Better apart: Why company break-ups can release hidden value and benefit shareholders
Demergers are back in fashion with five companies in the FTSE 350 index each preparing to split into two separately-listed entities. Another one has just completed its split and there are rumours that a further FTSE 350 stock could spin off one of its businesses.
Unbundled companies often flourish because they have the freedom to be more entrepreneurial and not be part of a larger company where management may be more interested in other parts of the business or cannot make decisions quickly.
You also must consider the true value of a business may not have been recognised by the market when part of a larger entity. Companies often trade at a discount to the sum of their individual parts and breaking them up via demergers can unlock this value.
Investors should take note of these events as history suggests they may be good times to invest, particularly in the company being spun out of the parent business.
WHICH COMPANIES ARE BREAKING UP?
Old Mutual (OML) will be the next UK-listed business to undergo this process, spinning off its UK wealth management subsidiary Quilter on 25 June. And analysts have suggested Playtech (PTEC), another FTSE 350 stock, could separate its Tradetech financial division.
HOW MUCH MONEY CAN YOU MAKE?
Various bits of research demonstrate that spun-off companies tend to outperform their former owner, at least in the early days of being a standalone business.
For example, investment bank Berenberg analysed circa 1,000 European stocks that were spun-off in the past 10 years and found that they tend to outperform the market by 11% within their first year of trading.
A study in 2003 by the Krannert School of Management found that subsidiaries spun out of companies outperformed their former parent by more than 20% over the first three years following the demerger; with most of the excess returns within the first 12 months of trading.
As a case in point, coal miner South32 (S32) was spun out of BHP Billiton in May 2015 and outperformed the latter by 6% in the first year and by four-fold over three years.
There are various exchange-traded funds which track indices of companies that have been spun out such as New York-listed VanEck Vectors Spin-Off ETF which launched three years ago. In 2016 it was up 44.7%, outperforming the S&P 500 total return index by 11.2%. So far in 2018 the ETF is up 5.6%, representing a 1.8% outperformance versus the benchmark.
GoCompare (GOCO) was demerged from insurer Esure (ESUR) in November 2016 and subsequently rose in price by 26% over the following 12 months. While impressive, it wasn’t as good as Esure’s 38% gain over the same period.
However, the more interesting movement has happened since its first year on the stock market. GoCompare is now up by nearly 67% since splitting from Esure versus a 13% gain from the latter.
That’s mainly down to Zoopla’s parent company ZPG (ZPG) making a takeover offer for GoCompare in November 2017.
Demerged companies can often be takeover targets. Predators find it easier to pounce on a business when it has been separated from a bigger entity rather than try and buy a company which has parts that are of no interest.
There are plenty of examples of demerged companies getting snapped up. Alent was spun out of industrials group Cookson in 2012 and bought three years later by private equity. Greene King (GNK) bought Spirit Pub Company in 2015, four years after it was spun out of Punch Taverns.
Both the demerged part of Cable & Wireless and its former parent company have been taken over since the telecoms group was broken up in 2010.
ARM, O2 (when known as Cellnet) and Foreign & Colonial were demerged from larger companies and subsequently acquired.
The trend stretches to other parts of the world such as in the US where Dr Pepper Snapple was spun out of Cadbury Schweppes in 2008 and a decade later received an $18.7bn takeover offer from consumer group JAB.
BENEFITS OF INVESTING IN SPIN-OFFS
Investors are increasingly asking for companies to focus on what they do best and not take a conglomerate approach with fingers in lots of pies.
It can be very hard to manage multiple businesses operating in a range of industries, hence why many companies are going down the demerger route to tighten their focus.
A demerged business can allow management to take control of their destiny and make the decisions that best serve their needs rather than a larger plc conglomerate.
They can be more entrepreneurial when they work as part of an independent company and compensation for key personnel can be more closely aligned with business objectives and performance.
There is an argument to suggest that demerged businesses tend to be better managed as the directors are responsible for their own profit and loss account, rather than working on initiatives across a wider group.
WHEN TO BUY FOLLOWING A DEMERGER
There are different strategies to play the demerger theme. The first involves the purchase of the demerged company when it starts trading on the stock market. Often the share price takes some time to get going as there will inevitably be a chunk of investors eager to sell their ‘free’ shares in the demerged business.
Let’s create a hypothetical situation where Company X spins-off a business called Subsidiary Y. Shareholders in Company X will suddenly see they have an additional holding in their portfolio. They may see it is worth £500, for example, and think selling would effectively net them free money worth £500.
