solutions, urbanization, health, sustainable resources), or a hybrid approach. combining a large cap "best in class" universe with a thematic overlay. Finally, engagement represented a form of shareholder activism where investors sought to influence how companies addressed material ESG issues to protect and enhance the value of their investments. SRI investing experienced dramatic growth in the 1990s and 2000s. Between 2001 and 2007 assets under management of socially responsible investors grew by $400 billion in the US, $600 billion in the U.K, and $400 billion in Canada. In 2007, mutual funds that invested in socially conscious firms had assets under management of more than $2.5 trillion in the United States, $2 trillion in Europe, $500 billion in Canada, $100 billion in Japan and 564 billion in Australia. ESG Analysis at Oddo D ESG Analysis at Oddo In June 2005, Oddo hired Jean-Phillippe Desmartin to head its SRI initiative. Desmartin, who had started his career in financial engineering at Credit du Nord, a subsidiary of Societe Generale, and subsequently worked for several social and environmental rating agencies, was charged with developing a systematic methodology for SRI analysis at Oddo. He subsequently hired Sebastien Thevoux-Chabuel as a senior analyst in the initiative. Thevoux-Chabuel had been with Oddo since 2005 as a sell-side analyst on the European Technology sector and he had experience at Deutsche Bank and BFT, a subsidiary of Credit Agricole, as a buy-side analyst. ESG research at Oddo was divided into three broad areas, Environmental, Social and Governance (Exhibit 1). Environmental factors included environmental management, risks and opportunities. Social factors covered regulatory risks, the management of the firm's human resources, its reputational capital and brands, and its supplier and partner relationships. Governance factors included the firm's commitment to sustainable development (Le. using resources to meet human The CAC 40 was an index of 40 stocks traded on the Paris Stock Exchange. The Dow Jones STOXX Euro 50 Index represented 50 super sector market leaders in the 12 Eurosone countries Austria, Belgium, Finland, France, Germany Greece, Ireland. Italy, Luxemburg, the Netherlands, Portugal and Spain. The Dow Jones STOXX 600 Index was comprised of 600 highly capitalized and actively traded stocks listed and traded on stock exchanges from 17 European countries The authors calculated these numbers from information provided by national and international organizations that track socially conscious funds, such as Eurosif, Social Investment Forum, Responsible Investment Association Australasia, Social Responsible Organization, and SRI funds in Asia needs while also preserving the environment), adherence to corporate governance best practices, and business ethics. The Oddo SRI Research team, working in collaboration with the firm's sector analysts, used a multi-step approach to build separate ESG models for each sector. Under the first step, the analyst team assessed which ESG factors were likely to be relevant and material for firms in the sector. Once these constructs were identified, the team developed quantitative and qualitative metrics for each material factor. Finally, the analyst team determined appropriate sector-specific weightings for the metrics, enabling them to be aggregated into separate environmental, social and governance performance scores, and into a total ESG score. In explaining how the weightings were created, Desmartin noted that they are "intended to reflect the degree to which our ESG performance factors correlate with returns." Weights were estimated using historical relations between the sector's metrics/factors and its stock returns. The time horizon over which the historical relations were estimated ranged between 1 and 5 years depending on the availability of data. The ESG analysts at Oddo then used the sector metrics and weightings generated from this process to construct ESG scores for individual companies within the sector. Based on a company's aggregate score, Oddo issued one of four ESG recommendations (Strong Opportunity, Opportunity, Moderate Risk, or High Risk). Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the ESG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysts who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESC analysis and do not have control over the analysis." ddo's ESG approach was designed to provide investors with insights into a firm's management ilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial aj d ESG Integration 100% & Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the RSG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that: "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysis who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESG analysis and do not have control over the analysis. Oddo's ESG approach was designed to provide investors with insights into a firm's management capabilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial performance. The goal of the ESG analysis, therefore, was to allow clients to optimize the ratio of returns to risk. Desmartin explained the firm's approach and the type of clients it sought to attract: In practice we are very far from some of the ethical approaches used in the U.S. We do not exclude companies, we do not exclude activities, and we do not say what is good and what is bad. Ours is not a religious or moral approach. We simply want to find the best investment opportunities for our clients in the long-term.... We want 80% of our SRI research business to come from mainstream investors, not explicitly socially-conscious investors. Already, 50% of our business is coming from mainstream investors. SRI research was targeted to large institutional investors with long-term time horizons such as pension funds and insurance companies. However, Desmartin observed "we have seen some recent interest in SRI from hedge funds. I would not say it is a trend, yet it is very interesting because their focus is exclusively on making money." Oddo's ESG recommendations reflected the expected performance of each stock over a long-term horizon (i.e., beyond 12 months). As reported in Exhibit 2. the stocks included in Oddo's SRI Strong Opportunity portfolio had outperformed the market for both the five-year and one-year horizons. 1+ *** addo Securities-ESG Integration 4/21 100% & Oddo calculated that from 2005 to 2010, its Strong Opportunity portfolio beat market indices by between 1,476 and 2,401 basis points (bps), depending on the index. For 2010, the portfolio beat the market by 181 to 970 bps, again depending on the index. Oddo's Telecom Sector Report Oddo's study of the telecom sector covered major equipment makers and service providers in the U.S. and Europe. ESG Model Desmartin and Thevoux-Chabuel created a model to evaluate and score telecommunication companies based on the three ESC factors. The environmental factor was labeled Health, Safety and Environment and covered whether the firm had an environmental management system, the environmental impact of telecom products and services, and the safety of products and services. Social factors included regulatory risks and opportunities, and intellectual capital (reflecting customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG I scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom ➜ customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential i electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom operators, the most important social factors identified were regulatory risks, and intellectual capital generated from the management of human resources and customer, supplier, and partner relationships (termed social ecosystem). On the human resources side the Oddo analysis attempted to identify companies characterized by a workforce that was productive and economically efficient but at the same time paid well. On the social ecosystem side the analysts assessed the innovation capacity, brand value, supply chain efficiency, the quality, durability, growth potential and diversification of distribution networks, product and service quality, and customer satisfaction. The criteria used to generate scores for human resource and social ecosystem factors are I shown in Exhibits 4 and 5. Governance The sustainable development and corporate governance criteria used in the ESG model are shown in Exhibits 6 and 7. The sustainable development criteria distinguished between companies that factored corporate social responsibility (CSR) and sustainable development into their internal and external communications and those that integrated CSR and sustainable development into their strategies and business models. The weightings used for corporate governance criteria differed for large-cap and mid to small sized firms, for firms with a controlling interest and for those with diversified owners, and for family-owned businesses. Exhibit 8 shows the scores that BT and FT received by Oddo analysts in each of the factors. BT scored higher by more than 20 points and outperformed FT in all three categories. Industry Drivers Oddo's SRI analysis of the telecom industry identified five long-term performance drivers: sustainable development, regulation, sector consolidation, emerging countries, and technological advances or breakthroughs. Sustainable Development. The analysts rated the sector highly for sustainable development, primarily because they assessed that it was well-positioned to create dematerialized growth (defined as making more products using fewer resources), facilitate entrepreneurial activities, open new markets, and help other organizations and industries become more sustainable. Regulation. Because the telecom operator sector was viewed as a natural monopoly, it had been subject to regulation. Oddo analysts perceived this to be a key industry risk, particularly for many European telecom operators as regulators focused on increasing competition to lower prices and offer more services options for retail consumers. Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with technological change were likely to face product obsolescence and financial failure. Operators also relied on technology so they needed to ensure that their offerings delivered the newest services, which often required heavy investment. Results and Recommendations Using the latest iteration of its ESG model, SRI Research analyzed 25 companies, assigning each an ESG score, rank, recommendation and outlook (see Exhibit 9). A summary of the findings is presented in Exhibit 10. Of those companies that were covered by Oddo's financial analysts and given a recommendation, only three-Iliad, Telefonica, and Vivendi-had ESG recommendations that matched the financial recommendation. Desmartin explained: The first reason there may be a difference is because we are looking at different time horizons. The SRI team looks at long-term prospects, usually between 12 to 60 months, while the financial analysts typically are looking more short-term. The other reason for differences is when there is a mismatch between the SRI team and the financial analyst covering the sector or the company, about what is material for the sector or the company. Our aim is not to cover all ESG indicators but those that are most relevant and the most material from a financial standpoint. Our goal is to be right 50% of the time or more. In looking at the past performance of the 25 stocks, those that SRI Research identified as strong opportunity or opportunity outperformed the DJ Stoxx Telecommunications index by 171%; while those companies SRI Research identified as having moderate to high risk, underperformed the same index by 32% (Exhibit 11). Keyes' Decision John Keyes reflected on the Oddo SRI Telecom report. The ESG and financial recommendations for British Telecom and France Telecom led him to the opposite conclusions. He reviewed the recent financial performance (see Exhibit 12) and stock market performance (see Exhibit 13) of the two companies. The performance of BT was impressively strong in 2006 and 2007 where earnings-per- share increased significantly and the company proposed an increase in dividends. However, BT's performance was completely reversed as the financial crisis hit and investors' expectations adjusted. How should he proceed? Should he follow the ESG recommendation and buy BT stock, or the financial recommendation and take a position in FT? Exhibit 1 Integrating ESG into valuation models ESG Research Environment Management Risks Opportunities Social Regulation IC-Human Capital IC-License to Operate/Reputation IC-Ecosystem, Quality, non-compliance Governance Sustainable development strategy Corporate Governance Business Ethics Source: Company documents. Note: L O N G T E RM DR I V E R S Materiality Business Model Management Statements →→Measurement ESG KPI's ESG Events Monetary Value Vahation Model Opportunities ↓ Performance Cash flow Cost of Capital Risk Premium Volatility 1 Risks "Management"refers to "Management quality". "Statements" refers to "Financial statements". "IC" is "Intellectual Capital" Exhibit 2 One-Year and Five-Year Performance Comparison: Oddo SRI vs. Industry Indices as of December 2010 Index Oddo SRI List (non-weighted) France CAC 40 France SBF 120 DJ STOXX Euro 50 DJ STOXX 600 Since Dec 31-2009 7.96% -1.74 0.77 -0.85 6.15 Since Dec- 31-2005 1.69% -17.95 -13.96 -22.32 Source: Company documents. -13.07 CAC 40 Compagnie des Agents de Change 40 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 40 French companies listed on the Paris Stock Exchange that were also traded on the options market. Construction principle: Capitalization-weighted value ratio SBF 120 Société des Bourses Françaises 120 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 120 French companies listed on the Paris Stock Exchange Construction principle: Capitalization-weighted value ratio DI STOXX Euro 50 Index Europe's leading blue-chip index provided a representation of super sector leaders in Europe. The index covered 50 stocks from 18 European countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. DI STOXX 600 Index Derived from the STOXX Europe Total Market Index (TMI) and was a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represented large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. Oddo Securities-ESG Integration Exhibit 3 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Human resources Organizational Ecosystem Social Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. Equipment Makers 3% 6 2 5 16 1 5194 29 46 2333 10 25 38 100% Operators 1% NOK 2 14 15 6235 54 10 25 3 38 100% Exhibit 4 Human Resources Indicators and Criteria for the Telecom Sector Indicator Governance and HR profile Attractiveness and recruitment ||| Career integration and planning Motivation and satisfaction Operational HR management Total Criteria Growth model Age pyramid management HR representation on executive board HR transparency Size-related attractiveness International presence-related attractiveness Economic attractiveness Average wage costs Employee share of ownership Growth in headcount Integration, annual review rate, career planning Training quality and effectiveness Management of reorganizational/restructuring measures Departure/arrival of key personnel Staff tumover Absenteeism Workplace climate and dialogue Payroll management Quality of local management Operating margin per employee Social liabilities (pension funds, healthcare, class actions) Weighting 10% 6 4 2 5 4 2 2 5 2 4 2 10 5 3 10 3 2 5 5 9 100% Nature of Criterion Quantitative & qualitative Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative & qualitative Quantitative & qualitative Mainly Qualitative Qualitative Qui Ive Quantitative Mainly Qualitative Quantitative Qualitative Quantitative Quantitative Exhibit 5 Ecosystem Criteria for the Telecom Sector Criteria Corporate culture, Internal organization Innovation/R&D/patents Brand Supply chain, logistics, industrial partnerships Distribution network Product and service quality Customer satisfaction Total Source Company documents. Criteria Length of sustainable development track record and learning curve Sustainable development organization: Direct reporting: Director profile; Resources allocated; Interactions - across functions Sustainable development information systems Products and services with sustainable development added value Sustainable development objectives and results Total Equipment Makers 4.0% Source: Company documents. 