CORPORATE DEMERGERS: NEW ENTITY OR MERGER REVERSALS

June Green

Westminster Business School

j.green@my.westminster.ac.uk

Modern Finance 4FIN7A2, September 2008

Abstract

Does a demerger add value to the new entity? Does the old parent benefit

from cutting the navel string of a subsidiary that was doing more financial

harm than good or was the parent doing more financial harm than good? Will

the new entity now be able to spread it’s wings and perform at it’s full

capacity and will the parent be able to continue performing without its cash

cow? This paper attempts to answer these questions by identifying the major

types of demerger, causes and effects as well as provide an empirical insight

into a major demerger both prior and post demerger.

Keywords: merger, debt, profit, divestiture, conglomerates, subsidiaries

Introduction

Businesses are ever increasingly more dynamic today operating mainly as a variety of common structures, all very

straightforward with the main purpose of providing a measurable profit or return on investment to the owner,

partners or shareholders while minimizing their risk. However, given the dynamics of current economies, the ever-

increasing rate of change in new technologies and the globalization of demand and supply, we find that the

historical demand/supply theory no longer applies. Historically, demand changed when a change in price occurred

and supply would change because of a factor other than price. However, given the global village we live in and the

ease of access to a variety of international markets, consumers can now change demand making it difficult for

suppliers to be able to predict demand and hence produce enough to meet this demand. This factor has seen the

creation of several new business structures including joint ventures, and other strategic alliances and combinations

such as mergers and demergers. Of these, we will be critically reviewing demergers, its types, influencing factors

and current trends.

Before we can look at demergers, we define merger as “absorption by a corporation of one or more others, also

any of various methods of combining two or more organizations as business concerns.1 ” Considering that de-

merger would be it’s antithesis, we define demerger as “a merger between two or more companies that is

dissolved, or the separation of one company from a larger company or group.2 ” It is only in the very rare occasion

that we actually see a merger dissolve and the two companies decide to revert to two separate corporations while

our second type of demerger is usually called a spin-off and is the more common type of demerger encountered

today.

Demerger – Spin-off

A spin-off usually occurs when a larger company decides to divest itself of smaller operating units. These units

continue to function entirely as a sole entity. The reason for this divestiture/disposal varies. They may include:

Until recently, dotcom firms made up the majority of demergers4. “European telecoms companies took on large

amounts of debt during 2000 in order to acquire 3G licences from the various governments. At the time this debt

was taken on, markets were high and the telecom companies anticipated being able to make asset sales in order to

1 (Merriam-Webster Online Dictionary, 2008)2 (MSN Encarta Dictionary, 2008)3 (Veryard Projects Ltd & Antelope Projects Ltd, 2003)4 (Doward, 2001)

reduce the debt burden. However, the collapse in the value of technology stocks, combined with the many

telecoms companies all needing to dispose of assets, meant that sales prices were far lower than originally

anticipated, leading to liquidity problems for many of the companies.5” However, since 2002, we have an ever

increasing trend for companies to demerge as a strategic manoeuvre to create additional value for shareholders. In

today’s economy, creativity is key, because as noted in the introduction, it is necessary to stimulate consumer

demand in an extremely dynamic economy. In contrast, firms must also successfully control and mitigate their risk

of any negative influences affecting their profit-making ability.

It is easy enough to acquire a business and some businesses appear to find it necessary to merge or acquire other

businesses to increase their profit margin and provide added value to their shareholders. “Markets admired the

company that could stretch its brand and managerial flair across everything... Those days are gone.”6 These are the

businesses that now struggle to appease their shareholders and maintain their profit in all their markets as they

have now become too diversified. In the past, the motto was “bigger is beautiful” and while conglomerates may

have indeed appeared “beautiful”, very often their bottom line did not. It had become quite a task to maintain an

adequate capital structure for all divisions as it is almost always guaranteed that some will outperform and ‘carry’

the poor performers therefore making the overall conglomerate performance quite average giving us the concept

of “the sum of the parts being greater than the whole”. For that reason, some of the smaller divisions suffered

financially and the overall corporate policy stifled smaller divisions who had the capability and capacity to perform

even better on their own. “Companies soon learn[t] to give themselves a clear label if they want[ed] to please

investors.7” It made more sense to focus and define the individual business sectors which enable shareholders to

view firsthand management’s comittment to improve and increase their performance and profitability8 in an area

that they are proficient in rather than being a “Jack of all trades and master of none.”

