Creating Wealth Through Value Unlocking
You will find value investors always on the lookout for stocks that are traded at let’s say Rs 100 per share but with actual intrinsic value of maybe Rs 200 per share. However, most investors never understand the concept of intrinsic value and hence are deprived of knowing what the underlying true value of their investment is. Value investors make maximum gains when ‘value unlocking’ takes place. Yogesh Supekar and Karan Bhojwani explain what value unlocking is and how investors can benefit by investing in those companies that are about to unlock value for shareholders
Mahendra Mishra is a resident of Uttar Pradesh and has been running a small sweetmeat shop in the name of ‘Chariot Sweets’ since 25 odd years. He has established himself in Kanpur, one of the biggest cities in the state. On an average, the shop generates sales of at least Rs 24,000 per day. As an entrepreneur he is happy with what he has been doing for several years and believes the sales are satisfactory. However, his son, who has recently finished management studies from one of the premier institutes in India, does not share the same feeling. He thinks efforts should be made to expand and generate higher cash flows.
Almost 18 years ago, Mishra had purchased a piece of land for a meagre amount of Rs 250,000 in the heart of the city, which is today worth nearly Rs 5 crore. He is undoubtedly happy with his investments and believes that the land can stay idle till the time his focus is on the shop which provides his family with all the required comforts. His son has other ideas. He believes that the land can be monetised either by selling and generating cash to expand the current business or be utilised for a new project such as constructing a hotel and thereby foraying into a fresh line of business or through an investment in a commercial partnership.
After internal discussions the family decides to construct a hotel with a multi-cuisine restaurant, thus putting the idle land to good use. The projections suggest that minimum revenue of Rs 30 lakhs per month is possible from the new project which will initially require an investment of Rs 5 crore at the very least. The project is expected to achieve breakeven in five years’ time after discounting the growth in revenue and other associated factors. This example drives home the meaning of ‘value unlocking’ for Mishra’s business in Kanpur. The main business remains as it is, given the fact that it has built up goodwill and brand value over more than two decades.
Here, Mishra’s son becomes a catalyst and decides to monetise the available asset in the most profitable manner with profit projections that are in multiples of the original revenue and profits of the sweetmeat shop. It is a simple example of an unlisted entity where the owner of the shop is the only shareholder of the company. However, in the real world the situation can be much more complex even though the concept of value unlocking remains more or less the same. Indeed, if any investor is able to buy a share just before any large conglomerate is in the process of unlocking its value, chances are the investor will be rewarded handsomely. In the above example, imagine if Chariot Sweets was not just an ordinary shop but a listed company and with monthly revenue of approximately Rs 720,000 per month forms a new subsidiary called Chariot Hotels to start generating additional revenue to the tune of Rs 3,000,000 per month. Chances are that this listed company will be in great demand as the revenues on a consolidated basis have jumped manifold. Thus, the stock price of such a company can create a lot of wealth for its shareholders. It is vital for investors to look at the consolidated results carefully and then take appropriate investment decisions. Not every investor will be able to pre-empt the value unlocking that may take place in the future. However, for the discerning few it is possible to identify such stocks in advance.
Understanding Value Unlocking
It is common to see companies attempting to unlock value and create shareholder value. Shareholder value can be created over long term if the company is able to execute its plan meticulously. It is not necessary that all companies are able to unlock value optimally as the end result is often dependent upon timely decisions, market environment and execution capability. Hence, such companies will never find a great number of buyers. However, there will be lot of buyers for those stocks where the catalysts for value unlocking are present.
Reliance Industries Limited is a point in case and a perfect example of how to unlock value and reward shareholders. After a lengthy underperformance, RIL has been able to create tremendous shareholder wealth since its launch of the Reliance Jio platform. It is speculated that soon RIL will launch an IPO for its flourishing telecom arm i.e. Jio. Investors should not be surprised if RIL decides to list its retail subsidiary, Reliance Retail, as well. It is widely expected that listing of these two business segments will unlock value for shareholders of RIL in three to five years as they are expected to hit the markets by then.
Lot of things are going on in favour of RIL. It is not just the telecom business and the retail business that are expected to create shareholder value but also the ARAMCO deal that is expected to help RIL reduce its debt beyond 2021 and almost make it a debt-free company. Being a debt-free company would be a great positive factor in favour of the RIL stock. In all probability, RIL will be able to create shareholder value or unlock value by selling stake in the petroleum business and by listing its business segments in the telecom and retail sectors.
The Method
Following are the various ways in which any conglomerate can unlock value: mergers and acquisitions, de-listings, spin-offs, reorganisations, recapitalisations, refinancing and other ways which lead to jump in earnings and revenues. There have been instances where the value is unlocked simply by a change in management. A reputed business leader taking over the helms of the business operations also acts as a catalyst. One of the best examples in corporate India is that of IndusInd bank. The change in management and the consequent recapitalisation was the catalyst in unlocking value at the bank. Romesh Sobti is known as a man who turned around IndusInd Bank. Under his management, IndusInd Bank has remained one of the best performing stocks on the Bankex index for a decade after 2008.
Sobti took charge of IndusInd Bank in February 2008 when the bank was in a bad shape. The bank had never reported losses in its existence of 15 years but now there was serious mismatch in its assets and liabilities while the quality of its books and capital was seriously impaired. Investors didn’t want to touch the stock and customers were closing their accounts. A change in management and an astute leader in the form of Romesh Sobti helped IndusInd Bank unlock its value, thus creating tremendous wealth for its shareholders. Value unlocking happens not only when demergers, listing of subsidiaries or change in management take place but also when any company decides to shut down its loss-making units or sell off its non-important businesses.
