Divestments - benefiting from a spin-off
It pays to understand the motives behind a company spinning off assets into a new listed entity.
For simplicity purposes, businesses are often referred to as:
- start-ups - early stage and fast-growing,
- established and cash-generating,
- mature and, finally,
- in decline.
These stages in the business cycle can be very long, or as we are observing in the modern disruptive business world, speed up and compress in time.
Along this continuum, businesses may access early stage capital in the form of private equity or venture capital, list on the stock exchange to access capital to fuel growth, or list once they are mature so that owners can effectively “cash out”.
When we talk about divestments (typically, ASX-listed companies spinning out assets into a separately listed company), each of these scenarios is possible and there is not a one-size-fits-all explanation.
Divestments can be early-stage ventures, fast-growing and requiring cash, mature and cash-generative or in decline. Interestingly, the modern listed corporate entity is often a place you will find businesses all under one roof that are at different stages in the business cycle. These businesses tend to be big, established corporations.
Generally speaking, the sharemarket has great difficulty valuing businesses at different stages in the business cycle all housed under one roof, in the one company. In fact, it can be quite difficult to estimate where a particular industry or stock is positioned in a business cycle even if the corporation is only operating in one business.
Divestments more popular
In a period of low interest rates and lower overall sharemarket returns, we can expect to see more divestments and potentially more merger-and-acquisition activity as a result of divestments, as board and management of listed entities look for ways to improve the overall shareholder return.
Divestments have become a common phenomenon of the current sharemarket. Otherwise called spin-offs, we have seen Orora spin off from Orica, part of Sydney Airports from Macquarie Group, Recall Holdings from Brambles, and South32 from BHP Billiton.
This phenomenon is not restricted to any peculiarity of the Australian sharemarket. There have been many mooted overseas divestment this year, such as the spin-off of assets from Bayer Group in Germany and the spin-off of PayPal from eBay, to name a few.
Spin-offs or divestments generally perform well for the reasons outlined in our August 2014 ASX Investor Update article ‘The Case for Corporate Spin-offs’.
(Editor’s note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to a financial adviser before acting on themes in this article).
Why divestments are attractive
In summary, directors and management are well incentivised and interests are aligned to make spin-offs successful. However, when we start to make general statements, there are always exceptions, and assessing at what stage of the business cycle a particular stock is in can help to assess the company being spun off and the company doing the spinning.
With Recall, it was generally accepted that it was a reasonably high-quality business with good stable cash flows and a stable and mature market position. The real question for Brambles management was: where to from here?
It was generally felt that Recall was not getting the valuation multiple it deserved within the Brambles structure. As soon as it was spun off, its share price started to rise and its earnings multiple increase, reflecting the quality of the business.
No doubt Brambles board and management considered that having Recall separately listed would also allow a potential acquirer to bid for the business and consolidate the industry. This is what has happened and Recall is being bid for by Iron Mountain out of the United States. Apart from Recall trading on higher multiples, spinning off the asset has allowed a pricing mechanism or bidding process to evolve, to maximise the value of its exit. This may not have been possible had Brambles attempted a trade sale of Recall to another company.
Sydney Airports has grown and become a reasonably mature business under Macquarie Group’s stewardship and the share price has more than doubled since Macquarie spun off its remaining shareholding. Again, there has been an earnings multiple re-rating of the stock and there is ongoing debate that Sydney Airports will one day be bid for by a major infrastructure investor.
Meanwhile, Macquarie has taken the proceeds from the sale and invested the funds in businesses at an earlier, more lucrative stage in the business cycle, thus recycling its investment in Sydney Airports.
The South32 spin-off from BHP does not fit easily into the above analysis. In simple terms, a number of smaller resource companies under the South32 banner were divested as they were taking up a disproportionate amount of management time within BHP. The underlying commodities these companies mine are themselves cyclical and it was generally thought in the market that the South32 assets would fare better in a standalone company.
As can be seen from a sample of spin offs above, there is a general rule of thumb that divestments tend to do well in the long run, or at least that the starting point for considering any divestment is that the board and management of a company must believe the divestment will add value, otherwise they would not recommend it.
However, even accepting this general rule, it is important to understand why the divestment is being proposed and at what stage in the business cycle a particular divestment company is in, to determine whether the motives for the move are sound.
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