UK: THE INDIAN ROPE TRICK. - The use of an old trick has been a major factor in the expansion of a number of companies - and the cause of several fatalities.

by Joanne Hart.
Last Updated: 31 Aug 2010

The use of an old trick has been a major factor in the expansion of a number of companies - and the cause of several fatalities.

On the streets of India, around the turn of the century, highly regarded magicians could be seen climbing up apparently unsupported ropes. The practice, which won its exponents many plaudits, eventually died out. No serious casualties were ever reported. Decades later, the Indian rope trick reappeared in the City of London. Here, however, it was conducted in a rather different fashion. A company with a high price/earnings ratio would take over a company with a low p/e ratio and, hey presto, the first company's earnings would go up, its share price would rise, and so therefore would its worth on the stock market. As a result, the company's head honcho would be dubbed a genius. The p/e ratio of his business would thereupon increase further, and with it his ability to use the trick again.

Unfortunately, in London there were casualties. Since the late 1980s there have been several fatalities and a number of businesses have needed a lot of nursing. Remember Coloroll? British and Commonwealth? Abaco? These were among the fatalities. WPP and Saatchi and Saatchi had to elicit outside help. Others are still on the life support machine. A few businesses - Hanson, Williams Holdings, Wassall - appear to have escaped unscathed. But linking all these companies there is a common thread: each one has (or, in the case of the casualties, had) a charismatic leader whose involvement in any transaction came to be perceived by the stock market - either instantly or by degrees - to be a virtual guarantee of riches all round.

Almost invariably, the Indian rope trick, City-style, takes one of two courses. In course one, company A is sitting on the stock market doing very little. In marches Newcomer with a good reputation in the City. The shares in company A go up on the back of the increased expectations of his City followers, even though the underlying position of its business has not changed. Let us say that it has after-tax profits of £1 million, and 10 million shares in issue giving earnings per share of 10p. On the arrival of Newcomer, its share price shoots up from 100p to 150p to 250p, and its market capitalisation leaps from £10 million to £25 million. Suddenly, it has a p/e ratio of 25 times.

Newcomer then casts round for targets. He spies company B - with after-tax profits of £1 million and a market capitalisation of £10 million. Company A buys company B for £10 million, issuing four million shares at 250p. Suddenly something magical happens. Company A now has after-tax profits of £2 million and 14 million shares. Earnings per share are 14.3p - up by more than 40%. The p/e of 25, which looks cheap for such a growth stock, gives a share price of 375p and a market capitalisation of £50 million. Shareholders who bought at 150p, or even 250p, admire their own sagacity in following Newcomer, tell their friends about company A and wait expectantly for the next deal.

Course two is basically very similar. After years of trading with moderate success, company X has earned itself a high p/e through the wit of its chief executive plus a fair level of interest in its brand of business. It takes over a company on a lower p/e and drags up the value of its victim's earnings along the way. The net effect is the same. Earnings per share go up, the share price goes up, market capitalisation goes up - and directors' remuneration isn't slow to follow. It's simple, clever, effective, and can be done again and again. But the effect cannot last for ever. The rope eventually rediscovers the laws of gravity. Often it plunges to the ground and leaves the magician nursing a sore head, or worse.

This happened repeatedly in the 1980s when a bull market and a booming economy catapulted a number of companies from obscure beginnings to valuations running into hundreds of millions of pounds. Take WPP. When Martin Sorrell moved into Wire and Plastic Products in the 1985, the company was a classic shell with little but a stock-market listing to recommend it. Sorrell arrived from Saatchi and Saatchi with a reputation as a financial whizz kid, and the share price of his new-found vehicle shot up. He turned WPP, once a manufacturer of supermarket trolleys, into a media services company via a string of ever bigger acquisitions in that sector. Almost all these transactions were for shares, and almost all enhanced his earnings - not difficult when the p/e of WPP was around 35 times and those of its victims were considerably less.

Yet when, in 1989, Sorrell was forced to resort to borrowings to finance the acquisition of the Ogilvy Group - because he had grown so big and had issued so many new shares - he ran into difficulties. Less than a year later, WPP was forced to admit that it was talking to its banks about financial restructuring. Four years on, it is only just emerging from that period of near-disaster. Meanwhile the share price - at 119p in early September is barely a tenth of what it was at its £11-plus peak. 'The fact that our earnings were enhanced with every deal because of our high share price was not the prime motivation,' insists Sorrell. But he cannot deny that 'it was beneficial, it gave us extra flexibility'.

Other high-fliers of the era sank without trace. John Ashcroft of Coloroll, having made hay in the 1980s, had to call in the administrators because his company could not dispose of businesses fast enough to service its debts. The financial services company Abaco, run by a triumvirate of City whizz kids, had a p/e of over 100 at one stage, and put it to constant use. But the crash of 1987 saw the group's share price plummet. It could no longer acquire other businesses with ease, and two months after Black Monday it was sold to B and C, only putting off the evil day.

