Jeremy Warner's Outlook: A stock market teeming with long term value

Centrica/AA; Rewriting history; Green's surplus cash
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The Independent Online

The stock market is stuck in a rut. It's gone nowhere since the start of the year. Renewed geo-political tensions, fears of a slow-down in China, and the spectre of higher interest rates have combined to produce an investment climate of near paralysis. Fast back a year, and with the Iraqi war apparently won, the mood was one of rising confidence, with an expected rapid rebound in corporate profits and prospects. It didn't last long, and on the old yardstick that a proper bull market doesn't fully begin until equities unambiguously break through their previous peak, the stock market still has an awfully long way to go before it's out of the sick ward.

The stock market is stuck in a rut. It's gone nowhere since the start of the year. Renewed geo-political tensions, fears of a slow-down in China, and the spectre of higher interest rates have combined to produce an investment climate of near paralysis. Fast back a year, and with the Iraqi war apparently won, the mood was one of rising confidence, with an expected rapid rebound in corporate profits and prospects. It didn't last long, and on the old yardstick that a proper bull market doesn't fully begin until equities unambiguously break through their previous peak, the stock market still has an awfully long way to go before it's out of the sick ward.

No one can predict where the stock market is heading in the short term. Yet for the brave, the long term prognosis remains an excellent one. The stock market is depressed because the public lost trust in equity investment in the traumas of the post-bubble years, and started investing in houses, cash and bonds instead. As the interest rate cycle turns, that phase too may be drawing to a close. Eventually, people will need to start saving again if they are to keep themselves above the breadline in their old age. When they do, there's really only one place they can go.

Centrica/AA

Few expected Centrica's stock market life to be anything but nasty, brutish and short when the company was forceably demerged from the downtrodden British Gas in the mid-1990s, yet it has proved anything but. Indeed Centrica is today one of the more remarkable business success stories of the last seven years. No wonder Sir Roy Gardner, Centrica's chief executive, looks so pleased with himself. It's not just the fun of being chairman of Manchester United that keeps him perky; he's also created a company to be genuinely proud of.

Yet the multi-utility strategy he pioneered hasn't always worked as it was supposed to. In the late 1990s, he bought the AA in the expectation he could cross sell its breakdown and insurance services to his core, domestic gas customer base alongside everything else. Perhaps strangely, the two businesses have failed to cross fertilise. The AA has remained a standalone business despite Centrica's best efforts to cross sell. Hence the decision to put the business up for sale so that the proceeds can be reinvested in upstream gas and electricity generating assets.

The reason why this came as a bit of a surprise to the stock market is that Centrica doesn't obviously have to sell anything to fund its acquisitions elsewhere. Centrica is already throwing off large amounts of surplus cash. This ought to be sufficient to buy Centrica all the gas reserves, storage facilities and electricity generating capacity it needs to hedge the demands of its domestic gas and electricity customers from the vagaries of ever changing energy prices.

On the other hand, if a business doesn't fit in with the strategy, then there's not much point in keeping it. What's more, the AA has continued to thrive under Centrica's wing, despite its lack of synergies with the rest of the group and ever more intense levels of competition from the in-house break-down services of other large motor insurers. The upshot is that a business bought for around £750m net of its cash could today be sold to private equity or one of the big insurers for double that. Sir Roy has plainly bought wisely, even if it turned out to be for the wrong reasons.

Whether shareholders will allow him to keep the proceeds when the company is already making more money than it can sensibly reinvest, is another thing. Centrica will have to put up an extraordinarily good case for further acquisition making on top of that already outlined and funded if it is to avoid demands for special payouts and share buy-backs.

Rewriting history

Sir Richard Sykes, former chairman of GlaxoSmithKline (GSK), was desperately back peddling yesterday on remarks he was reported to have made in the weekend press to the effect that he was forced into the GSK merger by a deal hungry City. I must say, that's not the way I remember it, with Sir Richard, in typically robust form, presenting the merger as an absolutely essential piece of industrial restructuring. Yet here he is all these years later suggesting it was all a big mistake and what's more that he half thought as much at the time.

His opposite number at Smith Kline Beecham, Jan Leschly, was by contrast not at all keen on the get-together even at the time, if only because he knew it would lead to his own demise. But Sir Richard was full on, and if he had any doubts at all, he was extraordinarily good at hiding them. This was not just about creating shareholder value, he insisted; it was also for the good of UK plc and the long term health of Britain's science base. Frankly, this was always dewy eyed nonsense, but it convinced the prime minister and it certainly inspired the City.

The reality is that like most mergers, the marriage of Glaxo Welcome with Smith Kline Beecham has yet to create any value at all. Though the deal has succeeded in delivering substantial cost cuts, the jury is still very much out on whether it has noticeably improved the drug development rate. This was the public interest benefit on which the deal was justified, yet as ever, the business of crunching together two such culturally different and product diverse companies has proved demoralising, traumatic and highly disruptive. The City never seems to learn, and nor do the chief executives that serve it; like marriage, mergers are a triumph of hope over experience.

Unsurprisingly, GSK is more than a little irritated by Sir Richard's remarks, which break the convention that former executives don't publicly comment on the affairs of their successors, especially in derogatory terms. Yesterday, Sir Richard - now rector of Imperial College, London - moved to repair the damage. His remarks had been misunderstood or taken out of context. In fact he was 100 per cent behind the merger when he was chairman and remains so now. He didn't say it, but you can almost hear him thinking it; and if I were still in charge, GSK wouldn't be in the mess it is today.

The truth is that mergers of large companies are extraordinarily difficult to engineer with any success. As Sir Richard's treatise for Tomorrow's Company on restoring trust in stock market investment observes, hardly any of them work. I won't say that GSK has proved the old rule anew, because there are signs of the pharmaceuticals leviathan finally beginning to come together with better product development rates and improving morale. But it's taken an awfully long time and I'm not sure whether the two companies wouldn't have been better off alone.

The latest public relations disaster, under which the company stands accused of misleading doctors over the side effects of one of its main products, would surely not have happened in the old Glaxo Wellcome. Much of the row over executive pay also has its genesis in the very different corporate culture that existed in Smith Kline Beecham. Sir Richard was right first time. Directors should be much more wary of the siren calls of fee hungry investment bankers than they are.

Green's surplus cash

A furious Philip Green phones to say I had it completely wrong in Saturday's column when I suggested that the great bulk of the £1.1bn he and his family are putting up for equity in the M&S bid would be borrowed money. Every penny of equity for both the Bhs and Arcadia takeovers was his own money, Mr Green insists, and the same would be true for M&S. It's hard to figure out quite how the retail financier has made such a large amount of surplus lolly, but if that's what he says, then I'm only too happy to accept it's true. Mr Green is plainly a great deal richer than I'd imagined. It would seem that he doesn't even need to give the banks a charge over his Bhs and Arcadia assets to fund his share of the bid. Even Bill Gates, who everyone assumes to be the world's richest man, would struggle to produce such a mountain of unencumbered, ready cash.

jeremy.warner@independent.co.uk

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