Investors often clamour for stock in Initial Public Offerings (IPO), believing the vendor has slightly underpriced the asset to attract buyers. Less considered are demergers where corporates jettison assets into a standalone listed company.
IPOs by their nature are more exciting. They typically involve a company raising capital and listing on ASX for the first time. Some IPOs deliver stellar returns. Many more disappoint investors and vendors these days seem less willing to sell at a discount.
In contrast, demergers usually involve a large company spinning off non-core assets into a new company, listing it on ASX and sometimes raising capital. Critics argue the “parent” company is dumping its low-growth or garbage assets into a new company.
Many of our largest companies have had demergers. Think BHP Billiton with South32, National Australia with CYBG bank in the UK, Foster’s Group and Treasury Wine Estates, Macquarie Group and Sydney Airport and, more recently, Wesfarmers and Coles.
Other spin-offs include Dulux Group, The Star Entertainment Group, Orora, Recall Group, the dual-listed New Zealand telco Chorus and Mayne Pharma Group.
I follow demergers closely and believe they are, on average, better investments than IPOs, although there are always exceptions. Demergers have collectively delivered solid returns and some, such as Treasury Wine Estates, Sydney Airport and South32 have starred.
Supermarket chain Coles Group, the market’s latest spin-off, could join them.
Demergers have some important differences from IPOs. The biggest is that the assets forming the basis of a new company are well known to the market. Investors in Treasury Wine Estates, for example, understood the wine assets because Foster’s disclosed information on them.
Compare that to an IPO where often the only information to go on is in the company prospectus. The IPO’s accounts have not been subjected to years of market scrutiny, continuous disclosure requirements and analysts and fund managers assessing the business.
Vendor motivation is another key difference between demergers and IPOs. The seller of the demerged assets often has a vested interest in the spin-off doing well. BHP brought South32 to market in excellent shape because BHP shareholders received shares in the new company.
In contrast, IPO vendors, especially private equity, want to maximise the sale price. Often, they sell all or most of their shares to new investors through the IPO as an exit strategy. Worse, the vendor might inflate profits by underinvesting in the business, to lift the sale price.
Like IPOs, demergers can be boosted with an ASX listing. The spun-off assets had struggled to compete for capital within the parent company, had a low market profile or were undervalued. Think Domain Holdings Australia when Fairfax Media fully owned it.
Free from the parent, the demerged company can raise capital, grow and communicate to investors. Management of the spin-off has more incentive to build the business; the CEO now runs an ASX-listed company, not an underperforming division of a larger business.
A 2015 Macquarie Group study of Australian demergers over 20 years found the spin-off tended to underperform the market for the first six months, before delivering stronger outperformance from about 12 months after the split.
Intuitively, that makes sense. The spin-off often needs a capital injection once free of the parent to fix things neglected under previous ownership. The parent may have underinvested in the spin-off because its assets struggled to compete internally for capital.
Once capital is secured and investment is underway, the spin-off gets new momentum. Not all demergers go this way, but there is a pattern of spin-offs struggling at the start before hitting their straps. The same is true of US spin-offs, shows McKinsey and Co research.
Coles has solid prospects
Which brings me to Coles Group. I was not convinced by Wesfarmers’ logic to demerge the asset. Wesfarmers wanted to separate Coles, a lower-growth asset, from its faster-growing assets such as Bunnings and K-Mart. Wesfarmers for capital growth; Coles for income.
I thought there was a clear strategic rationale for retaining Coles. Its connections with millions of Australian shoppers each week provide a treasure-trove of data that Wesfarmers’ other retail business could exploit. If data is the new boom asset, Coles is superbly positioned.
Wesfarmers saw it differently and the market accepted the Coles demerger, which listed on ASX late last year. Coles has fallen from a $12.49 listing price to $11.71 in a weak sharemarket. Most of the share-price decline occurred during the heavy market sell-off in October.
Coles has extra appeal in a shaky market. The company’s consumer-staples offering has defensive qualities in a slowing Australian economy. Households might cut back on discretionary items but they still need to eat. Also, big supermarkets are less affected by online competition compared to discretionary retailers.
Although competition from Woolworths and, increasingly, Aldi is growing, Coles’ sheer scale should underpin moderate earnings and dividend growth. The well-run supermarket has shown it can innovate through clever pricing and promotions and should be invigorated as a standalone business that is not competing for capital within Wesfarmers.
Coles won’t star, but an expected 6% yield, fully franked in FY20 (on Morningstar numbers), should take the total return to low double-digits; an attractive outcome given its defensive qualities and evaluated market risks.
Coles listed on ASX at a valuation discount to Woolworths – about 4 Price Earnings (PE) points on some broker numbers. Woolworths deserves to trade at a premium to Coles, but not by that much, creating scope for a steady re-rating of the latter that will take a few years to play out.
Chart 1: Coles GroupSource: The Bull
• Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at January 9, 2019.