The Urge To Demerge

Unshackled from their government moorings and given a remit to compete, many of Britain's utilities in the 1990s took the decade's "growth is good" mantra to heart and morphed into conglomerates. Some reached beyond their own sectors for opportunities, expecting to apply their management skills to marginally related businesses. That's how energy company Scottish Power ended up owning a water company, a telecom and 160 electronics shops, as well as hawking financial-services. But the expected "synergies" of such diverse companies never fully developed, and Scottish Power's earnings — as well as its share price — hit a brownout. So the Glasgow utility is selling Southern Water and spinning off Thus, its unprofitable telecom. It has already sold its retail outlets and pulled the plug on its financial-services venture. "We took a decision a year ago to focus on the business of energy," says Ian Russell, its recently named CEO. "We had become a pretty broadly spread business."

Scottish Power is a poster boy for the latest trend in European corporate finance: demerging. The '90s were years of stock market-inspired bulking up — in Europe there were $4.7 trillion worth of mergers and acquisitions as capital markets surged. But now that market valuations have retreated, this is a time of slimming down, as companies look to impress investors by shedding unprofitable or unnecessary divisions.

Like most market crazes, this one started in the U.S. Sales and spin-offs accounted for 35% of M and A activity on Wall Street last year, up from 21% in 2000. Companies like Tyco International and Citigroup are jettisoning divisions; others, including GE, the Hilton Group and Motorola, are expected to offload units soon. In Europe, the market is smaller, but it's growing exponentially. According to J.P. Morgan, sales and spin-offs represented 8.2% of pan-European M and A activity last year, up from 2.8% in 1999. In the same period, Europe's entire M and A market nosedived nearly 60%. "Europe is probably in the second inning of spin-off activity, while the U.S. is already in the sixth or seventh," says Mark C. Minichiello, principal at Spin-off Advisors in Chicago. "The trend in Europe is definitely picking up. There will be a lot more demergers." Indeed, companies as diverse as Diageo, Nestlé and Deutsche Telekom are contemplating at least partial separations from ill-fitting divisions.

"The main reason is to get stock prices up," says Steven Kaplan, a finance professor at the University of Chicago. When times were flush, mergers allowed companies to increase earnings and inflate their share prices quickly. But mergers often create strange hybrids — like power companies trying to sell insurance — and anticipated economies of scale often don't materialize. So now, "there is a trend away from conglomerates, there is a distaste for them because there is a lack of clarity and transparency, and they often fail to deliver diversification benefits," says Steve Russell, U.K. strategist at HSBC Investment Bank. Corporations are focusing on core businesses because pure plays are simpler for analysts and shareholders to understand.

That's certainly the case with British retailer Kingfisher, which mainly runs home-improvement stores in the U.K. and France. Last year, Kingfisher spun off its Woolworths general merchandise stores, and there is now intense speculation — not denied by Kingfisher — that the retailer will rid itself of its electronics group, which includes Comet in the U.K., Darty in France and other chains in Belgium, Germany, the Netherlands and Eastern Europe. Diageo wants to offload Burger King, the fast-food chain it has owned for about 13 years, to concentrate on alcoholic beverages.

Companies looking to recast themselves as lean, mean corporate machines have three options. The preferred method of divestment is a sale, especially if there's enough interest to create an auction — and get a premium price. But buyers are not always available in slow economic times, and some divisions are not appealing to anyone. "If you can't sell it or if it is very large, you do a spin-off," says Paul Gibbs, head of M and A research at J.P. Morgan in London. A spin-off is essentially giving a unit to shareholders. But because spin-offs are tax-free transactions in most European countries, they can pack benefits for shareholders and companies alike. Kingfisher even managed to recoup $1.4 billion from its Woolworths spin-off by selling the physical stores to a property manager, who in turn leased them back to the new, independent Woolworths. The third option is the carve-out. That's when a parent company floats a portion of a division in an initial public offering (IPO), retaining the lion's share for itself. That's what Switzerland's Nestlé has planned for Alcon, its U.S. eye-care unit. Nestlé expects to float nearly 25% of it in a $2.3 billion ipo this week. And Deutsche Telekom wants to offer part of its wireless operation, T-Mobile, in an ipo later this year, possibly raising $8.76 billion.

Minichiello of Spin-off Advisors says carve-outs enable parent companies to establish a division's market value, a particularly useful exercise if they plan to bail out of it altogether in a few years. Nestlé insists that it has no plans to sever all ties to Alcon, though analysts still expect the food giant to untether the eye-care group eventually. As for Deutsche Telekom, it won't be Europe's first long-distance operator to unload a wireless unit. British Telecom last year spun off mm02, and France Telcom floated a piece of its Orange mobile unit. In addition, the T-Mobile carve-out will help Deutsche Telekom put a small dent in its $54.4 billion debt. Deutsche Telekom also wants to sell its cable assets; regulators rejected a $4.8 billion deal with Liberty Media to do so last month.

Periods of takeovers followed by sprees of spin-offs are hardly new. M and A activity usually increases as markets and liquidity rise, while demergers often occur after things go bust. "Clearly there is quite a cyclical and fashionable element involved," says HSBC's Russell. That's partly explained by the investment banks' need to make money regardless of market performance. "If you can't do the merger, do the spin-off. In bad times, the spin-off is the easier sell," Minichiello says. Management comes under pressure from investors to "do something," and the investment banks are there with the answer — get rid of an unloved unit. And if markets regain their stratospheric heights, it's a safe bet bankers will make mergers popular again. That's despite evidence that linkups usually don't accomplish their goals. A 1999 study by KPMG International found that only 17% of mergers made shareholders richer, while 53% actually made things worse. Demergers, however, "really do unlock shareholder value," Kaplan insists.

That's what Scottish Power is banking on. But disentangling itself from extraneous ventures won't be enough to revive its fortunes fully. The utility recently acquired extensive operations in the U.S., which have sputtered so far. Chief executive Russell is confident Scottish Power can make those U.S. investments pay off, which means the utility's share price should eventually rebound. Of course, that would give the company the cash to become acquisitive once more. Just don't look for it to buy into water or telecoms again. "We're an energy business," Russell insists. "That's where our focus will be." And those words should rekindle the waterlogged hopes of its shareholders.