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far from scrumptious
| SEP 03 , 2015

Feature

Looks good, but
far from scrumptious
Demergers and spin-offs have not always worked wonders

Jitendra Kumar Gupta

If a bunch of Indian corporates and their financial pundits had their way, the basic mathematics taught at high schools across the world would need an urgent upgrade, given the rate at which the companies are getting key subsidiaries in their businesses listed of late. Take the case of the Bengaluru-based Biocon, which listed its contract research subsidiary Syngene; Gujarat Fluorochemicals, which listed wind power subsidiary Inox Wind; or Gateway Distriparks, which listed its cold-chain logistics arm Snowman Logistics.

And this is not all — a significant number of companies are waiting in the wings. While Kalpataru Power is looking to list its agri-logistics provider Shree Shubham Logistics with the objective of investing in new warehouses, other names such as HCC, Sadbhav Engineering, GMR and Pennar Industries have already filed the prospectus for getting their subsidiaries listed. Many of these subsidiaries and businesses (divisions) were groomed by the parent company and one of the objectives of these listings is purportedly to create value for existing shareholders.

“There is nothing wrong in listing a subsidiary to raise growth capital. It often happens that you feed and groom a particular business for a while and once it matures, it needs to grow independently through listing, which is possibly the best thing to do from a corporate point of view,” says Sanjay Bakshi, professor at MDI.

“Spinning off of businesses is a successful strategy in India for some companies and the reason is that you have a ready platform provided by an established company or a parent company that will not only provide resources but help supply funding and expertise. Take a look at the history of telecom licences handed out in the country. All of them were grabbed by the leading business groups. If you are a part of a leading group, you have the ability to get loans from banks or raise funds through equity,” says Ajay Garg, managing director, Equirus Capital.

Indiabulls and the Adani Group are probably the masters of the spin-offs space. In its 14 years of existence, Indiabulls has spun off six companies and got them listed. The combined market capitalisation of these listed companies in the real estate, housing finance, power, retail and financial services segments stands at ₹32,000 crore, compared with ₹260 crore at the time of first listing of Indiabulls Financial Services in the year 2004.

If someone had bought 100 shares of the original company at the IPO price of ₹19 a share, those same shares would have been worth ₹152,500 today, combining the value of these listed companies and assuming the dividend reinvested. Our research indicates that the motives behind these spin-offs often go unnoticed on Dalal Street. And since not all these bets pay off, enough companies have been left smarting. Indiabulls’ spin-off of its power business has not worked well and many other companies — like Adani, which has listed its power business — are facing huge challenges, which got reflected in their share prices.

“Spin-offs don’t always work. There are many disasters and one common reason is that a few of these groups have been going through turmoil in their core businesses. Many Indian corporate groups entered retail and now they are either scaling down or shutting those businesses — Bharti got into insurance with AXA and into the retail business with Wal-Mart; DLF entered multiplexes and Kishore Biyani got into financial services. What happened to these ventures is all in the public domain,” says Garg.

Even in the listed space, there is very little proof of success for 23 such spin-off cases. Almost 50% of these spin-offs by demerging the divisions and listing them have generated negative return (see: Tricky business). Part of this can be blamed on market conditions, while the choice of investors tripped up the other half. The mega demerger of Bajaj Group companies into three separate companies — Bajaj Holdings, Bajaj Auto and Bajaj Finserve — was announced in 2007, when the market capitalisation of the holding company was close to ₹27,000 crore. After six months of being listed in May 2008, these companies put together had a market capitalisation of a mere ₹8,525 crore because of the correction in the market from 20,000 to below 10,000 levels.

 

Tricky business

Almost 50% of the demerger of divisions by the parent has not generated positive return for shareholders

Then, Future Retail fell close to 45% within six months of separately listing its high-margin business Future Lifestyle in October 2013, leaving the group with just Big Bazaar and Food Bazaar. Analysts believe that the group gave an easy exit option to investors, who were looking to participate only in branded products. Also, after the hive-off, the valuations of low-margin business got hammered, which together had a negative impact on the stock price.

“A few motivations behind spinning off a business and listing it could be the need to raise cash for the parent during an opportune time, cutting the umbilical cord of an incubated business that is ready to stand on its own feet, exploiting the market’s fancy for an industry and creating a currency for the spun-off unit to enable it to issue Esops to its employees. The most common motivation I have found in India is a family split, where some members of the family are given the spun-off unit,” says Bakshi.

