Does Demerger Mean Leaving the Footsie?

Last Updated Mar 29, 2010 7:40 AM EDT

When executive teams work so hard to get into the FTSE-100 and battle to stay in this elite club, why do some deliberately have their company chucked out? Demergers are back in fashion, but splitting up the business can mean slipping out of the magic index.

When Cable & Wireless divides itself in two it is not feasible for both halves to remain FTSE components. Liberty International, worth around £3.8bn, cannot be certain that either side will pass the £2bn threshold for Footsie inclusion. Carphone Warehouse has hovered hopefully just outside the top 100, but after hiving off TalkTalk, neither half has a chance of making it to the premier league in the foreseeable future.

It is a brave chairman who voluntarily foregoes the perks of the FTSE-100. Simply being a member means index-tracking funds must buy the shares; more analysts follow companies of that size; and foreign fund managers are more likely to invest in bigger businesses. The larger size also means liquidity in the shares is greater and price spreads tighter, encouraging investors to deal.

And the higher the market capitalisation, the easier to justify high boardroom pay. FTSE membership opens doors in Whitehall and the City and directors are able to rub shoulders with other big business bosses.

Leaving the FTSE makes those bonuses disappear overnight. Some shareholders have to sell, some simply choose to; some can't be bothered to research the company when it shrinks. Share prices of groups that exit the index naturally usually fall further simply because of the ejection: dropping out, through demerging, risks additional damage to value

The argument for demerger is that the separated parts will add up to more than the original whole, but the gain must more than offset the downgrade caused by dropping out of the index.

Sometimes both sides of a demerger remain FTSE businesses, as when GUS divided into Home Retail and Experian. Sometimes one part stays in: Anglo American is still in the top 100 while its former Mondi subsidiary is far outside. Sometimes both drop out.

And while separating into specialist companies can concentrate the minds of management and fund managers, downsizing can make companies more vulnerable to takeovers. If Cadbury had not demerged its Schweppes drinks division, it might have remained too large a mouthful for Kraft to swallow. If ITV and Compass were still a single company (through Granada), the broadcaster might be stronger -- though perhaps it would have weakened the caterer even more.

There are trends in corporate activity: periods of takeover have been followed by phases of demerger as conglomerates faded from fashion. When managements choose to swap the safety of diversification for the upsides of specialisation, splitting the company is one solution. But when chairman has worked so hard to massage market value into the FTSE -- making rights issues and paper acquisitions to boost the share base -- throwing it all up is a major step backwards.

(Pic: I Don't Know, Maybe cc2.0)