A classic example of a demerger where focus of an individual business sector turned out to be a hugh success is

Vodafone minus its parent Racal. Brought into existence in the 1980’s, Vodafone was a complementary arm of an

electronics, defense, security and communication equipment conglomerate. Racal expected that spinning off

Vodafone would make their remaining sectors more visible thereby commanding a better share price. However, the

reverse happened and the spin-off significantly reduced Racal’s capitalization and opened the door for a hostile

5 (Bender & Ward, 2002)6 (1-Anon., 1997)7 (1-Anon., 1997)8 (Wirtz, 2006)

takeover which was attempted the day after the spin-off was announced9. On the other hand, after the initial

partial spin-off in 1988, Vodafone went on to become the “biggest company on the London Stock Market in

January 2000 ... [worth] double the value of any other UK company and equal to 15% of the value of the whole

FTSE index.10”

Demerger –Reversal of a former merger

In extreme cases, we find that some companies merge and then later demerge. The reasons behind the original

merger may include:

It is interesting to note that of the seven merger examples noted above, three (3) later went on to demerge

(DailmerBenz plus Chrysler, Bass Beer plus Pubs and Six Continents Hotel and GlaxoWelcome plus

SmithKleinBeecham and profits of WM Morrisons suffered a drop of 50% to 83% in profits under the weight of

Safeway.12

As in the case of SmithKleinBeecham, they assumed erroneously that this merger of “equals” would enable them

to gobble a bigger piece of the pharmaceutical market pie. In the case of Bass Beer we see several consecutive

mergers of complementary companies, however the general concensus is that it is “not clear that any value has

been created by all this wheeling and dealing. On the contrary, it seems that Bass management have wasted

9 (Business, 2008)10 (BBC, 2000)11 (Veryard Projects Ltd & Antelope Projects Ltd, 2003)12 (Wachman, 2006)

huge amounts of shareholder value in the process.13” Bass Beer expanded into too many markets to effectively

manage all. We also see the classic “the sum of the parts being greater than the whole” as the pub industry in the

UK began to suffer in the 1970’s and the more profitable entities were bearing the pubs’ dead weight. The need to

focus was evident hence the eventual demerger. As for DailmerBenz plus Chrysler, we see considerable conflicts of

interest in products and corporate policy which eventually led to their demise. These two companies produced

competing products and DaimlerBenz had a very different corporate structure which was not compatible to that of

Chrysler.14

Another major cause why companies merge then demerge is due to a massive turnover in top management

following the original merger. A study published in the Journal of Business Strategy “found that target companies

lose 21 percent of their executives each year.... for at least a decade following a deal suggest[ing] that mergers and

acquisitions destroy leadership continuity in target companies’ top management teams.15” This turnover is often

caused when top management of the target company refuses to acquiesce to the new corporate policies,

economies of scale (a major benefit and reason for merger) often entails a reduction in labour including managers

and difference in culture is often resented most by top management.

All of this creates massive upheaval which detracts from the original cause of the merger as energies now have to

be diverted to becalm the merged companies. The eventual settling that is expected does not always happen and

continuous conflict eventually causes the new merger to demerge.

Demerger – Blessing or a curse

Laws and Legislation

The laws and legislation guiding and guarding demergers differs greatly on both sides of the pond. Due to severe

abuse of demergers as a way to split shares without paying taxes, in 1934, the US had actually abolished demergers

as a tax neutral restructuring device16. However, to accomodate legitimate spin-off restructuring, it was eventually

reintroduced as a tax-free incentive (with stringent restrictions) in 1951 with this legislation most recently

amended in 1986. This legislation determines that a “spinoff is tax free if it satisfies the following criteria set forth

in Section 355 of the IRS code: (1) The distribution must constitute at least 80% of the outstanding shares of the

13 (Veryard Projects Ltd & Antelope Projects Ltd, 2003)14 (Central, 2007)15 (Gresham, 2008)16 (Wirtz, 2006)

subsidiary, and the shares retained by the parent should not constitute a ‘practical control’ of the subsidiary; (2)

both the parent and the subsidiary must be engaged in an active trade or business for at least five years prior to

the ex-date; and (3) the transaction is done for sound business reasons and not as a means of avoiding taxes.”17

In the UK, “the Income and Corporation tax Act of 1980 enabled British companies to engage in a tax free

demerger.... Geoffrey Howe then chancellor of the Exchequer .... reasoned that there are cases where businesses

are grouped together under a single company umbrella,. They could in practice be run more dynamically and

effectively if they could be demerged.... [Therefore], that means that the distribution of shares in the spin-off by

the parent company is tax-free.... This means the exemption of advance corporation tax (ACT) and therefore no

shareholder liability for income tax, capital gains or stamp duty.18”

We therefore find that demergers are increasingly becoming more and more attractive in the UK and Europe as

most legislation in Europe tends to be based on UK legislation.