In some cases, the businesses are perceived differently given the nature of the growth, business model and attractiveness of opportunities and their true value certainly does not get reflected in the valuations. Consider the case of Hinduja Group company Gulf Oil Corporation, which was holding businesses such as infrastructure, mining and real estate on the one hand and an oil lubricant business on the other.

It spun-off the latter, which was highly profitable with a great franchise and a market share of close to 7%, making decent return with Ebit of ₹105 crore on ₹166.4 crore capital employed. Compared to this, the construction business was making losses, mining was subdued and real estate, where huge capital was employed, did not take off, leading investors to worry. Around July 2014, existing shareholders were offered two shares of the spun-off lubricants business for every two shares held in the parent company.

Today, the market values Gulf Oil Lubricant at 30X its earnings, compared with 20X in the case of Gulf Oil Corporation. Post listing in July 2014, Gulf Oil Lubricant, the spun-off entity, has given close to 90% return, compared with 5% return given by Gulf Oil Corporation. While explaining the demerger, Gulf Oil Corporation’s managing director S Pramanik said in an interview, “[The company was] not getting the right valuation for its lubricants business because of the mix of other businesses, in addition to the investor demand in the past for a separate listing.”

Splitting to grow

The need to create value and seek growth capital is possibly one of the most common reasons that are cited by the companies spinning off subsidiaries. Many of the new power companies such as JSW Energy, Indiabulls Power and Adani Power were all being groomed under the parent company and when the sector opened and the companies needed capital for growth, they were all demerged for a separate listing.

Inox Wind, a subsidiary of Gujarat Fluorochemicals, which is the turnkey solution for the wind sector, commenced operations in 2010. In March 2015, realising that the market is opening up and it needs to scale up its manufacturing capacities, it raised funds through an IPO. Its promoters had already injected significant equity into the company but given that it needed large capex to grow in size, the listing came as a big support. Out of the total issue size of ₹1,000 crore, it planned a capex of close to ₹600 crore, which is close to 40% of the net assets of the standalone operations of parent company Gujarat Fluorochemicals. The company is also looking to expand its tower manufacturing capacity from 150 towers per annum to 300 towers per annum and will use funds to manage working capital, which is expanding with the growing order book and scale of business  because of the inventories at different sites.

Similarly, Snowman Logistics, the cold-chain logistics service provider and subsidiary of Gateway Distriparks, raised ₹200 crore through its IPO to fund its capex for setting up warehouses, which is again critical for its growth and scale and may not have been possible without support from the parent company. About six months before the spin-off of the company in September 2014, Gateway Distriparks was valued at ₹2,000 crore in terms of market capitalisation. Today, its subsidiary (40.26% stake) alone has got a valuation of close to ₹2,000 crore. 

In most of these cases, the spin-off IPO was also a function of taking advantage of investor sentiment regarding a particular sector or to attract higher valuations, which may or may not be the case with the parent company (see: A mixed bag). Gateway Distriparks was able to capitalise on the idea of cold-chain logistics, with investors willing to pay higher for the business considering its advantages and growth. Today, Snowman trades at 80X its earnings, compared with Gateway Distriparks, which is trading at 23X.

 

A mixed bag

Barring a few, the listing of subsidiaries has not really worked wonders for the mcap of parent companies 

“Typically, for the holding companies, the value should be the sum total of all their businesses and this should reflect in the sum-of-the-parts analysis. However, unfortunately, that does not happen. Look at any listed company today and most tend to trade at 60-70% discount,” says Soumendra Nath Lahiri, head-equity at L&T Investment Management. Of course, there are times when investors are not willing to take extra risk in the name of diversification. This is where demergers and separate listings could work.

However, if the listing happens without shares being issued to the existing shareholders of the subsidiary company — like in the case of Godrej Industries, Biocon, Financial Technologies and Bharti Airtel — it is quite possible that the minority shareholders might have an issue with not being given an option to exit.

In the case of Marico Kaya, the existing minority shareholders of Marico had demanded that they be issued shares of Marico Kaya. As a consideration, the shareholders of Marico as on the record date were to be issued one share of the company with a face value of ₹10 each at a premium of ₹200 per share for every 50 shares of Marico with a face value of ₹1 each. And this is not a stray case. 

