COVER STORY - Dividing the spoils.

It’s almost exactly a year since Hanson completed its radical four-way demerger. This floated-off its principal interests in energy, chemicals and tobacco, and reduced the once mighty £12bn conglomerate to one of the smallest constituents of the FTSE-100. The restructuring was complicated, costly and controversial – not least because its long-term payback to Hanson’s investors was uncertain and its immediate rewards non-existent. But now – and thanks in no small part to the tussle for control of Energy Group which has pushed the company’s market value up by nearly 70% since shortly after it was spun out of Hanson in February 1997 – the group’s long-suffering shareholders may at last be beginning to see some of the much-vaunted value emerge from the dismantled group. Add in a bid for another of the Hanson components – most probably Imperial Tobacco – over the next 12 months, and Lord Hanson will have restored some of the sheen to his dealmaker’s credentials. These were sorely tarnished by the market’s dismal response to the demerger scheme. The key issue was whether a bundle of shares in the four different companies would be worth more than a single share in Hanson in its conglomerate state. It was not. And, as the chart on page 28 illustrates, even with the bid premium attached to Energy Group, the sum of Hanson’s parts still does not add up to the value the group enjoyed as a whole the year before the demerger was announced. And yet, the consensus among impartial observers is that, in the circumstances, Hanson did as well as it was able. The hard fact is that the company had lost its way years before, and something had to be done. “Hanson as a group no longer made sense,” maintains Andrew Campbell of Ashridge Strategic Management Centre and co-author of Breakup! When large companies are worth more dead than alive. “There was no rationale for keeping its businesses together. Hanson’s top management could not possibly know enough about each company to give them suitable parenting,” he says. “The demerger was fantastically bold but it was the right decision. It was the best way of dealing with the problems the company faced.” Karel Williams of the University of Manchester believes that Hanson was ultimately a dealing, not an operating, creature. To do what it did successfully it needed a rising market. “After 1989 the conditions were not right and, in effect, Hanson became a buyer and not a seller of businesses. As it got bigger it had to do ever larger deals to get ever smaller amounts of profit. It could not go on and, in the end, Hanson did what any dealer would do – he quit. “Hanson basically sold the company back to its shareholders in bits,” Williams continues. “But it’s quite hard to find anybody who bought anything from Hanson who did well out of it. This applies equally to its shareholders.” On announcement of the demerger plan, Hanson’s shares initially rose by 15.5p to 230p. Just a few days later they fell back to 220p. The shares continued to fall and by the end of September 1996, ahead of the flotations of Imperial Tobacco and Millennium Chemical, had reached a new low of 150p. This compares with a peak of 283p in 1993. By February last year, with the demerger complete, investors who had stuck with the company were left with shares in four companies which together were worth the equivalent of 151p instead of one Hanson share worth about 205p. Advocates of the split argue that Hanson’s shareholders would have fared far worse had the company remained intact. “If Hanson had stayed in one piece a great deal more value would have faded away,” maintains Andrew Campbell. According to Campbell, it is too simplistic to compare the aggregate of Hanson’s post-demerger values with its former stockmarket capitalisations. “Then, the market perception of Hanson was not based on reality,” he says. “And because the City didn’t like the reflection of the inappropriate price it had put on Hanson in the past it took an overly negative view of the company during the demerger.” Campbell believes that during the 1980s the stockmarket attached a premium to Lord Hanson himself. It anointed him with value. For a while it was assumed that the new management would carry on working his magic. Then it became that clear no one else wanted to, or could, continue to play that game. “When Lords Hanson and White retired it was entirely appropriate to say ‘We need to change’ and to construct a new business around a different set of management skills,” Campbell asserts. As the listing particulars emerged, Hanson had to release more information about each individual business and their activities than ever before. Its market value suffered under this revealing and highly unflattering light and, particularly with regard to its accounting policies and other disclosures, Hanson’s past began to catch up with it. The most damaging impact came from Cornerstone, the aggregates business (now part of new Hanson) and Peabody, the US coal-mining business (now part of Energy Group). Here Hanson adopted new US accounting standards for long-life assets. At a stroke, their asset values were cut by £3.2bn. At the same time, a £300m charge was made against Peabody’s reserves to cover accounting changes over “industry liabilities”, notably the “black lung” disease suffered by its miners and environmental clean-up costs. All this added to speculation that Hanson might never have been what it seemed. Could its past success have been as much a result of acquisition accounting and tax measures as shrewd takeovers? “There were some nasty surprises. Various skeletons did fall out of the proverbial cupboards, but still the City took an unrealistically negative view of Hanson post the demerger announcement,” argues Campbell. “Hanson was punished excessively by the stockmarket in the lead-up to the demerger,” agrees analyst Charles Pick of Panmure Gordon. Apart from pulling the rug from under Hanson’s somewhat opaque accounting practices, the main downside to the demerger was that the divided group would carry multiple head office costs and central overheads. It would also face an increased interest and tax burden – part of Hanson’s skill had been its ability to minimise its taxes and maximise financial leverage