Abstract
The paper consists of a case study ‘sell off may soothe investors pain’, the Mayne Group Company is headed for a demerge of its two pharmaceutical and healthcare subsidaries. The management of the Company is woried that the fast gowing pharmaceutical subsidiary is affected by conglomerate discount, this has prompted the demerge consideration which has implications on the reporting boundaries. The Company is valued at $.2.6 billion but when indepentent valuation is done for the two subsidiaries the sum of their values exceeds the value of the Company as a whole. This is contrary to what normally happens and can be attributed to the conlomerate discount which leads undervaluation of the firm. The spliting of the two firms is motivated by global growth of the pharmaceutical industry with rivals postioning themselves for the benefits. This does not go down well with the Mayne Group and it embarks on searching for a possible finanincial solution which includes enlisting of the pharmaeutical unit with the NewYork Stock Exchange or the London Stock Exchange. However the demerge has its risks too, the new indepentent phamaceutical firm may be faced with Licensing and development of product line challenges. This case study provides vital insight into the accounting theory especially on discount boundaries.
Introduction
The idea of spliting the Mayne Company’s pharmaceutical and healthcare units to be indepententent companies was a move to enable the realisation of individual goals. The changing market situtation and the repostioning of the competitors in the global business arena prompted the break-up. However, the reporting boundary during the demerge considerations has been over estimated and the individual companies may not realise there objectives after the break-up of the conglomerate business. The two subsidiaries seem to depend on each other to a larger extend and a break up could be potentially dangerous for the their survival, especially the pharmaceutical subsdiary which relies to a larger extend on the cash flows of the healthcare unity to subsidise its growth strategy. The Mayne Goup hopes to enlist the pharmaceutical susidiary to the New York Stock Exchange or the London Stock Exchange and uses the industry average to project a re-rating that will give the company a higher rating. All this factors represent a case of changing reporting boundaries in view of saving the Mayne Group’s long suffering investors. The answes to the following questions are intended to analyse the changing boundaries in the case of the Mayne Group.
What is meant by reporting boundaries in this Case?
“In general the terms reporting boundary represents the owned or controlled group, company, companies, businesses or organizations to which the response relates.”(Financial accounting, 2010) Reporting boundaries have traditionally focused on the financial activities and there outcomes.
Godfrey et al, defines the term reporting boundary to include any unit or activity that encompasses legal, administrative, economic, accounting or other activities. (2006.p.96) “This activity must be able to utilise limited resources in the business environment. The resources should be able to lead to the achievement of some benefits particularly financial benefits from an accounting perspective.” (Kothari, 1997.p.55)The reporting boundary regarding Mayne Group Company has been extended to include the demerger information for various needs of the stake holders and the specific market activities of the two arms of healthcare and pharmaceutical company that constitutes the Mayne Group Company. This is because of a strategy that has been formulated to deliver value to the long suffering share holders of the Mayne Group. The estimated independent worth of the two subsidiaries has been determined using specific average financial turn over of the two respective industries. The pharmaceutical Company generates two thirds of its revenue from external markets; therefore its value has been calculated in reference to average of the international performance of the pharmaceutical industry. Furthermore, it is believed that the pharmaceutical industry will be upwardly re-rated if enlisted on stock markets such as the New York Stock Exchange or London Stock Exchange. In this case the reporting boundary is based on the projected growth and average industry performance rather than the equity share of the two subsidiaries. In effect, the social responsibility of delivering health services by the two subsidiaries has greatly influenced the financial projections. The two subsidiaries provide health services to the society, this health sector is one the businesses that is minimally affected by fluctuations in the economic environment.
Is legal entity the only determinant of reporting boundaries? What other extensions of reporting boundary can you suggest?
Traditionally, legal entity has been the sole main determinant of reporting boundaries however this has changed to include other entities such as administrative and accounting entities. In the Mayne Group’s case the reporting boundary is set by legal and development entities which is captured in the statement, “Growth by acquisition is not the only strategy for the pharmaceutical division, with earnings growth also depends on licensing and development of its product pipeline.” (Godfrey et al, 2006.p. 98) “Generally, report boundaries encompass legal, administrative, accounting and other entities depending on the specific type of business or organization involved.” (Financial accounting, 2010) The other reporting entities are vital for the incorporation of the information on various needs of the stakeholders in an organization and impacts on the society, especially on “social, economic and environmental issues.” (Morris, 2010.p.34) “This is not only confined to financial information but also for the purpose of qualitative information on the impact of the organization or business entity on the community and environment.”(Godfrey et al. 2006.p. 98). The reporting is extended to include the other entities depending on the specific activities of the organization/business and or requirements by the share holders.