SWOT Analysis

Strengths

There would be no actual exchange of cash as the force behind demerging is not to gain additional capital through

sale of assets but rather a distribution of shares where shareholders can decide to if to continue investing in the

parent company or to invest in the former subsidiary which is now it’s own separate publicly traded entity. This

often reiterates the reasons “why demergers are seen to add value including:

Separation into clearly defined business segments leads to market transparency and greater

understanding [by the investor rather than individual performance of subsidiary entities being buried in

the consolidated financials].

The different businesses can follow financial strategies more appropriate to their activities.

Improvement in corporate governance and efficiencies arise in companies which were subsidiaries but are

now separately accountable to the markets.

Incentive structures can be put in place that link management’s performance directly to the unit’s share

price.

Removal of the conglomerate discount.19”

17 (Desai & Jain, 1999)18 (Wirtz, 2006)19 (Bender & Ward, 2002)

Weaknesses

However, while value added theories bear some credence, spin-offs are not always the most viable solution as the

optimistic investor or manager would hope. Weaknesses associated with demergers include:

Management abilities are now questionable as it is implied that the parent’s management have conceded

that it has failed in obtaining the best performance from its subsidiary20

Management may be using the demerger to embody their own financial interests which may not be in the

best interest of the new firm or its shareholders.

Opportunities

As noted in the introduction, many telecom companies now face high levels of debt without the expected increase

in sales to reduce their debt, hence liquidity and additional capital funding has become a problem.

“In 2000, says KPMG, over a quarter of British companies in the Footsie 100 engaged in demergers or

disposals. Two years before, only four of the 100 companies got involved in demerger/disposal deals of

significance. 21“

Demergers are now a more attractive strategic option due to “the recent deterioration in debt markets...

[since] private equity has reduced its activity because of credit issues.22"

This is especially true in the UK where favorable tax conditions surrounding demergers exist. As evidenced by the

statistics below, we can therefore determine that the opportunities show deep potential. “Two-thirds of the FTSE

350 and Fortune 500 company executives surveyed saw active or very active demerger activity in their sectors in

the next 12 months, with growth coming mainly from continental Europe and the Asia Pacific region, according to

the study commissioned by Allen & Overy.23”

Threats

It has been noted that conglomerate (both parent and subsidiary) share prices fall immediately before a demerger.

However, a “Deloitte & Touche survey found that while demerger announcements are usually greeted with a two

to 10 per cent drop in share price, .... within a year of the demerger, the share price of most parent companies

increases from 12 per cent to more than 52 per cent, while the separated business also fares well, with share price

20 (Heller, 2005)21 (Heller, 2005)22 (Reuters, 2007)23 (Reuters, 2007)

rises of 13 per cent to more than 46 per cent.24” However, over time, we truly begin to see just how much the

subsidiary was carrying the parent as “after analysing 38 European demergers ... Kirchmaier found that, for three

years after a split, shares in the parent company underperformed the market average by 16 per cent. The spin-off,

however, outperformed the market by 8 per cent over the same period25”

Demerger may open newly demerged companies to hostile takeover as noted in the classic case of

Racal’s divestiture of Vodafone.

An ailing company is still an ailing company. Demerger is not a snakeoil remedy as was expected in the

case of Lucent Technologies spun off from AT&T. Given Lucent’s extensive century old background in

technology, everyone expected that a demerger would focus their expertise and increase profitability. So

while the demerger was greeted with the largest increase in market valuation, return on expectations was

nill. Lucent basked in the glow of praise for four years, but as expected, when delivery of promises did not

materialize, the market reversed on itself and it was another four years before Lucent saw another

profitable year.

24 (Vaughan-Adams, 2002)25 (Doward, 2001)

Empirical Review of Six Continents PLC

The case study consists of the examination of the series of mergers and demergers beginning with Bass Beer and

ending with Mitchells and Butlers Plc. It was selected by examining articles for rare situations in which it was

reported that a company merged and then demerged. This review is best thought to demonstrate the complete

turnaround of a company from its rise to its fall both as a merger and a demerger and how the stock market has

turned on itself and now regularly discounts conglomerates.

Corporate Chronology (adapted from Coors Brewery Company History 26 and Mitchell and Butlers PLC Timeline 27 )

1744: William Worthington starts brewing in Burton-on-Trent, UK.

1777: William Bass starts his own brewing business in Burton, UK.

1784: British ales were exported to St. Petersburg and the Baltics

1799 – 1850: Beginning of overseas exports and mass railway shipping thereby extensively increasing production.

1926: Bass and Worthington breweries merge.