by, for example, borrowing cheaply in the US to invest in the UK. The restructuring was also expensive – with each of the four companies engaging merchant banks, plus the legal complexities involved, the bill for splitting up Hanson eventually amounted to some £150m. However, all this is seemingly outweighed by the fact that separate reporting and business visibility have made it easier for investors to assess the value of the individual companies. The demerger has also promoted “management focus”. This, in theory, should improve performance and allow the companies to make value-building strategic acquisitions. As demonstrated already with Energy Group, it will certainly make it easier for the constituent companies themselves to be taken over. Energy Group is currently besieged by Texas Utilities and Pacificorp – Japanese financial giant Nomura has only just pulled out of the bidding. As Financial Director went to press, Energy’s shares, which ended their first day’s trading at 568p in February last year, were approaching 800p. “It could be argued that if there hadn’t been a demerger Energy would not have been bid for. There are far better disclosure levels now that it is a separate company,” observes Charles Pick. These sentiments are echoed by Dan Marcus, managing director of the value and performance consultancy Strategic Compensation Associates. He believes that, in general, it is hard to argue against demergers. “In creating much better information, demergers allow shareholders to make their own decisions about what to invest in,” he says. “A demerger won’t necessarily add up to more value but at least it gives shareholders a choice and clear information upon which to base their investment decisions. “And because demergers create transparency for management as well as shareholders this in itself presents the opportunity to create greater value even if, in the short-term, it means the company becomes more fairly valued,” Marcus observes. “With a stronger focus management should be better able to capture performance. They can also be incentivised more directly through equity options rather than being distanced from performance-related incentives as part of a large group,” he continues. “A demerger basically facilitates the creation of value. It doesn’t create value in itself, it is not the end. The demerger does not bring a one-off return. It brings returns on an ongoing basis from greater focus for management, by enabling shareholders to measure performance and from managers being properly incentivised,” Marcus adds. Marcus believes that it is almost irrelevant to question whether or not a demerger creates more shareholder value. “Almost certainly it is the right thing to do,” he says. “Bigger is not better – efficient is better, focused is better.” One of the major problems in selling the demerger idea to shareholders lay with the fact that Hanson was clearly not a classic breakup situation. “There was no averaging of p/e ratios, no potentially high-growth ‘jewels’. But still the demerger was really the only way of dealing with a company which was going nowhere,” Williams explains. “It was a peculiar set of circumstances but in the end even Hanson could not walk on water.” Despite its lacklustre performance, Hanson in its entirety would not have been attractive to predators. Quite apart from its sheer size, a bidder acquiring Hanson would have faced huge capital gains tax bills if it sold off Imperial and Millennium. The complexity of Hanson’s tax and accounting arrangements also acted as a deterrent, as did the perception that some of the group’s assets were over-valued. “It made sound sense for Hanson to be broken up into bite-size pieces. They have floated out into the M&A slip-stream and will be gobbled up,” Williams says. It seems that the group was left with little alternative but to go for demerger. “Perhaps Hanson could have papered over the cracks. Maybe the company could have kept the share price up for a while. But, ultimately, its lack of value-creating activity would have showed through,” says Campbell. Hanson was also under financial pressure and needed cash. It had been servicing a high dividend, its debt had risen to £4.7bn following its £2.7bn acquisition of Eastern Electricity in 1995 and it had balance sheet provisions of £5.5bn, primarily to cover the coal-related illnesses and environmental costs. “Hanson would not have been able to fund a buy-back of its own shares. The only alternative could have been to sell its businesses off piecemeal,” says Pick. “But it would still have had to cut the dividend and making hefty disposals in such a short period of time would have been tough.” UBS analyst Mark Cusack adds: “Strategically, Hanson was boxed in. Its poor cash flow would have done for it in due course. Either way it was not a pretty situation. It could have cracked on and cut the dividend but that would not have pleased shareholders either. The demerger was a radical strategy to address a difficult situation. Could Hanson really have transformed its cash flow, carried out a massive disposals programme, successfully reinvested the proceeds and traded its way out?” Interestingly, a slightly contrary view to all this comes from US Industries. It has performed remarkably well on the New York Stock Exchange since it was split from Hanson in 1995. Rapid disposals brought its debt down, its share price has tripled since flotation and the group has started making acquisitions again. USI is now seen to be mirroring both Hanson’s early prosperity and its philosophy as an unashamed conglomerate. USI’s chairman and chief executive, David Clarke, has recently been quoted as saying: “One of the things that bothered us about Hanson is that they would not use all the tools in the toolbox. We were urging them to buy in their shares 10 years ago.” USI, despite its high leverage, has bought in nearly 10% of its capital since 1995 and will continue to do so, says Clarke, as long as it enhances earnings per share. Perhaps, then, the current corporate obsession with “focus” is not so well-grounded after all. Could it be just a fad that not only fails to deliver new value but destroys existing value? As the demerger was concluded in February last year, Christopher Collins, deputy chairman of