UK: GRAND ILLUSIONS.

UK: GRAND ILLUSIONS. - The rumour that Britain's biggest conglomerates are embarking on a buying binge is welcomed by those who believe such activity creates a 'win-win' situation for investors. Others, less blinded by sheer faith, may find that the figu

by Terry Smith Smith.
Last Updated: 31 Aug 2010

The rumour that Britain's biggest conglomerates are embarking on a buying binge is welcomed by those who believe such activity creates a 'win-win' situation for investors. Others, less blinded by sheer faith, may find that the figures don't add up.

Britain's largest quoted conglomerates appear to be back on the acquisition trail. Hanson seems poised for a bid now that it has fully digested its 1993 purchase, the US chemical company Quantum. And BTR's wagon looks set to roll again now that its gearing, raised by the Hawker Siddeley deal four years ago, has been reduced. The big boys, say the newspapers, are 'scouring the world for takeovers'. Meanwhile, share prices of companies ranging from Allied Domecq through United Biscuits to Yorkshire Electric regularly move up the market on lazy Friday afternoons as the rumour mill grinds on.

Many people find reason to celebrate the potential return of corporate predators. Indeed, the acquisitive bent of companies may bring payoffs all round. Shareholders in target companies clearly benefit from their attention. And, as the move in BTR's share price around the Hawker Siddeley takeover of 1991 shows (see Table 1), the initial reaction of the market to a predator's strike is often to mark its shares better. Perhaps corporate UK and US rely on these corporate vultures to pick off ailing companies.

Faith in the acquisitive activity of conglomerates is based on the belief that their skill at extracting value from industries ensures that two plus two will equal five. Predatory deals also bolster market confidence in the capacity of a conglomerate to perform its basic acquisitive function, namely takeovers, without which it cannot grow. The confidence inspired by the ability to go on a buying binge appears more important than the wisdom of the acquisition itself.

However, blind market faith in conglomerate competency is ill-founded. All is not well with the simple market theory that acquisitive conglomerates create a 'win-win' situation for investors. BTR's share price, which performed so well for nearly two years after the Hawker Siddeley bid, has since lost almost all of its performance relative to the market. Part of this loss came in a particularly sharp fall in the BTR price when the 1994 interim results indicated problems in maintaining operating margins. Previously, superlative profit margins were BTR's trademark.

But the malaise in the conglomerates sector runs deeper than some simple evidence of pricing pressure at BTR. As Table 2 shows, the FT Diversified Industrials Sector now stands at a 10-year relative low against the market. But acquisitive conglomerates have always moved in and out of fashion. Slater Walker, for example, went from capitalist hero to asset-stripper to bust in less than a decade. In the late 1980s, conglomerates were very much in favour. So does the current fall from grace suggest a sector raddled by the vagaries of fashion or a sector in decline?

One test, perhaps, is to discover whether conglomerates provide shareholder value. By investing in a number of diverse businesses, conglomerates provide investors with portfolio diversification. Yet how valuable is that service? Investors can, after all, obtain diversification of portfolio risk more cheaply than the acquisitive conglomerate because of the premium for control which conglomerates usually pay in a takeover. The passive investor can obtain this diversification simply by investing in a variety of companies without the handicap of paying any premium to the market price.

Conglomeracy fans would argue that the payback for the premium that acquirers pay is the superior management that conglomerates bring to often mature industries in order to extract value for investors. But how can we measure this? Perhaps the kindest test is to examine what conglomerates themselves state as their aim. Extracting the raison d'etre of any conglomerate from its managerial pronouncements is difficult.

Annual reports contain such typical gems as 'BTR stands for growth' (the 1992 annual report). But by far the most commonly stated goal is some form of growth in earnings per share (EPS). Indeed, the only features on the front cover of the 1994 Tomkins annual report are a 10-year bar chart of EPS and the slogan, 'Working for shareholders'.

The problems with the EPS performance measure are manifold. Numerous accounting tricks can produce EPS growth without any real progress in the profitability of the business or its cash generation. Creative acquisition accounting has always been an area of special interest to conglomerates, and the reor-ganisation provision is a favourite target. Provisions to cover the costs of reorganising the target's businesses were taken against value of the assets which were brought into the conglomerate's balance sheet. These provisions were then available to meet future costs and so enhance profits.

BTR raised provisions of £223 million for Hawker Siddeley, a company which was only making profits of £120-£125 million in the year of its takeover. Even if Hawker Siddeley had only broken even under its new ownership, for two years BTR could have shown maintained profits by using the provisions it had raised. The year after the acquisition BTR chief executive Alan Jackson commented that 'Hawker Siddeley had exceeded all expectations'. Even without splitting hairs about measuring performance against unstated expectations, it is clear that with twice the annual profit available in provisions, it would be hard not to show some 'progress'.

The work of David Tweedie and the Accounting Standards Board has put a stop to the worst manifestations of creative accounting for acquisitions. New Financial Reporting Standards (FRS) require reorganisation provisions to be put through the profit and loss account. Together with other improvements such as the Statement of Total Recognised Gains and Losses, which has taken currency translation losses out of their hiding place in the reserves note to the balance sheet and put them in the profit and loss account, and FRS 3, which has banned the ubiquitous extraordinary item, they have brought the real performance of acquisitive companies more sharply into focus. Perhaps it is no coincidence that the underperformance of the conglomerates in the stock market has occurred just as these reforms have begun to bite.