Investors had issues in the case of Crompton Greaves as well, which at one time was reeling under severe pressure because of poor performance of its power equipment business and the shadow cast by the international power business on the consumer electric business. In Q4FY15, its power system business, accounting for 62% of the consolidated revenue, saw a 7% decline in sales, whereas profits halved to one-fifth.

Importantly, in FY15, the power system business made ₹135 crore profit (1.6% of sales) on sales of ₹8,574 crore and ₹4,086 crore capital employed, which explains what an inefficient user of capital it is. On the contrary, the consumer product business made a ₹401 crore profit (12% of sales) on turnover of ₹3,233 crore sales and on a negative capital employed. Despite this, its performance was not reflected in the price as on a consolidated basis it was making a RoCE of just 11%, compared with 30% in the case of the consumer product business.

That apart, the consumer business generates free cash flow, compared with other capital-intensive businesses that require continuous capex. Moreover, the beauty lies in the valuation. When news about the demerger of the consumer business came, its stock was trading at around ₹120 a share. But after the news, the market started to look at things differently. In line with the valuations of Havells (at around 20X FY16 earnings), the value of Crompton’s consumer products was estimated at ₹100 a share on estimated earnings of ₹5 in FY16. No wonder, then, that in September 2014, it made a high at around ₹226, which captures the entire value that the market saw.

Better prospects

Recently, Greenply Industries demerged Greenlam Laminates and issued shares in the ratio of 1:1 to get the entity listed separately. Market experts explain that this has largely to do with family issues. “If the business was flourishing and there were operating advantages, why would you go for a 1:1 ratio? To our mind, it was a split in the business between family members, which is why both the businesses are now headed by different members of the same family,” says Paras Bothra, who tracks the company at Ashika Broking.

And promoters don’t just have an eye on current fortunes. The flurry of positive developments such as policies on renewable energy and a pick-up in capex along with investor sentiments about the renewable sector helped companies like Inox Wind, with parent Gujarat Fluorochemicals selling 1 million shares valued at around ₹320 crore (50% of the market capitalisation of the parent) through an offer for sale. Not just the promoter company, even the promoter group companies, which held close to 25% stake, are today valued at ₹2,000 crore as against the original cost of their holding at around ₹10 crore. As against the allotment price of ₹325, Inox Wind is currently trading with a gain of 22% at ₹395 a share. 

“The listing has helped Gujarat Fluorochemicals in two ways: one, it has been able to capitalise on the listing by way of selling shares and getting money for itself, which it can use in future. Second, the parent still owns a 61% stake; whatever valuations expansion happens in the case of Inox Wind will directly get reflected in the valuations of the parent,” says Deepak Ashar, MD, Inox Wind.

Reliance Power is another classic example where the company was carved out from an already listed company Reliance Infrastructure (earlier called Reliance Energy) despite the parent company holding power generation business of its own. An year before the IPO, holding company Reliance Infrastructure was trading at around ₹500 a share, which jumped to around ₹2,500 levels after the IPO of Reliance Power in February 2008, with each share being issued for ₹450.

Not just Reliance Infrastructure, which holds a 42.2% stake in the company, its promoters and promoter companies also got a huge deal, as they were issued shares at ₹10 a share before the IPO. The public was offered a 10% stake in the company for an issue size of ₹10,000 crore, whereas promoters and group companies had a 90% stake for an existing ₹2,000 equity. Since listing at around ₹220 (adjusted for bonus) in February 2008, the stock has fallen to ₹41 a share at present, which means that the promoter and the promoter group were the only ones who made money in the IPO. 

Some of these spin-offs are also aimed at helping the parent company. Biocon sold an 11% stake in its contract research arm Syngene through a ₹550-crore offer for sale, which means that promoter Biocon will be the key beneficiary of the listing. In an analyst conference call in January, founder and CEO Kiran Mazumdar-Shaw said that the IPO proceeds from the offer will help fund Biocon’s requirement for cash, including R&D and its own capex requirements.

She also said that the expansion costs on things like the $200-million insulin plant it is building in Malaysia had affected the company’s bottom line and that selling shares in Syngene can help address that.