11.0 2.0 4.0 2.0 3.0 99 3.0 2 Exhibit 6 Sustainable Development Strategy Criteria for the Telecom Sector Equipment Makers 1.0% 29.0% 1.0 2.0 3.0 3.0 Operators 2.0% 4.0 3.0 2.0 10.0% 5.0 3.0 4.0 23.0% Operators 1.0% 1.0 2.0 3.0 3.0 Nature of Criteria Qualitative Quantitative & qualitative Quantitative & qualitative Qualitative 10.0% Qualitative Quantitative & qualitative Quantitative & qualitative Nature of Criteria Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative & qualitative Quantitative & qualitative Exhibit 7 Corporate Governance Criteria for the Telecom Sector Criteria 1. Minority shareholder rights (1 share-1 vote; anti- takeover measures) 2. Separation of functions. (CEO-Chairman) 3. Separation of roles (executives/shareholders/ board members) 4. Executive succession planning 5. Transparency and cohesion of executive pay 6. Assessment of executive pay and long-term performance 7. Board effectiveness (composition, functioning) 8. Committees reporting to the board. 9. Audit processes; degree of accountability, legal and tax transparency and complexity 10. Quality of financial communication Total Source: Company documents. Non- Controlled Controlled 17% 12% 13 2 10 3 20 63 13 12 Large Cap 100% 10 10 10 20 13 12 100% Mid-Small Cap Non- Controlled 18% 13 2 15 3 20 11 100% Controlled 11% 10 10 15 21 11 100% Family- owned 12% S 13 20 03 16 12 100% Exhibit 8 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Social Human resources Organizational Ecosystem Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. British Telecom 1.0 2.0 0.0 5.0 8.0 9.0 8.8 1.5 15.5 34.8 10.0 18.8 2.5 31.3 74.1 PHONE France Telecom 0.5 1.5 0.0 2.0 4.0 8.4 0.5 15.4 28.3 5.5 14.0 2.0 21.5 53.8 Exhibit 9 Telecom Sector: Summary of ESG Scores, Rank, Recommendation, Outlook, Financial Recommendation, and Target Prices Company Equipment Makers Alcatel-Lucent Clavu Ericsson Gemalto Motorola Nokia Oberthur Tandberg Operators AT&T Belgacom Bouygues British Telecom Deutsche Telekom France Telecom Iliad KPN Maroc Telecom Mobistar OTE Sprint Telecom Italia Telefonica Verizon Vivendi Vodafone Averages Equipment Makers Operators Telecom Sector Maximum possible score 1-Strong opportunity ESG ESG ESG ESG Score Rank Recommendation" Outlook 2 Opportunity 3-Moderate risk A High risk 51.5 00.0 65.3 59.8 50.3 77.1 57.1 70.7 61.7 53.2 55.5 74.0 51.4 53.3 62.1 61.6 51.0 50.8 47.8 38.7 54.1 59.2 60.7 63.2 61.7 Source: Company documents. SEK Swedish Krona Recommendation 62.3 56.5 58.3 100.0 75458162 3 329191655467108 7 2 4 32223131 2 NNNNWAAW WNNWW3333 Positive THE Negative na na Stable na na na na Positive Stable Negative Positive Stable Stable na na na na Negative Stable na Positive Stable Pinancial Recommendation" 2 Nut fullumed Not followed 2 Accept the offer Not followed Not followed 2 2727 Not followed Not followed Target Price €3,5 118 SEK 65,0 €29.0 na €16.0 €6,7 na na €25.5 €51.0 €170.0 €14.0 €24.0 €79.0 €13.0 €16,5 €60.0 €24.0 na €1.0 €17,5 na €33.0 £115 Exhibit 12 Financial performance of France Telecom and British Telecom France Telecom, for year ended December 31 (in Emil) Total revenue Revenue growth NOPAT Margin Asset tumover ROA Spread Leverage Impact of leverage ROE Percent of revenues Grom profit Operating expenses Unusual income (expenses) Discontinued operations Valuation multiples Price-to-eamings Price-to-book value British Telecom, for the year ended March 31 (in Emillion) Total revence Revenue growth NOPAT Margin Asstturnover ROA Spread Leverage Impact of leverage ROE Percent of revences Gross profit Operating expenses Unusual income (expenses) Discontinued operations 2006 51,702 7.5% 20 10.3% 0.71 7.2% 4.8% 1.95 9.4% 16.6% 43.6% 23.6% -0.3% 1.3% 11.82 2.28 2007 20,223 3.6% 17.0% 173 29.3% 23,5% 6.54 153.8% 183.2% 61.9% 45.7% -1.3% 0.0% 1007 46,568 4.9% 30.48 7.47 18.4% 0.68 12.6% 7.3% 1.55 10.9% 23.5% 46.7% 23.0% -7.5% 6.9% 31.23 2.37 2008 20,704 2.4% 11.6% 1.71 19.8% 11.4% 1.87 21.2% 41.0% 61.8% 45.5% -2.9% 0.0% 2000 46,712 0.3% 8.32 4.02 12.3% 0.70 8.6% 41% 1.26 5.2% 13.8% 42.4% 19.7% 1.4% 0.4% 9.40 1.77 2009 21,390 3.3% 2.4% 1.43 3.4% LO% Valuation multiples Price-to-samnings Price-to-book value NOTAT is net operating profit after taxe NOPAT margin i NOPAT over Not Ants Asset turnover is total revenue over asets. Spread is NOPAT margn minus the interest on all interest paying abilities, Leverage in total debt minus cash over gulty Impact of s spread times leverage Sou Capulced July 2011. 1.77 -7.0% -30% 61.4% 55.9% -26% 0.0% 6.66 2.20 1. From a company valuation perspective, how should we include the elements of the ESG analysis in the process? Should we include the elements of ESG in the cash flows or in the discount rate, or in both? (Remember at the end we need to arrive to an intrinsic value). Any ideas on how to do it? 2. Should the financial elements dominate the analysis? Those of ESG? Do they complement each other? How can we better understand the situation? Please provide your perspective on this situation. Oddo Securities-ESG Integration In January of 2009, John Keyes, portfolio manager for a medium-sized UK fund, reviewed the analyst report on the telecommunications industry he had just received from the French brokerage firm Oddo Securities (Oddo). Keyes was intrigued by Oddo's research, which provided two ratings of stocks covered, a financial rating and an environmental, social and governance (PSG) rating. Keyes was particularly struck by the returns generated by Oddo's ESG recommendations, which had outperformed most major stocks indices over the last five years. He reviewed the recommendations and analysis for two telecom stocks he was considering adding to his portfolio, British Telecom (BT) and France Telecom (FT). The Oddo analysis assigned BT its highest PSC rating (a Strong Opportunity) but rated the company as a "Reduce" in the financial recommendation. In contrast, FT was rated as a Moderate Risk under the ESC rating and a "Buy" for the financial rating, Keyes wondered how he should interpret these conflicting ratings, and which deserved more of his attention. Background on Oddo Securities Oddo Securities was owned by Oddo & Cie- an independent investment services firm that in 2010 had 900 employees, offices in Paris, Dubai, Madrid, and New York, and over €17 billion in assets under management. The firm was 80% owned by management, employees, and the Oddo family, and 20% by German-based insurer Allianz. It was headed by Philippe Oddo, whose family had been in the stockbroker business for five generations. In addition to its brokerage business, Oddo & Cie owned an investment bank, a financial advisory business, options and commodity businesses, a private bank, and an asset management unit. Oddo Securities was one of France's top brokers. The unit catered to an international institutional clientele providing brokerage services and research on a broad product range, including shares, futures, options and fixed income/credit. The research team, with 60 analysts, economists, and strategists, focused on the French and European market-equities, corporate bonds, and derivatives. The 5.momber prodit vocesuch term fomured on five incom and covered more than 120 1 capitalization of the France CAC 40 index, 89% of the DJ STOXX Euro 50 index and 60% of the DJ STOXX 600 index. ESG Investing and Analysis The use of ESC criteria for investing was a relatively recent innovation in the investment management industry and fell under the umbrella of socially responsible investing (SRI). SRI strategies could be broadly classified into five categories: negative screening, positive screening, integration, thematic, and engagement. Under negative screening, companies were excluded from investment portfolios based on ethical concerns about the safety of their products (e.g. tobacco, weapons, etc.) and their ethical standards of behavior. Positive screening identified companies with best-in-class ESG performance as investment candidates. Integration strategies focused on relations between ESG data, cash flows and/or cost of capital, and then embedded those relationships into valuation models. Thematic strategies followed either a multi-theme approach focusing on a broad range of long-term environmental or social issues (e.g. ageing societies, sustainable nutrition, clean energy, low-income solutions, urbanization, health, sustainable resources), or a hybrid approach. combining a large cap "best in class" universe with a thematic overlay. Finally, engagement represented a form of shareholder activism where investors sought to influence how companies addressed material ESG issues to protect and enhance the value of their investments. SRI investing experienced dramatic growth in the 1990s and 2000s. Between 2001 and 2007 assets under management of socially responsible investors grew by $400 billion in the US, $600 billion in the U.K, and $400 billion in Canada. In 2007, mutual funds that invested in socially conscious firms had assets under management of more than $2.5 trillion in the United States, $2 trillion in Europe, $500 billion in Canada, $100 billion in Japan and 564 billion in Australia. ESG Analysis at Oddo D ESG Analysis at Oddo In June 2005, Oddo hired Jean-Phillippe Desmartin to head its SRI initiative. Desmartin, who had started his career in financial engineering at Credit du Nord, a subsidiary of Societe Generale, and subsequently worked for several social and environmental rating agencies, was charged with developing a systematic methodology for SRI analysis at Oddo. He subsequently hired Sebastien Thevoux-Chabuel as a senior analyst in the initiative. Thevoux-Chabuel had been with Oddo since 2005 as a sell-side analyst on the European Technology sector and he had experience at Deutsche Bank and BFT, a subsidiary of Credit Agricole, as a buy-side analyst. ESG research at Oddo was divided into three broad areas, Environmental, Social and Governance (Exhibit 1). Environmental factors included environmental management, risks and opportunities. Social factors covered regulatory risks, the management of the firm's human resources, its reputational capital and brands, and its supplier and partner relationships. Governance factors included the firm's commitment to sustainable development (Le. using resources to meet human The CAC 40 was an index of 40 stocks traded on the Paris Stock Exchange. The Dow Jones STOXX Euro 50 Index represented 50 super sector market leaders in the 12 Eurosone countries Austria, Belgium, Finland, France, Germany Greece, Ireland. Italy, Luxemburg, the Netherlands, Portugal and Spain. The Dow Jones STOXX 600 Index was comprised of 600 highly capitalized and actively traded stocks listed and traded on stock exchanges from 17 European countries The authors calculated these numbers from information provided by national and international organizations that track socially conscious funds, such as Eurosif, Social Investment Forum, Responsible Investment Association Australasia, Social Responsible Organization, and SRI funds in Asia needs while also preserving the environment), adherence to corporate governance best practices, and business ethics. The Oddo SRI Research team, working in collaboration with the firm's sector analysts, used a multi-step approach to build separate ESG models for each sector. Under the first step, the analyst team assessed which ESG factors were likely to be relevant and material for firms in the sector. Once these constructs were identified, the team developed quantitative and qualitative metrics for each material factor. Finally, the analyst team determined appropriate sector-specific weightings for the metrics, enabling them to be aggregated into separate environmental, social and governance performance scores, and into a total ESG score. In explaining how the weightings were created, Desmartin noted that they are "intended to reflect the degree to which our ESG performance factors correlate with returns." Weights were estimated using historical relations between the sector's metrics/factors and its stock returns. The time horizon over which the historical relations were estimated ranged between 1 and 5 years depending on the availability of data. The ESG analysts at Oddo then used the sector metrics and weightings generated from this process to construct ESG scores for individual companies within the sector. Based on a company's aggregate score, Oddo issued one of four ESG recommendations (Strong Opportunity, Opportunity, Moderate Risk, or High Risk). Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the ESG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysts who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESC analysis and do not have control over the analysis." ddo's ESG approach was designed to provide investors with insights into a firm's management ilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial aj d ESG Integration 100% & Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the RSG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that: "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysis who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESG analysis and do not have control over the analysis. Oddo's ESG approach was designed to provide investors with insights into a firm's management capabilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial performance. The goal of the ESG analysis, therefore, was to allow clients to optimize the ratio of returns to risk. Desmartin explained the firm's approach and the type of clients it sought to attract: In practice we are very far from some of the ethical approaches used in the U.S. We do not exclude companies, we do not exclude activities, and we do not say what is good and what is bad. Ours is not a religious or moral approach. We simply want to find the best investment opportunities for our clients in the long-term.... We want 80% of our SRI research business to come from mainstream investors, not explicitly socially-conscious investors. Already, 50% of our business is coming from mainstream investors. SRI research was targeted to large institutional investors with long-term time horizons such as pension funds and insurance companies. However, Desmartin observed "we have seen some recent interest in SRI from hedge funds. I would not say it is a trend, yet it is very interesting because their focus is exclusively on making money." Oddo's ESG recommendations reflected the expected performance of each stock over a long-term horizon (i.e., beyond 12 months). As reported in Exhibit 2. the stocks included in Oddo's SRI Strong Opportunity portfolio had outperformed the market for both the five-year and one-year horizons. 