Demergers - On track for long term value

When BT spun off its mobile phone operation, mmO2, last November, it must have hoped the move would be good for both parties. And the early signs were encouraging. mmO2 shares rose 5% on their first trading day to 84p, while those of BT Group rose 4% to 290p.

Since then, the markets have not been so kind, although telecom shares in general have fallen out of favour. By early autumn, BT was languishing around 170p (having fallen as low as 154p), while mmO2 was hovering in the mid 40p range (having dipped to 37p). Had the whole demerger been a horrible mistake?

New research on demergers by Deloitte & Touche* suggests that some demerged entities experience a share dip before it becomes apparent to markets that the spin-off strategy is effective. Other factors being equal, a parent’s share price could decline by up to 8% in the immediate demerger period, before starting to rise. Similarly, the spin-off’s share price could dip by around 6% before climbing.

The study of 118 demergers suggests that share price could be as much 52% higher after a year for parent top-quartile performers, and 46% higher for the best performing spin-offs. The general travails of the global telecoms market may have ensured there won’t be such a happy outcome for either BT Group or mmO2 on the first anniversary of their demerger, but both could still benefit in the long term.

Najib Hashem, a director at Deloitte & Touche, who organised the research, says initial share price drops are caused by market fears that a company is selling a valuable asset and worries about how it will reinvest the funds from the sale. But when the market sees the demerger is effective, most parent companies find their share price rising. After a year, three-quarters of parents improve their share price, with just a quarter falling back further.

It is a similar picture for spin-offs. The top quartile in Hashem’s study show share prices rising by 8% in the first month after separation. The median group experience a marginal loss, but, once the market is comfortable with the demerger, that moves to a marginal increase and a healthier rise of 12% after a year. “Price rises tend to be driven by announcements of new alliances and growth plans the spin-off was unable to pursue while it was part of the parent,” says Hashem.

Demergers represent a tiny 1.2% of deals in an M&A market that is, in any event, quieter than for most of the 1990s. But the Deloitte & Touche evidence seems to suggest demergers have more potential to create shareholder value than tie-ups between companies. Several studies have suggested that M&As destroy shareholder value in the long-run.

For example, a study of large mergers by research firm Bernstein, found that while share prices rose 3% after the announcement, they had declined by 11% relative to the market three years later. And a Booz-Allen & Hamilton study of 78 mergers worth more than $1bn found that 53% failed to deliver the expected results – most because of clumsy integration rather than flawed strategy.

Yet, before FDs start searching their portfolios for demerger opportunities, it should be noted that demerger is not necessarily an easy path. Rod Eddington, chief executive at British Airways, could bear that out.

When BA sold off its low-cost airline, Go, it thought it was making a sound business decision. Trying to run a high-service business carrier alongside a cheap-seat operation for the backpack brigade was creating a kind of strategic schizophrenia. The airline couldn’t develop business strategies to take on the budget carriers without hitting its own baby.

But Eddington must now wonder if the company took the right decision.

He has seen flag-carrier business tumble in the wake of 11 September, while budget carriers’ passenger numbers have held up. Worst of all, he’s sat and watched Go sold to easyJet for nearly four times its value when it spun out of BA.

Although the Deloitte & Touche evidence suggests there can be a sound business case for demerging, losing parts of a business can smack of selling off the family silver – and divestments tend to be associated with companies that are in trouble. Some recent high-profile demergers have come from companies that markets felt had lost their way.

Retailing group Kingfisher, which listed Woolworth separately and sold Superdrug to Dutch company Kruidvat Holding, was one example where demerger proved painful. Chief executive Geoff Mulcahy was criticised for taking nearly a year and changing his mind over whether to demerge Woolworths – the original constituent of Kingfisher – while group’s shares slid steadily south.