1940s: Decline in demand due to world wars leading to focus-oriented mergers

1954 – 1988: Massive rebranding, renaming and mergers - of significance 1961 - The Bass, Ratcliffe and Gretton Ltd

merges with Mitchells & Butlers to form Bass, Mitchells & Butlers

1990s: Following the Beer Orders of 1989, Bass splits into Bass Brewers and Bass Taverns.

2000: Bass Brewers is sold to Interbrew and company renames itself Six Continents.

2001: The company sells 988 pubs to Nomura for £625m in February.

October 2002: Six Continents announces plans for a £109m demerger of its pub and hotel divisions, which become

Mitchells & Butlers and InterContinental Hotels Group a year later.

April 2003: Mitchells & Butlers (M&B) is created on its separation from Six Continents on 15 April, when it floats on

the stock market at 225p a share. The cost of the demerger is £32m.

November 2003: Mitchells & Butlers raises £1.9b through a securitisation deal to refinance the business, repay

existing debt and return £400m to shareholders

September 2006: The group returns £519m to shareholders after negotiating a refinancing deal.

26 (Coors, 2008)27 (Butlers, 2008)

August 2007: M&B announces that a deal in which R20 would buy a 50% stake in 1,300 pubs worth £4.5b is unlikely

to proceed until the debt markets improve. However, the group enters debt hedging arrangements for the

transaction worth £60m.By mid-September, the delay has cost the group £140m.

Mitchells & Butlers is now a leading pub operator in the UK owning 3% of the country's 60,000 pubs and a

significant player in the budget hotel sector operating more than 100 hotels (25 Express by Holiday Inns, 80-plus

Innkeepers Lodges)

A review of the 10 year period September 1998 to September 2007 was performed taking into

consideration demerger of Bass Brewery in 2000 and eventual demerger of the remaining leisure activities

division in 2002.

Pre-demerger period = 1998 to 2002 and Post-demerger period = 2003 to 2007

Financial data for parent and subsidiary firms was obtained from the parent and the subsidiary’s

consolidated financial statements. (See appendix)

Diagram 1

A healthy level of debt often indicates that a company is reinvesting in itself. However an excessive level of debt

may indicate a cash flow problem and frighten away potential investors who may want a quick return on

investment. This may also indicate an increasing inability to cover immediate debts as they fall due as underlined in

the chronology. This chart shows that prior to the demerger, Six Continents PLC had gotten their debt to what can

be considered a reasonable level. However, since divesting of it’s pubs and other leisure associated subsidiaries,

we see this ratio turning around and rising once again to where the company has had to refinance several times

and hedge debts to maintain a reasonable financial structure.

Table 1 EBITDA 1999 1998

Bass Brewers 703 668

Bass PLC 880 921

As a percentage of parent80% 73%

This indicates that immediately prior to the demerger, Bass Brewers Ltd made up an increasing amount of the

conglomerate’s EBITDA. This is supported by the overall EBITDA for the company for the 10 year period under

review (see chart below) as we see that the overall EBITDA has dropped by approximately 50% after the complete

demerger of their brewery and leisure activities division.

Diagram 2 EBITDA - Pre and Post Demerger

Diagram 3

Net Debt to Equity

Pre and Post Demerger

The significant increase in the debt to equity can also be construed as a bad thing. This factor combined with a

potential liquidity problem indicates that this company may have problems paying its current debts as well as

engineering any renegotiations on the same.

Diagram 4

Book Value Per Share (GBP)

Pre and Post Demerger

In this final graph, we see how since the demerger occured, the stock market has increasingly discounted it’s

shares in this company.

Overall, we see that Bass Breweries and Leisure activities supported the parent company to a great extent as since

the final demerger the company has not been able to recoup it’s profits. The general convergence noted in these

diagrams all indicate a rise prior to demerger and fall after completion of the demerger as indicated in chronology.

Conclusion

Demergers may be the light at the end of the tunnel for conglomerates who need to focus to bolster their

shareholders’ faith in their company. Given the favorable legislation in Europe and the UK, we can expect to

continue to see a significant increase in this form of strategic undertaking. However, it is not always a good thing

and may not guarantee a subsidiary’s turnaround or eventual success.

Approximate word length of 3290 excluding abstract, topic lines, end references and diagrams.

REFERENCES

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14. ‘Morrison's profits sink under Safeway's weight’ The Observer, http://www.guardian.co.uk/money/2006/mar/19/business.supermarkets retrieved on November 19, 2008, Wachman, R.

15. ‘The rapid rise of Vodafone’ BBC News-Business, http://news.bbc.co.uk/1/hi/business/the_company_file/527754.stm retrieved on November 19, 2008

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Appendices

1. Bass Annual Report and Financial Statements 19992. Bloomberg Financial Data