1+ *** addo Securities-ESG Integration 4/21 100% & Oddo calculated that from 2005 to 2010, its Strong Opportunity portfolio beat market indices by between 1,476 and 2,401 basis points (bps), depending on the index. For 2010, the portfolio beat the market by 181 to 970 bps, again depending on the index. Oddo's Telecom Sector Report Oddo's study of the telecom sector covered major equipment makers and service providers in the U.S. and Europe. ESG Model Desmartin and Thevoux-Chabuel created a model to evaluate and score telecommunication companies based on the three ESC factors. The environmental factor was labeled Health, Safety and Environment and covered whether the firm had an environmental management system, the environmental impact of telecom products and services, and the safety of products and services. Social factors included regulatory risks and opportunities, and intellectual capital (reflecting customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG I scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom ➜ customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential i electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom operators, the most important social factors identified were regulatory risks, and intellectual capital generated from the management of human resources and customer, supplier, and partner relationships (termed social ecosystem). On the human resources side the Oddo analysis attempted to identify companies characterized by a workforce that was productive and economically efficient but at the same time paid well. On the social ecosystem side the analysts assessed the innovation capacity, brand value, supply chain efficiency, the quality, durability, growth potential and diversification of distribution networks, product and service quality, and customer satisfaction. The criteria used to generate scores for human resource and social ecosystem factors are I shown in Exhibits 4 and 5. Governance The sustainable development and corporate governance criteria used in the ESG model are shown in Exhibits 6 and 7. The sustainable development criteria distinguished between companies that factored corporate social responsibility (CSR) and sustainable development into their internal and external communications and those that integrated CSR and sustainable development into their strategies and business models. The weightings used for corporate governance criteria differed for large-cap and mid to small sized firms, for firms with a controlling interest and for those with diversified owners, and for family-owned businesses. Exhibit 8 shows the scores that BT and FT received by Oddo analysts in each of the factors. BT scored higher by more than 20 points and outperformed FT in all three categories. Industry Drivers Oddo's SRI analysis of the telecom industry identified five long-term performance drivers: sustainable development, regulation, sector consolidation, emerging countries, and technological advances or breakthroughs. Sustainable Development. The analysts rated the sector highly for sustainable development, primarily because they assessed that it was well-positioned to create dematerialized growth (defined as making more products using fewer resources), facilitate entrepreneurial activities, open new markets, and help other organizations and industries become more sustainable. Regulation. Because the telecom operator sector was viewed as a natural monopoly, it had been subject to regulation. Oddo analysts perceived this to be a key industry risk, particularly for many European telecom operators as regulators focused on increasing competition to lower prices and offer more services options for retail consumers. Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with technological change were likely to face product obsolescence and financial failure. Operators also relied on technology so they needed to ensure that their offerings delivered the newest services, which often required heavy investment. Results and Recommendations Using the latest iteration of its ESG model, SRI Research analyzed 25 companies, assigning each an ESG score, rank, recommendation and outlook (see Exhibit 9). A summary of the findings is presented in Exhibit 10. Of those companies that were covered by Oddo's financial analysts and given a recommendation, only three-Iliad, Telefonica, and Vivendi-had ESG recommendations that matched the financial recommendation. Desmartin explained: The first reason there may be a difference is because we are looking at different time horizons. The SRI team looks at long-term prospects, usually between 12 to 60 months, while the financial analysts typically are looking more short-term. The other reason for differences is when there is a mismatch between the SRI team and the financial analyst covering the sector or the company, about what is material for the sector or the company. Our aim is not to cover all ESG indicators but those that are most relevant and the most material from a financial standpoint. Our goal is to be right 50% of the time or more. In looking at the past performance of the 25 stocks, those that SRI Research identified as strong opportunity or opportunity outperformed the DJ Stoxx Telecommunications index by 171%; while those companies SRI Research identified as having moderate to high risk, underperformed the same index by 32% (Exhibit 11). Keyes' Decision John Keyes reflected on the Oddo SRI Telecom report. The ESG and financial recommendations for British Telecom and France Telecom led him to the opposite conclusions. He reviewed the recent financial performance (see Exhibit 12) and stock market performance (see Exhibit 13) of the two companies. The performance of BT was impressively strong in 2006 and 2007 where earnings-per- share increased significantly and the company proposed an increase in dividends. However, BT's performance was completely reversed as the financial crisis hit and investors' expectations adjusted. How should he proceed? Should he follow the ESG recommendation and buy BT stock, or the financial recommendation and take a position in FT? Exhibit 1 Integrating ESG into valuation models ESG Research Environment Management Risks Opportunities Social Regulation IC-Human Capital IC-License to Operate/Reputation IC-Ecosystem, Quality, non-compliance Governance Sustainable development strategy Corporate Governance Business Ethics Source: Company documents. Note: L O N G T E RM DR I V E R S Materiality Business Model Management Statements →→Measurement ESG KPI's ESG Events Monetary Value Vahation Model Opportunities ↓ Performance Cash flow Cost of Capital Risk Premium Volatility 1 Risks "Management"refers to "Management quality". "Statements" refers to "Financial statements". "IC" is "Intellectual Capital" Exhibit 2 One-Year and Five-Year Performance Comparison: Oddo SRI vs. Industry Indices as of December 2010 Index Oddo SRI List (non-weighted) France CAC 40 France SBF 120 DJ STOXX Euro 50 DJ STOXX 600 Since Dec 31-2009 7.96% -1.74 0.77 -0.85 6.15 Since Dec- 31-2005 1.69% -17.95 -13.96 -22.32 Source: Company documents. -13.07 CAC 40 Compagnie des Agents de Change 40 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 40 French companies listed on the Paris Stock Exchange that were also traded on the options market. Construction principle: Capitalization-weighted value ratio SBF 120 Société des Bourses Françaises 120 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 120 French companies listed on the Paris Stock Exchange Construction principle: Capitalization-weighted value ratio DI STOXX Euro 50 Index Europe's leading blue-chip index provided a representation of super sector leaders in Europe. The index covered 50 stocks from 18 European countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. DI STOXX 600 Index Derived from the STOXX Europe Total Market Index (TMI) and was a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represented large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. Oddo Securities-ESG Integration Exhibit 3 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Human resources Organizational Ecosystem Social Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. Equipment Makers 3% 6 2 5 16 1 5194 29 46 2333 10 25 38 100% Operators 1% NOK 2 14 15 6235 54 10 25 3 38 100% Exhibit 4 Human Resources Indicators and Criteria for the Telecom Sector Indicator Governance and HR profile Attractiveness and recruitment ||| Career integration and planning Motivation and satisfaction Operational HR management Total Criteria Growth model Age pyramid management HR representation on executive board HR transparency Size-related attractiveness International presence-related attractiveness Economic attractiveness Average wage costs Employee share of ownership Growth in headcount Integration, annual review rate, career planning Training quality and effectiveness Management of reorganizational/restructuring measures Departure/arrival of key personnel Staff tumover Absenteeism Workplace climate and dialogue Payroll management Quality of local management Operating margin per employee Social liabilities (pension funds, healthcare, class actions) Weighting 10% 6 4 2 5 4 2 2 5 2 4 2 10 5 3 10 3 2 5 5 9 100% Nature of Criterion Quantitative & qualitative Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative & qualitative Quantitative & qualitative Mainly Qualitative Qualitative Qui Ive Quantitative Mainly Qualitative Quantitative Qualitative Quantitative Quantitative Exhibit 5 Ecosystem Criteria for the Telecom Sector Criteria Corporate culture, Internal organization Innovation/R&D/patents Brand Supply chain, logistics, industrial partnerships Distribution network Product and service quality Customer satisfaction Total Source Company documents. Criteria Length of sustainable development track record and learning curve Sustainable development organization: Direct reporting: Director profile; Resources allocated; Interactions - across functions Sustainable development information systems Products and services with sustainable development added value Sustainable development objectives and results Total Equipment Makers 4.0% Source: Company documents. 11.0 2.0 4.0 2.0 3.0 99 3.0 2 Exhibit 6 Sustainable Development Strategy Criteria for the Telecom Sector Equipment Makers 1.0% 29.0% 1.0 2.0 3.0 3.0 Operators 2.0% 4.0 3.0 2.0 10.0% 5.0 3.0 4.0 23.0% Operators 1.0% 1.0 2.0 3.0 3.0 Nature of Criteria Qualitative Quantitative & qualitative Quantitative & qualitative Qualitative 10.0% Qualitative Quantitative & qualitative Quantitative & qualitative Nature of Criteria Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative & qualitative Quantitative & qualitative Exhibit 7 Corporate Governance Criteria for the Telecom Sector Criteria 1. Minority shareholder rights (1 share-1 vote; anti- takeover measures) 2. Separation of functions. (CEO-Chairman) 3. Separation of roles (executives/shareholders/ board members) 4. Executive succession planning 5. Transparency and cohesion of executive pay 6. Assessment of executive pay and long-term performance 7. Board effectiveness (composition, functioning) 8. Committees reporting to the board. 9. Audit processes; degree of accountability, legal and tax transparency and complexity 10. Quality of financial communication Total Source: Company documents. Non- Controlled Controlled 17% 12% 13 2 10 3 20 63 13 12 Large Cap 100% 10 10 10 20 13 12 100% Mid-Small Cap Non- Controlled 18% 13 2 15 3 20 11 100% Controlled 11% 10 10 15 21 11 100% Family- owned 12% S 13 20 03 16 12 100% Exhibit 8 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Social Human resources Organizational Ecosystem Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. British Telecom 1.0 2.0 0.0 5.0 8.0 9.0 8.8 1.5 15.5 34.8 10.0 18.8 2.5 31.3 74.1 PHONE France Telecom 0.5 1.5 0.0 2.0 4.0 8.4 0.5 15.4 28.3 5.5 14.0 2.0 21.5 53.8 Exhibit 9 Telecom Sector: Summary of ESG Scores, Rank, Recommendation, Outlook, Financial Recommendation, and Target Prices Company Equipment Makers Alcatel-Lucent Clavu Ericsson Gemalto Motorola Nokia Oberthur Tandberg Operators AT&T Belgacom Bouygues British Telecom Deutsche Telekom France Telecom Iliad KPN Maroc Telecom Mobistar OTE Sprint Telecom Italia Telefonica Verizon Vivendi Vodafone Averages Equipment Makers Operators Telecom Sector Maximum possible score 1-Strong opportunity ESG ESG ESG ESG Score Rank Recommendation" Outlook 2 Opportunity 3-Moderate risk A High risk 51.5 00.0 65.3 59.8 50.3 77.1 57.1 70.7 61.7 53.2 55.5 74.0 51.4 53.3 62.1 61.6 51.0 50.8 47.8 38.7 54.1 59.2 60.7 63.2 61.7 Source: Company documents. SEK Swedish Krona Recommendation 62.3 56.5 58.3 100.0 75458162 3 329191655467108 7 2 4 32223131 2 NNNNWAAW WNNWW3333 Positive THE Negative na na Stable na na na na Positive Stable Negative Positive Stable Stable na na na na Negative Stable na Positive Stable Pinancial Recommendation" 2 Nut fullumed Not followed 2 Accept the offer Not followed Not followed 2 2727 Not followed Not followed Target Price €3,5 118 SEK 65,0 €29.0 na €16.0 €6,7 na na €25.5 €51.0 €170.0 €14.0 €24.0 €79.0 €13.0 €16,5 €60.0 €24.0 na €1.0 €17,5 na €33.0 £115 Exhibit 12 Financial performance of France Telecom and British Telecom France Telecom, for year ended December 31 (in Emil) Total revenue Revenue growth NOPAT Margin Asset tumover ROA Spread Leverage Impact of leverage ROE Percent of revenues Grom profit Operating expenses Unusual income (expenses) Discontinued operations Valuation multiples Price-to-eamings Price-to-book value British Telecom, for the year ended March 31 (in Emillion) Total revence Revenue growth NOPAT Margin Asstturnover ROA Spread Leverage Impact of leverage ROE Percent of revences Gross profit Operating expenses Unusual income (expenses) Discontinued operations 2006 51,702 7.5% 20 10.3% 0.71 7.2% 4.8% 1.95 9.4% 16.6% 43.6% 23.6% -0.3% 1.3% 11.82 2.28 2007 20,223 3.6% 17.0% 173 29.3% 23,5% 6.54 153.8% 183.2% 61.9% 45.7% -1.3% 0.0% 1007 46,568 4.9% 30.48 7.47 18.4% 0.68 12.6% 7.3% 1.55 10.9% 23.5% 46.7% 23.0% -7.5% 6.9% 31.23 2.37 2008 20,704 2.4% 11.6% 1.71 19.8% 11.4% 1.87 21.2% 41.0% 61.8% 45.5% -2.9% 0.0% 2000 46,712 0.3% 8.32 4.02 12.3% 0.70 8.6% 41% 1.26 5.2% 13.8% 42.4% 19.7% 1.4% 0.4% 9.40 1.77 2009 21,390 3.3% 2.4% 1.43 3.4% LO% Valuation multiples Price-to-samnings Price-to-book value NOTAT is net operating profit after taxe NOPAT margin i NOPAT over Not Ants Asset turnover is total revenue over asets. Spread is NOPAT margn minus the interest on all interest paying abilities, Leverage in total debt minus cash over gulty Impact of s spread times leverage Sou Capulced July 2011. 