Investment Matters

Demergers

It is demerger central out there at the moment. And many are sizable.  There are also a number of asset sales, which are similar in many respects.  Here are a few that are currently on the table or have been recently completed:

  • Wesfarmers’ demerger of Coles – scheduled for Nov-18
  • Telstra’s CEO has discussed the possibility of asset sales in the order of $2bill
  • The big 4 banks are selling or demerging, or are reportedly planning to sell or demerge, their wealth and insurance divisions
  • Conglomerate Woolworths has stated the sale of its petrol business is being “actively pursued”, and it is contemplating “further capital management” (both quotes from their FY-18 results presentation) if it sells its petrol business (i.e. the sale of BigW)
  • Brambles demerger of IFCO (its reusable plastic crates business) from CHEP (its pallets business) – planned for CY19
  • Fairfax’s Nov-17 demerger of Domain
  • Ansell sold its sexual wellness division in Sep-17 (enacting a share buyback subsequently)

And some associated with companies you own:

  • Suncorp’s sale of its life insurance division – completion expected by end 2018
  • HT&E’s sale of their Adshel business to oOh!Media – completion expected by end 2018
  • BHP ‘s sale of their onshore US onshore O&G assets – completion expected end Oct-18

Why do companies de-merge / sell major assets?

The specific reasons vary greatly – but the underlying principle for demergers is that the assets / businesses run separately are worth more than as a group, i.e. future profit from two separate businesses > future profit from the group.  And this needs to include any costs of separation, and of running the businesses individually (for example two sets of management / corporate expenses, two Boards, two sets ASX listing fees, and two potentially more expensive capital structures).

For asset sales, it makes sense if the price the purchaser is willing to pay is more than the value ascribed to the asset (both financially and strategically) by the market.

Other factors to note: capital structure and constraints can play a role, and businesses may be better off with different capital structures (e.g. one business growing and one late life-cycle).  Changes in strategic direction can be a driver e.g. changing technology or markets.  Currently, regulatory environment is a factor in relation to the banks – whereby the cross selling proposition doesn’t stack up any more (never really did!), and conflicts of interest, structural and regulatory issues make getting back to core banking necessary.  Additionally, a red flag is if a demerger or asset sale was being used to hide or distract from other issues, for example declining earnings.

A true need to demerge?

We are cognisant of looking at each demerger / asset sale on its merits.  Origin’s sale of Lattice is a case in point – where the gas assets had been discovered by Origin, and ended up being a significant size, value and operation opportunity in themselves.  Therefore, selling them to what we consider a more natural holder of the assets, Beach Energy, made sense.  Additionally, the sale allowed Origin to reduce its gearing level.

But in other cases one really wonders what the company’s strategy was all along.  An example is where a company buys an asset, then demerges or sells that asset a number of years later.  BHP’s purchase of the US onshore oil and gas assets is an example.  Wesfarmers’ purchase of Coles, and the demerger scheduled for November is another example.  In relation to the latter, it could be argued that Wesfarmers applied its corporate retail expertise to turn Coles around (it was widely considered an underperforming business at the time of acquisition).  But then again, is the turnaround something that Coles would have done anyway, without being under the Wesfarmers umbrella…

Some thoughts / observations

De-mergers (and mergers) are usually boom times for investment bankers, lawyers, advisors and even the share registries.  Fees, fees and more fees.  Company boards should obviously build this into the assessment of whether a demerger is in the interest of shareholders.  Often there is a degree of cynicism surrounding this (certainly by us) – as the entities recommending a company to demerge can be the same ones to benefit from the fees if it proceeds.

And a totally unrelated observation – often it is the smaller or unfashionable entity that was demerged that does better in the longer term (which can be contrary to the impression at the time of the demerger where the smaller unloved entity gets less attention).  Reasons for this are not clearly identified, but could be due to the dedicated management focus, and ability to source capital to grow (which might have been rationed when the smaller company was part of a larger conglomerate).  An example of smaller doing better is Dulux which demerged from Orica in May-10 (89.5% and -17.8% total return respectively [source: IRESS] for Dulux and Orica subsequently, share price performance as shown in the graph below).

Source: IRESS, First Samuel

A broader perspective

Post GFC we have lived in a world of low interest rates / cost of debt.  Traditionally this would have encouraged businesses to invest – whether internally (e.g. new plant or equipment or IT infrastructure), or via acquisition.  It is notable to your investment team that the in the 10 years post the GFC (the collapse of Lehman Brothers has become known as the marker), that we have not seen this investment to a meaningful degree – certainly not in the context of an extended period of very low interest rates.

The extent of de-mergers and asset sales currently being enacted and contemplated is another typification of this.  Instead of expanding, acquiring and growing scale, businesses are doing the opposite - often returning funds to shareholders in one way or another as part of the process (including special dividends or share buybacks).  All this comes with the aim of boosting shareholder returns - in the short term.

Whilst it may be beneficial in the short term, the concern of your Investment Team is that it perhaps doesn’t speak well as to the growth outlook for many listed companies, or even from a broader economic perspective, in the longer term.

Conclusion

The extent of demergers and asset sales (number and size) is notable at the moment.  Whilst a demerger or asset sale can make sense, we do hold some concerns – particularly when they are considered from a longer term perspective.

- Fleur Graves