Carving out value: dna 25TH July 2007

It is not unusual to see a company separating one of its divisions into a new entity and getting a nod in the stock market for its action.
The share price goes up and the shareholders gain, thus vindicating the decision. This keeps happening in USA, Europe and Japan. In the last six years there have been a number of such actions in India which come under the umbrella of the synonyms of demergers, spin-offs, carve-outs, and so on.
There was a time when companies went in for diversification — very often in unrelated fields, either because it was trendy or because it came along with an alliance with a foreign collaborator.
After a while, the management realises that this business is a burden on the P&L account. Demergers then are the logical corollary, and the market applauds it with higher valuation for both the entities.
The basic premise here is that parts of the company get a better valuation than the single entity. The issue now is whether or not this can be a workable strategic proposition: Can we get superior valuations from demergers?
Companies such as Hindustan Lever, L&T, Tata Steel and Tata Motors have moved away from their non-core businesses using this route. Exiting from unviable businesses has been a common corporate strategy to address the challenges of competition.
Two aspects need to be debated: the motivations for such an action and the actual experiences of companies in this regard.
Spin-offs or demergers are definitely used to get better market valuations. That’s so because the market now gets more information on both the companies, thus reducing the information asymmetry, and investors are able to evaluate the companies in a better way.
A company would typically try and spin-off a unit or line of business which no longer adds value to the balance sheet.
Selling unwanted and surplus or unconnected parts in the business is a restructuring strategy to get rid of the sick parts of the company.
The other reason could be to return to its core competence and move away from unrelated fields. At times the better valuation helps it garner resources to finance an acquisition.
Such moves also help to make financial and managerial resources available for developing other, more profitable opportunities.
Take the case of L&T, which is primarily an engineering firm. It had capital locked in cement, which was driving the profit level down. So it made sense to demerge this unit so that the valuation of L&T improved. How did this happen?
The profit ratios improved as the balance sheet of the cement division was separated and the share price rose manifold.
Similarly, EID Parry was able to separate its sugar business from fertilizers, which went to Coromandel fertilizers. Now Reliance Communications is planning to hive off its towers business to unlock value at the bourses.
These success stories could be attributed to proper planning where there is better management focus and greater flexibility in operations.
While the results have been encouraging in terms of better valuation, the motivation was definitely restructuring of business lines. All spin offs have not been successful even when they’ve made theoretical sense.
This holds especially for the IT education business, where companies such as Aptech and NIIT separated software from education.

However, this could be attributed more to the diminishing importance of the education business where it was no longer the prerogative of these institutes to provide the service.
The question now is whether or not the value created through such separations is real. Most spin-offs are invariably of divisions that are not performing: rarely does a company find an unrelated business a burden if the profits are streaming in!
In the last 6 years or so, there have been more successes than failures. As long as the premises are right, the chances of success are greater. However, there are some preconditions.
The resulting business has to be a viable one (NIIT). Secondly, the business (to be spun-off) must be one which is bringing down the value of a company due to the absence of the required skills or management time for the same (L&T). Thirdly, the hived off unit must have a capable management.
Anecdotal evidence suggests that the market is mostly rational and awards a better valuation only if enhanced value is seen. Mere spin-offs do not guarantee better valuations. This critical point must not be missed.