“Listing helps to a great extent, particularly when parent companies can leverage and sell some some of their holdings in the market to pocket some money,” says Anand Shah, CIO, BNP Paribas. This is apparent in the case of Bharti Airtel, whose tower arm Bharti Infratel used to get nothing at one time but post listing in 2012 has attracted many investors and got close to ₹91,000 crore market capitalisation. More importantly, promoter Bharti Airtel has been selling shares in the secondary market. Since the June 2014 quarter, Bharti Airtel’s stake has fallen from 79.42% to currently at 71.72%. “The stake sale has helped Bharti raise money for its own capex and for spectrum auctions,” says Vivekanand Subbaraman of HDFC Securities.

Helping hand

The need for funds for the parent company and increasing pressure from banks and private equity have also led many companies to opt for listing. Sadbhav Engineering, which has a debt to equity of 4X because of the road BOT assets in its subsidiary company Sadbhav Infrastructure Project, is now looking to reduce its debt through listing. Kalpataru Power’s logistics arm, Shree Shubham Logistics, Pennar Industries’ Pennar Engineered Buildings Systems, HCC’s Lavasa — all of these have filed their prospectuses and are looking to reduce debt.

 

Waiting in the wings

The value of subsidiaries are much higher than that of their parents

 

 

 

 

 

 

 

If the companies are able to list these subsidiaries, that will not only help in providing growth capital and reduce leverage but will also unlock value for the shareholders. For instance, the value of HCC’s Lavasa is a mere ₹17-18 because of the deep discount of 50-60% applied on the fair value of Lavasa. Once listed, Lavasa will not only be market-driven but the discount will also narrow down. Barring Kalpataru Power, where the embedded value of its subsidiary is only about 17% of the market capitalisation of Kalpataru Power, in all the other cases, the embedded value is high, which indicates that if a rerating happens on the higher side post the listing, there could be higher gains for the parent company. 

Lavasa, HCC’s prestigious real estate project, had been looking to raise funds through an IPO for a while. Since its IPO plans have seen huge delays, the company had to depend on its parent HCC. The parent had originally planned for a ₹2,000-crore IPO in November 2010, which was later shelved because of litigations with the environment ministry and other issues. It again filed a draft prospectus for ₹750 crore, for which it got approval in November 2014.

Around ₹200 crore of the issue proceeds is earmarked for the repayment of debt. Even today, the prospects of this IPO are dim because of the lack of investor appetite for the real estate sector. Meanwhile, the risk of these mega projects, which are cash guzzlers, is sitting on the books of HCC. “With estimated debt of ₹3,500 crore as of FY15, Lavasa currently has an annual interest obligation of ₹400 crore. However, in FY15, Lavasa failed to generate any surplus operating cash flow to service this interest, on account of weak sales and operating expenses on city maintenance. With no visible near-term improvement in sales expected, we expect Lavasa’s debt to rise further in FY16E barring any large sale to institutions,” says Adhidev Chattopadhyay, analyst, Elara Capital. The subsidiary has been making losses because of the interest cost and other operating expenses that have had a negative impact on the books of the parent company HCC, which on a standalone basis remains profitable. 

In a recent development, Sterlite Technologies, which is the leading player in optic fibres and power transmission, is separating its power business, which got into trouble after winning six BOT transmission projects and taking debt on the books, leading to overall losses despite its optic fibre business being highly lucrative given its leadership, growth, technology, fully integrated operations and high margins.

“We aim to reduce shareholder risk and at the same time create value for our optic fibre business, which could get greater recognition once the capital-intensive power business is separated,” says Ankit Agarwal, global head, telecom products, Sterlite Technologies. While this could be a good move, the existing shareholders either have the choice of selling the demerged entity’s shares, priced at ₹22 a share, to its promoters or wait for the listing.

While there have some successful spin-offs, for the rest, especially companies in the power and infra space, the ability to raise funds is limited and the process could be challenging if they aren’t able to raise funds and infuse capital into these companies, especially if it is an unlisted arm. Spin-offs and demergers have been largely driven by the promoters and are fed by their need to create more value for themselves rather than the investors.

For some, this has been a means of raising money to fund their own capex plans and for others, it has been the route to provide an exit to private equity investors. Only in cases where the business fundamentals have been strong has spin-offs been a winning strategy for investors. Sometimes, you just can’t win. 

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