In traditional reporting, “The practice was to report only on the financial activities and outcomes for the entity which were supposed to be within the legal frame.” (Kothari, 1997.p. 67)More recently there has been a push for incorporation of other information into in the reporting, this has led to the inclusion of other entities other than the legal entity. The common approach to the extension of the reporting boundaries is referred to as the “triple bottom-line accounting which extends the reporting to social, economic and environmental issues.” (Champy, 1995.p.243)The triple bottom-line concept was coined by John Elkington, who viewed a business unit as an entity that encompassed economic prosperity, environmental quality and social justice. Thus extensions to reporting boundaries are intended to capture the wide ranging effects of a business entity to the society. “There is no limit to entities to be included in the extension; the purpose of the extension is to certify that the business firm in question is operating within accepted social and environmental guidelines.” (Godfrey et al.2006.p. 98) The extension is both beneficial to the organization and the society since both are mutually dependent on each other though it is in the favour of the company or organization since the community has options at its disposal.
Due to the “central role played by the society in any business,” the Mayne group should have extended its reporting boundary to capture the impact of the Company’s activities on the community. (Gordon, 2008) This may have included the firm’s social responsibilities such as; health activities aimed at promoting health and may be a strategy for improvement on health care service delivery, rather than dwelling on financial projections alone. This was particularly important because of the fact that Mayne group Company line is in the health sector. For Example, “A mining firm in Kenya was ejected from the mining site because it had neglected a social responsibility. “(Kemboi, 1996.p. 78)Like the Mayne Group Company the firm only focused on financial position and didn’t care for the needs of the “local community from which it drew its much needed labour.” (Kemboi 2006.p.128)
What external factors motivated the decision to split the Mayne group? Why and how do such external factors influence the structure of reporting entities?
Various external factors relating to the pharmaceutical market and rival firms’ activities prompted the management to consider splitting the Mayne group. Other multinational pharmaceutical firms were increasing their product ranges which included and were taking over the Mayne group pharmaceutical arms markets. The warning bells were sounded by activities such as; The Teva had acquired injectible generics group Sicor for $US3.4 billion ($4.4 billon) in January 2004 and the Pfzer’s Italian generics business for $ 116 million in December. Norvatis acquired Denmark’s number two generics group Durascan and Canada’s leading producer of injectible medicines, Sabex, in June 2004. This followed the Company’s 900 million pounds purchase of Lek, which provided a platform into the strongly growing Eastern Europe market. American Pharmaceutical Partners acquired the European manufacturing facilities and oncology products of US-based Bigmer in July 2004. In relation to the market, the management of Mayne group Company was aware of the rapidly growing external pharmaceutical market. The firm was in dire need of funds to bolster its production and maintain its share in the global arena. The only way to get the much needed funds for growth of the pharmaceutical division was the demerger which could have enabled the pharmaceutical division to realize its net worth of between $ 1.5 billion and $2billion. Another external factor that may have prompted the demerger was the idea of potential listing the Pharmaceutical division as an independent Company on the New York Stock Exchange or London Stock Exchange. Hopefully, this could have led to the upward re-rating of the pharmaceutical division in line with industry averages and provide the much needed funds for Company growth through acquisition.
The external factors that led to the demerger influenced the reporting boundaries in the following ways. First, the Mayne group for the first time reported on the financial projections and estimations of the individual divisions of the Pharmaceutical and healthcare units, traditionally this was considered as a single entity. Secondly, the external pharmaceutical industry was used to determine the value of the pharmaceutical division at $1.5 billion to $2 billion which was arrived at by applying an average of global pharmaceutical industry multiple of 13 times to the divisions earnings before interest, tax, depreciation and amortisation. Similarly, applying the EBITDA multiple of between 8 and10 times to the healthcare unit earnings yielded a valuation of $1.5 billion to $2 billion. This led to the specific value of the two divisions exceeding their combined worth. The reporting boundary therefore was extended to include the industry performance of the two divisions which were initially together and this has caused none of them to identify with its respective industry. This also led to the projections of future financial position of the two independent entities which relied very much on each other, For Example the pharmaceutical unit relied on the Cash flows of the healthcare unit to subsidise its growth strategy.
