This weekend I was caught up in an interesting debate with a good friend of mine. Paul's business is about to take over a competitor. And the question is should it be a merger, or acquisition?
It's a potentially devastating dilemma. If he merges the new business with his existing operations and things start to go wrong, then he risks losing the whole lot.
Whereas if he keeps the two things operating separately then he's got two bites of the cherry if the new thing doesn't work out and it goes bust he'll still hold on to his existing operations.
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As we discussed the dilemma it got me thinking. What struck me is of paramount importance to anyone investing in the stock market.
As investors we need to understand what's really behind corporate restructurings like mergers and acquisitions (M&A). Because once we do, it can help us identify some stocks with serious growth opportunities.
The secret story behind these mergers
As I looked at Paul's problem, I started to look at M&A in a whole new light.
What struck me was that if Paul is so concerned that a merger could end up with him losing the lot, then maybe I need look a little harder at demergers.
What I hadn't really considered before is that a demerger may be a ruse used by company management that is fearful the business may go bust.
For example, Woolworths was set adrift from the better performing retail estate of Kingfisher Group. In the end Woolies went broke but at least it didn't drag down the rest of the group with it. Hiving it off turned out to be a smart move.
Unigate dairies was cut out from the better performing logistics unit Wincanton. And just like Woolies, Unigate died a slow and agonising death. But at least the better performing Wincanton logistics group lived to see another day.
And as I look at what's going on with Punch Taverns today, I start to feel a little nervous. This looks like it could be yet another example of a demerger that ends up with a corpse on the table.
Getting rid of the chaff
On 1 August Punch de-merged its boring pubs division from its higher growth Spirit operation. Punch shareholders received shares in the two new businesses; Punch Taverns (LSE:PUB) and Spirit (LSE:SPRT).
And things have panned out very differently for the two businesses. Over the last twelve weeks, sales at Punch slipped 5%, while sales at Spirit were up 3.8%.
Analysts are forecasting two very different outlooks for these businesses
Source: Digital Look
Analysts reckon Punch will see a fall in earnings per share (EPS) of 12% next year. And there'll be no dividend.
Spirit earnings are set to grow 15% next year. And shareholders can look forward to receiving a 5.1% yield.
The problem with Punch is that the traditional pubs business is decaying and it's loaded up with debt. Spirit, on the other hand, holds the better-performing managed pubs that operate under popular chains such as Chef & Brewer and Wacky Warehouse.
It strikes me that shareholders have been left with a dud and a winner.
When it comes to demergers, you need to find the winner and dump the loser.
Find the winner from demergers
In a demerger, shareholders get an equal weighing of each of the new businesses created. But I think you should probably only keep hold of one of them.
There are two things you need to look at to help you decide which shares to keep.
First, look at liabilities and debt. In the case of Unigate, the vast pension fund liabilities for retired milkmen stayed with the demerged dairies business, Uniq. In the end, these liabilities were more than the business could stand.
Looks to me like Punch has been loaded up with the lion's share of debt after the demerger.
Secondly, look at growth. The stock market is forward-looking. It doesn't care too much for past glories like retailing giant Woolies, or former national treasure Unigate. What the stock market wants is earnings growth. And if there's no growth, then a stock gets slaughtered.
Punch's EPS are deteriorating. And with the economic environment looking dicey, the future looks bleak for this traditional pub operator.
Not all demergers are about cutting out deadwood. But when they are, you have to be on the ball. Keep hold of the high-growth, low debt winner and sell your shares in the loser.
This article is taken from the free investment email The Right side. Sign up to The Right Side here.
Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.
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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.
He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.
Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.
Bengt also writes our free email, The Right Side, an aid for free-thinkers on how to make money across financial markets.
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