Apart from the erstwhile ability of acquirers to fix the EPS numbers, there are more fundamental problems in allowing conglomerates to choose growth in earnings per share as the yardstick to measure their performance. The EPS method of performance measurement and valuation completely ignores the concept of return. Stockbrokers' research and press comment frequently recommends investment in a particular company because of its superior EPS growth. This yardstick not only has the ability to 'fix' the EPS growth through the magic of acquisition accounting but it also completely ignores the amount that has been invested in order to generate the EPS.

Imagine visiting a building society to invest some savings. Would you choose the society which offered the highest increase in the rate offered without any other information? 'We will offer you 20% pa growth in the interest rate over the next two years' sounds like an attractive offer until you elicit the supplementary information that the initial rate was 4% versus 7% current market rates. If you had stopped at the first question, you would be committing the cardinal sin of ignoring the rate of return and just focusing upon growth.

Yet this is what analysts and investors are encouraged to do every day in the London stock market as stockbrokers voice the litany of earnings growth over the telephone to their clients. Try finding a piece of research on conglomerates which gives as much prominence to return on equity (ROE) or return on capital employed (ROCE) as it does to growth in earnings per share. Even finding a piece of research which mentions these measures of performance is difficult enough.

Even investors attuned to the need to measure corporate performance by return on investment find themselves handicapped by the UK's accounting system, which enables companies to write off goodwill on acquisitions. The UK is virtually alone in this respect. Amazingly it is still possible to find analysts who do not appreciate that the ability to write off goodwill, which is often bolstered by the fair value adjustments that are used to reduce the target's asset values, is the perfect opportunity for acquisitive managements to reduce the 'E' in the ROE or ROCE calculation. Therefore, a pedestrian performance in terms of return on shareholders' money spent can be presented as a dazzling result using a standard return on capital formula.

An investor who calculated Hanson's return on equity net of tax at 24.9% in 1994, and therefore concluded that its management was creating value based upon this measure, would be unpleasantly surprised when the cumulative goodwill of £4.9 billion written off was added back to the equity base to produce a much more pedestrian ROE of 11.6%. And, in fairness, that sum clearly should be added back - the management did expend the money on shareholders' behalf. But isn't this all obvious? After all, the goodwill write-offs are hardly hidden and are given in the notes to the accounts.

Apparently not. When searchlights are turned on accounting methods the returns - after adding back goodwill - for our leading conglomerates are clearly poor and declining. Yet the stock market and press still appear enthusiastic about the prospect of a conglomerate spending spree.

A study by James Capel (see table below) reveals that the return on capital, including goodwill for the four conglomerates in the FTSE 100 Index, has been below the returns earned by the average quoted UK industrial company for four out of the past five years. So much for the theory that investors should accept the penalty of the premium that these conglomerates pay for control in order to obtain diversification since their management will deliver superior returns. These figures show that as the conglomerates have grown, they have succumbed to the law of diminishing returns.

Clearly the conglomeracy argument thrown up by the simple expedient of measuring returns rather than 'growth' and including goodwill is flawed. During the period measured by the James Capel study there was still plenty of scope to exaggerate the 'R' component of profits. What would the prognosis look like if we explored the returns using the acid test of cash flow?

One method of analysing corporate value creation and strategy is that of HOLT Value Associates which examines the cash-flow return on investment (CFROI) generated by a company and compares this with its estimated cost of capital. A company that earns a return greater than its cost of capital is creating shareholder value and vice versa.

The HOLT CFROI chart for Tomkins (Table 3 on previous page) shows that since 1987 its cash-flow returns have been declining below its cost of capital - all characteristics of a destroyer of shareholder value. The correct strategic response from a company with inadequate returns, and reducing value,is to shrink the size of its business and even hand funds back to shareholders so that they can invest elsewhere in a company with a positive spread between its cost of capital and its returns. However, Tomkins clearly took the opposite tack and embarked on rapid asset growth often by acquisition. The RHM acquisition in 1992 came at a time when Tomkins's cash-flow returns on its existing businesses were clearly below its cost of capital, where they remain.

The image which this conjures up is that of a gambler at the roulette wheel placing losing bets and doubling up each successive bet in an effort to recoup his losses. Or, as conglomerates teeter on the brink of yet another round of feverish takeover activity, is a more appropriate image that of a final whirl round the floor by the dinosaurs of the corporate scene?

% Return on invested capital (including goodwill)

Company Year ending

1989 1990 1991 1992 1993 1994

BTR 24.8 22.6 15.1 15.6 15.5 15.8

Hanson 11.7 12.2 9.1 8.6 6.1 7.0

Tomkins - 10.0 12.9 14.0 10.4 11.4

Williams 15.7 12.1 13.5 10.4 11.3 8.6

General UK

Industrials* 19.8 19.0 15.5 11.5 11.8 -

+Not James Capel figures

*Datastream figures (excludes goodwill which is negligible across the

whole market)

Source: James Capel.

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