Blades , Batteries and a Fifth of Gillette
By Roger Lowenstein

09/19/1996 The Wall Street Journal Page C1

Back in 1988, when Kraft Inc. decided to unload its battery subsidiary, Gillette Co. was tempted. But the bidding went up and up and out of Gillette's reach. Kohlberg, Kravis, Roberts & Co. eventually bought the battery maker -- it was Duracell, of course -- for a seemingly extravagant $1.8 billion.

After eight years of due diligence, Gillette has finally agreed to fork over stock valued at more than $7 billion for the very same Duracell International Inc. Just as KKR now looks shrewd, rear-view analysts may snicker at Gillette for buying dear what it could have had then for, let us assume, only $2 billion in stock.

In fact, Gillette shareholders should thank their lucky stars the earlier deal didn't happen. In share-for-share acquisitions, what you are getting is only half the picture; what you are giving up is just as important. The standard analysis values such deals according to the dollar value of the target, but that approach is flawed. The key question isn't whether Duracell is worth $7 billion, because Gillette isn't giving up $7 billion. It is giving up a part -- in this case 20% -- of itself.

Schematically, Gillette is trading razor blades for batteries (not bucks for batteries), and the results can be very different. Since 1988, for instance, the blade business, at least under Gillette's management, has performed much better than batteries. While Duracell's stock has quadrupled, Gillette's has multiplied eight times. Thus if Gillette had in fact made that "cheap" $2 billion acquisition, it would have acquired a jackrabbit but given up a prize thoroughbred. The passed-over purchase back then would have cost Gillette more than one-third of its stock; today, it is buying the same business for only a fifth of its stock.

Clearly, taking a pass was the right move. Duracell was cheap in 1988, but Gillette was cheaper. And shopping with inexpensive currency, meaning issuing undervalued stock, amounts to selling the company (or a piece of it) on the cheap.

Going forward, the same analysis holds. The imputed dollar value of the deal will forever drift with Gillette's share price; the one constant is that each shareholder is trading away one-fifth of his interest in the old Gillette. Whether Duracell will be worth it, a subject no analyst has addressed, is what matters.

Such deals are manna for investment bankers (and bound to wind up in B-school texts) because you need to size up two businesses instead of one. Within the same industry, this can be straightforward. NationsBank's merger with Boatmen's Bancshares (60% to be paid in stock) got a deserved Bronx cheer. Why? By swapping two-thirds of a share of NationsBank for a share of Boatmen's, the eager suitor is giving up $30.13 in book value and getting $22.26 in return. "I'd rather wake up in the morning explaining the high price than wake up explaining why we didn't do this deal," Kenneth D. Lewis, president of NationsBank, noted when the deal was hatched. And wake up explaining he did. This week, Mr. Lewis wasn't talking.

Blades or batteries is a closer call. The blade market is as universal as the whisker, and Gillette's lead in it is seemingly insurmountable. Also, because a customer gets pretty close to his blade, and because even a good blade is relatively inexpensive, Gillette has had great flexibility to raise its prices. Most people don't choose to economize by dragging a rusty saw across their cheek.

The same can't be said for Duracell. Folks generally don't feel sentimental about their brand of battery, assuming they even know it. Price matters.

On the other hand, the battery market is growing more quickly. Men shave their faces every day, but that is all they shave. Demand for batteries is rising as society becomes more portable, both here and overseas.

In fact, Gillette's sales have been growing at only 9% a year; only by improving profit margins has its net income grown at twice that rate. Duracell, on the other hand, is banking on revenue growth. Its profit hasn't grown as quickly as Gillette's, but the notion that Gillette, with its huge distribution network, will energize Duracell's presence in far-flung regions of the globe is more than pie-in-the-sky.

On balance, the blade business is more distinct, and better, than batteries. But how much better? Duracell for one- fifth Gillette works out to this: For each dollar of Gillette earnings that shareholders are giving up, they are getting roughly $1.30 in cash earnings from batteries.

Blades should trade at a premium, but this one is steep. That premium, of course, reflects the current very high price of Gillette's stock, which in turn reflects a view that Gillette will forever keep profit growing twice as fast as its sales. Gillette's managers wouldn't come out and say that 34 times earnings reflects unwarranted optimism, or even a bull-market joie de vivre, but if that is what they thought, trading part of their company at that price for a cheaper one would be a smart move. And that is what they are doing.