Demerger survival

Bryan Hucker, finance director of
Coda,
the accounting software supplier, still bears the scars of the company’s 2006
demerger from AIM-listed CodaSciSys.

“I was talking to analysts recently,” he recalls. “I told them that if an FD
tells them they’ve been through a demerger and knows everything about it, ask
them one question: would you like to do another. Those who really understand it
will be the ones heading for the door before you’ve even finished speaking.”

He adds, “It was a massive exercise, beyond the understanding of anyone who
has never done it.” Yet, if the trend towards demergers continues to grow, more
FDs could find themselves wanting to head for the door.

“Normally, you find demergers follow on after waves of substantial and
sustained merger and acquisition activity,” says Dr Duncan Angwin an associate
professor in the strategic management group at Warwick Business School.
“Sometimes, companies expand beyond their ability to control and co-ordinate.
Then, perhaps, they find that they’re not realising the benefits they originally
anticipated,” he says.

According to Thomson Financial, there were (euro) 1.35 trillion of mergers
and acquisitions in Europe last year. So, if Angwin is right, FDs should brace
themselves for the demerger fall-out in the next few years. Demergers have
grabbed the headlines in recent weeks because of Cadbury Schweppes’s stated
intention to separate its confectionery and American beverages businesses.
According to chief executive Todd Stitzer, the move will enable the demerged
companies “to focus on generating further revenue growth, increasing margin and
enhancing returns for their respective share owners.”

As Stitzer and his management team have set out a reasonably convincing
strategic rationale for the demerger, he may well be right. New research (see
The spin on spin-offs) suggests that companies that demerge to
improve business focus as well as communication with investors are more likely
to create value in the long run.

It’s a message that’s been borne out by Hucker’s experience. The CodaSciSys
demerger was the result of a previous merger (in 2000) which never delivered on
the expected synergies. “On the face of it, the two were software businesses
which should have sat nicely together,” recalls Hucker. “In reality, Coda was an
international product group with a strong cashflow, while SciSys was a
fixed-price project type of company with a lumpy cashflow.”

Hucker adds, “In terms of the City, it was a very confusing message.
Investors didn’t understand it and what we thought was happening was that people
were investing in Coda, and SciSys was almost thrown into the package without a
great deal of value attached to it.”

The confusion restricted the share price. “We thought we were losing
shareholder value,” says Hucker. “In very simple terms, Coda could almost
justify the share price on its own.” That proved to be the case. The day after
the demerger, a like-for-like share price comparison put Coda on £4.80 and
SciSys on £1. “Immediately, we had a £25m increase in shareholder value,” says
Hucker.

The CodaSciSys case illustrates a feature of a number of demergers. “Almost
invariably, when you split businesses there is a winner and a loser,” says John
Bronjewski, client services director at Resources Global Professionals. In the
Cadbury Schweppes case, for example, Bronjewski sees the beverages business
being in a growth market while the confectionery side faces more challenging
conditions.

Increased pace
But, winner or loser, he believes business drivers will quicken the pace of
demergers. “In recent years, while the operating costs associated with global
conglomerates have increased, shareholder acceptance of those costs has reduced
significantly,” he says.

“Additionally, with increased costs of regulation, compliance,
sustainability, financial transparency and accountability, many organisations
have been driven to standardise their policies, process templates and systems
globally. There are some cases where this is very difficult and so demerger
becomes a serious strategic option.

“Most multinationals are engaged in global transformation programmes. They
want a standard operating model – including chart of accounts and reporting, if
not standard shared services and outsourcing strategies. In some cases, where a
globally standardised operating model is not realistic, organisations are
looking to separate global divisions to maximise the impact of these investments
in process and technology improvements.”

Bronjewski is underscoring the point that demergers happen for a variety of
reasons – and that number is growing. But the most common is the need for focus.

When Whitbread sold its TGI Friday chain of 45 restaurants, chief executive
Alan Parker said, “We are now a leaner, more focused group, concentrating our
management and capital on those businesses where we have owned brands with
leading positions and strong growth prospects.”

When LogicaCMG sold its telecoms products division to Atlantic Bridge
Ventures, chief executive Martin Read said, “This divestment allows LogicaCMG to
focus on its core strengths in IT and business services.”

Demergers such as these are presented by divesting company management as a
rational decision, usually based on the ability to allocate resources to the
core business more effectively in the future. Yet although that prize seems
worth having, the FD and other members of the board should be in no doubt about
the work they’ve created for themselves when they take a decision to demerge.

Unscrambling the different parts of the same organisation is rarely easy.
“There are often questions around shared services,” says Matthew Howell,
corporate FD at Deloitte & Touche. “Eventually, standalone accounting, tax
and pension functions will be needed for the individual entities after the
demerger. There may be a need for some shared service or transitional service
agreement and the costing and service levels involved will be important.”

Howell flags up the problems around splitting pension schemes as being
particularly thorny. “It can take a long time before you’ve allocated the
appropriate people to the appropriate pots.”

Tales of the unexpected
FDs who’ve never been involved in a demerger before may encounter unexpected
problems. “One of the things that often gets neglected initially is that, not
only do you need to do the restructuring in a tax-effective way, but you also
need to do it in such a way that the new companies will be able to pay
dividends,” says Will Rainey, head of financial reporting advisory at Ernst
& Young. “It’s easy to create a situation where there are dividend blocks in
the structure and the ability to pay dividends up the line and onwards to the
ultimate shareholders gets complicated.”

