Divide and prosper

How splits created wealth Sical Logistics announced demerger of Sicagen India in October 2006. Price: THEN Rs 172 NOW Rs 209 Gain: 18% Reliance Energy created Reliance Power as a separate entity in September 2007. Price: THEN Rs 1,206 NOW Rs 1,600 Gain: 33% Indiabulls Financial Services spun off Indiabulls Real Estate in July 2006. Price: THEN Rs 245 NOW Rs 639 Gain: 161% Zee Telefilms demerged three new entities in January 2006. Price: THEN Rs 165 NOW Rs 242 Gain: 47% Current share prices as on 28 February

Whenever the board of a company meets, its shareholders wait with bated breath. An announcement of a bonus, a stock split or even a generous dividend can boost the share price-and the value of their investment. But this conventional way of rewarding shareholders through bonus shares and dividends may soon become a thing of the past. What many shareholders now want to hear are announcements of demergers or the spinning off of a subsidiary into a listed entity.

If a company hives off a division and lists it as a new company, the combined valuation of the demerged entities is often greater than the market price of the parent company before the split. After the parting, one plus one is not two but almost three. That's because though there is no addition to the assets of the two companies, the new company is usually more focused.

Also, the split unlocks the value of assets such as real estate and cross holdings in other group companies and brings the subsidiary's contribution into the limelight. As a result, the market rerates the parent company and assigns a value to the newborn entity.

"Demerger of group entities brings greater investor focus onto the subsidiary company and its business potential," explains Sonam H Udasi, director (research), Prime Broking Company. Not only does the market get the much needed information about the subsidiary's contribution to the parent company, the parent company also sees a substantial rise in valuations. Idea Cellular was not fairly valued as long as it was privately held by the Aditya Birla Group.

The demerger of a group brings greater investor focus onto the subsidiary company and its potential becomes clearly defined. That leads to a re-rating by the market Sonam H Udasi, Director (research), Prime Broking Company

Sum-of-the-parts valuation is used for businesses in a diversified company whose earnings do not impact the consolidated firm’s earnings right now but will in future Nandan Chakraborty, Head of research, Enam Securities

That changed after its initial public offering (IPO) in 2007. The GSM mobile operator which was valued at Rs 12,000 crore in October 2006 is now valued at over Rs 31,000 crore. The re-rating begins immediately after the demerger announcement.

When Indiabulls announced its plans to demerge its real estate business in July 2006, its shares were trading at Rs 245. By the time the real estate company was hived off and existing Indiabulls shareholders allocated shares of the new company in March 2007, the share price of the parent company had shot up to Rs 659. That's besides one share being allotted to each shareholder. In December 2007, the company demerged its brokerage business, sending the share price zooming to Rs 979.

A company may not even allot its shareholders any shares of the new company but still they stand to benefit. Reliance Energy demerged its power business and raised money through an IPO in January. Though they did not get shares in Reliance Power, the shareholders of Reliance Energy benefited because the valuation of Reliance Power pushed up their share price up by 42% in four months-from Rs 1,205 in September 2007 to Rs 1,716 in January 2008.

The potential demergers
Parent company	What may be hived off	Contribution of demerging entity to		Stock price
		Turnover (Rs cr)	Profit (Rs cr)
Videocon Industries	Crude oil and natural gas business	379.89 (15.84%)	134.53 (44.91%)	424
Triveni Engineering	Turbines and gear businesses	137 (39.50%)	34.5 (48.52%)	139
S Kumars Nationwide	Brandhouse Retail, which has over 250 retail stores	NA	NA	153
Reliance Communications	Tower company Reliance Infratel	NA	NA	584
Larsen & Toubro#	Infotech business	1,280 (7.28%)	170 (8.47%)	3,641
Kesoram Industries	Cement and tyre businesses	433.46 (48.55%)	145.71 (93.97%)	405
Jaiprakash Assoc	Infrastructure business	Yet to start operations	NA	269
ITC	FMCG business (including cigarettes)	2,348.47 (67.91%)	896.61 (72.15%)	202
ICICI Bank	ICICI Securities and insurance companies	257 (2.48%)	71 (4.73%)	1,103
HDFC#	AMC business	187.5 (8.7%)	101.89 (11.56%)	2,775
Reliance Capital	AMC business	1,231.3 (10.65%)	282.1 (19.16%)	1,90
Results are for the quarter ended 31 December 2007. # Results are for the year ended 31 March 2007. HDFC's % does not include income from subsidaries. ICICI Securities profits are after tax. All share prices as on 28 February