1.77 -7.0% -30% 61.4% 55.9% -26% 0.0% 6.66 2.20 1. From a company valuation perspective, how should we include the elements of the ESG analysis in the process? Should we include the elements of ESG in the cash flows or in the discount rate, or in both? (Remember at the end we need to arrive to an intrinsic value). Any ideas on how to do it? 2. Should the financial elements dominate the analysis? Those of ESG? Do they complement each other? How can we better understand the situation? Please provide your perspective on this situation. Oddo Securities-ESG Integration In January of 2009, John Keyes, portfolio manager for a medium-sized UK fund, reviewed the analyst report on the telecommunications industry he had just received from the French brokerage firm Oddo Securities (Oddo). Keyes was intrigued by Oddo's research, which provided two ratings of stocks covered, a financial rating and an environmental, social and governance (PSG) rating. Keyes was particularly struck by the returns generated by Oddo's ESG recommendations, which had outperformed most major stocks indices over the last five years. He reviewed the recommendations and analysis for two telecom stocks he was considering adding to his portfolio, British Telecom (BT) and France Telecom (FT). The Oddo analysis assigned BT its highest PSC rating (a Strong Opportunity) but rated the company as a "Reduce" in the financial recommendation. In contrast, FT was rated as a Moderate Risk under the ESC rating and a "Buy" for the financial rating, Keyes wondered how he should interpret these conflicting ratings, and which deserved more of his attention. Background on Oddo Securities Oddo Securities was owned by Oddo & Cie- an independent investment services firm that in 2010 had 900 employees, offices in Paris, Dubai, Madrid, and New York, and over €17 billion in assets under management. The firm was 80% owned by management, employees, and the Oddo family, and 20% by German-based insurer Allianz. It was headed by Philippe Oddo, whose family had been in the stockbroker business for five generations. In addition to its brokerage business, Oddo & Cie owned an investment bank, a financial advisory business, options and commodity businesses, a private bank, and an asset management unit. Oddo Securities was one of France's top brokers. The unit catered to an international institutional clientele providing brokerage services and research on a broad product range, including shares, futures, options and fixed income/credit. The research team, with 60 analysts, economists, and strategists, focused on the French and European market-equities, corporate bonds, and derivatives. The 5.momber prodit vocesuch term fomured on five incom and covered more than 120 1 capitalization of the France CAC 40 index, 89% of the DJ STOXX Euro 50 index and 60% of the DJ STOXX 600 index. ESG Investing and Analysis The use of ESC criteria for investing was a relatively recent innovation in the investment management industry and fell under the umbrella of socially responsible investing (SRI). SRI strategies could be broadly classified into five categories: negative screening, positive screening, integration, thematic, and engagement. Under negative screening, companies were excluded from investment portfolios based on ethical concerns about the safety of their products (e.g. tobacco, weapons, etc.) and their ethical standards of behavior. Positive screening identified companies with best-in-class ESG performance as investment candidates. Integration strategies focused on relations between ESG data, cash flows and/or cost of capital, and then embedded those relationships into valuation models. Thematic strategies followed either a multi-theme approach focusing on a broad range of long-term environmental or social issues (e.g. ageing societies, sustainable nutrition, clean energy, low-income solutions, urbanization, health, sustainable resources), or a hybrid approach. combining a large cap "best in class" universe with a thematic overlay. Finally, engagement represented a form of shareholder activism where investors sought to influence how companies addressed material ESG issues to protect and enhance the value of their investments. SRI investing experienced dramatic growth in the 1990s and 2000s. Between 2001 and 2007 assets under management of socially responsible investors grew by $400 billion in the US, $600 billion in the U.K, and $400 billion in Canada. In 2007, mutual funds that invested in socially conscious firms had assets under management of more than $2.5 trillion in the United States, $2 trillion in Europe, $500 billion in Canada, $100 billion in Japan and 564 billion in Australia. ESG Analysis at Oddo D ESG Analysis at Oddo In June 2005, Oddo hired Jean-Phillippe Desmartin to head its SRI initiative. Desmartin, who had started his career in financial engineering at Credit du Nord, a subsidiary of Societe Generale, and subsequently worked for several social and environmental rating agencies, was charged with developing a systematic methodology for SRI analysis at Oddo. He subsequently hired Sebastien Thevoux-Chabuel as a senior analyst in the initiative. Thevoux-Chabuel had been with Oddo since 2005 as a sell-side analyst on the European Technology sector and he had experience at Deutsche Bank and BFT, a subsidiary of Credit Agricole, as a buy-side analyst. ESG research at Oddo was divided into three broad areas, Environmental, Social and Governance (Exhibit 1). Environmental factors included environmental management, risks and opportunities. Social factors covered regulatory risks, the management of the firm's human resources, its reputational capital and brands, and its supplier and partner relationships. Governance factors included the firm's commitment to sustainable development (Le. using resources to meet human The CAC 40 was an index of 40 stocks traded on the Paris Stock Exchange. The Dow Jones STOXX Euro 50 Index represented 50 super sector market leaders in the 12 Eurosone countries Austria, Belgium, Finland, France, Germany Greece, Ireland. Italy, Luxemburg, the Netherlands, Portugal and Spain. The Dow Jones STOXX 600 Index was comprised of 600 highly capitalized and actively traded stocks listed and traded on stock exchanges from 17 European countries The authors calculated these numbers from information provided by national and international organizations that track socially conscious funds, such as Eurosif, Social Investment Forum, Responsible Investment Association Australasia, Social Responsible Organization, and SRI funds in Asia needs while also preserving the environment), adherence to corporate governance best practices, and business ethics. The Oddo SRI Research team, working in collaboration with the firm's sector analysts, used a multi-step approach to build separate ESG models for each sector. Under the first step, the analyst team assessed which ESG factors were likely to be relevant and material for firms in the sector. Once these constructs were identified, the team developed quantitative and qualitative metrics for each material factor. Finally, the analyst team determined appropriate sector-specific weightings for the metrics, enabling them to be aggregated into separate environmental, social and governance performance scores, and into a total ESG score. In explaining how the weightings were created, Desmartin noted that they are "intended to reflect the degree to which our ESG performance factors correlate with returns." Weights were estimated using historical relations between the sector's metrics/factors and its stock returns. The time horizon over which the historical relations were estimated ranged between 1 and 5 years depending on the availability of data. The ESG analysts at Oddo then used the sector metrics and weightings generated from this process to construct ESG scores for individual companies within the sector. Based on a company's aggregate score, Oddo issued one of four ESG recommendations (Strong Opportunity, Opportunity, Moderate Risk, or High Risk). Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the ESG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysts who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESC analysis and do not have control over the analysis." ddo's ESG approach was designed to provide investors with insights into a firm's management ilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial aj d ESG Integration 100% & Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the RSG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that: "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysis who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESG analysis and do not have control over the analysis. Oddo's ESG approach was designed to provide investors with insights into a firm's management capabilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial performance. The goal of the ESG analysis, therefore, was to allow clients to optimize the ratio of returns to risk. Desmartin explained the firm's approach and the type of clients it sought to attract: In practice we are very far from some of the ethical approaches used in the U.S. We do not exclude companies, we do not exclude activities, and we do not say what is good and what is bad. Ours is not a religious or moral approach. We simply want to find the best investment opportunities for our clients in the long-term.... We want 80% of our SRI research business to come from mainstream investors, not explicitly socially-conscious investors. Already, 50% of our business is coming from mainstream investors. SRI research was targeted to large institutional investors with long-term time horizons such as pension funds and insurance companies. However, Desmartin observed "we have seen some recent interest in SRI from hedge funds. I would not say it is a trend, yet it is very interesting because their focus is exclusively on making money." Oddo's ESG recommendations reflected the expected performance of each stock over a long-term horizon (i.e., beyond 12 months). As reported in Exhibit 2. the stocks included in Oddo's SRI Strong Opportunity portfolio had outperformed the market for both the five-year and one-year horizons. 1+ *** addo Securities-ESG Integration 4/21 100% & Oddo calculated that from 2005 to 2010, its Strong Opportunity portfolio beat market indices by between 1,476 and 2,401 basis points (bps), depending on the index. For 2010, the portfolio beat the market by 181 to 970 bps, again depending on the index. Oddo's Telecom Sector Report Oddo's study of the telecom sector covered major equipment makers and service providers in the U.S. and Europe. ESG Model Desmartin and Thevoux-Chabuel created a model to evaluate and score telecommunication companies based on the three ESC factors. The environmental factor was labeled Health, Safety and Environment and covered whether the firm had an environmental management system, the environmental impact of telecom products and services, and the safety of products and services. Social factors included regulatory risks and opportunities, and intellectual capital (reflecting customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG I scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom ➜ customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential i electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom operators, the most important social factors identified were regulatory risks, and intellectual capital generated from the management of human resources and customer, supplier, and partner relationships (termed social ecosystem). On the human resources side the Oddo analysis attempted to identify companies characterized by a workforce that was productive and economically efficient but at the same time paid well. On the social ecosystem side the analysts assessed the innovation capacity, brand value, supply chain efficiency, the quality, durability, growth potential and diversification of distribution networks, product and service quality, and customer satisfaction. The criteria used to generate scores for human resource and social ecosystem factors are I shown in Exhibits 4 and 5. Governance The sustainable development and corporate governance criteria used in the ESG model are shown in Exhibits 6 and 7. The sustainable development criteria distinguished between companies that factored corporate social responsibility (CSR) and sustainable development into their internal and external communications and those that integrated CSR and sustainable development into their strategies and business models. The weightings used for corporate governance criteria differed for large-cap and mid to small sized firms, for firms with a controlling interest and for those with diversified owners, and for family-owned businesses. Exhibit 8 shows the scores that BT and FT received by Oddo analysts in each of the factors. BT scored higher by more than 20 points and outperformed FT in all three categories. Industry Drivers Oddo's SRI analysis of the telecom industry identified five long-term performance drivers: sustainable development, regulation, sector consolidation, emerging countries, and technological advances or breakthroughs. Sustainable Development. The analysts rated the sector highly for sustainable development, primarily because they assessed that it was well-positioned to create dematerialized growth (defined as making more products using fewer resources), facilitate entrepreneurial activities, open new markets, and help other organizations and industries become more sustainable. Regulation. Because the telecom operator sector was viewed as a natural monopoly, it had been subject to regulation. Oddo analysts perceived this to be a key industry risk, particularly for many European telecom operators as regulators focused on increasing competition to lower prices and offer more services options for retail consumers. Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with technological change were likely to face product obsolescence and financial failure. Operators also relied on technology so they needed to ensure that their offerings delivered the newest services, which often required heavy investment. Results and Recommendations Using the latest iteration of its ESG model, SRI Research analyzed 25 companies, assigning each an ESG score, rank, recommendation and outlook (see Exhibit 9). A summary of the findings is presented in Exhibit 10. Of those companies that were covered by Oddo's financial analysts and given a recommendation, only three-Iliad, Telefonica, and Vivendi-had ESG recommendations that matched the financial recommendation. Desmartin explained: The first reason there may be a difference is because we are looking at different time horizons. The SRI team looks at long-term prospects, usually between 12 to 60 months, while the financial analysts typically are looking more short-term. The other reason for differences is when there is a mismatch between the SRI team and the financial analyst covering the sector or the company, about what is material for the sector or the company. Our aim is not to cover all ESG indicators but those that are most relevant and the most material from a financial standpoint. Our goal is to be right 50% of the time or more. In looking at the past performance of the 25 stocks, those that SRI Research identified as strong opportunity or opportunity outperformed the DJ Stoxx Telecommunications index by 171%; while those companies SRI Research identified as having moderate to high risk, underperformed the same index by 32% (Exhibit 11). Keyes' Decision John Keyes reflected on the Oddo SRI Telecom report. The ESG and financial recommendations for British Telecom and France Telecom led him to the opposite conclusions. He reviewed the recent financial performance (see Exhibit 12) and stock market performance (see Exhibit 13) of the two companies. The performance of BT was impressively strong in 2006 and 2007 where earnings-per- share increased significantly and the company proposed an increase in dividends. However, BT's performance was completely reversed as the financial crisis hit and investors' expectations adjusted. How should he proceed? Should he follow the ESG recommendation and buy BT stock, or the financial recommendation and take a position in FT? Exhibit 1 Integrating ESG into valuation models ESG Research Environment Management Risks Opportunities Social Regulation IC-Human Capital IC-License to Operate/Reputation IC-Ecosystem, Quality, non-compliance Governance Sustainable development strategy Corporate Governance Business Ethics Source: Company documents. Note: L O N G T E RM DR I V E R S Materiality Business Model Management Statements →→Measurement ESG KPI's ESG Events Monetary Value Vahation Model Opportunities ↓ Performance Cash flow Cost of Capital Risk Premium Volatility 1 Risks "Management"refers to "Management quality". "Statements" refers to "Financial statements". "IC" is "Intellectual Capital" Exhibit 2 One-Year and Five-Year Performance Comparison: Oddo SRI vs. Industry Indices as of December 2010 Index Oddo SRI List (non-weighted) France CAC 40 France SBF 120 DJ STOXX Euro 50 DJ STOXX 600 Since Dec 31-2009 7.96% -1.74 0.77 -0.85 6.15 Since Dec- 31-2005 1.69% -17.95 -13.96 -22.32 Source: Company documents. -13.07 CAC 40 Compagnie des Agents de Change 40 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 40 French companies listed on the Paris Stock Exchange that were also traded on the options market. Construction principle: Capitalization-weighted value ratio SBF 120 Société des Bourses Françaises 120 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 120 French companies listed on the Paris Stock Exchange Construction principle: Capitalization-weighted value ratio DI STOXX Euro 50 Index Europe's leading blue-chip index provided a representation of super sector leaders in Europe. The index covered 50 stocks from 18 European countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. DI STOXX 600 Index Derived from the STOXX Europe Total Market Index (TMI) and was a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represented large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. Oddo Securities-ESG Integration Exhibit 3 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Human resources Organizational Ecosystem Social Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. Equipment Makers 3% 6 2 5 16 1 5194 29 46 2333 10 25 38 100% Operators 1% NOK 2 14 15 6235 54 10 25 3 38 100% Exhibit 4 Human Resources Indicators and Criteria for the Telecom Sector Indicator Governance and HR profile Attractiveness and recruitment ||| Career integration and planning Motivation and satisfaction Operational HR management Total Criteria Growth model Age pyramid management HR representation on executive board HR transparency Size-related attractiveness International presence-related attractiveness Economic attractiveness Average wage costs Employee share of ownership Growth in headcount Integration, annual review rate, career planning Training quality and effectiveness Management of reorganizational/restructuring measures Departure/arrival of key personnel Staff tumover Absenteeism Workplace climate and dialogue Payroll management Quality of local management Operating margin per employee Social liabilities (pension funds, healthcare, class actions) Weighting 10% 6 4 2 5 4 2 2 5 2 4 2 10 5 3 10 3 2 5 5 9 100% Nature of Criterion Quantitative & qualitative Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative & qualitative Quantitative & qualitative Mainly Qualitative Qualitative Qui Ive Quantitative Mainly Qualitative Quantitative Qualitative Quantitative Quantitative Exhibit 5 Ecosystem Criteria for the Telecom Sector Criteria Corporate culture, Internal organization Innovation/R&D/patents Brand Supply chain, logistics, industrial partnerships Distribution network Product and service quality Customer satisfaction Total Source Company documents. Criteria Length of sustainable development track record and learning curve Sustainable development organization: Direct reporting: Director profile; Resources allocated; Interactions - across functions Sustainable development information systems Products and services with sustainable development added value Sustainable development objectives and results Total Equipment Makers 4.0% Source: Company documents. 11.0 2.0 4.0 2.0 3.0 99 3.0 2 Exhibit 6 Sustainable Development Strategy Criteria for the Telecom Sector Equipment Makers 1.0% 29.0% 1.0 2.0 3.0 3.0 Operators 2.0% 4.0 3.0 2.0 10.0% 5.0 3.0 4.0 23.0% Operators 1.0% 1.0 2.0 3.0 3.0 Nature of Criteria Qualitative Quantitative & qualitative Quantitative & qualitative Qualitative 10.0% Qualitative Quantitative & qualitative Quantitative & qualitative Nature of Criteria Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative & qualitative Quantitative & qualitative Exhibit 7 Corporate Governance Criteria for the Telecom Sector Criteria 1. Minority shareholder rights (1 share-1 vote; anti- takeover measures) 2. Separation of functions. (CEO-Chairman) 3. Separation of roles (executives/shareholders/ board members) 4. Executive succession planning 5. Transparency and cohesion of executive pay 6. Assessment of executive pay and long-term performance 7. Board effectiveness (composition, functioning) 8. Committees reporting to the board. 9. Audit processes; degree of accountability, legal and tax transparency and complexity 10. Quality of financial communication Total Source: Company documents. Non- Controlled Controlled 17% 12% 13 2 10 3 20 63 13 12 Large Cap 100% 10 10 10 20 13 12 100% Mid-Small Cap Non- Controlled 18% 13 2 15 3 20 11 100% Controlled 11% 10 10 15 21 11 100% Family- owned 12% S 13 20 03 16 12 100% Exhibit 8 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Social Human resources Organizational Ecosystem Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. British Telecom 1.0 2.0 0.0 5.0 8.0 9.0 8.8 1.5 15.5 34.8 10.0 18.8 2.5 31.3 74.1 PHONE France Telecom 0.5 1.5 0.0 2.0 4.0 8.4 0.5 15.4 28.3 5.5 14.0 2.0 21.5 53.8 Exhibit 9 Telecom Sector: Summary of ESG Scores, Rank, Recommendation, Outlook, Financial Recommendation, and Target Prices Company Equipment Makers Alcatel-Lucent Clavu Ericsson Gemalto Motorola Nokia Oberthur Tandberg Operators AT&T Belgacom Bouygues British Telecom Deutsche Telekom France Telecom Iliad KPN Maroc Telecom Mobistar OTE Sprint Telecom Italia Telefonica Verizon Vivendi Vodafone Averages Equipment Makers Operators Telecom Sector Maximum possible score 1-Strong opportunity ESG ESG ESG ESG Score Rank Recommendation" Outlook 2 Opportunity 3-Moderate risk A High risk 51.5 00.0 65.3 59.8 50.3 77.1 57.1 70.7 61.7 53.2 55.5 74.0 51.4 53.3 62.1 61.6 51.0 50.8 47.8 38.7 54.1 59.2 60.7 63.2 61.7 Source: Company documents. SEK Swedish Krona Recommendation 62.3 56.5 58.3 100.0 75458162 3 329191655467108 7 2 4 32223131 2 NNNNWAAW WNNWW3333 Positive THE Negative na na Stable na na na na Positive Stable Negative Positive Stable Stable na na na na Negative Stable na Positive Stable Pinancial Recommendation" 2 Nut fullumed Not followed 2 Accept the offer Not followed Not followed 2 2727 Not followed Not followed Target Price €3,5 118 SEK 65,0 €29.0 na €16.0 €6,7 na na €25.5 €51.0 €170.0 €14.0 €24.0 €79.0 €13.0 €16,5 €60.0 €24.0 na €1.0 €17,5 na €33.0 £115 Exhibit 12 Financial performance of France Telecom and British Telecom France Telecom, for year ended December 31 (in Emil) Total revenue Revenue growth NOPAT Margin Asset tumover ROA Spread Leverage Impact of leverage ROE Percent of revenues Grom profit Operating expenses Unusual income (expenses) Discontinued operations Valuation multiples Price-to-eamings Price-to-book value British Telecom, for the year ended March 31 (in Emillion) Total revence Revenue growth NOPAT Margin Asstturnover ROA Spread Leverage Impact of leverage ROE Percent of revences Gross profit Operating expenses Unusual income (expenses) Discontinued operations 2006 51,702 7.5% 20 10.3% 0.71 7.2% 4.8% 1.95 9.4% 16.6% 43.6% 23.6% -0.3% 1.3% 11.82 2.28 2007 20,223 3.6% 17.0% 173 29.3% 23,5% 6.54 153.8% 183.2% 61.9% 45.7% -1.3% 0.0% 1007 46,568 4.9% 30.48 7.47 18.4% 0.68 12.6% 7.3% 1.55 10.9% 23.5% 46.7% 23.0% -7.5% 6.9% 31.23 2.37 2008 20,704 2.4% 11.6% 1.71 19.8% 11.4% 1.87 21.2% 41.0% 61.8% 45.5% -2.9% 0.0% 2000 46,712 0.3% 8.32 4.02 12.3% 0.70 8.6% 41% 1.26 5.2% 13.8% 42.4% 19.7% 1.4% 0.4% 9.40 1.77 2009 21,390 3.3% 2.4% 1.43 3.4% LO% Valuation multiples Price-to-samnings Price-to-book value NOTAT is net operating profit after taxe NOPAT margin i NOPAT over Not Ants Asset turnover is total revenue over asets. Spread is NOPAT margn minus the interest on all interest paying abilities, Leverage in total debt minus cash over gulty Impact of s spread times leverage Sou Capulced July 2011. 1.77 -7.0% -30% 61.4% 55.9% -26% 0.0% 6.66 2.20 1. From a company valuation perspective, how should we include the elements of the ESG analysis in the process? Should we include the elements of ESG in the cash flows or in the discount rate, or in both? (Remember at the end we need to arrive to an intrinsic value). Any ideas on how to do it? 2. Should the financial elements dominate the analysis? Those of ESG? Do they complement each other? How can we better understand the situation? Please provide your perspective on this situation. Oddo Securities-ESG Integration In January of 2009, John Keyes, portfolio manager for a medium-sized UK fund, reviewed the analyst report on the telecommunications industry he had just received from the French brokerage firm Oddo Securities (Oddo). Keyes was intrigued by Oddo's research, which provided two ratings of stocks covered, a financial rating and an environmental, social and governance (PSG) rating. Keyes was particularly struck by the returns generated by Oddo's ESG recommendations, which had outperformed most major stocks indices over the last five years. He reviewed the recommendations and analysis for two telecom stocks he was considering adding to his portfolio, British Telecom (BT) and France Telecom (FT). The Oddo analysis assigned BT its highest PSC rating (a Strong Opportunity) but rated the company as a "Reduce" in the financial recommendation. In contrast, FT was rated as a Moderate Risk under the ESC rating and a "Buy" for the financial rating, Keyes wondered how he should interpret these conflicting ratings, and which deserved more of his attention. Background on Oddo Securities Oddo Securities was owned by Oddo & Cie- an independent investment services firm that in 2010 had 900 employees, offices in Paris, Dubai, Madrid, and New York, and over €17 billion in assets under management. The firm was 80% owned by management, employees, and the Oddo family, and 20% by German-based insurer Allianz. It was headed by Philippe Oddo, whose family had been in the stockbroker business for five generations. In addition to its brokerage business, Oddo & Cie owned an investment bank, a financial advisory business, options and commodity businesses, a private bank, and an asset management unit. Oddo Securities was one of France's top brokers. The unit catered to an international institutional clientele providing brokerage services and research on a broad product range, including shares, futures, options and fixed income/credit. The research team, with 60 analysts, economists, and strategists, focused on the French and European market-equities, corporate bonds, and derivatives. The 5.momber prodit vocesuch term fomured on five incom and covered more than 120 1 capitalization of the France CAC 40 index, 89% of the DJ STOXX Euro 50 index and 60% of the DJ STOXX 600 index. ESG Investing and Analysis The use of ESC criteria for investing was a relatively recent innovation in the investment management industry and fell under the umbrella of socially responsible investing (SRI). SRI strategies could be broadly classified into five categories: negative screening, positive screening, integration, thematic, and engagement. Under negative screening, companies were excluded from investment portfolios based on ethical concerns about the safety of their products (e.g. tobacco, weapons, etc.) and their ethical standards of behavior. Positive screening identified companies with best-in-class ESG performance as investment candidates. Integration strategies focused on relations between ESG data, cash flows and/or cost of capital, and then embedded those relationships into valuation models. Thematic strategies followed either a multi-theme approach focusing on a broad range of long-term environmental or social issues (e.g. ageing societies, sustainable nutrition, clean energy, low-income solutions, urbanization, health, sustainable resources), or a hybrid approach. combining a large cap "best in class" universe with a thematic overlay. Finally, engagement represented a form of shareholder activism where investors sought to influence how companies addressed material ESG issues to protect and enhance the value of their investments. SRI investing experienced dramatic growth in the 1990s and 2000s. Between 2001 and 2007 assets under management of socially responsible investors grew by $400 billion in the US, $600 billion in the U.K, and $400 billion in Canada. In 2007, mutual funds that invested in socially conscious firms had assets under management of more than $2.5 trillion in the United States, $2 trillion in Europe, $500 billion in Canada, $100 billion in Japan and 564 billion in Australia. ESG Analysis at Oddo D ESG Analysis at Oddo In June 2005, Oddo hired Jean-Phillippe Desmartin to head its SRI initiative. Desmartin, who had started his career in financial engineering at Credit du Nord, a subsidiary of Societe Generale, and subsequently worked for several social and environmental rating agencies, was charged with developing a systematic methodology for SRI analysis at Oddo. He subsequently hired Sebastien Thevoux-Chabuel as a senior analyst in the initiative. Thevoux-Chabuel had been with Oddo since 2005 as a sell-side analyst on the European Technology sector and he had experience at Deutsche Bank and BFT, a subsidiary of Credit Agricole, as a buy-side analyst. ESG research at Oddo was divided into three broad areas, Environmental, Social and Governance (Exhibit 1). Environmental factors included environmental management, risks and opportunities. Social factors covered regulatory risks, the management of the firm's human resources, its reputational capital and brands, and its supplier and partner relationships. Governance factors included the firm's commitment to sustainable development (Le. using resources to meet human The CAC 40 was an index of 40 stocks traded on the Paris Stock Exchange. The Dow Jones STOXX Euro 50 Index represented 50 super sector market leaders in the 12 Eurosone countries Austria, Belgium, Finland, France, Germany Greece, Ireland. Italy, Luxemburg, the Netherlands, Portugal and Spain. The Dow Jones STOXX 600 Index was comprised of 600 highly capitalized and actively traded stocks listed and traded on stock exchanges from 17 European countries The authors calculated these numbers from information provided by national and international organizations that track socially conscious funds, such as Eurosif, Social Investment Forum, Responsible Investment Association Australasia, Social Responsible Organization, and SRI funds in Asia needs while also preserving the environment), adherence to corporate governance best practices, and business ethics. The Oddo SRI Research team, working in collaboration with the firm's sector analysts, used a multi-step approach to build separate ESG models for each sector. Under the first step, the analyst team assessed which ESG factors were likely to be relevant and material for firms in the sector. Once these constructs were identified, the team developed quantitative and qualitative metrics for each material factor. Finally, the analyst team determined appropriate sector-specific weightings for the metrics, enabling them to be aggregated into separate environmental, social and governance performance scores, and into a total ESG score. In explaining how the weightings were created, Desmartin noted that they are "intended to reflect the degree to which our ESG performance factors correlate with returns." Weights were estimated using historical relations between the sector's metrics/factors and its stock returns. The time horizon over which the historical relations were estimated ranged between 1 and 5 years depending on the availability of data. The ESG analysts at Oddo then used the sector metrics and weightings generated from this process to construct ESG scores for individual companies within the sector. Based on a company's aggregate score, Oddo issued one of four ESG recommendations (Strong Opportunity, Opportunity, Moderate Risk, or High Risk). Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the ESG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysts who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESC analysis and do not have control over the analysis." ddo's ESG approach was designed to provide investors with insights into a firm's management ilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial aj d ESG Integration 100% & Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the RSG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that: "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysis who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESG analysis and do not have control over the analysis. Oddo's ESG approach was designed to provide investors with insights into a firm's management capabilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial performance. The goal of the ESG analysis, therefore, was to allow clients to optimize the ratio of returns to risk. Desmartin explained the firm's approach and the type of clients it sought to attract: In practice we are very far from some of the ethical approaches used in the U.S. We do not exclude companies, we do not exclude activities, and we do not say what is good and what is bad. Ours is not a religious or moral approach. We simply want to find the best investment opportunities for our clients in the long-term.... We want 80% of our SRI research business to come from mainstream investors, not explicitly socially-conscious investors. Already, 50% of our business is coming from mainstream investors. SRI research was targeted to large institutional investors with long-term time horizons such as pension funds and insurance companies. However, Desmartin observed "we have seen some recent interest in SRI from hedge funds. I would not say it is a trend, yet it is very interesting because their focus is exclusively on making money." Oddo's ESG recommendations reflected the expected performance of each stock over a long-term horizon (i.e., beyond 12 months). As reported in Exhibit 2. the stocks included in Oddo's SRI Strong Opportunity portfolio had outperformed the market for both the five-year and one-year horizons. 1+ *** addo Securities-ESG Integration 4/21 100% & Oddo calculated that from 2005 to 2010, its Strong Opportunity portfolio beat market indices by between 1,476 and 2,401 basis points (bps), depending on the index. For 2010, the portfolio beat the market by 181 to 970 bps, again depending on the index. Oddo's Telecom Sector Report Oddo's study of the telecom sector covered major equipment makers and service providers in the U.S. and Europe. ESG Model Desmartin and Thevoux-Chabuel created a model to evaluate and score telecommunication companies based on the three ESC factors. The environmental factor was labeled Health, Safety and Environment and covered whether the firm had an environmental management system, the environmental impact of telecom products and services, and the safety of products and services. Social factors included regulatory risks and opportunities, and intellectual capital (reflecting customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG I scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom ➜ customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential i electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom operators, the most important social factors identified were regulatory risks, and intellectual capital generated from the management of human resources and customer, supplier, and partner relationships (termed social ecosystem). On the human resources side the Oddo analysis attempted to identify companies characterized by a workforce that was productive and economically efficient but at the same time paid well. On the social ecosystem side the analysts assessed the innovation capacity, brand value, supply chain efficiency, the quality, durability, growth potential and diversification of distribution networks, product and service quality, and customer satisfaction. The criteria used to generate scores for human resource and social ecosystem factors are I shown in Exhibits 4 and 5. Governance The sustainable development and corporate governance criteria used in the ESG model are shown in Exhibits 6 and 7. The sustainable development criteria distinguished between companies that factored corporate social responsibility (CSR) and sustainable development into their internal and external communications and those that integrated CSR and sustainable development into their strategies and business models. The weightings used for corporate governance criteria differed for large-cap and mid to small sized firms, for firms with a controlling interest and for those with diversified owners, and for family-owned businesses. Exhibit 8 shows the scores that BT and FT received by Oddo analysts in each of the factors. BT scored higher by more than 20 points and outperformed FT in all three categories. Industry Drivers Oddo's SRI analysis of the telecom industry identified five long-term performance drivers: sustainable development, regulation, sector consolidation, emerging countries, and technological advances or breakthroughs. Sustainable Development. The analysts rated the sector highly for sustainable development, primarily because they assessed that it was well-positioned to create dematerialized growth (defined as making more products using fewer resources), facilitate entrepreneurial activities, open new markets, and help other organizations and industries become more sustainable. Regulation. Because the telecom operator sector was viewed as a natural monopoly, it had been subject to regulation. Oddo analysts perceived this to be a key industry risk, particularly for many European telecom operators as regulators focused on increasing competition to lower prices and offer more services options for retail consumers. Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with technological change were likely to face product obsolescence and financial failure. Operators also relied on technology so they needed to ensure that their offerings delivered the newest services, which often required heavy investment. Results and Recommendations Using the latest iteration of its ESG model, SRI Research analyzed 25 companies, assigning each an ESG score, rank, recommendation and outlook (see Exhibit 9). A summary of the findings is presented in Exhibit 10. Of those companies that were covered by Oddo's financial analysts and given a recommendation, only three-Iliad, Telefonica, and Vivendi-had ESG recommendations that matched the financial recommendation. Desmartin explained: The first reason there may be a difference is because we are looking at different time horizons. The SRI team looks at long-term prospects, usually between 12 to 60 months, while the financial analysts typically are looking more short-term. The other reason for differences is when there is a mismatch between the SRI team and the financial analyst covering the sector or the company, about what is material for the sector or the company. Our aim is not to cover all ESG indicators but those that are most relevant and the most material from a financial standpoint. Our goal is to be right 50% of the time or more. In looking at the past performance of the 25 stocks, those that SRI Research identified as strong opportunity or opportunity outperformed the DJ Stoxx Telecommunications index by 171%; while those companies SRI Research identified as having moderate to high risk, underperformed the same index by 32% (Exhibit 11). Keyes' Decision John Keyes reflected on the Oddo SRI Telecom report. The ESG and financial recommendations for British Telecom and France Telecom led him to the opposite conclusions. He reviewed the recent financial performance (see Exhibit 12) and stock market performance (see Exhibit 13) of the two companies. The performance of BT was impressively strong in 2006 and 2007 where earnings-per- share increased significantly and the company proposed an increase in dividends. However, BT's performance was completely reversed as the financial crisis hit and investors' expectations adjusted. How should he proceed? Should he follow the ESG recommendation and buy BT stock, or the financial recommendation and take a position in FT? Exhibit 1 Integrating ESG into valuation models ESG Research Environment Management Risks Opportunities Social Regulation IC-Human Capital IC-License to Operate/Reputation IC-Ecosystem, Quality, non-compliance Governance Sustainable development strategy Corporate Governance Business Ethics Source: Company documents. Note: L O N G T E RM DR I V E R S Materiality Business Model Management Statements →→Measurement ESG KPI's ESG Events Monetary Value Vahation Model Opportunities ↓ Performance Cash flow Cost of Capital Risk Premium Volatility 1 Risks "Management"refers to "Management quality". "Statements" refers to "Financial statements". "IC" is "Intellectual Capital" Exhibit 2 One-Year and Five-Year Performance Comparison: Oddo SRI vs. Industry Indices as of December 2010 Index Oddo SRI List (non-weighted) France CAC 40 France SBF 120 DJ STOXX Euro 50 DJ STOXX 600 Since Dec 31-2009 7.96% -1.74 0.77 -0.85 6.15 Since Dec- 31-2005 1.69% -17.95 -13.96 -22.32 Source: Company documents. -13.07 CAC 40 Compagnie des Agents de Change 40 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 40 French companies listed on the Paris Stock Exchange that were also traded on the options market. Construction principle: Capitalization-weighted value ratio SBF 120 Société des Bourses Françaises 120 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 120 French companies listed on the Paris Stock Exchange Construction principle: Capitalization-weighted value ratio DI STOXX Euro 50 Index Europe's leading blue-chip index provided a representation of super sector leaders in Europe. The index covered 50 stocks from 18 European countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. DI STOXX 600 Index Derived from the STOXX Europe Total Market Index (TMI) and was a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represented large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. Oddo Securities-ESG Integration Exhibit 3 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Human resources Organizational Ecosystem Social Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. Equipment Makers 3% 6 2 5 16 1 5194 29 46 2333 10 25 38 100% Operators 1% NOK 2 14 15 6235 54 10 25 3 38 100% Exhibit 4 Human Resources Indicators and Criteria for the Telecom Sector Indicator Governance and HR profile Attractiveness and recruitment ||| Career integration and planning Motivation and satisfaction Operational HR management Total Criteria Growth model Age pyramid management HR representation on executive board HR transparency Size-related attractiveness International presence-related attractiveness Economic attractiveness Average wage costs Employee share of ownership Growth in headcount Integration, annual review rate, career planning Training quality and effectiveness Management of reorganizational/restructuring measures Departure/arrival of key personnel Staff tumover Absenteeism Workplace climate and dialogue Payroll management Quality of local management Operating margin per employee Social liabilities (pension funds, healthcare, class actions) Weighting 10% 6 4 2 5 4 2 2 5 2 4 2 10 5 3 10 3 2 5 5 9 100% Nature of Criterion Quantitative & qualitative Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative & qualitative Quantitative & qualitative Mainly Qualitative Qualitative Qui Ive Quantitative Mainly Qualitative Quantitative Qualitative Quantitative Quantitative Exhibit 5 Ecosystem Criteria for the Telecom Sector Criteria Corporate culture, Internal organization Innovation/R&D/patents Brand Supply chain, logistics, industrial partnerships Distribution network Product and service quality Customer satisfaction Total Source Company documents. Criteria Length of sustainable development track record and learning curve Sustainable development organization: Direct reporting: Director profile; Resources allocated; Interactions - across functions Sustainable development information systems Products and services with sustainable development added value Sustainable development objectives and results Total Equipment Makers 4.0% Source: Company documents. 11.0 2.0 4.0 2.0 3.0 99 3.0 2 Exhibit 6 Sustainable Development Strategy Criteria for the Telecom Sector Equipment Makers 1.0% 29.0% 1.0 2.0 3.0 3.0 Operators 2.0% 4.0 3.0 2.0 10.0% 5.0 3.0 4.0 23.0% Operators 1.0% 1.0 2.0 3.0 3.0 Nature of Criteria Qualitative Quantitative & qualitative Quantitative & qualitative Qualitative 10.0% Qualitative Quantitative & qualitative Quantitative & qualitative Nature of Criteria Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative & qualitative Quantitative & qualitative Exhibit 7 Corporate Governance Criteria for the Telecom Sector Criteria 1. Minority shareholder rights (1 share-1 vote; anti- takeover measures) 2. Separation of functions. (CEO-Chairman) 3. Separation of roles (executives/shareholders/ board members) 4. Executive succession planning 5. Transparency and cohesion of executive pay 6. Assessment of executive pay and long-term performance 7. Board effectiveness (composition, functioning) 8. Committees reporting to the board. 