Whose interests are served by waves of mergers and demergers?
Demergers are in fashion. National Power plans to split its electricity business into domestic and international divisions. Retailer Storehouse intends to divide itself into components. Almost every firm with an internet business is thinking of floating it off: Dixon’s has already done so with Freeserve, Prudential has similar plans for Egg. These moves follow some huge demergers – ICI spinning off its pharmaceutical business, BAT separating its financial services activities, British Gas splitting itself into two.
And yet all this is happening in the middle of the largest wave of mergers in business history, which climaxed – for now – with the largest ever hostile bid, Vodafone’s offer for Mannesmann. And it is not so long since many of the current demerger candidates were being merged on the basis of diametrically opposite arguments. National Power, we were told, needed to develop international operations to utilise its skills fully and diversify its earnings. Storehouse would be a powerhouse whose dominance of the High Street and ability to transfer retailing skills between businesses would change the face of British retailing. Any company which serves the public but isn’t integrated into e-business has no future.
Now it is no crime to change your mind, particularly if circumstances change. There is no inconsistency in putting your umbrella up when it rains and closing it again when the rain stops. But if you constantly put your umbrella up and down, independently of weather conditions, then it may seem as though you really don’t know what an umbrella is for. Or possibly that you are unduly influenced by the manufacturers of umbrellas, who hope to sell you a new one when the mechanism wears out. The analogy breaks down here: in the financial markets, you are charged a fee when you put your umbrella up and another one when you put it away.
But given the thinness of some of the arguments that are deployed, one might be tempted to think that the latter explanation has some truth. Perhaps the most common claim is that the stock market will value the whole of a company’s earnings on a basis which is appropriate for only part of it. Sometimes this is an argument for diversification. If you add a sexy new international division, or e-commerce capability, to your pedestrian established earnings stream, the market will ascribe a higher rating to your shares. And – so the theory goes – this rating will apply, not just to the new earnings, but also to the old one. In this way, the whole will be worth more than the sum of the parts.
And sometimes the same argument is used to reach exactly the opposite conclusion. The market doesn’t apply an appropriate rating to your exciting activities because they are bundled with the boring ones. If you separate the two, the sum of the parts will be worth more than the whole.
So you can add value when you merge, and again when you demerge. The two propositions taken together are the philosopher’s stone: they turn base metal into gold, hot air into hard cash. And as far as investment banks and other advisers are concerned, this is indeed true. It is less clear, however, that investors and the institutions which represent them should welcome this financial equivalent of the perpetual motion machine. As with perpetual motion machines, the mechinism assumes not just that people in markets are extremely stupid, but that they will continue to be duped even after the intended deception has been carefully explained to them. This contradicts not just common sense, but experience. The unfashionability of conglomerate businesses in the 1990’s is directly attributable to the growing ability of markets to see behind the smoke and mirrors of acquisition accounting to the tawdry reality of what was going on.
A slightly more subtle version of the same argument justifies the acquisition of mobile phone companies by the operations of foreign networks, or of wholesalers by pharmaceutical companies. If you are paying exorbitant carriage charges when your customers make international calls, you can reduce or avoid these charges if both domestic and foreign provider are under common ownership. You can indeed: but at a price which more than offsets the savings you make. The earnings stream for which you are paying an inflated multiple includes the exorbitant charges you are hoping to reduce. It is like dealing with a highwayman by buying out his business at a premium to the market value of his earnings. You will find it cheaper to go on paying him his ransom.
Diversifying merger adds value if, and only if, there is a source of competitive advantage in one business which can be deployed effectively in another. If your financial services business has a reputation with consumers which will encourage them to buy insurance products, then it may make sense for you to get into the insurance business. And if you do that through acquisition, you will add more value to a weaker insurance business than a strong one.
But you can add value only by strengthening operating activities, not by financial engineering. Still, you can engage in destructive financial engineering. Different investors have different preferences and different expectations, and – as in any other business – you will be wise to cater for them by allowing them to pick and choose what they want rather than forcing bundled products on them. Some people will want the safe earnings and dividends of a regulated utility, others the excitement of investing in the new infrastructure of developing companies. Some will want to invest in a chain of electrical shops, others hanker after the excitement of an internet play. Until the recent demergers, it was impossible to invest in a tobacco stock without also investing in brick manufacture, or financial services provision. So demergers increase investor choice. And that greater opportunity to tailor portfolios to particular requirements should add to share valuations. Not much, but a bit. If in doubt, leave your umbrella furled.