To depict the concept of reporting boundaries that encompasses many different areas the Solvay group can be used as an example. “The Solvay group has 178 production sites, which includes 58 joint ventures that deal in production of plastic pipes and fittings, Inergy Automotive systems which deals with vehicle fuel systems. The company operates in total of 37 countries according to 2007 figures.” (Solvay sustainable development, 2010) The Solvay group’s reporting boundaries are dependent on the subsidiaries. “Qualitative data on environmental parameters relates to 112 production sites including those operated by the joint ventures where production involves significant releases into the environment. Quantitative data relating to safety refers to all the operations for which the Solvay is in charge of the technical management amounting to 154 sites.” (Solvay sustainable development, 2010) The human resource management and policies encompasses all the management units including all the joint ventures in which the Solvay group has the majority shareholding.
Usually the value of a combined business is greater than the sum of the values of individual businesses making up the group. However, the opposite seems to be true in this case.
What is meant by the concept of ‘conglomerate discount’? How can the sum-of the-parts value of the company be greater than the group as a whole?
“The term conglomerate refers to a corporation that is made up of different companies that operate in diversified.” (Conglomerate discount, 2010) “Conglomerate discount is used to refer to the tendency of the stock markets to undervalue the stocks of a conglomerate business. The conglomerate discount is arrived at by adding an estimated value of each of the subsidiary companies in a conglomerate and subtracting the conglomerate’s market capitalization from that value.” (Conglomerate discount, 2010) The conglomerate discount is considered to be a stock market’s inefficiency and is the primary factor that often leads to demerging of conglomerate businesses. “Some investors have argued that the conglomerate discount is a strategy used by the market to buy undervalued stocks.” (Champy, 1995.p. 51)
The sum of the parts values of a company can be greater than the group as a whole under the following circumstances: first, when the conglomerate discount deliberately undervalues the net worth of the company. “This is because in determining the value of a conglomerate company, a conglomerate discount is subtracted from the market capitalization which is not done for one Line Company.” (Conglomerate discount, 2010) Secondly, the sum of the parts values of a company can be greater than the group as a whole when the two subsidiaries are in different industry with varied estimation of the net value of a business due to market difference. In the case of the Mayne group the pharmaceutical subsidiary had two thirds of its revenue generated from external market while the healthcare unit concentrated on the Australian Market thus creating a big market difference. When a decision to demerge is considered, the values of the two divisions are calculated by their respective industry which leads to the sum of the value of two individual businesses being higher than the group as a whole.
For example, “warren Buffet, owns a company known as Berkshire Hathaways which has two subsidiaries, one dealing with construction materials and the other dealing with insurance business.”(Berkshire Hathaway, 2010) The divisions synergistic in the sense that when one experiences a bad year the other offsets the losses because the units are in totally different fields whose markets cannot fluctuate in the same pattern. In fact the “insurance subsidiary once produced a large surplus which enabled Buffet to invest in different manufacturing and service businesses” (Berkshire Hathaway, 2010)
There appears to be a significant variance ($500 million) as to the estimated value of each of the entities to be created by the break-up of the Mayne group.
Why would there be such variance in the value of the new entities?
The Mayne Group Company that constitutes a pharmaceutical and healthcare unit is valued at $2.6 billion; the potential demerger intends to divide the company to form an independent healthcare Company and a Pharmaceutical Company. The initial valuation is based on the assets and financial performance of the Company as a whole. This has led to the ‘conglomerate discount’ where by the value of the components is not reflected in the group holdings structure. The potential demerger leads to valuation of the two units depending on their respective industry performance where by it is agued that the value of the pharmaceutical division at $1.5 billion to $2 billion which was arrived at by applying an average of global pharmaceutical industry multiple of 13 times to the divisions earnings before interest, tax, depreciation and amortisation. Similarly, applying the EBITDA multiple of between 8 and10 times to the healthcare unit earnings yielded a valuation of $1.5 billion to $2 billion. These are estimates which are based on particular industry performance. The variance of $500 million in the new entities is due to the unpredictable market behaviour which can fluctuate within a margin that will result in the value of the two entities varying between $1.5billion and $2billion.
Conclusion
The case study of the changing boundaries- sell off may soothe investor’s pain provides a classical example of how reporting boundaries can be affected y changing circumstances of a conglomerate corporation. In view of the changing business environment the Mayne group considers the splitting of the two subsidiaries into independent business units. This results in independent valuation of the two divisions which shows that the sum of the two is greater than value of the whole. This brings the concept of conglomerate discount which is thought to play a role in the frustrations of the pharmaceutical arm of the business. Demerging of the two arms is intended to enable the new independent firms to realize growth through new valuations that are industry based. Though this is a welcome move, there are still a number of factors that can cause challenges, for instance the pharmaceutical arm depends on the healthcare unit to provide funds for its subsidised growth strategy and may still face challenges in acquisition of licences and development of a production line new drugs.
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