Corporate Finance - A parting of the ways for corporate Britain

It’s a familiar sight late at night in the City: fleets of minicabs waiting outside the headquarters of London’s major merchant banks, in anticipation of picking up the army of young, overworked corporate financiers as they finally pack up their spreadsheets and head for home in the early hours of the morning. The drivers say they can sometimes wait for two or three hours, clocking up charges that will eventually be recouped, along with the cost of the corporate financiers themselves, from the fees charged to the client company.

What are they working so hard for? Corporate Britain, having spent years building itself up into giant agglomerations of often disparate businesses, has suddenly reversed its course, and is demerging itself in a hurry.

The financiers are so laden with work, they’re recruiting at a rate not seen since the 1980s.

Demerger fever is set to reach its peak in 1996. Next month, Hanson officially separates (barring shareholder disapproval) into four stand-alone business units. Last month Thorn EMI shareholders approved the company’s long-awaited plan to split itself into a pure music business (EMI) and a television rental and electrical products business (Thorn).

This year they will be joined on the demerger track by Lonrho, the Rank Organisation, and BTR. Last month Lonrho took its first step towards becoming a pure mining company by announcing the flotation of its Princess Metropole hotel business; Rank has tabled a #300m disposal plan, including its lighting and coach holiday division; and BTR has thus far only said it is contemplating non-core disposals. More companies are waiting in line: transport and logistics group Christian Salvesen has also indicated that it will hive off some of its core businesses, and just last month the Financial Times’s influential Lex column went out on a limb to argue for the demerger of oil majors like BP and Shell, a subject that is sure to have come up at board level.

With the weight of companies contemplating their own deconstruction, it is safe to say corporate Britain has another fad on its hands, to succeed the previous fascination with business process re-engineering (BPR) (and total quality management before that), and to reverse the philosophy of the 70s and 80s that big, and preferably diverse as well, is better. So, what has caused this change?

Seasoned corporate chiefs might look to the consultancy business for the answer to the first question. It is they, after all, who coined the phrase BPR and subsequently coined it in. Doing the rounds lately has been the concept of economic value added (EVA), a system, devised by the New York consultancy Stern Stewart, for measuring financial performance of individual business units across a swathe of businesses. The basic EVA premise places a cost of capital on both debt and equity, and measures the return on the capital against it.

In fact, EVA has been around for a while – it was known as residual income at General Electric in the 60s, and references can be found to similar concepts in Arthur Sloan’s management philosophy at General Motors in the 20s. It also has a fairly obvious logic to it: an underperforming business unit, once identified, needs to be put back on the right track or got rid of – a sort of modern equivalent of the biblical “if your left hand displeases you, cut it off.” But while EVA relates to business decisions such as whether to build a new factory or buy someone else’s, it is hard to hold it accountable for wholesale corporate demergers.

It seems to be generally agreed among finance directors at public companies that financial engineering proposals from their City advisers are getting more frequent and imaginative – though most report that the likelihood of implementing these proposals has not increased greatly. “I get maybe three proposals a week,” says one finance director at a FTSE 100 company, who did not want to be named. “Some are thought-provoking, others are downright stupid – I wonder sometimes whether they’ve actually considered the full implications of what they’re saying. I guess they see it as pitching for business, and if we think it’s rubbish, no harm done.”

The most obvious example of this freelance strategising by financial services companies came in July, when it was revealed that Guinness had considered demerging its brewing interests and bidding for Grand Metropolitan.

Lazards, the authors of the strategy, pitched the idea to Guinness who promptly rejected it. It was then leaked, apparently by Lazards itself, to a friendly Sunday newspaper, forcing Guinness to issue a swift and public denial of interest in GrandMet. It was interesting to note, however, that the prospect of an old and famous brewing company getting rid of its core business was welcomed by City analysts as a great way of increasing shareholder value, and there was ill-disguised disappointment when the deal failed to materialise.

The shareholder value rallying cry is a strong one. Its UK origins can be found in the demerger of ICI and Zeneca in late 1992, a deal that left ICI plodding along on its traditionally sleepy stockmarket rating, but allowed Zeneca shares to race up 100% in value in three years. Ever since, the alchemy of dividing a company in two and suddenly getting more value in the market from the parts than the sum did before has tempted investors, and therefore analysts, into running slide-rules over most of the FTSE 100’s large and diverse holding companies.

The flurry of financial engineering does not look necessarily to be the result of merchant bankers gunning aggressively for business, a theory which assumes corporate chiefs in Britain are totally in the thrall of their City advisers. Nor is it the consultants, at least not this time.

