December-January 2015

EQUITIES: Fashion led by bankers

Fasion modelBreaking up conglomerates is challenging, but investment banks often pitch the concept that value in individual businesses will be set free. Stefanie Eschenbacher explores the investment case for conglomerates. “Fashion led by bankers” is how Hermes Investment Management’s head of global equities Geir Lode describes the investment case for conglomerates.  The fashion rotates in a cycle much slower than the short-term economic cycle. And while break-ups of conglomerates are hard, investment banks can earn substantial fees from initial public offerings, mergers and acquisitions. So is the suggestion that conglomerate investment is sparked by a bank’s need for fees? “There is no doubt that banks need to maximise earnings. However, an increased investor appetite for conglomerates cannot be attributed to a simple rise in the number of banks pushing corporate activity,” Lode says.  “It is also connected with the ever-evolving business model; as corporations grow and change over time, they attract attention and management will seek as much security as possible, which can lead to activities such as IPOs and M&As.” Alex Morozov, director of equity research for Europe at Morningstar, says break-ups are often driven by activist investors.  “When a conglomerate does break up or sell some of its parts, the market tends to react favourably to that. Investors believe that there is a lot of value trapped in those conglomerates.” Dylan Ball, a portfolio manager at the Templeton Global Equity Group, adds that the conglomerate ideas that have given him and his team the most upside are those where a group unwinds and this leads to a discount in valuation. Ball highlights the cases of US industrial Tyco and, more recently, manufacturer SPX. When Tyco exited non-core businesses, like its US residential security business ADT, Ball says valuations rose as the stock market focused on the remaining fire detection business.  He adds: “Given comments made by Philips with regards to exiting its lighting business or even Siemens and its healthcare unit, we could again see this unwind of the conglomerate discount coming into similar play for these two European industrials. ”Pauline McPherson, co manager of the Kames Global Equity Fund at Kames Capital, says the concept of value being trapped in a conglomerate is indeed frequently pitched by banks to potential corporate clients. “The only real value-creating opportunities for these companies is when the divisional management are incentivised and empowered through a standalone structure to run the business and maximise the returns if they are not in a group conglomerate structure,” McPherson says.  There are few conglomerates left in Europe, and even those have been shedding parts, or have indicated that they plan to. Chemical and pharmaceutical conglomerate Bayer plans to float its plastics business in what could be one of the biggest IPOs in Europe for years. Founded in 1863 as a manufacturer of synthetic dyes, it is now shifting its focus to life sciences. TRANSFORMATIONS
Siemens, with a history dating back to 1847 and a product range spanning home appliances, healthcare and energy, has also started streamlining its business. The healthcare business, deemed non-core, has been separated from the rest of the business. The German company sold its hospital information technology and its microbiology business.  Nokia, which started out in 1865 with a paper mill, has seen one of the most drastic transformations. Over the years, it manufactured goods as diverse as wellington boots, chemicals and televisions, until it decided back in the 1990s to make telecommunications its core business.  It partnered with Siemens in 2007 to focus on mobile broadband, and with Microsoft in 2011 to strengthen its position in the smartphone market. Two years later Nokia sold its devices and services business to Microsoft to focus on networks and technology.  None of these companies have the same breadth of business that conglomerates had even in the 1970s after the focus of recent years on core businesses. McPherson, who holds Nokia, Bayer and Novartis in her portfolio, says one of the reasons conglomerates typically trade at discounts is that they have high central cost structures to manage their businesses.  McPherson says Bayer’s central costs have fallen and should be reduced further through the spin-off of its plastics division. “That focus allows the board and the executive management team to maximise the parts of the business that are left,” she says. “It is simple common sense.” McPherson says there should be no change in value across the remaining businesses and the business that has been spun off to shareholders. While there is a possibility for a self-fulfilling prophecy, the effect is likely to be only short term. “I would never bet on a change in value just because of that change in structure, but there is empirical evidence that the asset that has been spun off does have an increase in value,” she says.  “The investment bankers who are pitching these deals to potential investors will be using these kind of arguments, trying to win their fees, but theoretically there should be no difference.” There are a few exceptions. One of them is the now defunct Fortis Group, which was once active in insurance, banking and asset management before it was broken up and its non-insurance businesses were sold in parts.  The group received a bailout from the governments of Belgium, the Netherlands and Luxembourg during the financial crisis. Its Belgian banking operations were later sold to BNP Paribas, and its insurance and banking subsidiaries in the Netherlands were nationalised.  McPherson says the combined ratio of the non-insurance businesses in Belgium, the Netherlands and Luxembourg has improved and the management of the insurance business, Ageas, has been able to focus its efforts. With less complexity, it is easier for fund managers like McPherson to evaluate the investment case for these businesses. “There is a greater disclosure on what was previously a divisional level when it becomes a free-standing company,” she says. Daniel Hemmant, a senior portfolio manager, European equities, at BNP Paribas Investment Partners, holds Smiths, an industrial company that also has a large healthcare division. “Part of the potential appeal is that they are becoming more focused,” Hemmant says. “The market does not like [conglomerates], it prefers businesses that are focused.” There is pressure from shareholders, and management is often criticised for wanting to run a larger company as opposed to a better company. In those cases, they are more likely to be viewed as value destructive. MOVING PARTS
“When a company gets really complicated, the market will start to apply a conglomerate discount on the basis that there are too many moving parts,” Hemmant says. There is no data on how large these conglomerate discounts are, but Morozov says they do exist, primarily because of a belief that conglomerates are not the most effective at getting the real value out of their individual segments. McPherson says the financial crisis did reassert the strengths of some of these conglomerates, in part because they were able to diverge cash flows. Ball tends to find the most upside in conglomerates in periods of macro crisis when earnings of units are under pressure. The valuation discount in a pure-play business is much greater when its single earnings source comes under pressure. Lode estimates the discount applied to conglomerates had narrowed to as little as 5%, but is now up to as much as 15%. Lode says they are “too big to fail” and stable companies are typically favoured during times of uncertainty or when fund managers want to spread risk through diversification.  “Conglomerates also have a fancy tax department so they are good at taxes and minimise their tax exposure,” he says. “That might be more difficult for companies that are not as diversified and involved in as many businesses.”  Lode says he prefers transparent companies, but one conglomerate he does call a high conviction stock is Berkshire Hathaway, which owns a large number of subsidiaries and significant stakes in others. In its portfolio is a company called MidAmerican Energy, which Lode says investors often consider as a legacy business and do not value it.  “When we look at the company, we actually find that it has a lot of clean energy, a big focus on solar energy and that is hard to find because it is hidden in reports.”  “Transparency is a big issue with these companies.” Lode says conglomerates need to become better at communicating with investors and highlighting the businesses they have, because investors tend to be “a little lazy” when looking at firms’ valuations.  In Berkshire Hathaway’s case Lode credits the ability to allocate capital of chief executive officer Warren Buffett – who, incidentally, is often quoted saying that “wide diversification is only required when investors do not understand what they are doing”. ©2014 funds europe

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