Hanson, said: “We feel that the time for judging the demerger process is a year or so down the track.” This statement may yet be vindicated. The demerger provided Hanson with an elegant way out of a difficulty that had been growing for years. The successor companies each offer – or have already delivered – gains for investors not readily available in the conglomerate and, while it could be construed that the break-up destroyed value, the more likely conclusion is that it merely reduced the potential for further loss of shareholder value and has given shareholders the prospect of sharing in a much greater upside. “The strategy is working and it will work better in the future. There is quite a lot of the shareholder value still to come from the demerger,” maintains Campbell. Charles Pick says: “Hanson contained no hidden value. But, ultimately, what Hanson did was okay. It is just a pity it didn’t do it sooner.” Hanson: Then and now In the 1980s the Hanson formula – to acquire badly performing businesses, clean them up and sell them on – had produced exceptional returns for shareholders. The acquisition of Imperial Group is held as the classic example. Of the £2.5bn purchase price, £2.4bn was recouped from asset disposals leaving Hanson with the tobacco business intact. No surprise then that Hanson’s share price was at that time outperforming Britain’s top 100 companies by a staggering 368%. But with the recession at the beginning of the 1990s, Hanson seemed to lose its touch and virtually nothing it did could satisfy investors or analysts. In 1991, Hanson was beaten off by ICI. A year later it was outbid for RHM. Meanwhile, conglomerates were out of fashion on both sides of the Atlantic. Even then, set against the likes of BTR, Williams Holdings and Tomkins, Hanson was the ugly sister. Hanson even failed to inspire a stockmarket recovery through the highly successful flotation in New York of US Industries, comprising 34 of Hanson’s smaller US manufacturing businesses, in 1995; or the agreed £2.5bn takeover of Eastern Electricity later that same year. In fact, in 1995 Hanson’s share price, which had stopped moving ahead in 1990, actually fell sharply in a rising market. Hanson also suffered from the lack of a natural management successor to Lord Hanson. Derek Bonham, who became chief executive in 1993, was more at home with capital investment and organic growth than swashbuckling deals. As the company grew larger, the small head-office team found it increasingly difficult to assess the underlying performance of such a diverse bunch of businesses. This made it harder for them to set them tough, but realistic, financial targets. Moreover, there seemed to be fewer underperforming companies out there that were also big enough to warrant the full Hanson treatment. The 1990s also heralded a preoccupation with “management focus”. Companies began to rationalise, divest peripheral interests and concentrate on ‘core competencies’. Investors, meanwhile, looked to fund managers, and not conglomerates, to spread portfolio risk. Hanson, in contrast to more streamlined stocks, appeared to be lumbering about with a bag of unconnected, low-growth businesses assembled for a different era. At the time of the demerger, Lord Hanson stated: “We are making this exciting and radical move to create even greater management and growth opportunities and to improve the operations, profitability and long-term prospects of these four major businesses which will become substantial public companies in their own right.” Imperial Tobacco Shares in Imperial Tobacco, number two in the UK cigarette market and maker of the Embassy brand, opened on the London Stock Exchange on 1 October 1996. Trading at around 380p, Imps was capitalised at £2bn. The company hit the acquisitions trail in January last year with the £185m purchase of hand-rolled cigarette paper manufacturer Rizla. In its first full year’s results since the demerger, Imps returned operating profits of £391m on turnover of £3.89bn. This compares with an operating profit of £348m on turnover of £3.6bn in its last full year as part of the Hanson group in 1995. Despite its reasonably strong performance, the outlook for Imps is not brilliant. It faces tough competition from Gallaher to which it has already lost market share, and its business is very mature. Imperial has also been hit by legal action by UK cancer victims. However, its shares are boosted periodically by takeover speculation, notably concerning BAT. Millennium Chemical Millennium’s shares opened on the New York Stock Exchange on 2 October 1996 at $24 a share, valuing the company at £1.2bn. As expected, the business was immediately hit by a wave of selling by UK investors. This, together with its £1.3bn debt burden designed to make it bid proof, has depressed the share price. Also dampening Millennium’s performance are the volatile markets for its main product, titanium dioxide. Energy Group Energy Group joined the London and New York stockmarkets in February 1997. With its shares trading at 525p it was valued at about £2.7bn. At the time of the demerger it was felt that the inclusion within Energy of the liability-ridden Peabody, the biggest coal producer in the US, alongside the more obviously attractive UK electricity and gas business Eastern, would deter predators. Yet the critics were confounded at the beginning of this year when, following an earlier £3.65bn bid by the US utility Pacificorp last summer which lapsed following an MMC referral, Energy became the subject of a £4bn bid battle between Pacificorp, Texan Utilities and Nomura. In its latest set of results, Energy increased its operating profits by 15% to £379m in the nine months to 31 December. This compares with pro-forma third-quarter operating profits of £330m in 1996. New Hanson Shares in the Hanson rump, which comprises its construction and building materials businesses, have lately been trading at around 15% off their low. But with a market value of some £1.9bn this has not been enough to maintain Hanson’s position in the FTSE-100. Strong US and UK construction markets helped Hanson lift operating profits by 9% to £121m in the six months to the end of June last year. Since then the company has managed to sell its Grove Crane subsidiary for £370m.