Nevertheless, despite all the disaster stories, the Indian rope trick has been a major factor in the expansion of many large companies. The big conglomerates, in particular - BTR, Hanson, Tomkins, Wassall, Williams - have grown big by using it, and are still trading profitably. In the UK, as in the US, the size and sophistication of the stock market - and an overwhelming preoccupation with earnings growth on the part of institutional investors - makes the trick simple to perform even at its most spectacular.

Of course, it also worries many people. It is criticised as a product of, and an encouragement to, short-termism. By causing financially naive, but otherwise blameless, managements to be permanently fearful lest they be cast for the role of the rope, it is said to represent a fundamental obstacle to a much needed strengthening of the country's manufacturing base. The rope tricksters themselves, being constantly on the look-out for their next victim, are accused of neglecting the businesses they acquire. They argue, on the contrary, that their intervention gingers-up managers, and brings about more efficient use of resources.

In the end, however, the magicians usually find that the knack has deserted them. Maybe they have grown too big. 'The point about this trick is that the bigger you get, the bigger your acquisitions have to be to enhance earnings. Eventually either a deal will go wrong or you can't find one that's big enough,' says analyst Terry Smith of Collins Stewart. 'There is obviously a size beyond which it is difficult to maintain a premium rating,' concedes David Roper, deputy chief executive of highly-rated Wassall.

In WPP's case, Sorrell acknowledges that it was the bid for Ogilvy that so nearly broke the camel's back. 'I do regret the pricing and timing of the Ogilvy deal,' he confesses. Tomkins, another arch-exponent of the rope trick, has suffered from City doubts ever since its £930 million takeover of RHM two years ago, and its rating has languished at a discount to the sector. The focus of anxiety has quite simply been the rationale behind the bid. Tomkins' flamboyant chief executive, Greg Hutchings, had for years been accustomed to trading at a substantial premium to his peers. Many erstwhile fans of the company concluded that the purchase of an ex-growth bread business was motivated primarily by the desire to keep the trick going.

Nigel Rudd, chairman of Williams Holdings, is well aware of the rope trick's charms and pitfalls: 'An appetite for one's equity is clearly helpful when one is making acquisitions.' But he adds: 'There is a temptation to buy anything when there is a huge premium for management. You have to look at the quality of earnings, not just focus on whether earnings are being diluted in the short-term.' Roper of Wassall puts it the other way round: 'Shareholders have to be confident that their company is buying companies which it will enhance.' Most successful practitioners of the rope trick argue that they do improve the situation and outlook of the companies they acquire. Some even claim to focus on a long-term horizon and to be enthusiastic about investment projects. 'We are rather keen on capital investment,' declares Roper. 'Provided it meets certain criteria, we think it is a good way to spend shareholders' money.' Williams, too, is generally considered to be in favour of capital expenditure: Hanson and Tomkins have been regarded as less so.

Behind such fine distinctions lie key differences in corporate philosophy. True exponents of the rope trick must, almost by definition, concentrate on the short-term. For earnings to go on rising their attention needs to be fixed unblinkingly on acquisitions, on stripping-out costs, on disposals and then bigger acquisitions. But, as has been shown, the trick cannot be sustained indefinitely. Roper thinks he has the solution as far as Wassall is concerned: 'With a market capitalisation of around £500 million, we now have to begin to realise value by demergers, MBOs and the like.' But at what point does a conglomerate reach a sensible, manageable size, at which it should consider embarking on a process of break-up? Theoretically, demerging is a mirror-image of climbing up the rope: sell businesses at a higher p/e than the group's p/e; buy back the group's shares with the cash, and earnings per share are enhanced. In practice, the tricksters seem happier when buying companies than when selling them. Further, is a policy of dispersal any more in the interests of the national economy - or of the companies in the portfolio - than a policy of agglomeration? Putting acquisitions into disposable form is hardly likely to encourage long-term investment.

When rope tricksters begin disposing of companies, the usual explanation is that they need to reduce debt. Lords Hanson and White are currently in selling mode (witness the flotations of Beazer and Ertl) for exactly that reason. But it may also be that Hanson has just reached the maximum size attainable by the rope trick. The suspicion is rife that it cannot find a target company big enough - and cheap enough - to make a worthwhile difference to earnings.

If the preoccupation with earnings truly were to die away, then performances of the Indian rope trick would come to an end in London just as surely as they ended in India all those years ago. But it would be a brave (or naive and idealistic) man who would bet on any such occurrence. Fund managers still tend to think about earnings when they decide what they can afford to pay their pensioners. And while London continues to offer the benefits of a free market, there will be little to persuade them to do otherwise. So look out for a new generation of budding magicians the next time the bull market starts to roll. And be prepared for casualties.

Joanne Hart is a journalist on the Evening Standard's City pages.

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