Yet, unscrambling shared functions and watching out for financial and legal
elephant traps is only part of the work an FD will have to master in a demerger.
One of the key issues to sort out will be how to split the assets.

In CodaSciSys’s case that came down to which companies were going which way,
says Hucker. “Having done that, the assets naturally follow,” he says. Working
out how they follow may not be so simple as Hucker discovered. Unusually for a
software house, the company had significant freehold properties. There was also
around £14m to £15m of free cash in the business at the time.

“We knew that Coda would end up with a capitalisation of around £120m and
SciSys with around £25m to £30m. It didn’t make sense to have buildings worth
£15m in a company with a £25m cap. But because the nature of SciSys’s business
meant it had ebbs and flows of cash, it was important for it to have a proper
working cashflow so that it could move forward,” he says.

The solution adopted was to vest the buildings with Coda and ensure the cash
was split in such a way that SciSys had a strong cashflow to finance its
business. “Before the merger, we were fine-tuning the payment of dividends or
the insertion of share capital to make sure that we had the right amount of
assets and cash in the respective companies,” Hucker recalls.

Then there was the question of working out how to facilitate the merger. The
solution was to take Coda out of the existing CodaSciSys business and float it
separately on Aim.

“Technically, the Coda business was taken out from CodaSciSys as a ‘dividend
in specie’. We set up a new holding company and the Coda business was sold to it
in return for its paper. Then the paper was passed up to the shareholders as a
dividend in specie or a dividend in kind,” says Hucker.

Because CodaSciSys didn’t have the £45m of distributable reserves that this
exercise involved, it was necessary to apply to a court to allow the share
premium account to be transferred into the distributable reserve to allow it to
happen. That, in turn, meant providing evidence to show that the interests of
creditors were properly protected.

With complex tasks such as these a commonplace of demergers, it is not
surprising that professional advisers recommend that FDs give themselves plenty
of time to complete the work. “It’s important to leave enough time to plan the
process,” says Howell. “You must identify the appropriate resource for the
different work streams within the company – and you need to understand at the
beginning what the key road blocks might be.”

While it may be possible in some demergers to bring in a project manager to
keep top-level control of the work, the reality is that FDs and their teams have
to handle the bulk of the chores themselves alongside their normal work. “So
much of the information that’s needed is in the brains of the people working in
the company,” points out Howell.

Ease the pain
Advice for FDs on making a demerger easier? “Don’t just choose your auditors to
act as professional advisers,” says Hucker. “We used KPMG, our auditors, because
we thought it would know the company. In fact, it sent in a completely new team
and started from a position of zero knowledge taking no account of their firm’s
history with ours.”

Looking back, Hucker says that the demerger took place successfully without
affecting the working lives of other employees. “It did not affect their
day-to-day life in any way. But there were about three of us who took a
hammering.”

THE SPIN ON SPIN-OFFS
Companies that are spun-off from a parent because they look like hot properties
may produce above average short-term returns but don’t create value in the long
run.

However, when the reason for the spin-off is to improve focus in the parent
company, there is more likely to be long-term value creation in both the parent
and offspring.

These are the findings from new work on spin-offs by Sudi Sudarsanam,
professor of finance and corporate control at Cranfield School of Management,
and Dr Binsheng Qian. They studied the post-spin-off performance of 170
companies completed between 1987 and 2005.

They measured the stock market valuation of the parent and offspring in the
days immediately following a spin-off announcement. Then they looked at
valuation three years later. “At the time of an announcement, there is a
positive reaction from the stock market,” says Sudarsanam. “But over the next
three years, we didn’t find that any further value was created.”

Real motives
But whether there is long-term value often depends on motives for the spin-off.
“One of the motivations is to improve the focus of the parent company. The more
focused the parent becomes, the greater the shareholder value.” Sudarsanam and
Qian measured focus by comparing the number of market segments the company
operated in both pre- and post-spin-off.

Another value creating factor is whether the spin-off improves the
information flow between the company and stock market. Perhaps shorn of marginal
activities, the company’s focus becomes more apparent to investors.

Trendy spin-offs
The research suggests that when market sentiment thinks that part of a company
is hot or trendy, managers take advantage by spinning off the division to raise
cash. Share price is likely to leap in the early days, but three years on, no
new value is created.

“Investor sentiment changes over time. Therefore, corporate transactions that
are initially favoured by stock markets due to investor sentiment may turn out
to be value-destroying for shareholders. The consideration of the relationship
between investor sentiment and spin-off announcement returns could resolve why
there are generally positive market reactions to spin-off announcements, but
long-term performance of post-spin-off firms differs substantially across
different periods and locations.”

Sudarsanam and Qian quote the case of 3Com which floated 5% of its Palm
subsidiary in March 2000 at the height of the dotcom frenzy. Within days the
market was pricing Palm stock at $104.13 – valuing the company at more than its
parent. But the price of Palm’s stock had plummeted to 10 cents a share within
three years.

“To do a spin-off just because the market is clamouring for the stock may not
work,” warns Sudarsanam.