What's in a share price?
Does Hotel Chocolat prove that markets don't work?
Well now. Who’d have thought when reading this post about Hotel Chocolat here on Moving Tribes only a couple of weeks ago that the business would solve some of the problems which had seen its share price drop massively over the last 18 months by selling itself to Mars only a few days later?
And equally, who’d have thought that the deal would go through at 375p a share, an enormous premium to its share price of 139p the day before the deal was announced?
That obviously merits a huge congratulations to the HC team for pulling off such a deal, but it also gets you thinking about how businesses are valued and what a share price actually means. (Well, it gets me thinking about it, at least, and that’s the kind of nerdery you signed up to Moving Tribes for, isn’t it?)
Firstly, let’s give some thought to how buying a business off the stock market works. If you buy one share in a business, then you are effectively buying whatever very small percentage of the future dividends from that business that your share entitles you to. You are a part-owner of the business, but a very small one and so you have no influence over the direction the business will take or the decisions it will make.
Buy all the shares, however, and you have not only bought 100% of that future dividend stream, you now get to make the decisions yourself, and so if you thought the company was missing out on opportunities you can now go off and chase the extra profits it was missing out on.
In other words, when you buy all the shares in a company you not only buy (on a proportionately bigger scale) what all shareholders get, you are also buying control over the business. And that control usually costs extra.
The result of that is that when someone bids for a company that is listed on the stock market, they usually end up paying an ‘acquisition premium’ to buy it in its entirety. Whatever the pre-deal shareprice was, the deal ends up being done at a higher value to reflect that purchase of control.
How much of a premium? Over the long run in the UK, typically about 40% or so, with occasional leaps up to 60% or even 70% in periods when private buyers (usually private equity funds) have been particularly keen to get their hands on certain assets. Morrisons, for example, went for just over a 60% premium.
That, then, explains the market shock when Hotel Chocolat changed hands for a whopping 170% premium to its pre-deal share price. What on Earth is going on, and what conclusions should we draw from it? Here are a few:
Not all stock market listings are the same. In the case of HC, about 54% of the shares were actually owned by the two founders of the business, meaning less than half were ‘free floating’ on the stock market. That means that in all practical terms the business was really sold by 2 controlling shareholders to Mars, which must change the dynamic of the deal making
Hotel Chocolat’s problems were local and solvable buy the buyer. As the share price chart at the top indicates, the 375p deal looks huge by comparison to this year’s share price but is only about the average of where the business has traded over the longer term. The whole point of the Moving Tribes piece 2 weeks ago was that it was a strong, well run business with some more recent executional problems - if you back yourself as a buyer to solve those, then the sums begin to add up.
The strategy may change - this is probably the more controversial point for the management team, but as we’ve explored in this piece one of the reasons you pay a premium to acquire a business is to make decisions about it, and it could very well be the case that Mars take the opportunity to do just that. There must be raw material sourcing, manufacturing and other synergies between the businesses, for example, even if you assume that the HC product formulation doesn’t change at all (and as those who remember the Cadbury acquisition will know, that isn’t a given either).
But there is another, larger point behind this discussion of the acquisition premium. What if the stock market just wasn’t doing a very good job of valuing the business? After all, the price of a share is just the result of the buying and selling of individual and institutional investors, and any decent student of economics can tell you that a market can be vulnerable to bubbles, troughs, rumours, speculation and all sort of other irrationality. Could it be the case that Hotel Chocolat was just over-sold and out of fashion? A few big shareholders decide they don’t like it, sell their shares and everyone else just follows like sheep?
Let’s consider another recent retail example. SCS, the furniture retailer was purchased off the stock market by an Italian company for about £100m. That was a 280p a share deal, another very healthy 66% premium to the share price pre-deal.
And yet, at the last point it published results the SCS business had £70m of cash on its balance sheet. That means that the entire future value of the dividend stream from the business has been valued at only £30m in this deal, and it also means that the pre-deal share price was putting a negative value on the business, by valuing it at less than the cash it had in the bank.
Can it be right that a profitable retail business is worth a negative amount of money? Well, the Italian acquirer obviously thinks not, but that was the result of the collective decisions of the shareholders on the London market.
Generally, I find the closer I look at share price movements the odder they appear. House builders, for example, are worth between a third and a half less now than they were 2 years ago on the London market. That’s an obvious reflection of the short term difficulties in the UK economy, but surely the value of a company is supposed to reflect its fundamental value over the long term? When the monthly publication of house price statistics impacts the value of listed businesses so fundamentally, it is hard to see those share prices as anything other than a short term scorecard, rather than a long term valuation.
Of course there is opportunity there. If certain parts of the market are structurally undervalued, surely that presents an interesting opportunity for those investors brave enough to take a longer term view? Just ask the nice folks at Mars.
P.S.
Autumn statement tomorrow, and if Jeremy Hunt is still fine-tuning the announcement, I can’t resist a little call back to a previous Moving Tribes piece offering some suggestions on what he can do that might actually drive economic growth:
Was looking forward to your take on this Ian.
Thanks for sharing and I like your point that "HC's problems were local and solvable by the buyer".