Deciding to spin off a division or subsidiary is certainly not easy, but it may become increasingly attractive. “In a lot of companies, the complexity of multiple divisions can become a distraction for senior management,” says Hashem. “By separating out a spin-off, both sides can see more clearly what their core business is and, as a result, can focus on it.”

Hashem sees four primary motivations behind demergers. The first is the desire for improved financial rating by the markets. One of former Hewlett Packard CEO Lew Platt’s last moves at the company was to “re-invent” it as a high-tech operation, able to compete on equal terms with IBM and Oracle, by spinning off much of the measurement and instrumentation activity as Agilent Technologies.

“Often divisions have different growth prospects and p/e ratios,” says Hashem. “Markets often don’t value a business as the sum of its parts. But the challenge of that kind of demerger is to achieve a quick re-rating of both parent and child and capture the full value of the child while that takes place.”

The second motivation is portfolio refocus – as at Kingfisher. “In this instance, the benefits of being a conglomerate are unclear and management is distracted by complexity. The aim is to enable both the parent and child of the spin-off to focus on the core business,” says Hashem. But he warns that challenges include separating heavily integrated support and corporate functions and overcoming loss of scale.

The third motivation is industry restructuring. A good example of this was the creation of Syngenta, the world’s largest producer of crop-protection chemicals, by AstraZeneca and Novaris, each of which spun off their agro-chemicals businesses. “In this situation, the strategic objective is to enhance the value of the business as a going concern instead of dividing the people and assets between two companies,” says Hashem. A potential downside is the loss of contact with the parent companies and the market weight they carry.

The Syngenta case also illustrates the fact that demergers are often far from straightforward and may require complex financial engineering.

Both AstraZeneca and Novaris put aside £700m to buy back up to 10% of Syntenga’s stock in the first 10 days of trading. It was felt investors that only hold pharmaceutical stock would off-load their Syngenta shares, depressing the price. And, as the primary listing was in Zurich – and, therefore, the new company would not appear in the FTSE-100 – London-based tracker funds would automatically sell their holdings.

A final motivation for demergers is to raise capital for the parent.

While this can be a valid reason for a public company, it has been the principle motivation behind government privatisations. One of the challenges here is not to sell cheaply, but to recover a fair future value for the demerged entity, something a number of privatisations have failed to achieve.

So how do you demerge? Hashem says one key challenge is to make sure people in all parts of the business understand the rationale behind the demerger. “The FD and the board may understand why they want it, but they don’t always translate their thinking into reasons that are palatable to managers,” says Hashem.

“People can sometimes be left wondering: ‘Why are we doing this?'” he adds. If that happens, then, when it comes to making important decisions, managers can “start jockeying for position rather than organising the demerger to achieve the strategic objective”.

Hashem says that presenting a demerger as purely a way of creating new shareholder value can look a bit cold-blooded to people deeply committed to managing parts of the business. “You need to present the underlying arguments about how demerged businesses will be more nimble,” he says.

Besides all that, Hashem recommends putting in place a governance structure to manage a demerger right at the start. “You need to have identified who will be leading both sides, right up-front,” he says. “The leaders will need to be worrying not only about how to do the separation but also the future strategies of the independent businesses. They need to start behaving as though they were independent well before they actually are.”

Going from one to two creates more top jobs. The problem is, they are usually smaller jobs. So one of the skills is to build those jobs up again, perhaps by adding in new responsibilities. For example, a finance director might take on overall responsibility for IT.

Demerging operations is not going to be a first choice for all companies. But in some situations it may look like an increasingly attractive option. It can improve the focus in both new operations and provide better profit and loss transparency by, for example, separating out head-office overheads or enabling a new operation to benchmark its performance against pure-play competitors. By improving its financial rating, it may gain better access to capital for both the parent and child.

Not all benefits will flow to all demergers and not all will flow quickly. But they’re out there somewhere. That, at least, is one hope for the likes of BT and mmO2, while they wait for markets to smile on them again.

* Demerger study: analysing the value of demergers through share price performance, March 2002.