When mergers go flat

To date, the reaction to the possible £1.4bn merger between Barr and Britvic has been surprisingly muted. Surprising because, from the viewpoint of Barr shareholders, their company will be fundamentally changed. It will shift from being almost wholly UK orientated to being diversified. Currently almost all of its £250m annual turnover comes from the UK (and not far short of half of that is probably made within a 50-mile radius of its main plant in Scotland's industrial belt), whereas 30 per cent of Britvic's £1.3bn sales are made outside the UK. And Barr's focus on carbonated drinks - led by its most famous creation, Irn-Bru - will be diluted by Britvic's greater emphasis on still drinks, where its best-known brands are Robinsons and J20.

More important, the merger could threaten Barr's growth record and would almost certainly undermine its sexy share rating, which hardly seems to be in shareholders' interests.

Let's explain. The idea of the merger is caricatured as a cheeky move by the upstarts from Glasgow - although Barr has been around for over 100 years - trying to get their hands on a much bigger company while it was down. There is some truth in that. Britvic messed up big time in the summer when it had to recall a children's soft drink - Fruit Shoot - because the top was faulty. Then it dug its hole a little deeper when it could not fix the fault quickly. As a result, its share price, which had been trending down for two years anyway, lurched sickeningly, losing a third of its value in the three months to mid July.

Meanwhile, Barr's share price had been doing what it generally does - rising. Suddenly the gap between the stock market value of the two companies was proportionately much less than the gap between their sales and, to a lesser extent, profits. By the start of September the market value of Britvic's equity was just 1.6 times Barr's even though Britvic makes five times more sales and its 'normalised' profits are almost three times higher.

Clearly the gap was sufficiently reduced for Barr's bosses to put the question of the merger to Britvic's directors.

However, to focus on respective sales and profits is to miss the point. Of the two companies, Barr is far more successful (see table). Average out its profit margin for the past five years and the figure is 14.4 per cent, compared with 10.8 per cent for Britvic. Sure, a 10.8 per cent return on sales is a decent ratio for a company that supplies low-growth customers, such as supermarkets and pubs operators. But that just makes Barr's returns all the better. Similarly, Barr claims a return on capital of approaching 23 per cent for 2011-12. There is no telling what the figure would be for Britvic since the book value of its equity has been made meaningless by past restatements, but it would not come close to Barr's. The stock market tells us this by its respective rating of the two companies. In the past five years Barr's shares have traded on an average earnings multiple of 17.2 times, whereas Britvic's have managed 12.3 times.

For Barr's shareholders, therein lies the rub. If and when Barr is merged with Britvic, its former shareholders will no longer see their pro-rata earnings capitalised at a stellar rating, but at the more mundane weighted average of the two companies - about 14 times. True, that will be - or should be - compensated by the extra earnings that Barr shareholders will 'capture' through the final use of their highly rated shares. But, after that, they have a future to look forward to where earnings grow slower than in the past and, consequently, are capitalised at a higher discount rate (ie, a lower earnings multiple).

Unless, that is, there really will be worthwhile synergies on offer. It does not look like it; at least, investors seem utterly underwhelmed. Compare the stock market value of the two companies just before merger talks were announced (£1.28bn) with the figure now and just £90m has been added. In other words, in their collective wisdom, investors reckon the two businesses would be worth just 7 per cent more together than they are apart. That's another way of saying that the synergies would be worth about an extra £7m a year in net profits.

It seems hardly worth the effort. Although that's often how it is in mergers. Yet, given how much they stand to lose, Barr's bigger shareholders are being surprisingly quiescent. They can no longer say they have no excuse.