9. Audit processes; degree of accountability, legal and tax transparency and complexity 10. Quality of financial communication Total Source: Company documents. Non- Controlled Controlled 17% 12% 13 2 10 3 20 63 13 12 Large Cap 100% 10 10 10 20 13 12 100% Mid-Small Cap Non- Controlled 18% 13 2 15 3 20 11 100% Controlled 11% 10 10 15 21 11 100% Family- owned 12% S 13 20 03 16 12 100% Exhibit 8 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Social Human resources Organizational Ecosystem Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. British Telecom 1.0 2.0 0.0 5.0 8.0 9.0 8.8 1.5 15.5 34.8 10.0 18.8 2.5 31.3 74.1 PHONE France Telecom 0.5 1.5 0.0 2.0 4.0 8.4 0.5 15.4 28.3 5.5 14.0 2.0 21.5 53.8 Exhibit 9 Telecom Sector: Summary of ESG Scores, Rank, Recommendation, Outlook, Financial Recommendation, and Target Prices Company Equipment Makers Alcatel-Lucent Clavu Ericsson Gemalto Motorola Nokia Oberthur Tandberg Operators AT&T Belgacom Bouygues British Telecom Deutsche Telekom France Telecom Iliad KPN Maroc Telecom Mobistar OTE Sprint Telecom Italia Telefonica Verizon Vivendi Vodafone Averages Equipment Makers Operators Telecom Sector Maximum possible score 1-Strong opportunity ESG ESG ESG ESG Score Rank Recommendation" Outlook 2 Opportunity 3-Moderate risk A High risk 51.5 00.0 65.3 59.8 50.3 77.1 57.1 70.7 61.7 53.2 55.5 74.0 51.4 53.3 62.1 61.6 51.0 50.8 47.8 38.7 54.1 59.2 60.7 63.2 61.7 Source: Company documents. SEK Swedish Krona Recommendation 62.3 56.5 58.3 100.0 75458162 3 329191655467108 7 2 4 32223131 2 NNNNWAAW WNNWW3333 Positive THE Negative na na Stable na na na na Positive Stable Negative Positive Stable Stable na na na na Negative Stable na Positive Stable Pinancial Recommendation" 2 Nut fullumed Not followed 2 Accept the offer Not followed Not followed 2 2727 Not followed Not followed Target Price €3,5 118 SEK 65,0 €29.0 na €16.0 €6,7 na na €25.5 €51.0 €170.0 €14.0 €24.0 €79.0 €13.0 €16,5 €60.0 €24.0 na €1.0 €17,5 na €33.0 £115 Exhibit 12 Financial performance of France Telecom and British Telecom France Telecom, for year ended December 31 (in Emil) Total revenue Revenue growth NOPAT Margin Asset tumover ROA Spread Leverage Impact of leverage ROE Percent of revenues Grom profit Operating expenses Unusual income (expenses) Discontinued operations Valuation multiples Price-to-eamings Price-to-book value British Telecom, for the year ended March 31 (in Emillion) Total revence Revenue growth NOPAT Margin Asstturnover ROA Spread Leverage Impact of leverage ROE Percent of revences Gross profit Operating expenses Unusual income (expenses) Discontinued operations 2006 51,702 7.5% 20 10.3% 0.71 7.2% 4.8% 1.95 9.4% 16.6% 43.6% 23.6% -0.3% 1.3% 11.82 2.28 2007 20,223 3.6% 17.0% 173 29.3% 23,5% 6.54 153.8% 183.2% 61.9% 45.7% -1.3% 0.0% 1007 46,568 4.9% 30.48 7.47 18.4% 0.68 12.6% 7.3% 1.55 10.9% 23.5% 46.7% 23.0% -7.5% 6.9% 31.23 2.37 2008 20,704 2.4% 11.6% 1.71 19.8% 11.4% 1.87 21.2% 41.0% 61.8% 45.5% -2.9% 0.0% 2000 46,712 0.3% 8.32 4.02 12.3% 0.70 8.6% 41% 1.26 5.2% 13.8% 42.4% 19.7% 1.4% 0.4% 9.40 1.77 2009 21,390 3.3% 2.4% 1.43 3.4% LO% Valuation multiples Price-to-samnings Price-to-book value NOTAT is net operating profit after taxe NOPAT margin i NOPAT over Not Ants Asset turnover is total revenue over asets. Spread is NOPAT margn minus the interest on all interest paying abilities, Leverage in total debt minus cash over gulty Impact of s spread times leverage Sou Capulced July 2011. 1.77 -7.0% -30% 61.4% 55.9% -26% 0.0% 6.66 2.20 1. From a company valuation perspective, how should we include the elements of the ESG analysis in the process? Should we include the elements of ESG in the cash flows or in the discount rate, or in both? (Remember at the end we need to arrive to an intrinsic value). Any ideas on how to do it? 2. Should the financial elements dominate the analysis? Those of ESG? Do they complement each other? How can we better understand the situation? Please provide your perspective on this situation. Oddo Securities-ESG Integration In January of 2009, John Keyes, portfolio manager for a medium-sized UK fund, reviewed the analyst report on the telecommunications industry he had just received from the French brokerage firm Oddo Securities (Oddo). Keyes was intrigued by Oddo's research, which provided two ratings of stocks covered, a financial rating and an environmental, social and governance (PSG) rating. Keyes was particularly struck by the returns generated by Oddo's ESG recommendations, which had outperformed most major stocks indices over the last five years. He reviewed the recommendations and analysis for two telecom stocks he was considering adding to his portfolio, British Telecom (BT) and France Telecom (FT). The Oddo analysis assigned BT its highest PSC rating (a Strong Opportunity) but rated the company as a "Reduce" in the financial recommendation. In contrast, FT was rated as a Moderate Risk under the ESC rating and a "Buy" for the financial rating, Keyes wondered how he should interpret these conflicting ratings, and which deserved more of his attention. Background on Oddo Securities Oddo Securities was owned by Oddo & Cie- an independent investment services firm that in 2010 had 900 employees, offices in Paris, Dubai, Madrid, and New York, and over €17 billion in assets under management. The firm was 80% owned by management, employees, and the Oddo family, and 20% by German-based insurer Allianz. It was headed by Philippe Oddo, whose family had been in the stockbroker business for five generations. In addition to its brokerage business, Oddo & Cie owned an investment bank, a financial advisory business, options and commodity businesses, a private bank, and an asset management unit. Oddo Securities was one of France's top brokers. The unit catered to an international institutional clientele providing brokerage services and research on a broad product range, including shares, futures, options and fixed income/credit. The research team, with 60 analysts, economists, and strategists, focused on the French and European market-equities, corporate bonds, and derivatives. The 5.momber prodit vocesuch term fomured on five incom and covered more than 120 1 capitalization of the France CAC 40 index, 89% of the DJ STOXX Euro 50 index and 60% of the DJ STOXX 600 index. ESG Investing and Analysis The use of ESC criteria for investing was a relatively recent innovation in the investment management industry and fell under the umbrella of socially responsible investing (SRI). SRI strategies could be broadly classified into five categories: negative screening, positive screening, integration, thematic, and engagement. Under negative screening, companies were excluded from investment portfolios based on ethical concerns about the safety of their products (e.g. tobacco, weapons, etc.) and their ethical standards of behavior. Positive screening identified companies with best-in-class ESG performance as investment candidates. Integration strategies focused on relations between ESG data, cash flows and/or cost of capital, and then embedded those relationships into valuation models. Thematic strategies followed either a multi-theme approach focusing on a broad range of long-term environmental or social issues (e.g. ageing societies, sustainable nutrition, clean energy, low-income solutions, urbanization, health, sustainable resources), or a hybrid approach. combining a large cap "best in class" universe with a thematic overlay. Finally, engagement represented a form of shareholder activism where investors sought to influence how companies addressed material ESG issues to protect and enhance the value of their investments. SRI investing experienced dramatic growth in the 1990s and 2000s. Between 2001 and 2007 assets under management of socially responsible investors grew by $400 billion in the US, $600 billion in the U.K, and $400 billion in Canada. In 2007, mutual funds that invested in socially conscious firms had assets under management of more than $2.5 trillion in the United States, $2 trillion in Europe, $500 billion in Canada, $100 billion in Japan and 564 billion in Australia. ESG Analysis at Oddo D ESG Analysis at Oddo In June 2005, Oddo hired Jean-Phillippe Desmartin to head its SRI initiative. Desmartin, who had started his career in financial engineering at Credit du Nord, a subsidiary of Societe Generale, and subsequently worked for several social and environmental rating agencies, was charged with developing a systematic methodology for SRI analysis at Oddo. He subsequently hired Sebastien Thevoux-Chabuel as a senior analyst in the initiative. Thevoux-Chabuel had been with Oddo since 2005 as a sell-side analyst on the European Technology sector and he had experience at Deutsche Bank and BFT, a subsidiary of Credit Agricole, as a buy-side analyst. ESG research at Oddo was divided into three broad areas, Environmental, Social and Governance (Exhibit 1). Environmental factors included environmental management, risks and opportunities. Social factors covered regulatory risks, the management of the firm's human resources, its reputational capital and brands, and its supplier and partner relationships. Governance factors included the firm's commitment to sustainable development (Le. using resources to meet human The CAC 40 was an index of 40 stocks traded on the Paris Stock Exchange. The Dow Jones STOXX Euro 50 Index represented 50 super sector market leaders in the 12 Eurosone countries Austria, Belgium, Finland, France, Germany Greece, Ireland. Italy, Luxemburg, the Netherlands, Portugal and Spain. The Dow Jones STOXX 600 Index was comprised of 600 highly capitalized and actively traded stocks listed and traded on stock exchanges from 17 European countries The authors calculated these numbers from information provided by national and international organizations that track socially conscious funds, such as Eurosif, Social Investment Forum, Responsible Investment Association Australasia, Social Responsible Organization, and SRI funds in Asia needs while also preserving the environment), adherence to corporate governance best practices, and business ethics. The Oddo SRI Research team, working in collaboration with the firm's sector analysts, used a multi-step approach to build separate ESG models for each sector. Under the first step, the analyst team assessed which ESG factors were likely to be relevant and material for firms in the sector. Once these constructs were identified, the team developed quantitative and qualitative metrics for each material factor. Finally, the analyst team determined appropriate sector-specific weightings for the metrics, enabling them to be aggregated into separate environmental, social and governance performance scores, and into a total ESG score. In explaining how the weightings were created, Desmartin noted that they are "intended to reflect the degree to which our ESG performance factors correlate with returns." Weights were estimated using historical relations between the sector's metrics/factors and its stock returns. The time horizon over which the historical relations were estimated ranged between 1 and 5 years depending on the availability of data. The ESG analysts at Oddo then used the sector metrics and weightings generated from this process to construct ESG scores for individual companies within the sector. Based on a company's aggregate score, Oddo issued one of four ESG recommendations (Strong Opportunity, Opportunity, Moderate Risk, or High Risk). Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the ESG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysts who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESC analysis and do not have control over the analysis." ddo's ESG approach was designed to provide investors with insights into a firm's management ilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial aj d ESG Integration 100% & Around 25% of Oddo's non-ESG analysts believed that the firm's ESG research was a useful input into their company research and equity valuations. These analysts typically estimated how the opportunities and risks associated with the RSG scores would affect the future cash flow projections and/or the cost of capital for the companies they covered. Desmartin observed that: "the best financial analysts are most eager to use ESG research in their analysis and recommendations. The analysis who have the best reputation in the market are always trying to find ways to innovate and stay ahead of the curve." He added that "10% of financial analysts are skeptical about the value of ESG research." Thevoux-Chabuel explained that these analysts "are reluctant to incorporate ESG factors into their valuation models because they do not fully understand ESG analysis and do not have control over the analysis. Oddo's ESG approach was designed to provide investors with insights into a firm's management capabilities, identify its key risks and opportunities, and drivers of its long-term sustainable financial performance. The goal of the ESG analysis, therefore, was to allow clients to optimize the ratio of returns to risk. Desmartin explained the firm's approach and the type of clients it sought to attract: In practice we are very far from some of the ethical approaches used in the U.S. We do not exclude companies, we do not exclude activities, and we do not say what is good and what is bad. Ours is not a religious or moral approach. We simply want to find the best investment opportunities for our clients in the long-term.... We want 80% of our SRI research business to come from mainstream investors, not explicitly socially-conscious investors. Already, 50% of our business is coming from mainstream investors. SRI research was targeted to large institutional investors with long-term time horizons such as pension funds and insurance companies. However, Desmartin observed "we have seen some recent interest in SRI from hedge funds. I would not say it is a trend, yet it is very interesting because their focus is exclusively on making money." Oddo's ESG recommendations reflected the expected performance of each stock over a long-term horizon (i.e., beyond 12 months). As reported in Exhibit 2. the stocks included in Oddo's SRI Strong Opportunity portfolio had outperformed the market for both the five-year and one-year horizons. 