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Brambles and the de-merger proposition

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By Roger Montgomery

Brambles, the world’s leading supplier of pallets, has recently announced that it will demerge its Recall business, which specializes in document management.

In setting out a rationale for the demerger, management and the media have presented various ways that the transaction may create value for shareholders. As value investors, we at Montgomery Investment Management are keen students of anything that has the potential to do such a thing. But when we study the rationale for the transaction, we can’t help feeling that when others talk about value, they are talking about a concept that is rather different to our own.

Real value

On the surface, a demerger is not much more than an accounting change. Shareholders of the combined company will receive a proportionate amount of shares in each of the separated divisions, but in aggregate, there will still be the same amount of debt, the same amount of equity, and each business will still have the same fundamentals.

Companies merge when they believe their combined value would be greater than the sum of their parts. Mergers can create value from synergies, either through cost efficiencies or revenue opportunities from the combined operations. To the extent that these synergies can give rise to incremental earnings and cashflow that would not otherwise have existed, this is an entirely legitimate rationale.

Where is the value creation in a demerger?

In the case of Brambles, while the pallet division shares little synergistic benefits with the document management division, it doesn’t appear that there should be any value destruction inherent in the current structure, and which could be avoided by demerging.

Demergers are often justified on the grounds that the businesses will be operated more effectively by two separate management teams. This is normally referred to as “focus” and this is certainly one reason proffered by Brambles.

Management has reasoned that Brambles will be able to focus on ongoing opportunities for growth and shareholder returns from the company’s global Pooling Solutions operations, while the newly independent Recall Holdings, will provide investors with stable revenues and strong cash flows.

We have trouble accepting this as a valid reason to demerge a corporation. Under the same parent company, the Pooling Solutions division has become a world leader, and by management’s admission, the Recall business has a strong financial profile that has consistently created value for Brambles shareholders.

At its heart, these are two fundamentally different businesses; the paper management industry is in decline, while Pooling Solutions is growing strongly. This isn’t going to change if the two companies operate separately or within the one parent company, but it is a clearer insight into why management is seeking to demerge.

Share prices post merger the key

A demerger will create two separate share prices for the high and low growth divisions, and these share prices will move in accordance to these growth profiles. In this sense, management’s reference to maximizing shareholder returns has more to do with the post-merger movements of the share prices than the fundamentals of the businesses.

At Montgomery, when we talk about value creation, we are referring to changes that lead to incremental earnings and cashflows, rather than something that may lead to the same earnings attracting a higher multiple. Value creation as we see it can take many forms, including minimizing costs, having an effective corporate strategy, and making the right business investment decisions.

Demergers can have benefits, but it is easy to get caught up in things that create a perception of value creation, but may not do much to improve the fundamentals of the respective businesses.

The one thing you can be sure of is that the investment bankers will extract real – not perceived – value in the form of their transaction fees. In order to overcome this frictional cost, there should at least be some real value creation on the other side.

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.

Published on: Saturday, July 13, 2013

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