In reality the value of Company X would have fallen by £500, or thereabouts, to reflect the removal of Subsidiary Y from its interests. So, the total value of a shareholder’s position in Company X and Subsidiary Y may not have changed on day one of the split.
Yet that won’t be immediately apparent to everyone. You also have to consider that some investors may not want to hold the demerged business, instead preferring to keep the parent company and so they sell shares in the spun-off firm.
These decisions naturally take some time to play out, hence giving prospective investors a chance to take a position without having to worry about missing out on first-day gains that often accompany traditional stock market floats.
While there are studies which suggest decent gains can be made from buying demerged businesses, you must consider that past performance is not always an indicator of future returns.
SOMETIMES THE PARENT COMPANY IS THE BETTER BET
A different strategy is to buy the parent company as soon as the spin-off is declared likely or confirmed. Markets like to price in events before they happen, so you could see the value of the combined entity rise before the separation as the spin-off subsidiary is deemed to be worth more.
Investors can then decide whether they want to keep both stocks in their portfolio or just one of them.
There could be good reason for the corporate separation such as using a demerger as a way of getting rid of non-core interests or a business that doesn’t have a healthy future. The slimmed down parent business could ultimately be the more attractive option for investors in this situation.
Just look at the different fortunes of WH Smith (SMWH) and Connect (CNCT) which was spun out of the former in 2006 when it was called Smiths News. At the time WH Smith said the split would let both companies benefit from increased focus on their respective strategies.
It said there were limited operational synergies and no strategic logic for keeping them together as a single business.
Fast forward 12 years and the shareholder rewards are vastly different. WH Smith has achieved a 481% share price gain since the split and Connect is down by 78% (although shareholders would have benefited from steady dividends to cushion this blow).
Connect has suffered from a core business in steady decline (newspaper and magazine distribution) and efforts to make a name for itself in the parcels delivery world haven’t yielded great results, as evidenced by a horrific profit warning on 13 June this year.
DEMERGERS NOT ALWAYS RECEIVED WELL
Occasionally the market doesn’t react to demerger news in the way you might expect. Shares in Puma were down by 15% at one stage upon news in January that French parent Kering would give 70% of the German sportswear group to its shareholders and focus solely on its luxury fashion and jewellery labels. Investors were disappointed that the business wouldn’t be sold at a premium.
At the time of the split from Kering in May analysts at Berenberg said the demerger made Puma investable for the first time in more than a decade. They said increasing appetite by sports footwear collectors for Puma showed brand health.
They added that Puma matched the characteristics of most spin-off stocks, having been ignored by the market for years due to the relatively low amount of its shares available for public trading. It was clearly a good call as the share price has since risen by 17% in value.
HOW DO DEMERGERS WORK?
It’s a fairly simple process. Typically, a company would issue a prospectus detailing the reasons behind the proposed demerger and provide in-depth information on the business.
Shareholders are then asked to vote on the demerger and, if approved, shares in the demerged entity are distributed to shareholders shortly afterwards.
Esure took less than a month from issuing a prospectus to seeing GoCompare listed on the London Stock Exchange. In comparison, Prudential’s proposed break-up may take nearly two years to complete because of complicated legal and regulatory issues.
A CLOSER LOOK AT FOUR DEMERGER SITUATIONS
OLD MUTUAL / QUILTER
Old Mutual is to unbundle its UK wealth management business Quilter and list it on the London and Johannesburg stock exchanges on 25 June.
Companies normally distribute shares in the spin-off business to their shareholders like they would with cash dividend payments, but Old Mutual is going down a slightly different route. It is selling 9.5% of the business to institutional investors and distributing the rest to Old Mutual shareholders.
The distribution is structured as one Quilter share for every three shares someone holds in Old Mutual.
The demerger price is effectively being dictated by the level at which the institutions are prepared to pay for a slice of the 9.5% stake. Old Mutual has already said that the price range is between 125p and 155p each; at the midpoint Quilter would be worth £2.66bn. The final price should be confirmed on the listing day.
Old Mutual’s South African shareholders account for circa 55% of the business. ‘Does a South African really want to hold a UK mid cap wealth manager? Probably not in the long term,’ says Oliver Brown, fund manager at MFM UK Primary Opportunities Fund (GB00B8HGN522). ‘They aren’t natural owners for a business like this, so you could see a slow but steady drip of selling.’
Brown says there are pros and cons to the Quilter story from an investment perspective. He views wealth management as a ‘broadly attractive’ industry with strong markets and increasing emphasis on individuals to save more for retirement.
However, he views it as a ‘mishmash business’ going through a risky IT system upgrade and a clear share overhang from the South African side of the shareholder register, and so he believes it must trade on a discount to its UK quoted peers in order to be worth an investment.
