ASX Index Inclusions And Corporate Spin-Offs

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Research suggests investors ultimately benefit from demergers but patience is often necessary, while the latest index changes have gone largely unnoticed

-Latest index inclusions, ahead of ASX departure of Coca-Cola Amatil, have gone largely unchanged
-Studies show listed spin-offs typically outperform the parent after 12 months
-Initial underperformance can offer timely entry points
-Telstra spin-off strategy offers 50% bull case upside

By Rudi Filapek-Vandyck & Mark Story

Bye Bye Coca-Cola Amatil

There is plenty of research out there on how inclusions and exclusions from major share market indices can have a noticeable short-term impact on share prices, but let's just say not all index adjustments are equal.

As of today, 22 April 2021, Coca-Cola Amatil ((CCL)) is no longer included in either the S&P/ASX100 or S&P/ASX200 now that the Supreme Court of NSW has approved the scheme of arrangement through which the company shall be acquired by Coca-Cola European Partners, (CCEP).

Index manager Standard and Poor's has chosen Lynas Rare Earths ((LYC)) and Redbubble ((RBL)) to fill in the vacant spots for ASX100 and ASX200, respectively. There's never but one single factor in play when it comes to judging share price movements, but investors would have to call upon quite an unhealthy portion of imaginative price chart reading to find any noticeable impact from the S&P announcement made on April 16th.

Share prices for both fresh index additions have tracked lower over the past week, as the market in general is losing a bit of steam having previously rallied past the 7000 mark with quite some gusto. Lynas has added more momentum to the downside with the release of its quarterly activities report on Thursday, which clearly didn't please everyone.

Investors should also note: Lynas now being included in the ASX100 means the stock will be removed from the Small Ordinaries Index.

As far as Coca-Cola Amatil is concerned, its share price peaked back in 2012, at $15, and nearly nine years later trades are happening at around $13.31 (shareholders stand to receive $13.32 in cash next month, on top of 18c in dividends if they were on the register on April 19).

Once considered the equivalent of a solid Warren Buffett stock on the local exchange, the past near-decade has been characterised by painful vulnerabilities, failures and structural challenges for the local Coke bottler. New management tried hard to right the ship, but never quite succeeded in its quest, as also demonstrated by the fact it is a fellow Coke bottler that is buying the lot, warts and all included.

Which makes one wonder: is any investor truly feeling sad about the pending departure of Coca-Cola Amatil from the local exchange? Not even the prospective yield, on current consensus forecasts, looks particularly attractive. When another household brand name, DuluxGroup, was acquired by Nippon Paint Holdings back in 2019 there was equally an absence of deep national mourning, but Dulux, at least, had much better performance numbers to show since its spin-off from Orica in 2010.

The latest index inclusions might not have inspired many an investor to climb on board the register, but maybe the studies below into corporate spin-offs might.^(*) Vale Coca-Cola Amatil. Thou shalt not be missed. (Still sad about losing DuluxGroup though, that was a true, under-appreciated All-Weather performer).

Spin-off spoils go to those willing to wait

While there are many reasons cited by companies when embarking on a break-up strategy, including disruption, ESG issues and hidden value, notes Wilsons, most often companies are responding to a period of sub-optimal returns for shareholders.

Having looked at 16 demergers since 2010, the broker concludes in most cases demergers create value during both the demerger period as well as post-demerger over the following 12 and 24 months.

Wilsons' data reveal the smaller asset or spin-off typically performs better than the parent, and on average outperforms the parent by almost 2x over the following 12 and 24 months.

In the best of these examples, Macquarie Atlas Roads outperformed its parent 144% to 21% in the first 12 months, followed by Orora (65% versus 27%) and Recall (43% versus 15%).

However, based on Macquarie’s analysis of 42 demergers in the Australian market dating back to 1995, there’s initial weakness in demerged entities, with the child entity typically underperforming the market by up to -10% in the first six months.

Yet in the last five years, Macquarie data suggest the underperformance has been stronger and longer. Macquarie research also suggests the child entity begins to perform more strongly from 12 months after the split.

The broker notes this initial underperformance can offer ASX investors timely entry points for longer-term outperformance. For example, while recent spin-offs United Malt Group ((UMG)) and Deterra Royalties ((DRR)) have both underperformed in line with historical trends, Macquarie’s fundamental equities research team has an Outperform rating on both stocks.