Instead, the current demerger revolution seems to have a lot more to do with a fundamental belief in the market that the industrial conglomerate is no longer the most efficient business unit.

This is a remarkable about-face from the thinking of just a few years ago. The mantra now among the Hansons, Lonrhos and Thorn EMIs is to allow separate businesses to stand alone, to gain full advantage if their performance improves, and by the same token suffer if they rest on their laurels.

Not everyone agrees that smaller is better. For one thing, the logic of combining certain businesses like tobacco and heavy industry remains, according to analysts who have criticised the Hanson demerger. They have argued that cash generated by tobacco is a vital prop to cyclical and highly capital-intensive businesses like construction and chemicals, and that separating them will not necessarily realise shareholder value. Their thoughts have been borne out thus far in the Hanson share price, which has fallen some 20% since the merger was announced.

Some strategic thinkers are now arguing that a demerger in itself is a sign of lack of imagination at board level. According to Sumantra Ghoshal, professor of strategic leadership at the London Business School, businesses now tempted by financial engineering (to follow their recently-completed business process re-engineering) are suffering from what he calls “change overload”. “The disease affecting these large companies is what I have called satisfactory underperformance,” says Ghoshal, “but corporate renewal can only come from creating the right environment for the people of the company, not trying to impose yet another top-down strategy.”

Giving the annual Investors in People lecture last month, Ghoshal drew an unflattering portrait of US conglomerate, Westinghouse. In 1976 its market capitalisation was virtually identical to that of its nearest competitor, General Electric (GE) of the US. Since then it has made numerous strategic changes and espoused numerous shareholder value strategies, yet its market capitalisation today is one seventh of GE’s. “The history of Westinghouse is a series of false dawns,” says Ghoshal.

Ghoshal argues that the concept of financial engineering, as practiced by top management in search of shareholder value, is merely a substitute for getting properly involved in the business and creating shareholder value out of doing business better.

With this in mind, it is worth considering the divergent strategies of two cases for the demerger treatment, BTR and Hanson. Both grew aggressively through acquisition in the 80s, and both faced the same dilemma of declining earnings growth and eroding margins as the initial savings from cutting overheads and research spending petered out. As growth has faded, so the City’s knives have been sharpened. BTR’s margin erosion problem (plus having to maintain a very high dividend, plus instituting an unpopular warrants scheme) caused the share price to erode over the course of 18 months by almost a third. Hanson faced a crisis of direction as its prime movers for three decades, Lords Hanson and White, faded from the scene.

Hanson’s demerger, an ironic development for the former breaker of other companies – including, indirectly, ICI, which started the whole demerger business to fight off Hanson’s unwelcome embrace – was the idea of chief executive Derek Bonham. His 24 years in Hanson’s finance department has given him a commanding insight into the company’s financial innards, but his demerger strategy has come under fire.

While Hanson has gone full-tilt into demerger mode, with distinctly mixed results, BTR’s new chief executive, Ian Strachan, has resisted. Shortly after the company had issued a profits warning, BTR finance director Kathleen O’Donovan told a briefing of analysts in June to expect a programme of disposals of non-core businesses – up to 20% of BTR’s assets across 150 subsidiary businesses – but ruled out a full-scale demerger. “The Hanson experience hasn’t exactly produced shareholder value,” said one analyst after the meeting. “With BTR’s structure, it wouldn’t make any sense for it to demerge.”

In BTR’s case, the group’s increasing financial complexity has meant that investors must negotiate a whole raft of provisions and restatements appearing in the company’s accounts. Even seasoned BTR observers in the City admit they have a hard time keeping up. In his book Accounting for Growth, former UBS analyst Terry Smith argues that BTR’s 1992 purchase of Hawker Siddeley, and the provisions and goodwill write-offs that followed, made the company’s true performance very hard to gauge. When the provisions ran out in 1994 Smith says he was “less surprised than some others” to note that BTR’s margins had fallen.

Though Smith does not say it directly, his underlying argument is that some conglomerates, and he talks of BTR and Hanson in particular, just aren’t meant to be broken up. They are tied together by the complex financial bundling that accompanied their original construction, and when it comes to unwinding them financial engineers are finding that the value is fully spoken for in the current share price.

Having seen this coming, or perhaps just using traditional hard-headed BTR logic, Strachan and O’Donovan have opted instead for a refocussing of the company. There will still be plenty of work for the corporate finance foot-soldiers to burn their midnight oil over, but the wholesale deconstruction of this particular conglomerate looks to have been shelved. It may not quite signal the beginning of the end of the demerger revolution, which by the timescale of modern fads has at least two years left to run. But it may be the end of the beginning.

Richard Halstead is a freelance journalist.