Breaking up is good for some

Splitsville: Foster’s put its wine business into newly listed Treasury Wine Estates.

A corporate takeover may deliver a windfall to a funds manager invested in the target but it’s also likely to make them wince as they ponder where to place the newly received funds. Finding value stocks with good growth potential is not a simple task following a decade of mergers and acquisitions and a tough economic environment.

But a market cycle largely absent for many years may help address the issue. Spin-offs and demergers are on the rise and if done correctly can release value that may go unnoticed.

Commodity market followers will know Lynas Corp has received significant interest over the past 12 months as its Mt Weld rare earths project in Western Australia moves towards production at a time when rare earths are in hot demand by the technology sector.

Perhaps not as many remember that at the start of the decade Mt Weld was held by Ashton Mining before the diamond producer was sold to Rio Tinto for $600 million. The Mt Weld assets were valued by the market at zero before the takeover and Rio concurred with the assessment – it sold the Mt Weld tenements to Lynas for $12 million but a decade on they are worth more than $3 billion.

UBS chief strategist David Cassidy notes two high-profile demergers were recently completed. In May, Foster’s Group completed the split of its wine operations into newly listed Treasury Wine Estates and a month later Tabcorp Holdings split its wagering and casino operating businesses, with the latter spun-off into newly listed Echo Entertainment Group.

An early entree to the demerger cycle was provided by explosives and mining services group Orica year ago when it spun-off its $1 billion paint and do-it-yourself product group Dulux.

Greenhill Caliburn co-chief executive and corporate adviser Ron Malek says: “There are many reasons a corporate may pursue a demerger over other options like a trade sale. It may be management have not realised the full value of an asset but believe that value can be released for existing shareholders under a separate dedicated corporate structure in which they participate.”

Clearly we are in the midst of some interesting demergers and if perceived to be successfully executed, it may prompt others to examine similar options and add momentum to the demerger cycle. Demergers can offer a more focused pathway to growth, but it is one of a number of options to consider when seeking to release value in an asset.

Cassidy says demergers can bring a number of benefits, including enhanced focus for the separated units, closer alignment with each unit’s performance for executive compensation and total shareholder returns, an independent capital structure, improved transparency and greater equity appeal through the unwinding of conglomerate structures.

A unit within a larger corporation may be a great business with huge potential but starved of capital because it is not a core operation within the company. Setting that business free with its own focused management and capital structure can be very rewarding for the released business and if shareholders in the parent company get a slice, it can create value that otherwise may never be realised.

A straight asset sale can also achieve many of these objectives but the demerger normally allows existing shareholders to get a discounted or free entry into the new group and can bring tax benefits to shareholders.

Some analysis done by UBS in the lead-up to the Foster’s and Tabcorp demergers showed that over the past decade the parent company typically outperforms the market in the 50 days leading up to the announcement of a demerger, with a sharp spike on the day of announcement.

But it’s the demerged unit that is the real beneficiary. The research shows that in the medium to long term, the “spin-off” significantly outperforms the market while the parent tracks a similar path to that expected before the demerger.

However, often the parent has underperformed the market in the couple of years before the demerger, suggesting it is the underperformance that leads to a rethink of corporate strategy and a refocus on core businesses. In that light, demergers are a natural efficiency mechanism of the sharemarket.

Demergers can also create immediate heavyweights in particular sectors. The spin-off of CSR’s building products division into Rinker in 2003 created a $5 billion multinational that grew rapidly before Mexico’s Cemex bought the group for $17 billion in July 2007. The whole process delivered enormous value to CSR shareholders, particularly as much of Rinker’s growth was attributed to the resilient US housing market, which collapsed in a heap just months after the takeover and would have weighted heavily on Rinker’s share price had it remained listed.

Of 17 large demergers since 1997, only six became successful takeover targets, so demergers do add to the diversity of pickings on the Australian Stock Exchange.

Some of those demergers included the spin-off of Origin Energy from Boral, the creation of PaperlinX out of Amcor, the delivery of Crown from Consolidated Media Holdings and the BlueScope Steel business from BHP Billiton. And there are still many potential demergers that might occur in coming years.

Cassidy notes a few, including BHP Billiton’s oil and gas interests, Telstra’s Sensis/Foxtel unit, Origin Energy’s coal seam has business, Fairfax Media’s radio and online platforms, the Qantas Frequent Flyer program and its budget airline Jetstar and Toll Holdings’ Asian operations.

But the two Cassidy likes for creating value are the sale of Asciano’s ports division and Brambles spinning off its Recall division, which operates about 300 operations centres in 20 countries and offers secure storage, retrieval and destruction of digital and physical information.

The demerger or sale of the Patrick Container Ports business of Asciano would realise about $2.8 billion to $3.2 billion for the group and allow it to reduce its debt to easily manageable levels and provide significant capital to expand its higher margin rail operations. The ports business is a duopoly with about 50 per cent market share of all container movements, making it an attractive trade sale but it is also a reason many investors bought Asciano and a spin-off would allow investors to maintain an interest.

UBS values Brambles Recall business at $1.7 billion and its sale or demerger would be more for purposes of streamlining Brambles and making it a dedicated pallet and container pooling service while removing the current conglomerate stigma attached to the group. Brambles is not desperate for the capital but it could be argued the Recall business distracts the full attention of management from the larger core pallet and container pooling business and it would complete the strategy of divestment of non-core businesses that occurred in 2006.

One group that nurtures its conglomerate status is Wesfarmers. But at the same time, management under Richard Goyder is not wedded to any of its assets and would quickly accept a well-priced offer for a business unit or spin-off if it could be proved to add value to shareholders.

The group is dominated by its Coles supermarket operations and its Bunnings hardware operations but it has large businesses in coal production, insurance, chemicals and fertilisers and industrial safety equipment and services.

BRW

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