 

That's because Reliance Energy holds about 45% stake in Reliance Power. What that means is that the intrinsic value of Reliance Energy shares went up with the listing of Reliance Power.

"The investments of Reliance Energy in its power subsidiary got a huge premium," says Chinmay Desai, a research analyst at Finquest Securities. Similarly, Pantaloon Retail rose from Rs 539 in September 2007 to Rs 626 when the IPO of its subsidiary, Future Capital, came out in January 2008. There's more.

The Mahindra & Mahindra stock, for instance, has been re-rated positively in light of its subsidiary Mahindra Holidays reaching the final leg of its IPO journey. Mumbaibased investment banker Enam Securities valued the new company at Rs 3,400 crore, which adds Rs 122 per share to the value of the parent company.

Some Of The Parts (SOTP) valuation • SOTP is regarded as the best tool to value companies with diversified business interests • It evaluates each business or division of the company separately and assigns a value to its contribution • This valuation also captures future potential of the new ventures which are not generating revenues right now • At the end, the value of all the parts (including core business) are added up to arrive at an approximate value of the company as a whole • SOTP valuation indicates if the company’s value would be increased if it was split into separate business units SOTP valuation of Bajaj Auto by Indiainfoline on 13 July 2007 Bajaj Auto (vehicle manufacturing) Rs 933 + Bajaj Auto Finserv Rs 450 + Bajaj Holdings and Investment Rs 1,037 = SOTP Rs 2,420 value > Rs 2,195 Stock price on 13 July 2007 Figures show what different businesses of Bajaj Auto would have contributed to its valuation

The feud between the Ambani brothers might have forced them to carve several companies out of Reliance Industries, but there are also financial reasons for the split. Sun Pharma demerged its research arm in April 2007 to mitigate the risks involved in the expensive drug discovery process. Reliance Power was hived off to raise funds for the huge capital expenditure.

There are different ways of valuing the diversified interests of a company. The most common tool is sum of the parts (SOTP) valuation. This essentially takes the non-core business units into consideration and assigns monetary values according to their value addition to the company as a whole (see box).

If you pick up a company after it has made its demerger plans public, the gains would be limited. It is best to buy before the plans are formally announced. Money Today zeroed in on some potential demergers that investors can benefit from when the split happens.

The financial services industry has several demerger candidates, notably ICICI Bank, which is in the process of listing its broking arm, HDFC and Reliance Capital. "In the case of ICICI Bank, its broking business is doing well on a standalone basis. Investors will see value unlocking in this stock," says Desai. Reliance Capital has already divested a 5% stake in its asset management company (for Rs 500 crore), valuing the subsidiary at Rs 10,000 crore.

The demerger of ITC's FMCG business also seems possible, given the fact that the packaged food business grew by an impressive 60% in the quarter ended December 2007. Of the total revenues of Rs 5,351.89 crore for the quarter, packaged foods contributed around Rs 655 crore.

However, it's not all positive. Demerging and listing need not always translate into monetary benefit. "Often, promoters create special purpose vehicles or holding structures and then keep bringing new investors in without any big vision or strategy for growth," says Udasi.

Analysts are also quick to caution investors against companies investing through a web of cross-holding structures, where the parent company never lists the subsidiary company. These holding companies do not generate cash flows on their own; they only hold stakes in a web of companies that actually generate revenues.