|Summary: A number of large Australian companies have recently announced de-merger plans, including paper and packaging giant Amcor, logistics group Brambles, and property corporation UGL. History shows that it is typically the spun-out entities that surge ahead over a one- and two-year period.|
|Key take-out: Research by investment bank Goldman Sachs has found that, over the past 15 years, parent entities have run ahead of the broader market by 1% on average in their first year post-demerger, while spin-offs have generated a 14% average outperformance.|
|Key beneficiaries: General investors. Category: Shares.|
Buying companies that are looking to demerge part of their business is one of the surest ways to make money, especially given that one-in-four tend to attract a takeover bid.
But don’t chase these opportunities until you read further, as there is a conflict between intuition and logic when it comes to demergers that is likely to lead many to act against their better judgement.
The latest large cap companies to announce plans to demerge (which is to spin-off part of the business into a separately listed entity), include packaging conglomerate Amcor (AMC), logistics giant Brambles (BXB), and engineering and property group UGL (UGL).
These stocks have lagged the market since news of their demerger plans broke, despite a wealth of research showing how stocks that have undergone a separation have generated vastly superior returns to the market over the medium term.
This argument makes the three demerger candidates an interesting investment proposition, given that Amcor has shed around 1.2%, while the S&P/ASX 200 has rallied 2.3%, since its break-up news announcement on August 1. And Brambles has slipped 6.6%, while the market has moved 7.1% in the opposite direction, since its demerger announcement on July 2.
UGL confirmed its asset divestment plans last month, but it first highlighted the potential for a restructure during a market update on March 26. Its shares have lost a quarter of their value in the past 5½ months, while the market is up 4.5% over the same period.
The portfolio manager for Prime Value Asset Management, ST Wong, believes that value will be unlocked from these stocks, as our market has a strong historical track record to support this argument.
“There is definitely merit in the demergers in terms of potential positive outcomes,” says Wong. “This is about allocation of resources and I would probably rank Brambles, UGL and Amcor in order [of the best outcomes from their demerger plans].”
If history is any guide, investors should be buying these stocks on dips ahead of the demerger, but they shouldn’t be buying them for their core business. This is because it is typically the spun-out entity that surges ahead over a one- and two-year period.
Looking at the past 15 years, investment bank Goldman Sachs found that the parent entity runs ahead of the broader market by 1% on average in the first year post-demerger, while the spin-off generates a 14% outperformance.
What’s more, a quarter of the spin-offs attracted a takeover bid and 20% of the parent companies became targets as well.
However, the real performance stunner comes in year two of the separation. Another investment bank, Morgan Stanley, found that the “child entity” delivered 45% more than the market after 720 days compared with the 10%-plus outperformance by the parent.
That sounds counterintuitive given that the spin-off is often regarded as the “problem child”, as the demerged businesses are generally seen to be “non-core” to the group and a drag on the main business. After all, this is the rational often espoused by management to justify a restructure.
This certainly looks to be the case for Amcor, Brambles and UGL. For instance, Amcor is looking to cleanse itself of its Asia-Pacific focused fibre, metal, glass and packaging distribution businesses.
These divisions will be folded into a separate company called Amcor Australasia and Packaging Distribution (AAPD), while the parent will keep the original name with global operations in flexible and rigid plastics packaging.
AAPD’s businesses are widely acknowledged as being a drag on returns of Amcor, and Citigroup estimates that the parent Amcor will command a higher valuation post demerger as its return on invested capital and earnings exposure to fast-growing emerging markets will increase by 1.7 and 5 percentage points, respectively.
Meanwhile, the document management business (Recall) that Brambles is spinning out, and the property management division UGL is offloading, have chequered histories and are also seen to be underperforming businesses.
Brambles and Amcor are aiming to list their spin-offs by end of this calendar year, but UGL has been vague by saying it “aims to complete a demerger in FY2015”.
The downbeat views on the child entities of the three are not unique, but there are reasons why many of these so-called ugly ducklings have transformed beyond investors’ expectations. Look at DuluxGroup (DXL) when it was orphaned by Orica (ORI), or Cochlear (COH) when Pacific Dunlop cut its umbilical cord.
The director of capital market research for Russell Consulting, Graham Harman, points out that the spin-off is not always a dog. It could quite easily be the case that the demerged business is just not a natural fit for the parent.
“To spin something off, it’s got to be something with a standalone identity, and often this identity is well regarded by the market,” says Harman.
“[Also] sometimes the decision to spin-off is made because the parent needs the money, and it will be the most marketable part of the business that will get demerged.”
Even if the spin-off is a problem child, it could be because the parent had underinvested in the business. Selling a problem child is often undertaken at an attractive discount, which leaves lots of upside potential if the new managers can turnaround the business, adds Harman.
These factors could apply to the demerged businesses of Brambles and UGL – the head of research for Bell Potter Securities, Peter Quinton, holds a favourable outlook for Recall and UGL’s property division, DTZ.
“UGL’s property business is attractive because it is one of the biggest global players in property services, and a lot of companies are outsourcing their property services [needs],” says Quinton.
“I suspect once they spin off that business, the new entity is going to go out and make a fairly large acquisition. I’ve got no evidence for that, but it just strikes me as the logical thing to do.”
Brambles’ Recall business is also one with a well-recognised name, global footprint, and is in a sector that is growing, explains Quinton.
While AAPD might be a harder sell to investors, Citigroup did acknowledge it has some redeeming attributes. The broker was impressed with the quality of the management team and notes that the stock will be priced attractively to its listed peers.
“Following the recent $1 billion in capex [capital expenditure], AAPD will have strong cash flow generation, improved earnings certainty, [and a] favourable duopoly industry structure with $68 million in cost savings between FY13 and FY15,” Citigroup said in a note following the demerger news.
These are qualities that will be prized by risk-averse investors, and the market should be hoping for far more demergers than takeovers.
Research has shown that mergers on the whole create no value when the share price performance of both the bidder and target are considered, while Morgan Stanley calculated that demergers produce an average return of 20% between the parent and child entity.
Marriages may be made in heaven, but divorces are clearly made for markets.