As an active value manager, we like investing in companies where we believe there are hidden assets not being properly valued by the market. And sometimes it takes a demerger for parts of a business to really show their worth. Portfolio manager Anthony Aboud and Deputy Portfolio Manager Sean Roger look at some recent demergers, analyse why they have succeeded or failed and offer insight into what makes for a good demerger candidate.
We have looked at all the significant Australian corporate demergers over the last 20 years to determine whether they added value and if we could glean any insights from the trends this analysis revealed. Intuitively, splitting a company in two shouldn’t create any additional value given the cost of transaction and the ongoing costs associated with duplication of overheads. However, our research has indicated that, for a variety of reasons, demergers can create value. Broadly, we found that the continuing entity – the larger portion of the split up that often retains the CEO and Board of the previous company − narrowly outperformed the S&P/ASX 200 in the following couple of years. However, the demerged entity outperformed this market significantly in the following two years. On our estimates the median outperformance is around 35% over two years, although there is a massive range in outcomes.
Some examples of demerged entities which have performed very well over a longer period were Dulux (spun out of Orica in 2010), Treasury Wine (spun out of Foster’s in 2011), Henderson (spun out of AMP in 2003) and Orora (spun out of Amcor in 2014).
However, it is important to note that demergers don’t always go well. Paperlinx (spun out of Amcor in 2000) and Onesteel (spun out of BHP in 2000) did not end well for shareholders. The range of outcomes is also significant with Asciano (spun off from Toll in 2007) underperforming by 49% in the following two years while Australian Wealth Management (spun off from Tower in 2005) outperformed the market by almost 200%.
When are demergers successful?
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Our analysis of demergers concluded that there are two fundamental reasons behind their success.
Splitting the company into two bite-sized pieces increases the chances that one of the two companies will get acquired. Of the 28 demergers we analysed, 18 saw at least one of the two parts taken over, generally within a couple of years.
The demerged entity received more attention once it had been demerged. Commenting on Orica’s successful demerger from Dulux we noted (Perpetual SHARE-PLUS Long-Short fund update, January 2020):
“Capital allocation, human resources, marketing etc. would be completely different between these two businesses (paint and explosives). Once demerged, attracting and retaining top quality management is made easier as employees of the demerged entity can be incentivised with equity in an entity in which you can make a difference rather than being part of a larger conglomerate.”
Our view is that while CEOs or chairpersons usually won’t reveal which division of the company they are most excited about, they all have their favourites. Capital is a scarce asset and, when push comes to shove, that capital will tend to gravitate to the ‘favourite child’. Conversely, when there are extra corporate costs, they will tend to be shoved over to the less favoured division, which has the impact of understating the earnings of this entity. What is interesting in demergers is that the CEO and chairperson are eventually forced to make a choice about which division is their favourite as they must make the decision about where they are going to remain.
In the recent demergers of Woolworths/Endeavour, Graincorp/United Malt and Iluka/Deterra, the CEO and chairperson both decided to go to Woolworths, United Malt and Iluka respectively. What typically then happens is the ‘ugly duckling’ company will get a new CEO, a new board and generally a new culture. Often you get divisional management promoted to the C-suite. There often emerges an almost underdog status within the new company. We think that some of the outperformance that may follow can be explained by this renewed focus a demerged entity gets from its leadership group.
And this runs potentially deeper over time. The new team running the demerged business is unshackled from corporate overheads and other frustrating constraints. This can give way to a new culture which is hungrier, leaner and more agile. The demerged business can make the right investments and seize on market opportunities without having to prepare a pitch book for head office. We have observed from the performance of recent demerged entities like Endeavour, Graincorp and Deterra how a new culture and lease on life can take hold post demerger.
Originally published by Anthony Aboud, Portfolio Manager, Perpetual