By Peter Thal Larsen and Sarah Spikes
Appeared in The Financial Times on 19 December 2006
When Terry Smith made the first transformational deal for his broking firm Collins Stewart in early 2003 by buying Tullett, the former analyst argued that the deal would spread risk and make his business more able to weather turbulent markets.
"This increased diversity of revenues should further safeguard results and shareholders' returns from a downturn in any one area of the markets and enable the group to continue delivering superior returns," the chief executive of Collins Stewart said at the time about the £212m acquisition of the interdealer broker.
Four years later, Mr Smith is praising the benefits of being focused rather than diverse.
This morning Collins Stewart Tullett will split in two again, when the stockbroking division is spun off to shareholders. Mr Smith is chairman of Collins Stewart and chief executive of Tullett Prebon. The demerger, which includes plans to return £300m in cash to investors, is designed to boost the group's combined value by encouraging the market to judge each business on its individual merits.
The demerger is more than a reflection of changing stock market fashions. It also underlines how the company's centre of gravity has shifted. Four years ago, stockbroking was its main source of revenues. But rapid growth in the interdealer broking business, bolstered by the acquisition of Prebon in 2004, means that Collins Stewart is now the smaller entity.
Pre-demerger dealings in the shares suggest that the stockbroker will be valued at about £557m, while the remaining business, now called Tullett Prebon, will be worth almost three times as much.
Mr Smith insists that the initial combination made sense because Collins Stewart, which has a high rate of return on capital, could fund the investment in building up interdealer broking. "CS provided the fuel that allowed us to do Tullett and Prebon," he says.
But he also believes that Collins Stewart Tullett's share price has traded at a discount to other interdealer brokers because the two businesses have different characteristics and no obvious synergies. "It is a fact that when you combine businesses with different valuations you tend to attract the rating of the lower-rated part of the group," he says.
The valuation that Mr Smith clearly has his eyes on is that of Icap, the larger rival interdealer broker run by his contemporary Michael Spencer. Indeed, the demerger is not the only option that Mr Smith has explored: last year he considered approaches from several private-equity groups that wanted to take the business private.
According to Jeremy Grime, an analyst at Altium, Icap trades on a multiple of 19.5 times forecast 2007 earnings, while Tullett currently trades on an implied multiple of about 15 times.
However, Mr Grime says that the rating gap is unlikely to close completely because Icap has greater market share in the global inter-dealer broking market, and also has a more developed electronic broking business.
Demand for electronic broking is increasing quickly, and is seen as more valuable by investors because it benefits more from economies of scale than traditional voice broking.
Chris Smith at Oriel Securities also says that Tullett should trade on a higher rating after the demerger, but it would not match Icap in the near future. "I think that after the private equity approach, Collins Stewart Tullett did a good private-equity job on themselves, and the demerger should deliver value for shareholders," he says.
The other question for shareholders is whether Collins Stewart will benefit from being an independent business again. Calculations are complicated by its acquisition of Hawkpoint, the independent boutique, prior to the demerger.
However, it remains unclear whether Collins Stewart will be able to absorb Hawkpoint's bankers smoothly, without a clash of cultures.
However, Mr Smith said separating Collins Stewart from the larger Tullett Prebon business should help it to attract staff. "People are not particularly motivated if their part of the business is dominated by a larger group that they cannot control," he says.
If successful, the independent Collins Stewart should also be in a stronger position to pursue further deals. It has already been snapping up smaller wealth management businesses, and now looks after assets worth about £3.6bn on behalf of private clients. At the same time, it is looking to strengthen its position in emerging markets: last week it bought half of Inga Advisers, an Indian bank, in part an effort to find more companies which it could list on Aim.
Judging by Mr Smith's record over the past four years, few investors are likely to bet against his latest plan delivering further shareholder value. But if circumstances change, it will not be surprising if in a few years' time he is once again arguing the benefits of diversification.
© The Financial Times Limited. All rights reserved