Demerging to build value?

Demerging to build value?

Brambles, the world’s largest pallet provider, has proposed to demerge its Recall business, which specialises in document management. The company has recently held its Annual General Meeting (AGM), and the board had much to say about the value that would be created for shareholders from the transaction.

Question: is this concept of value creation different to how we consider it at Montgomery Investment Management?

Below is an excerpt from the AGM speech made by the Chairman of Brambles, Graham Kraehe, in which he discusses the proposed merger:

“It is the Board’s strong view that the demerger will deliver sustainable value creation opportunities for shareholders while offering the greatest certainty of execution compared with other separation alternatives. The demerger will enable Brambles to focus on the ongoing opportunities in the Pooling Solutions businesses under the CHEP and IFCO brands. The newly-independent Recall Holdings will offer investors exposure to a global, industry-leading information management business with stable revenues and strong cash flow from which to fund dividends and investments in growth.”

As value investors, we are keen students of anything that has the potential to create value. But when we study the rationale for the transaction, we can’t help feeling that when others talk about value, they are talking about a concept that is rather different to our own.

The Chairman’s speech continues:

“Demergers have a track record of creating value for shareholders of ASX-listed companies. For example, of 20 demergers where the demerged entity had a market capitalisation of more than 100 million Australian dollars since 2000, the average share-price performance in the first year of the demerged entity has been 17 per cent and of the parent entity has been 5 per cent. That compared with an average performance on the ASX200 of less than 1 per cent in the same period”.

At Montgomery, when we talk about building value, we are referring to changes that lead to incremental earnings, profitability and cashflows – those things that add to intrinsic value – rather than something that may lead to the same earnings attracting a higher multiple by some unseen market force. Value creation as we see it can take many forms, including minimizing costs, having an effective corporate strategy, and making the right capital allocation decisions.

At its heart, Recall and the Brambles Pooling Solutions are two fundamentally different businesses; the paper management industry is in decline, while Pooling Solutions is growing strongly. A demerger will create two separate share prices for the high and low growth divisions, and these share prices will move in accordance with their individual long term prospects and profitability. In this sense, the Chairman’s reference to ‘value creation’ has more to do with the post-merger movements of the share prices than the fundamentals of the businesses.

Management has reasoned that the demerger will “enable Brambles to focus on the ongoing opportunities in the Pooling Solutions businesses”, while the newly independent Recall Holdings will provide investors with stable revenues and strong cash flows. Yet under the same parent company, the Pooling Solutions division has become a world leader, and by management’s admission the Recall business has a strong financial profile that has consistently created value for Brambles shareholders. We thus find it difficult to reconcile the words with the actions. Why spin a business off, if it has a strong financial profile that has consistently created value for shareholders. We further find it difficult to accept that the relative earnings profiles of the two divisions will change materially after a demerger.

Rising share prices are frequently cited as the measure of success for a business, even when the underlying fundamentals remain largely unchanged. On the surface, a demerger often demonstrates little more than great penmanship. Shareholders of the combined company will receive a proportionate amount of shares in each of the separated divisions, but in aggregate there will still be the same amount of debt, the same amount of equity, and each business will still have the same fundamentals. For a clue to where the real value lies, it’s often worth waiting to see where the debt finds a home.

In looking at value, there’s a great deal to consider but staring at share prices movements won’t reveal much at all.