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6 things to know about unlocking value through demergers
If you follow stock market news closely, you may have identified a trend. Many companies like Crompton Greaves, Future Group, and Piramal Enterprises have announced a demerger of their subsidiaries in the past few months.
During such demergers, analysts often say it will ‘unlock value’.
Here are six things to know about this phenomenon:
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Sum of parts:
Many companies conduct business across different industries. Take the example of Reliance, which has subsidiaries in oil and gas, retail and telecom. Each of these subsidiary businesses has a different value because of their different profits. So, logic suggests the value of the parent company should be a simple sum of the values of all these businesses. Yet, that is not so.
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Conglomerate discount:
The value of the parent company is not a simple sum of these businesses. This is especially so when you talk about company values through the price of its stock. Shares of such companies usually have a lower price in the market than their simple value. This is called ‘conglomerate discount’.
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Why conglomerate discount?:
The idea is that when investors buy stocks, they want exposure to a single industry. Instead, they are unwittingly exposed to the dynamics of other industries. Moreover, there’s a good chance that the company may be a dominant business in one industry, but a small player in another. In such a case, the investor is compromising. He or she could have instead bought the shares of that dominant company. As a result, they are willing to pay a lower rate than the conglomerate’s true value. Moreover, investors can also find it hard to understand the company’s business model because of the large structure. In short, more often than not, transparency gets compromised in a conglomerate structure.
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Unlocking value:
This is why share prices of companies often perform better after it cuts off one or more of its businesses into a separate entity. Investors then have the option to choose which businesses to invest in. Secondly, it could so happen that the demerged company operates better for reasons like better debt/corporate rating. For example, suppose a profitable company can end up paying higher interest rates on its debt simply because its parent company and sister businesses have high debt on their books. In this case, the company could cut down its costs by being demerged into a separate entity.
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Demergers may backfire:
Investors should not automatically assume that a demerger will unlock value. In some cases, it could simply be gimmicks to improve market value. Secondly, certain businesses may actually enjoy being merged with the parent company. This could be for various reasons like brand value, better management control or simple cost-sharing. In such cases, a demerger could be detrimental to you as the investor.
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Prepare for volatility:
Usually, when a company demerges its business, it announces a distribution of shares from the new company for its existing investors. This also leads to a fall in the price of the company’s own stock. After all, the company just gave up part of its business. However, the actual quantum of the fall is not fixed. As a result, the stock usually sees extra volatility in the days after the merger.
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Rs 33 billion
An example of unlocking value is that of Adani Enterprise, which restructured its businesses in 2015. It demerged its power business and merged it with sister company Adani Power. Similarly, it merged its port business with Adani Ports & SEZ. Analysts suggested that this could unlock value of Rs 33 billion in equity, according to media reports.
