How Demergers can help Unlock Shareholder Value

Demergers have emerged as a powerful method in corporate restructuring (or business re-arrangement) that allows companies to reorganise their businesses to best suit their strategic priorities. The Indian equity market has witnessed a series of successful demergers in the past that have not only resulted in better business results for the resulting entities, but also the augmentation of value for its shareholders.

In this article, we explore the world of demergers, and how they help businesses unlock value. Additionally, we also dive into its obvious merits, which are long established, in both qualitative and quantitative terms.

So, let’s dive in!

Understanding the Concept of a Demerger

Demergers are no rocket science. A demerger simply splits a company into two or more separate entities, enabling each to operate independently. Demergers are also termed as “spin-offs”, “hive-offs” or “equity carve-outs” in some cases.

Why do Companies Opt for a Demerger?

There comes a point in the growth cycle of any company (usually large companies) where it attains a scale such that each of its business verticals are now large businesses, requiring dedicated business focus. Alternatively, large companies may choose to hive off smaller subsidiaries/segments from their core business, in order to retain focus on their core business.

Considering these and other obvious operational, financial, & tax related benefits, top executives may consider going for a demerger.

The Demerger Math

As a shareholder, if the company whose shares you own announces a demerger, then your current holding in that company will be split into shares of two (or more) companies, as announced in the “scheme of arrangement” of the demerger.

There are two things to understand here:

1. Share quantity held in each entity post-demerger:
   This is determined on the basis of the ratio announced by the company (eg. 1-for-2 ratio would mean the shareholder would receive 1 share of the newly demerged entity for every 2 shares held in the pre-demerger entity).
2. What will be my eventual “cost of acquisition” of the demerged stocks?
   This will be determined using the percentage(s) quoted by the company in their demerger announcement.

Let’s take an example to understand this better.

Assume that Company A Ltd. announces a demerger into two entities A Ltd. & A1 Ltd. Assume that an Investor Ms. Seema Nair, owns ₹35,000 worth of shares in A Ltd. at an acquisition cost of ₹500/share.

The details of the demerger are as follows:

Ratio: 1-for-2 (i.e the shareholder would receive 1 share of A1 Ltd. for every 2 shares held in the pre-demerger A Ltd.)

Split % for COA (cost of acquisition):

On basis of the given details, we can ascertain the pre and post demerger “Cost of Acquisition” and quantities: -

Details of Pre-Demerger Entity:

Details of Post-Demerger Entities:

In most cases, the parent entity will determine their eventual % holdings in the resultant demerged entities.

Now that we know what a demerger means, let’s explore some of its merits: -

Merits of Demerger:

1. Strategic Business Focus: To transform the existing subsidiary, business segment or product line into an independently run company.
2. Improved Capital Efficiency: Enabling the new entities to operate at lower levels of debt and working capital, thus boosting liquidity and capital efficiency.
3. Ability to raise more capital: The demerged entities can raise more capital on the basis of their lighter balance sheets.
4. Higher Profitability: A by-product of points 1, 2 & 3 above.
5. More Accurate Equity Valuations: The entities may start getting a more accurate appraisal of their valuations, on the basis of peers in exactly the same line of business.

Quantitative Example: Value Creation Through a Demerger

The table below shows how a hypothetical conglomerate benefits from a demerger:

Key Takeaways:

• Unit A (manufacturing), with steady cash flows, commands a P/E multiple of 15x.
• Unit B (financial services), a high-growth business, commands a higher P/E multiple of 40x.
• The demerger allows the market to apply sector-specific multiples, leading to valuation transparency and potential upside for investors.
• We can relate the Reliance-Jio Financial Services demerger to the above example.

Conclusion

Some critics may point out that the valuation gains are actually an outcome of the prevailing bull market, or the inherent growth potential of these businesses (when not separated). To this, we’d say that the magnitude of the gains made in the post-demerger periods show that demergers have played a crucial role in the business & valuation outcomes that have materialized for the demerged companies.

Having said this, investors must never blindly invest in companies undergoing demergers, as there are several factors to be considered, before an investment decision can be made.

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