Making money from corporate ‘divorces’
Demergers have been a source of solid long-term returns, on average.
If a corporate merger is like a marriage, a demerger is the divorce. Companies, like lovers, come together in optimism, with thoughts of future health and prosperity. Then, as the years pass the goodwill and optimism sometimes gives way to disengagement and acrimony.
Pessimism maybe, but the facts don’t lie. One in three marriages end in divorce, with the numbers for mergers and acquisitions far worse. In March 2011, the Harvard Business Review claimed their failure rate was more than 70 per cent and as high as 90 per cent.
Here the analogy breaks down. Divorce is an expensive business. Demergers, on the other hand, can be laden with opportunity. Fairfax Media reports that of the 22 key ASX demergers since 2000, the annualised median three-year return was 19 per cent, compared to the ASX 200 return of 5 per cent.
South32 is an interesting example. Almost two years ago, BHP Billiton, which has previously spun-off its steel division, BlueScope, and Arrium, its rod and tube steel business, undertook one of the largest demergers in Australian corporate history. South32 debuted on ASX at $2.13 a share but within a year had fallen below a dollar. It now trades closer to $3 than $2.
Eventually, the market gets its head around a new business, which can lead to significant price appreciation. But before explaining how investors should approach the opportunities in corporate demergers and spin-offs, let’s define our terms.
The difference between a demerger, a spin-off and an IPO
As the name suggests, a demerger is essentially the opposite of a merger, with one company splitting from another by allocating its equity in the subsidiary to shareholders.
Usually it is the smaller company that gets separated from a larger one, which is why you will sometimes hear a demerger called a spin-off. Aside from BHP and South32, recent examples include National Australia Bank and CYBG, its UK-based bank; and Brambles and Recall.
A demerger or spin-off is distinct from an initial public offer (IPO) because, unless a capital raising is part of the demerger process, no money is raised. Usually, shareholders simply end up with stock in two separate companies rather than one. An IPO involves selling a business to new shareholders through a public listing.
Why companies demerge
There are three main reasons. First, different businesses have different needs. Having two or more companies under the one roof usually means one misses out.
Few companies get diversification right, with Wesfarmers the exception that proves the rule. The now delisted Foster’s Group spent a decade buying various wine businesses to complement its beer division only to realise wine had as much in common with its beer business as fish fingers have with door knobs.
That led to a demerger and the creation of Treasury Wine Estates in 2011. The result was the elimination of negative synergies that were initially thought to be positive, which prompted the merger in the first place. For shareholders in the new entity, it has been a big winner.
Second, even if two businesses have some overlap, the largest tends to get more attention. By demerging, the smaller business has its own focused management team that can take advantage of the opportunities before it. To push the metaphor, in a demerger the mistress gets as much attention as the wife.
The third reason is access to capital. Before its demerger from Brambles, Recall had to compete with the pallet-pooling operation for capital. As an independent business, it was freed from these shackles, allowing it to expand where management felt appropriate, with its own line of credit.
Finally, demergers offer valuation transparency. The market often values two separately listed companies at a higher total value than when combined, for all the reasons listed above.
It is obvious when you think about it. The financials of South32 were buried within its parent’s accounts. That made it hard for investors to fully appreciate its true value. After listing, we had far more detail about the company’s business drivers, profit and cash flow.
It took time for the market to understand, but once the negative synergies were eliminated by a focused management team and detailed accounts were made public, the share price rose (yes, the recovery in resources helped).
Are demergers good investments?
You are more likely to find a cheap stock in a demerger than an IPO but that doesn’t make them all good investments. Although theory suggests that the benefits of a demerger should be reflected in the price on listing, they often aren’t.
Selling shareholders might depress the price while existing shareholders wait on the first set of financial results. It also takes time for management to communicate its strategy to the market and for evidence of success to emerge. Despite the increased possibility of a takeover down the track, which can add to returns, each demerger should be assessed on its own merits.
Nevertheless, academic research suggests that on average, demergers outperform. Of 24 selected studies covering spin-offs and demergers between 1962 and 2007, average cumulative abnormal returns (those above the benchmark market) ranged from 1.7 per cent a year to 5.6 per cent.
What are the risks?
Interestingly, the major risk is the same as with IPOs. Economists call it information asymmetry, where one party in a transaction knows more than the other. In an IPO, the sellers typically knows more than the retail investors participating in the float. In a demerger, it is the parent company with the inside knowledge.
The major risk therefore is that investors are being sold a pup and that the value a demerger is supposed to unlock doesn’t materialise. Demergers can be a way for a parent company to sell mutton dressed as lamb.
One way of guarding against this is to look at senior management shareholdings in the newly created entity, and their share purchases subsequent to listing. Yet more academic research indicates a strong positive correlation between insider share purchases in a demerger and future share price appreciation.
Finally, remember that the last peak in global demergers was just before the financial crisis, when parent companies used demergers as a way to offload over-valued businesses they didn’t want and reduce their debt load. When anything investing-related becomes popular it is usually a warning sign.
Are there any opportunities now?
There is talk of Fairfax demerging with its Domain business and Origin Energy spinning off its oil and gas projects. But Crown’s proposal to demerge its international hotels and operations has been ditched
One stock to keep an eye on, though, is Reckon. It is offloading its documents management business, combined with a capital raising around the same time. Reckon has been on our buy list since last August and the demerger of its fastest-growing business on London’s AIM will be one to watch. More information is due to be released over the coming months.
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