Yesterday's heroes, tomorrow's fools

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The Independent Online
THE TURMOIL in financial markets since mid-July has meant a reassessment of European corporate restructuring both by companies and investors. We see no slowing of the pace. However, the means by which companies restructure may change. The problems in emerging markets may have stymied the global expansion ambitions of certain companies, or there may be changes in investors' attitudes as to which strategies are effective.

In the recent past the formula for success was clear: the model company would cut costs, invest in the emerging markets, retire equity and focus on a narrow range of product areas. Now, even though we would argue that many of these strategies are as valid as they were before, we suspect that many investors have become concerned about those companies which they feel have taken these strategies too far. Companies can rapidly fall out of favour and strategies which led to premium valuations in a bull market may lead to P/E discounts in the future.

Sudden changes in perception towards fashionable restructuring stories have an historical precedent. In 1985, a book called The Risk Takers was published which studied successful business people who had adopted value- adding strategies in vogue at the time. The list included Robert Maxwell, Gerald Ronson and Asil Nadir, names which would become notorious.

The very strategies used to generate out-performance in one era are often subject to ridicule in the next. We may be living through such an inflection point.

The last generation of risk takers relied on "clever" financial engineering to create value. This worked as long as asset values continued to grow more quickly than the cost of financing. However, as interest rates rose, growth eventually collapsed and the value of assets, notably property, dropped precipitously. Modern-day risk takers are in some ways no different from the risk takers of the past: all are intent on out-performing the trend. However, the benchmark to beat, nominal GDP growth, is much lower now than in the past. In the 1980s, the nominal rates of GDP growth in the OECD averaged 10.9 per cent; in the 1990s it has slipped to just 5.8 per cent. However, we believe that risk takers are still trying to achieve the same rates of nominal growth as they did in the 1980s. Indeed, shareholders still appear to demand the same rate of nominal profits growth they have seen in the past, despite much lower levels of nominal GDP growth.

One corporate restructuring strategy that may be up for reassessment is that of globalisation. While we believe that this strategy will be as valid in the future as it has in the past, the sustained push by some companies into emerging markets may now attract a degree of criticism. Companies sometimes used the globalisation theme as a smoke screen for jumping into the emerging markets to make up for the slow growth they were experiencing in competitive local markets.

Good examples of this are the acquisitions in Latin America made by Spanish banks, which attempted to compensate for the low returns in their home market by investing in emerging markets. The companies themselves cannot be too heavily criticised for their investment in the region, given that they typically paid around two times book value, while investors were applying multiples of close to five times earnings to the Spanish banks because they were perceived to be achieving rapid growth through acquisitions.

While the Spanish banks had assessed the risks well by paying only two times earnings, investors got it wrong. When global markets slumped after the Russian default crisis, investors were left nursing substantial losses on their Spanish banks' holdings, as the market reassessed the attractiveness of what were now seen as high-risk investments.

Even share buy-backs, one of the most popular forms of restructuring, could be up for reassessment. Although changes to tax legislation now make the fiscal environment much more positive in most European countries than it was a year ago, the natural inclination of European companies to conserve cash when the going gets tough could inhibit activity.

It is also worth remembering that the whole process of a company stripping itself back to its core competency by disposing of businesses through spin- offs and trade sales negates the ability of that company to diversify its risk. Multi-product companies - otherwise known as conglomerates - are deeply unfashionable at the moment, but are investors aware that their bias towards single-product companies may mean greater volatility in the performance of their stocks?

In an environment where investors become more risk-averse, those companies which are stripped back to their core businesses may suffer greater swings in valuation. While we have no doubt that the process by which a company enhances its focus is a positive one for its share price, how the stock performs after that process is open to question.

Despite some apparent drawbacks, we strongly believe that European companies will continue to push ahead with various forms of restructuring. Indeed, before this summer's slide in the markets, we were concerned that European companies might have been tempted to use the strong dollar and recovering GDP growth to postpone significant restructuring.

However, given the pressure exerted by the dollar's weakness and the apparent slowdown in European growth, companies are back under pressure to generate growth through restructuring efforts. One form of restructuring that we believe will continue to gather pace is that of industry consolidation through mergers and acquisitions.

In the first nine months of 1998, the volume of European M&A reached $522bn (pounds 312bn), 66 per cent higher than in the first nine months of 1997. However, in the third quarter, volume fell 24 per cent compared with the record-breaking second quarter, to $170bn from $222bn. This drop was driven primarily by a decline in the volume of deals valued at a minimum of $1bn, which fell 29 per cent on the quarter, from $159bn to $113bn, reflecting reductions in both the number of deals (which fell from 37 to 31), and their average size (down from $4.3bn to $3.6bn). The extreme volatility of the financial markets in the third quarter of the year must have played at least some part in slowing the pace.

However, there has been a revival in activity recently. Just this week, the German utility company, VIAG, proposed a merger with Alusuisse, the Swiss aluminium manufacturer.

Another feature of the recent turmoil in the markets was the collapse in the share prices of some of the most high profile of the European restructuring stories, such as Alcatel, Philips and Shell. Within a few weeks, these three companies had seen their share prices fall sharply as analysts slashed profit forecasts in the light of poor trading statements.

However, the one encouraging element of the corporate sector in recent weeks, from an investor's point of view, is that these companies appear to be redoubling their efforts to deliver value to shareholders.

After the sharp fall in its share price, Alcatel has announced a share buy-back programme and has said it is considering moving to quarterly reporting to improve transparency.

Similarly, since the announcement of a poor set of third-quarter results, Philips has announced the closure of a substantial portion of its European factories. Shell has also indicated its intention to accelerate its restructuring programme.

Gary Dugan is chief strategist for JP Morgan Securities in London.

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