Are demergers a value opportunity for shareholders?
De-merging single or multiple operating business units into a separate entity is also known as a “spinoff”. The result: incumbent investors are frequently faced with the consequences of a company in which they own shares, rolling out one of its businesses to create a separately listed company.
Typically, in demergers, and as part of the consequent restructure, the parent company will transfer a related number of shares in the spinoff to its incumbent shareholders. Frequently, but not always, the parent company will also maintain an equity interest in the demerged entity.
Incumbent shareholders must assess the prospects and value of the new entity to decide whether to hold or sell their allocated shares or add to them.
Similarly, new investors are faced with the task of assessing whether investment merit inheres in the demerged company, or in the newly slimmed-down parent.
Often undertaken to simplify the parent business, some investors regard spinoffs as the poorer second cousin, burdened with all the group’s debt and saddled with inferior management.
Others, however, contend that demerged companies are inevitably in a superior position to focus on their individual underlying competencies.
Which is correct? Are conventional assumptions accurate? Do demergers create value? Let’s find out.
Why demergers happen
I think of business cycles like the playing of a piano accordion; the expanding bellows of industry fragmentation are always followed by the compressing bellows of industry consolidation. Fragmentation. Consolidation. Fragmentation, and so on.
If management teams, economic conditions, industry leadership, or technology change, and they always do, there will be consolidation and fragmentations rendering spinoffs an inevitable part of the business and investing landscape.
As demergers have been occurring for a long time, there is a veritable mountain of research analysing equity performance post the demerger announcement.
It is, for example, broadly accepted that the way to trade demergers is to buy the parent company ahead of the split to capture the value created by the demerger. This makes sense if there are assets “hidden” from analysts in the parent and therefore not properly valued by the market.
And while some research shows demerged companies outperform, all research is a function of the time it was undertaken and the experience before it. As they say, past experience is no guarantee of future performance!
Superior returns require a fundamental basis for them to be sustained. One possible source of outperformance of some demergers is the removal of cost sharing and corporate overhead allocation.
In addition to a renewed focus on the core competencies of the respective businesses, each management team is required to establish a reputation for profitability without the skirt of the parent or subsidiary to hide behind. Management accountability and financial transparency are unforgiving task masters, refining the team of both the parent and the spinoff.
But there are no free lunches with demergers. Significant risks include the claims noted earlier that a spinoff is an opportunity for management to reduce debt by burdening the demerged entity with all of the group’s unwanted interest-bearing obligations.
There is also the opportunity for the parent to demerge unwanted and underperforming assets. We tend to be suspicious about demergers for this reason, and the possibility the parent couldn’t find a buyer and so is handing the unit over to shareholders to be done with it.
And of course, so much is made of the synergies that accrue when companies merge, that it is vital for the investor to assess whether the reverse occurs following a demerger.
There has been no shortage of recent demerger examples to analyse in Australia:
- Tabcorp Holdings Ltd (ASX: TAH), this year spun off The Lottery Corporation (ASX: TLC).
- Woolworths Group (ASX: WOW) spun off Endeavour Group Ltd (ASX: EDV) last year.
- In late 2018, Coles Group (ASX: COL) was spun out from Wesfarmers (ASX: WES).
Although several demergers have delivered solid share-price gains for investors, other demergers have destroyed wealth for shareholders over the years.
The quantitative analysts at Macquarie Bank analysed 44 demergers since 1995. Looking at the averages, Macquarie concluded that demerged businesses usually underperform in the first six months and that in the last five years the underperformance has lasted 12 months.
And for investors in the parent company, outperformance takes even longer to commence, with 18 months passing after the demerger before outperformance is registered. Remember, this is based on averages. If I put my head in an oven and my feet in a freezer, my “average” temperature will be fine, but I will be dead.
It would be nice to find a theme across which you could happily and even nonchalantly invest. Demergers, however, are not such a theme. And so it seems the rules of investing more generally, also apply to demergers.
According to our work above, to assess the potential for really great returns from demergers, you’ll need to do the same work on assessing quality, value, catalysts, and management as you would with any investment.