From demerger announcement until implementation, Macquarie’s data indicate the trend for the combined entity appears to be more negative than positive. But the broker notes there is typically limited detail announced around these transactions, hence creating uncertainty and broad valuations by analysts.

In addition to quite broad analyst valuations, Macquarie suspects that issues around shareholder approval also add to spin-off uncertainty. The broker suspects shareholders not wishing to own the child entity will be reluctant to own too much of the parent stock prior to the split, as they would then be entitled to a larger part of the child.

It is not until around 18 months post-split that Macquarie research observes outperformance from the parent stock.

11 spin-offs in play

Despite empirical evidence that spin-offs, demergers, and asset sales can create significant value, Wilsons concludes for most companies, the focus on growing value is highly correlated with growing in size.

While the (demerger) process -which can consume 12-24 months of work and hefty external legal and advisory fees- can also divert focus away from the day-to-day running of the business, Wilsons believes the value creation opportunity can be significant.

The broker has identified 11 companies within the S&P/ASX 200 that are pursuing a break-up strategy. The Wilsons Australian Equity Focus List currently has 7% of the Focus List in “Asset Valuation Plays” where the broker argues that within each company there is significant hidden value.

A corporate break-up strategy to release value has been well-proven across all markets over many years and Wilsons notes investor preferences for defined, narrow businesses rather than conglomerate structures began in the 1990s.

Wilsons can see clear signs of significant value uplift being created for seven of the 11 companies currently in spin-off mode: IGO Group ((IGO)), Link Administration ((LNK)), News Corp ((NWS)), Seek ((SEK)), Suncorp Group (SUN)), Tabcorp Holdings ((TAH)), and Telstra ((TLS)).

While it’s still early days for many of these spin-offs, Wilsons believes companies with the biggest potential upside include News Corp (25%), IGO Group (20%), and Tabcorp 10-20%.

In a bull case the broker believes Telstra implies 50% upside -using offshore multiples of infrastructure asset- from splitting infrastructure and its low multiple retail business. But Wilsons notes this could take five years to execute.

Given Suncorp’s sub-scale banking operations puts its core insurance business on a large net tangible asset discount to Insurance group Australia ((IAG)) –1.5x NTA versus 3.0x NTA– Wilsons believes a divestment of the bank assets, and move away from a ‘bancassurance’ model could see a significant valuation uplift.

On the other hand, the broker believes there are question marks over how much value (if any) spin-offs for AGL Energy ((AGL)), AMP Ltd ((AMP)), Woolworths ((WOW)), and even Westpac ((WBC)) will create.

In the case of AGL Energy, Wilsons believes it’s unclear if investors will be willing to re-rate legacy generation assets. Similarly, the broker thinks the inability for investors to value AMP Wealth with any confidence adds to valuation uncertainty for AMP, even under a potential break-up scenario.

While Wilsons believe stocks that can show a quality/growth bias will outperform over the long term, the broker notes such stocks can suffer from periods of underperformance, and cites rotation from growth into value over the last six months.

News Corp

For example, since News Corp -which is splitting the business into a pure-play global online housing portal, and online premium media/content business- adopted its simplification strategy in mid-2019, the stock has outperformed the market by almost 70%.

Wilsons believes a demerger or corporate restructuring would likely see the market re-rate the company materially higher.

But demerger aside, Wilsons’ strong conviction on News Corp is also based on the prospect of a very strong post US cyclical recovery; particularly relevant for the REA Group ((REA)) and Move (US online property), a global housing upcycle, and the company’s simplification strategy.

The broker notes before the valuation there was a disconnect on various assets. For example, The New York Times trades in earnings (EV/EBITDA) basis of 35x, almost double the News Corp earnings (EBITDA) multiple of 18x.

Wilsons believes the NYT provides a clear valuation reference point for News Corp’s Dow Jones and Wall Street Journal assets; both of which are premium content properties with global reach.

Under this scenario Wilsons believes the unwinding of the News Corp conglomerate discount and adoption of pure-play multiples implies a valuation of close to $40 per share.

Adding further to the broker’s conviction around the potential for near term restructuring is the end of favourable tax advantages for News Corp.

This follows the sale of News Corp’s 21st Century Fox to Disney in 2019 for US$71bn. These restrictions lifted in March 2021, and with Rupert Murdoch turning 90 this year, Wilsons notes rival press reports have already started anticpating a final burst of deal-making before handing over the reins, most likely to son Lachlan.

^{(*) Always do your own research!}

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