I came across something interesting the other day, something that has the potential to make us a decent gain if it plays out the way some of these situations have in the past.
This isn’t a standard small-caps play. In fact, the company hasn’t even been formed yet, so I don’t have that many details!
But it’s an opportunity I want us to look at. It’s a pretty rare occurrence nowadays and I think we’d be crazy not to have a look at it.
This isn’t something I’d normally be interested in
BHP Billiton, the multinational mining and metals company is going to spin-off a division of unwanted assets into a new company.
It’s pretty common for large companies to dispose of divisions from time to time. But I’m a bit cynical about this whole acquisition/disposal game. It just seems like an endless back and forth.
One CEO will get bound up in the excitement of doing a major deal, egged on by investment bankers sniffing mega fees.
Then one of his successors will probably end up paying out another king’s ransom in fees to undo that same deal in the name of ‘restructuring’.
And on and on it goes.
It’s hard keeping track of financial fashion
There have been plenty of academic studies over the years which suggest takeovers don’t create value and often destroy it. And a lot of deals get done as a homage to corporate fashion. As a result, these things go through cycles.
For instance, in the ’60s and ’70s, conglomerates were all the rage. In fact, my first employer was one of the leading examples of this craze.
ITT stood for International Telephone and Telegraph. It began life as a US owner of phone networks. But it had greater ambitions and expanded internationally.
In the UK, it owned electronics company STC (Standard Telephone and Cables), which made some sense. But – a bit more strangely – it was also big in financial services and owned Abbey Life Assurance (where I started my investment career).
With conglomerates at the time, it didn’t necessarily matter what assets you had – just that you had a lot of them.
And it wasn’t just American giants like ITT who were acquiring assets this way. Over here, we had Hanson Trust which was a huge stock market success in the ’80s. Hanson made everything from cigarettes to bricks – hard to spot the synergies there!
Back then, conglomerates could get a premium rating, with the market believing that the more assets a good management controlled, the better. Diversification was seen as ‘a good thing’.
But then fashion changed and ‘focus’ became the buzzword. Diversification was now bad. Companies needed to be focused to get the best results. So, most of the conglomerates were dismembered – more fees for the bankers.
The next big mania has been scale. You’ve got to be big! So in 2007, mining giant Rio Tinto acquired Alcan at the top of the cycle and destroyed tons of shareholder value in the process.
Of course, not all of these mergers ended as badly as Rio’s.
In 2001, Billiton merged with BHP to combine mining with oil and create a colossus.
But life has become a bit trickier as the commodities boom has faded. So, it’s time to downsize and focus the portfolio a bit – hence the Billiton spin-off.
I said I was a bit cynical about all this – actually, I’m very cynical about it as you can tell. But one thing interests me about this latest deal.
What makes BHP’s deal different?
The BHP deal is somewhat different to many other disposals in that it’s a proper spin-off to shareholders. That means that the shareholders will get 100% of the shares of the new company.
These sorts of arrangements are relatively rare nowadays. Quite often, the company making the disposal will take the opportunity to raise some cash as well by IPO-ing (initial public offering) the assets it wants to get rid of. This was the step taken by Lloyds with its TSB disposal.
Otherwise, we might get a trade sale with the proceeds returned to shareholders if the company doesn’t need them. Like Vodafone and its Verizon stake sale.
But if the parent company can’t get a premium price from a sale, simply handing the assets over to shareholders makes sense on several levels. After all, the shareholders already own them. And by distributing shares in the new company as a ‘scrip dividend’ – a type of bonus dividend – the parent company avoids the huge expense of an IPO.
Pricing is a lot easier too. The market simply decides what the shares are worth when they are introduced to the exchange and start trading.
But the really interesting thing about spin-offs like this is that they can offer some excellent buying opportunities.
BHP shareholders are going to be selling like crazy
The spin-off company, we’ll call it Newco, is usually a peripheral business, which is deemed ‘non-core’. By definition, it’s unfashionable. Or it contains troublesome assets, or operations that the management just doesn’t like for whatever reason.
So there isn’t a ready-made fan club in place for Newco. Likewise, there’s no incentive for investment banks to drum up support like there is in an IPO.
But there is the chance that under a focused management and with its own identity, Newco will become a better business in the long term. At least that’s the rationale behind the deal – and it’s not a silly one.
In the short term though, value can emerge for sharp-eyed investors.
This value largely comes from the unfriendly attitude of the shareholders to this new piece of paper they’ve just been given. They are invested in the parent company – that’s who they bought shares in, not Newco.
On top of that, there’s the problem of weightings. Let’s say an investor has 2% of her portfolio in the parent company. This drops to 1.8% after the spin-off with Newco accounting for 0.2%. Well, a 1.8% weighting is still meaningful and the investor can top it up if she wants.
But what does she do with the 0.2% scrap in Newco? The easiest thing is just to dump such a small holding rather than research Newco and build it up.
So you tend to see a lot of uninformed selling of Newco just because it’s the line of least resistance.
As a result, Newco ends up being significantly undervalued while it finds a shareholder base that actually wants to own it.
The Billiton spin-off is also complicated by Newco not having a London listing. This factor will likely encourage a lot of selling purely because many UK funds simply won’t be allowed to own it.
So, the scope for extra value being thrown up by the process is increased.
Now, I haven’t done any research on the deal yet and I’m not a keen investor in resource stocks. But the nature of the spin-off certainly makes it interesting and could well create a value opportunity.
The press comments on Newco have generally been negative, which also ties in with my reading of these situations. It could well end up being a bargain.
Definitely one to keep an eye on.
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