1+ *** addo Securities-ESG Integration 4/21 100% & Oddo calculated that from 2005 to 2010, its Strong Opportunity portfolio beat market indices by between 1,476 and 2,401 basis points (bps), depending on the index. For 2010, the portfolio beat the market by 181 to 970 bps, again depending on the index. Oddo's Telecom Sector Report Oddo's study of the telecom sector covered major equipment makers and service providers in the U.S. and Europe. ESG Model Desmartin and Thevoux-Chabuel created a model to evaluate and score telecommunication companies based on the three ESC factors. The environmental factor was labeled Health, Safety and Environment and covered whether the firm had an environmental management system, the environmental impact of telecom products and services, and the safety of products and services. Social factors included regulatory risks and opportunities, and intellectual capital (reflecting customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG I scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom ➜ customer relationships and branding, human resource management, and supplier and partner relationships). Governance covered commitment to a sustainable development strategy, corporate governance, and business ethics. For each of these factors, Oddo analysts identified lower level quantitative and qualitative metrics. The weights assigned to each of these factors are shown in Exhibit 3. For operators, intellectual capital accounted for 40% and governance for 38% of ESG scoring. Health/safety/environment (HSE) Oddo analysts rated HSE factors as less important for the telecom sector than other sectors (e.g., energy, transportation, etc.). Telecom companies contributed less than 1% of CO₂ emissions, and telecom products and services could lower transportation demand, paper consumption, etc. The principal HSE risk identified was exposure to potential i electromagnetic waves, which insurance companies were hesitant to cover. Risk exposure to electromagnetic waves was driven by exposure to mobile communications (80%) and by prevention measures (20%). Social Factors For telecom operators, the most important social factors identified were regulatory risks, and intellectual capital generated from the management of human resources and customer, supplier, and partner relationships (termed social ecosystem). On the human resources side the Oddo analysis attempted to identify companies characterized by a workforce that was productive and economically efficient but at the same time paid well. On the social ecosystem side the analysts assessed the innovation capacity, brand value, supply chain efficiency, the quality, durability, growth potential and diversification of distribution networks, product and service quality, and customer satisfaction. The criteria used to generate scores for human resource and social ecosystem factors are I shown in Exhibits 4 and 5. Governance The sustainable development and corporate governance criteria used in the ESG model are shown in Exhibits 6 and 7. The sustainable development criteria distinguished between companies that factored corporate social responsibility (CSR) and sustainable development into their internal and external communications and those that integrated CSR and sustainable development into their strategies and business models. The weightings used for corporate governance criteria differed for large-cap and mid to small sized firms, for firms with a controlling interest and for those with diversified owners, and for family-owned businesses. Exhibit 8 shows the scores that BT and FT received by Oddo analysts in each of the factors. BT scored higher by more than 20 points and outperformed FT in all three categories. Industry Drivers Oddo's SRI analysis of the telecom industry identified five long-term performance drivers: sustainable development, regulation, sector consolidation, emerging countries, and technological advances or breakthroughs. Sustainable Development. The analysts rated the sector highly for sustainable development, primarily because they assessed that it was well-positioned to create dematerialized growth (defined as making more products using fewer resources), facilitate entrepreneurial activities, open new markets, and help other organizations and industries become more sustainable. Regulation. Because the telecom operator sector was viewed as a natural monopoly, it had been subject to regulation. Oddo analysts perceived this to be a key industry risk, particularly for many European telecom operators as regulators focused on increasing competition to lower prices and offer more services options for retail consumers. Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with Consolidation. Oddo analysts argued that countries with fragmented operator markets could see more consolidations to take advantage of economies of scale. Consolidations had already occurred in France, reducing the number of operators from nine to three, and in the Netherlands, where the number had fallen from five to three. However, Oddo analysts cautioned that cross-border acquisitions, although popular, presented political and implementation risks that made synergies elusive. Emerging countries. According to Oddo's analysis, with little growth opportunities in home markets, operators and equipment makers would seek opportunities in emerging markets in Africa, Asia, and Latin America where penetration rates remained low. Technological advances or breakthroughs. Advances in telecommunication technology were perceived to generate opportunities and threats. Equipment makers that failed to keep up with technological change were likely to face product obsolescence and financial failure. Operators also relied on technology so they needed to ensure that their offerings delivered the newest services, which often required heavy investment. Results and Recommendations Using the latest iteration of its ESG model, SRI Research analyzed 25 companies, assigning each an ESG score, rank, recommendation and outlook (see Exhibit 9). A summary of the findings is presented in Exhibit 10. Of those companies that were covered by Oddo's financial analysts and given a recommendation, only three-Iliad, Telefonica, and Vivendi-had ESG recommendations that matched the financial recommendation. Desmartin explained: The first reason there may be a difference is because we are looking at different time horizons. The SRI team looks at long-term prospects, usually between 12 to 60 months, while the financial analysts typically are looking more short-term. The other reason for differences is when there is a mismatch between the SRI team and the financial analyst covering the sector or the company, about what is material for the sector or the company. Our aim is not to cover all ESG indicators but those that are most relevant and the most material from a financial standpoint. Our goal is to be right 50% of the time or more. In looking at the past performance of the 25 stocks, those that SRI Research identified as strong opportunity or opportunity outperformed the DJ Stoxx Telecommunications index by 171%; while those companies SRI Research identified as having moderate to high risk, underperformed the same index by 32% (Exhibit 11). Keyes' Decision John Keyes reflected on the Oddo SRI Telecom report. The ESG and financial recommendations for British Telecom and France Telecom led him to the opposite conclusions. He reviewed the recent financial performance (see Exhibit 12) and stock market performance (see Exhibit 13) of the two companies. The performance of BT was impressively strong in 2006 and 2007 where earnings-per- share increased significantly and the company proposed an increase in dividends. However, BT's performance was completely reversed as the financial crisis hit and investors' expectations adjusted. How should he proceed? Should he follow the ESG recommendation and buy BT stock, or the financial recommendation and take a position in FT? Exhibit 1 Integrating ESG into valuation models ESG Research Environment Management Risks Opportunities Social Regulation IC-Human Capital IC-License to Operate/Reputation IC-Ecosystem, Quality, non-compliance Governance Sustainable development strategy Corporate Governance Business Ethics Source: Company documents. Note: L O N G T E RM DR I V E R S Materiality Business Model Management Statements →→Measurement ESG KPI's ESG Events Monetary Value Vahation Model Opportunities ↓ Performance Cash flow Cost of Capital Risk Premium Volatility 1 Risks "Management"refers to "Management quality". "Statements" refers to "Financial statements". "IC" is "Intellectual Capital" Exhibit 2 One-Year and Five-Year Performance Comparison: Oddo SRI vs. Industry Indices as of December 2010 Index Oddo SRI List (non-weighted) France CAC 40 France SBF 120 DJ STOXX Euro 50 DJ STOXX 600 Since Dec 31-2009 7.96% -1.74 0.77 -0.85 6.15 Since Dec- 31-2005 1.69% -17.95 -13.96 -22.32 Source: Company documents. -13.07 CAC 40 Compagnie des Agents de Change 40 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 40 French companies listed on the Paris Stock Exchange that were also traded on the options market. Construction principle: Capitalization-weighted value ratio SBF 120 Société des Bourses Françaises 120 Index Owner/publisher/sponsor: Association of French Stock Exchanges - Paris Stock Exchange Number of constituents: 120 French companies listed on the Paris Stock Exchange Construction principle: Capitalization-weighted value ratio DI STOXX Euro 50 Index Europe's leading blue-chip index provided a representation of super sector leaders in Europe. The index covered 50 stocks from 18 European countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. DI STOXX 600 Index Derived from the STOXX Europe Total Market Index (TMI) and was a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represented large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K. Oddo Securities-ESG Integration Exhibit 3 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Human resources Organizational Ecosystem Social Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. Equipment Makers 3% 6 2 5 16 1 5194 29 46 2333 10 25 38 100% Operators 1% NOK 2 14 15 6235 54 10 25 3 38 100% Exhibit 4 Human Resources Indicators and Criteria for the Telecom Sector Indicator Governance and HR profile Attractiveness and recruitment ||| Career integration and planning Motivation and satisfaction Operational HR management Total Criteria Growth model Age pyramid management HR representation on executive board HR transparency Size-related attractiveness International presence-related attractiveness Economic attractiveness Average wage costs Employee share of ownership Growth in headcount Integration, annual review rate, career planning Training quality and effectiveness Management of reorganizational/restructuring measures Departure/arrival of key personnel Staff tumover Absenteeism Workplace climate and dialogue Payroll management Quality of local management Operating margin per employee Social liabilities (pension funds, healthcare, class actions) Weighting 10% 6 4 2 5 4 2 2 5 2 4 2 10 5 3 10 3 2 5 5 9 100% Nature of Criterion Quantitative & qualitative Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative Quantitative & qualitative Quantitative & qualitative Mainly Qualitative Qualitative Qui Ive Quantitative Mainly Qualitative Quantitative Qualitative Quantitative Quantitative Exhibit 5 Ecosystem Criteria for the Telecom Sector Criteria Corporate culture, Internal organization Innovation/R&D/patents Brand Supply chain, logistics, industrial partnerships Distribution network Product and service quality Customer satisfaction Total Source Company documents. Criteria Length of sustainable development track record and learning curve Sustainable development organization: Direct reporting: Director profile; Resources allocated; Interactions - across functions Sustainable development information systems Products and services with sustainable development added value Sustainable development objectives and results Total Equipment Makers 4.0% Source: Company documents. 11.0 2.0 4.0 2.0 3.0 99 3.0 2 Exhibit 6 Sustainable Development Strategy Criteria for the Telecom Sector Equipment Makers 1.0% 29.0% 1.0 2.0 3.0 3.0 Operators 2.0% 4.0 3.0 2.0 10.0% 5.0 3.0 4.0 23.0% Operators 1.0% 1.0 2.0 3.0 3.0 Nature of Criteria Qualitative Quantitative & qualitative Quantitative & qualitative Qualitative 10.0% Qualitative Quantitative & qualitative Quantitative & qualitative Nature of Criteria Quantitative & qualitative Qualitative Quantitative & qualitative Quantitative & qualitative Quantitative & qualitative Exhibit 7 Corporate Governance Criteria for the Telecom Sector Criteria 1. Minority shareholder rights (1 share-1 vote; anti- takeover measures) 2. Separation of functions. (CEO-Chairman) 3. Separation of roles (executives/shareholders/ board members) 4. Executive succession planning 5. Transparency and cohesion of executive pay 6. Assessment of executive pay and long-term performance 7. Board effectiveness (composition, functioning) 8. Committees reporting to the board. 9. Audit processes; degree of accountability, legal and tax transparency and complexity 10. Quality of financial communication Total Source: Company documents. Non- Controlled Controlled 17% 12% 13 2 10 3 20 63 13 12 Large Cap 100% 10 10 10 20 13 12 100% Mid-Small Cap Non- Controlled 18% 13 2 15 3 20 11 100% Controlled 11% 10 10 15 21 11 100% Family- owned 12% S 13 20 03 16 12 100% Exhibit 8 Overview of the ESG Scoring Model for the Telecom Sector ESG criteria/positioning EMS (Environmental Management System) Products and services (environmental impacts) Industrial accidents (frequency rate) Risk of exposure to electromagnetic waves HSE (health/safety/environment) Regulation Intellectual capital Social Human resources Organizational Ecosystem Sustainable development strategy Corporate governance Business ethics Governance Total ESG Source: Company documents. British Telecom 1.0 2.0 0.0 5.0 8.0 9.0 8.8 1.5 15.5 34.8 10.0 18.8 2.5 31.3 74.1 PHONE France Telecom 0.5 1.5 0.0 2.0 4.0 8.4 0.5 15.4 28.3 5.5 14.0 2.0 21.5 53.8 Exhibit 9 Telecom Sector: Summary of ESG Scores, Rank, Recommendation, Outlook, Financial Recommendation, and Target Prices Company Equipment Makers Alcatel-Lucent Clavu Ericsson Gemalto Motorola Nokia Oberthur Tandberg Operators AT&T Belgacom Bouygues British Telecom Deutsche Telekom France Telecom Iliad KPN Maroc Telecom Mobistar OTE Sprint Telecom Italia Telefonica Verizon Vivendi Vodafone Averages Equipment Makers Operators Telecom Sector Maximum possible score 1-Strong opportunity ESG ESG ESG ESG Score Rank Recommendation" Outlook 2 Opportunity 3-Moderate risk A High risk 51.5 00.0 65.3 59.8 50.3 77.1 57.1 70.7 61.7 53.2 55.5 74.0 51.4 53.3 62.1 61.6 51.0 50.8 47.8 38.7 54.1 59.2 60.7 63.2 61.7 Source: Company documents. SEK Swedish Krona Recommendation 62.3 56.5 58.3 100.0 75458162 3 329191655467108 7 2 4 32223131 2 NNNNWAAW WNNWW3333 Positive THE Negative na na Stable na na na na Positive Stable Negative Positive Stable Stable na na na na Negative Stable na Positive Stable Pinancial Recommendation" 2 Nut fullumed Not followed 2 Accept the offer Not followed Not followed 2 2727 Not followed Not followed Target Price €3,5 118 SEK 65,0 €29.0 na €16.0 €6,7 na na €25.5 €51.0 €170.0 €14.0 €24.0 €79.0 €13.0 €16,5 €60.0 €24.0 na €1.0 €17,5 na €33.0 £115 Exhibit 12 Financial performance of France Telecom and British Telecom France Telecom, for year ended December 31 (in Emil) Total revenue Revenue growth NOPAT Margin Asset tumover ROA Spread Leverage Impact of leverage ROE Percent of revenues Grom profit Operating expenses Unusual income (expenses) Discontinued operations Valuation multiples Price-to-eamings Price-to-book value British Telecom, for the year ended March 31 (in Emillion) Total revence Revenue growth NOPAT Margin Asstturnover ROA Spread Leverage Impact of leverage ROE Percent of revences Gross profit Operating expenses Unusual income (expenses) Discontinued operations 2006 51,702 7.5% 20 10.3% 0.71 7.2% 4.8% 1.95 9.4% 16.6% 43.6% 23.6% -0.3% 1.3% 11.82 2.28 2007 20,223 3.6% 17.0% 173 29.3% 23,5% 6.54 153.8% 183.2% 61.9% 45.7% -1.3% 0.0% 1007 46,568 4.9% 30.48 7.47 18.4% 0.68 12.6% 7.3% 1.55 10.9% 23.5% 46.7% 23.0% -7.5% 6.9% 31.23 2.37 2008 20,704 2.4% 11.6% 1.71 19.8% 11.4% 1.87 21.2% 41.0% 61.8% 45.5% -2.9% 0.0% 2000 46,712 0.3% 8.32 4.02 12.3% 0.70 8.6% 41% 1.26 5.2% 13.8% 42.4% 19.7% 1.4% 0.4% 9.40 1.77 2009 21,390 3.3% 2.4% 1.43 3.4% LO% Valuation multiples Price-to-samnings Price-to-book value NOTAT is net operating profit after taxe NOPAT margin i NOPAT over Not Ants Asset turnover is total revenue over asets. Spread is NOPAT margn minus the interest on all interest paying abilities, Leverage in total debt minus cash over gulty Impact of s spread times leverage Sou Capulced July 2011. 1.77 -7.0% -30% 61.4% 55.9% -26% 0.0% 6.66 2.20 1. From a company valuation perspective, how should we include the elements of the ESG analysis in the process? Should we include the elements of ESG in the cash flows or in the discount rate, or in both? (Remember at the end we need to arrive to an intrinsic value). Any ideas on how to do it? 2. Should the financial elements dominate the analysis? Those of ESG? Do they complement each other? How can we better understand the situation? Please provide your perspective on this situation.

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Environmental Social as well as Corporate Governance ESG is an acronym that stands for Environmental Social and Corporate Governance These are the three major categories or topics that socially respon... View the full answer