Investors do have a great opportunity to enter into an investment when one sees a company unlocking its value. However, it is not as simple as it seems. Often enough, an investor can get excited on hearing terms like delisting, demerger, merger and acquisition, unlocking value, special dividends, listing of subsidiary, etc. Not all corporate actions may create wealth for shareholders in the long term. One needs to tread carefully.
Recently, with the whole world fighting a seemingly unending war with corona virus, Mahindra & Mahindra announced that it was willing to let go of its ownership stake in SsangYong, its South Korean subsidiary. SsangYong is believed to have picked Samsung Securities – expected to work with its global strategic partner Rothschild – to find a new investor. Such a development at Mahindra & Mahindra can be termed as value unlocking for shareholders if such subsidiaries are not contributing to the revenues and profitability on expected lines and are dragging the overall profitability of the parent company. Such a shift in strategy augurs well for the parent company as it helps raise capital in tough market conditions and also improves overall profitability while allowing the capital to be allocated to the most profitable projects.
Case Study
Several media reports suggested in 2015 that unlocking value of almost Rs 33 billion in equity was possible by Adani Enterprises as it underwent restructuring of businesses. Adani Enterprises demerged its power business and merged it with sister company Adani Power and it merged its port business with Adani Ports & SEZ. Adani Enterprises and Adani Power have both outperformed the markets since 2015 running up to the start of 2020.
Unlocking Value and Demergers
Unlocking value in simple words could also mean selling undervalued assets and thereby increasing the value of the company for its shareholders. Demerger is one of the most popular methods adopted by large conglomerates such as RIL, Adani Group, Aditya Birla Group, etc. to unlock value. What the demerger of a group essentially does is to usher in greater investor focus on to the subsidiary company and its business potential – just as RIL has done with reference to Reliance Jio or Aditya Birla Group did with IDEA when it was listed on the bourses. It is common to hear analysts say the group is unlocking value whenever demergers are announced.
What investors ought to know is the sum of parts for the businesses under consideration. For example, there are several companies that conduct business across different industries or verticals such as Tata Group, Aditya Birla Group or Reliance Group. If we consider RIL, which has subsidiaries spanning oil and gas, telecom and retail, an investor has to understand that the value of the parent company should be a simple sum of the values of all the businesses. Logically speaking, this is how it should be but it may not always be the case. At times the value of the parent company is substantially below the sum of the parts valuation. This identification of discounted value in a parent company should trigger a buying decision for the investors.
Great investors are not unemotional, but are inversely emotional – they get worried when the market is up and feel good when everyone is worried.
Bill Miller
At times such a discount is also known as conglomerate discount. Whenever the value of the parent company is not a simple sum of its subsidiaries, a conglomerate discount is available. It is common to see the share price of such conglomerates at discount to their simple value i.e. sum of parts. Investors need to understand the discount on offer while buying a conglomerate company’s share which is about to unlock value by demerging its subsidiaries. There could be many reasons why the conglomerate discount exists. Most of the times investors do not want to take exposure to the subsidiary companies but are forced to do so when they buy the conglomerate companies.
Consider, for example, Piramal Enterprises. After thorough due diligence, the pharmaceutical business of Piramal Enterprises looks extremely lucrative and investors would be tempted to get exposed to this business segment of the group. However, when one buys this share on the bourses there is the baggage of buying the non-banking financial company run as a subsidiary by Piramal Enterprises. An investor may like the pharmaceutical business but does not want to be exposed to the NBFC segment of the parent company. This situation leads to the parent company trading at discount and unable to command true valuation.
Being a value investor means you look at the downside before looking at the upside. Face up to two unpleasant facts: the future is never clear and you pay a very high price in the stock market for a cherry consensus. Uncertainty is the friend of the buyer of long-term values.
Investors often compromise in such situations. Another example can be that of RIL. Let’s say an investor is extremely bullish on the prospects of the oil and gas sector in India. RIL being one of the leading players in the sector, an investor may consider buying RIL’s shares. However, after due diligence the investor is concerned about the prospects of its telecom business and also of its retail business, for example. In such a case, the investor will either not take exposure at all in the stock or will reduce his or her appetite for the stock.
Also, most of the times the conglomerate businesses are complex and beyond the understanding of investors, and that can also lead to conglomerate discount. Demerger can lead to unlocking of value as the demerged entity can have better debt and credit ratings, renewed focus, etc. It is quite possible that RIL may have huge debts and hence the cost of debt for Reliance Jio is also high. However, once demerged, the debt will be reduced and the risk perception for the company changes and can enjoy lower cost of debts.
While demergers and unlocking value do go hand-in-hand, the end results are more subjective than what appears to the naked eyes. Demergers could backfire and investors have to be cautious of being caught on the wrong foot. At times the demergers could simply be gimmicks to improve market value and demerged businesses may actually have been better off staying merged with the parent company. The reasons could be brand value, cost sharing or even better management control. Demerger should not always be considered as being ‘always profitable’ for shareholders.
Conclusion
Investors do have a great opportunity to enter into an investment when one sees a company unlocking its value. However, it is not as simple as it seems. Often enough, an investor can get excited on hearing terms like delisting, demerger, merger and acquisition, unlocking value, special dividends, listing of subsidiary, etc. Not all corporate actions may create wealth for shareholders in the long term. One needs to tread carefully.
That said, investors have to carefully analyse the investing opportunities by carrying a sum of parts’ valuation exercise and arrive at the conclusion whether the parent company is available at a discount. One of the better ways to study such opportunities is to look at the gap between the consolidated results and the standalone results. If on a consistent basis a subsidiary is contributing higher revenues and profits, it is a good sign and chances are the profitable subsidiaries could be demerged and listed separately, thus creating an investment opportunity.