Unlocking shareholder value through demergers

By Thomas Mutswiti

“THE crisis in Zimbabwe has prompted company managers to develop unique capabilities in a time of profound economic decline…” read an article on ZWNews on July 18. With

the current investment climate in Zimbabwe corporate managers are having a difficult time trying to keep companies from steering business courses that destroy shareholder value. Various corporate strategies have been adopted in trying to create or unlock shareholder value.

We have seen mergers such as the “fraudulent” CFX Financial Services and Century merger, the recent FBCH where FBC merged with Sare and ZBS among others. In recent years, we also have seen a spate of demergers in Zimbabwe ostensibly to unlock shareholder value. But how do demergers create shareholder value?

In a demerger, a company is split into two or more fully independent parts. In 1980, Geoffrey Howe, then British Chancellor of the Exchequer, reasoned: “There are cases where businesses are grouped together under a single company umbrella. They could in practice be run more dynamically and effectively if they could be demerged … and allowed to pursue their own separate ways under independent management.”

When a company is trading at a market value considerably below fair value for its shares, there is a real danger of a speculative takeover bid. Directors must adopt strategies that will lead to correct valuation of the company. Management must design strategies to address the market perceptions and demerger is one option. Demergers represent the final significant step in the transformation of companies into a focused business. Demergers take the form of sell off, equity carve out or spin offs.

Value sources

Much of the impressive performance comes from the altered dynamics of the demerged business and its parent. Demergers do well partly because when a business and its management are freed from a large corporate parent, pent-up entrepreneurial forces are unleashed. The combination of accountability, responsibility and more direct incentives take their natural course. Managers have greater freedom to pursue new ventures, streamline production, and pare overheads.

After the spin-off, stock options can more directly compensate management. For employees of the new separate entity, there is a publicly traded stock to motivate and reward them. Stock options in the parent company often provide little incentive to subsidiary managers, especially since their efforts are buried in the overall firm performance. Separating a subsidiary from the parent company can reduce internal competition for corporate funds. For shareholders, that is great news because it curbs the kind of negative internal wrangling that can compromise the unity and productivity of the company.

The different business units can follow financial strategies which are more appropriate to their activities (individual business risk) which should impact positively on shareholder value. These strategies are meant to correlate with the inverse relationship that should exist between business risk and financial risk. Correct classification of businesses units in their industry and area of competency results in greater market visibility for the company and a lower risk premium in raising finance. Financial strategies that are non-generic lead to lower cost of capital for businesses.

There will be improvements in corporate governance and efficiencies now that the units are separately accountable to the markets and decisions are localised. Restructuring can improve corporate governance and increase strategic flexibility. The localised decision-making by each unit should be cognisant of this market evaluation, hence management is unlikely to engage in dysfunctional behaviour or try to satisfice.

Another way of shareholder value creation in demergers is the destruction of the “conglomerate discount” which causes transfer of value from shareholders to lenders. Because a well-diversified conglomerate has immunised itself against volatility of earnings, according to Capital Asset Pricing Model and Option Pricing Theory, this decreases the potential of shareholder wealth creation.

This argument hinges on the fact that management should not be for doing for shareholders what shareholders can do for themselves easily and cheaply. Shareholder diversification is much cheaper as individuals can easily buy stocks in different companies or easily buy into mutual funds. The volatility of earnings, a source value for options, is reduced as firms merge. OPT therefore argues, firms should demerge to undo the harmful effects of merges and unlock value by destroying the conglomerate discount.

Demergers may reduce uncertainty pertaining to information asymmetry attributable to individual units hidden within a merged entity. Gains in stock prices flow from four changes. First, there is an increase in coverage by analysts. This seems to support investment bankers’ claims that floating equity in business units not previously exposed to the market makes their operating performance more transparent and raises shareholder returns by revealing hidden value. This transparency comes from an improvement in the quality of analysts’ coverage.

Benefits of being a conglomerate are unclear and management is distracted by complexity. In their different fields of activity, the new entities face exceptional opportunities which will need to be pursued in conjunction with continuing rapid change and the sustained achievement of superior performance. This helps the companies to extend time period of competitive advantage.

Following the demerger of Astra Ltd, the turnover for the parent company has grown by 76% and EBIT grew by 3 290%. Cairns had turnover growing by 356% and EBIT by 4 072% with TPH experiencing a growth of 281% in turnover and 5 186% in EBIT for the period 2001 to June 2004. Thus unbundling can be said to have released exciting opportunities particularly for the two new entities which have been experiencing phenomenal growth since steering their individual courses. The interests of management in these firms are therefore better aligned with shareholder value creation.

Delta Corporation split into Delta, OK, Pelhams, Zimsun, with Delta focusing on beverages. The OK division focusing mainly on high volume retail market and has stood the competition from Food World, TM, FCG, Spar and Lucky 7 etc. Zimsun concentrated on hotel business and tourism. Zimsun has also offloaded Dawn Properties. The purpose was to unbundle real estate business from the core hotel and leisure focus of the group to unlock shareholder value. For many years the real estate owned by the company has not been reflected in the market value of the company.

Expectations were that among other things the separately listed property would be able to source its own capital in the open market without having to seek recourse from the instruments that would weigh down on the whole group operations. TA Holdings separately listed Zimnat Insurance. The horticultural concern TZI spun off the Strategis concern, which is now planning to merge with pharmaceutical concern Medtech. ZSR has been considering for a long time the demerging and subsequent listing on the ZSE of its units Advance Wholesalers and Red Star.

Demerger problems

Demerged companies are likely to be substantially smaller than their parents, possibly making it harder to tap credit markets and costlier finance that may be affordable only for larger companies and thus might not lower costs of capital. The smaller size of the firm may mean it has less representation on the Zimbabwe Stock Exchange indices, making it more difficult to attract interest from institutional investors.

There are also extra costs that the parts of the business face if separated.

When a firm divides itself into smaller units it may lose synergy that it had as a larger entity. Economies of scale enable optimisation of costs such as advertising, marketing, research and development and legal. Division of expenses into different units may cause redundant costs without increasing overall revenues.

Sometimes companies carve out a subsidiary because it’s not doing well but because it’s a burden. Such an intention won’t lead to a successful result, especially if a carved out subsidiary is too loaded with debt, or had trouble even when it was part of the parent, lacking an established track record for growing revenues and profits. Carve outs can also create unexpected friction between the parent and subsidiary. Problems can arise if the carved out company must be accountable to their public shareholders as well as the owners of the parent company. This can create divided loyalties.

Finally, demerging operations is not going to be a first choice for all companies. But in some situations it may look like an increasingly attractive option. Given the scale and nature of the opportunities now foreseen, the continuing organic growth of the parent company will no longer be sufficient to realise the full potential for building shareholder value.

Structural growth through demergers must play a part. Here, the ability of the successor companies to use their own shares as “currency” will be a significant benefit, creating greater freedom than that available to parent company, with their principal businesses each different in character for equity investors.

Thomas Mutswiti holds a bachelor of commerce finance honours degree from the National University of Science and Technology. He can be contacted at omutswiti@ecoweb.co.zw

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