Kudos to National Australia Bank for demerging its UK banks, Clydesdale and Yorkshire, through the listing of CYBG Plc in London this week and subsequent trading on ASX (under code CYB). Current sharemarket volatility is an awful backdrop to list any business, let alone one with a troubled history. But it can create opportunities.
I have followed CYBG for two reasons. First, demergers in Australia have had a knack of outperforming in the past five years. Second, difficult businesses such as CYBG can have a significant upside in the medium term when set free from their parent and managed independently.
Expect more demergers in 2016. Record low interest rates and a sluggish share market will encourage companies to engineer value for shareholders through corporate deals. A spike in mergers and acquisitions in the past 12 months reflects this.
Many listed companies will have modest capital growth prospects and an increasingly challenged outlook for dividends in 2016. Witness the pressure on BHP Billiton this week to cut its dividend and help its credit rating. As such, unlocking value by spinning off assets and listing them as standalone companies on ASX will have greater appeal. A partial divestment of the Domain property business from Fairfax Media and a spin-off of Qantas’ valuable loyalty program, considered in 2014, are some of a long list of demerger candidates.
In many ways, demergers are a better bet than Initial Public Offerings (IPOs). Information asymmetries often work against IPO investors: the vendor knows a lot more about the company than its new shareholders and the odds favour the seller.
Demerged assets are typically well known in the market, if not always appropriately valued. For example, institutional investors in BHP Billiton spin-off South32 were familiar with its assets and information through it being subject to ASX Listing Rules. Compare that with an IPO where all you really have to go on is a prospectus that is sometimes more fiction than fact, and are bombarded by management and market hype.
Demergers also have better alignment of incentives. It is in the parent company’s interests to ensure the demerger is a success for shareholders who receive scrip in the new entity. Compare that with IPOs where assets can be bundled up by private equity firms or other vendors and the float’s main purpose is as a quick exit mechanism for deal doers.
The rationale for demergers is another attraction. Some assets struggle for attention in large companies or are not valued appropriately. That is why BHP Billiton demerged South32 last year: its mostly tier 2 assets (in the production cost curve) could not compete for capital because BHP had more deserving tier 1 operations elsewhere.
That does not mean all demergers succeed or that they should be favoured over IPOs. Every company must be analysed on its merits. South32’s poor share-price performance since listing, albeit in a sector where almost everything is falling, is a case in point. But there’s enough evidence to suggest investors should put demergers on their watchlist.
Australia has had some cracking demergers in recent years: Macquarie Group’s spin-off of its remaining shares in Sydney Airport; the Orora spin-off from Amcor; and the Brambles divestment of Recall Holdings are among the best. Woolworths spin-off Shopping Centres Australasia Property Group has performed well, as has the much smaller Asia Pacific Data Centre Group, a property spin-off from the fast-growing NEXTDC. Orica’s spin-off of Incitec Pivot and the DuluxGroup is another example.
Macquarie Group last year did some outstanding quantitative research on demergers. In an analysis of demergers over the past 20 years, it found the child (demerged) company tends to underperform for the first six months, before delivering stronger outperformance from about 12 months after that spilt.
The potential for early underperformance and the problematic outlook for the resource sector was one the reasons I suggested in May 2015 that readers of the Super Switzer Report watch and wait for better value in South32 because there was no compelling need to buy.
It is also one of the reasons why prospective investors should watch CYBG rather than dive in. With a new strategy and largely new management team, CYBG’s performance should improve. There has to be upside after being the underperforming division of an underperforming bank for so long.
However, buying shares in NAB, which will have less baggage after the divestment, and is now attractively priced after underperforming the other banks in the past year, is the better option. NAB looks the pick of the big banks at current prices.
Three demerged companies to own
Three divestments in this market appeal: a large-cap (Sydney Airport), mid-cap (DuluxGroup) and small-cap (Asia Pacific Data Centre). South32 is getting close to value territory and it fits the thesis of buying demergers after their first year of being listed. But there is the risk of further asset write-downs from South32 as commodity prices fall and the turning point for resource stocks, while getting much closer, is not here yet.
1. Sydney Airport
I first outlined a bullish view on Sydney Airport for this publication in March 2014, and again in January this year, nominating it as one of five stocks to buy during this correction. The market has continually underestimated Sydney Airport. For years, analysts have said it has too much debt, a complicated balance sheet, a distribution payout ratio that is too high, and that it is overvalued. But it has kept rising.
Sydney Airport’s three-year annualised total return (including distributions) is 35 per cent. My central thesis for the airport owner and operator – that it is superbly leveraged to growth in inbound and outbound tourism over the coming decade – is strongly intact. Sydney Airport is benefiting as Chinese and Indian tourists travel to Australia, and as low airfares encourage more Australians to travel overseas, despite our lower currency.
Sydney Airport’s December traffic performance showed total customer growth of 6.7 per cent year-on-year. Most other large Australian companies would kill for this type of annual growth in customer volumes in a patchy economy.
Sydney Airport is due for a price pullback and consolidation after such strong gains, but it is a core long-term portfolio holding for income investors and its defensive characteristics from owning a monopoly infrastructure have even greater appeal in a volatile sharemarket.
Chart 1: SYD
[1]Source: Yahoo!7 Finance
2. DuluxGroup
Australia’s leading paint maker is one of this columnist’s favoured mid-cap stocks. I wrote in the Super Switzer Report in November 2015 that it was approaching value territory after falling from a 52-week high of $6.88 to $5.88. It has since rallied to $6.45.
Short-term gains might be slower from here: the housing market has probably peaked and the renovations and refit market could slow as consumers struggle with anaemic wages growth and high debt, and become less confident in 2016.
Longer term, DuluxGroup has an enviable position in the Australian paint market. It should benefit from a stronger performance in its Alesco garage-door and openers business, and has clearly backed the right horse in Bunnings choosing it over the troubled Masters chain. DuluxGroup should grow as Bunnings benefits from Masters’ demise.
DuluxGroup’s FY15 result was slightly ahead of market expectation and an increase in market share in the crowded renovation and repaint market was a good sign. Product launches under the Wash ‘n Wear brand and good cost control were other features. An expected yield of almost 4 per cent this financial year, fully franked, is another attraction.
Chart 2: DLX
[2]Source: Yahoo!7 Finance
3. Asia Pacific Data Centre Group (AJD)
I nominated the data-centre property owner, a lower-risk play on growth in cloud-computing, as one of five specialist Australian Real Estate Investment Trusts (A-REITs) to watch in September 2015 for this publication. It has edged higher to $1.30 – a reasonable result in a falling market.
Growth in outsourcing of data storage shows no signs of slowing and AJD’s former parent, NEXTDC, is building a strong first-mover advantage in this market. The alliance between AJD and NEXTDC expired in December, but they can collaborate on data-centre properties on commercial arms-length terms.
I suspect the market is underestimating the value of state-of-the-art data centres in capital cities. They require large amounts of water and power and central locations, and are not easy assets to replicate. AJD’s properties received valuation uplifts in FY15 and should continue to do so as the value of data-centre assets rises.
AJD is trading slightly ahead of its book value of $1.24 and is expected to yield a touch over 7 per cent, unfranked, in FY16. That is attractive for long-term income investors and comes with reasonable capital growth prospects given the positive outlook for cloud-computing and outsourced data storage. AJD suits experienced investors who are comfortable with micro-cap, specialist A-REITs that have higher risk than traditional A-REITs.
Chart 3: AJD
[3]Source: Yahoo!7 Finance
– Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply any stock recommendations or offer financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at Feb 3, 2015.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.