‘My feeling is that Quilter should trade on 13 to 14 times forward earnings with a 3% to 3.5% yield. That would be a 25% discount to Brewin Dolphin (BRW), which is the most similar company in the quoted space.
‘The IT upgrade is a big issue. It has already written off a lot of money on IT work and is now getting FNZ to install a new system which is supposedly ready by the end of the year. Note that Aviva (AV.) and Barclays (BARC) both use FNZ and both encountered problems with the system when it launched.’
The bottom end of the 125p to 155p pricing range equates to a 2019 price-to-earnings ratio of 11.3-times, he adds.
Stockbroker Numis calls Quilter a ‘Jack of all trades, master of none’, referring to its broad range of services. ‘In trying to be all things to all people in the wealth management industry, Quilter lacks focus. As a result, we think that it will struggle to become a market-leading vertically integrated player. This does not necessarily make Quilter a bad business, just a less valuable one compared to some in our opinion.’
Numis is concerned that Quilter will miss its 30% operating margin target set for 2020. It also flags that it and five other life assurance peers are being investigated by the Financial Conduct Authority, a regulator, principally around the appropriateness of certain charges levied on long-standing customer products.
Despite these issues, Numis says wealth management is an attractive industry with long-term structural growth of 10% to 12% per year, adding: ‘A rising tide lifts all ships’.
Its sum-of-the-parts valuation is 143p per share.
BGEO: BANK OF GEORGIA / GEORGIA CAPITAL
FTSE 250 financial services group BGEO last month split into two companies, Bank of Georgia and Georgia Capital. The former is expected to stay in the FTSE 250 and the latter will go in the FTSE Small Cap index.
While both companies are linked to economic activities in Georgia, there are very sensible reasons to separate the businesses and have them operate and be listed as standalone entities.
Bank of Georgia is now a pure play banking story offering exposure to a country with superior GDP growth. As a separate business it will have a more efficient capital structure and balance sheet, focusing on retail banking, wealth management, plus corporate and investment banking.
Georgia Capital is an investment business with interests in healthcare, real estate, utilities/energy, beverages, banking and insurance. ‘As a separate entity, Georgia Capital would not be subject to the banking regulatory regime thereby improving its ability and flexibility to allocate capital, take advantage of various investment opportunities and better execute its growth strategy,’ said BGEO ahead of the demerger.
‘Georgia is a relatively small country (3.7m population) and lacks commodity wealth. However, its geographical position gives it an important strategic position, with the ability to act as a regional trading hub between Europe, Asia and the Middle East, supported by political stability and a business-friendly regime,’ say the investment trust team at stockbroker Numis.
‘Georgia Capital targets a minimum IRR of 25% on its investments through a focus on sectors that are expected to benefit from the continued growth and further diversification of the Georgian economy.’
Numis reckons many investors will have bought into BGEO for the banking exposure and so it wouldn’t be surprised if some sold their inherited stake in Georgia Capital. However, it suggests there is potential for new investors to mop up these shares if they are interested in emerging markets and investment companies.
WHITBREAD / COSTA
Whitbread plans to demerge its Costa coffee chain by mid-2020 at the latest; most analysts expect it to happen in 2019. For the time being it will continue to invest across the group.
It recently came under pressure from activist investors which prompted the demerger news. It is unusual for a business to say it will split and give a two-year timeframe, which suggests that Whitbread was caught off guard by the presence of activists and intense speculation regarding the future of Costa.
Once Costa is listed separately, Whitbread will be left with its Premier Inn hotel assets and some restaurants. The one issue to consider is whether Whitbread gets a takeover bid for Costa – or even Premier Inn – before the demerger.
PRUDENTIAL / M&G PRUDENTIAL
Shareholders in savings and protection group Prudential will have their holding split into two separately-listed companies, both potentially qualifying for the FTSE 100 index.
Prudential is to demerge its UK operations and list them as M&G Prudential. Its remaining business will contain its faster growth US and Asian operations.
The demerger may not happen until late 2019 or early 2020 as Prudential first needs to undertake some legal paperwork.
M&G will focus on savings and retirement needs for people in the UK and Europe. It has more than 7m customers and £351bn of assets under management across 18 European markets.
The remaining business will keep the Prudential name. It has nearly 20m customers across Asia and the US. It says the working age population in Asia is growing by 1m people every month and they are under-protected, creating a huge opportunity for the business.
In the US, it believes 10,000 people will be retiring every day over the next 20 years – ‘This is the wealthiest generation that has ever lived and they have a growing need for the protection products we provide,’ it says.