Understanding Demergers with the ITC example
What is the BIG DEAL.
Market has a brain of its own, it has a collective wisdom to value a company and while we are not a fan of efficient market hypothesis (it fails at the tails), generally speaking it gets it right.
Market in its wisdom, values a conglomerate at a discount, always has, always will. (never say never or always but you get the drift)
Lets say a couple has 3 kids. One is a IVY league with distinction, currently working as VP at google. Second is an IAS officer currently working in PMO and third is a college dropout, a beach bum with drug issues.
Now, if all 03 kids are living under the same roof, market would consider that family as a conglomerate and therefore NOT price it exorbitantly.
Kid 1 and Kid 2 will have hard time getting an arrange marriage proposals, thanks to kid 3 image.
To solve for this problem and many other alignment and focus problems, companies often decide to separate the divisions.
This process of separation is called demerger and corresponding marriage proposals for the bright kids is called Value unlocking. Sometimes the beach bum druggie gets beaten so bad and blue post demerger, that some value starts emerging there as well and a nice rags to riches story gets sewn.
Lets understand some KEY WORDS.
EX date: No, we are not talking about your x girlfriends birthday, It is the last date before which you need to be holding ITC to be eligible for the demerged entity. Stock would trade EXcluding demerged entity after that and therefore the share price will adjust (gapdown) accordingly.
The shares of demerged entity would list after a few months (usually 1-3) and eligible shareholders will receive shares in pre decided proportions in their dmat.
ITC demerger is one of those stories that every value investor has been hearing since eternity. The story has been passed from one generation to another. ITS FINALLY HAPPENING.
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Lets see the Return on capital earned by each division of ITC.
No prize for guessing, the earning boy of the family is Cigarette followed by Agri business. Again, no prize of guessing Hotel business is capital intensive and returns are in single digits there.
This still doesn’t bring home the point. We will be able to see a clear contrast when we see how much contribution each kid is making for the family (conglomerate)
If we will look at capex distribution, you would realize that hotels eat up around 20% of total capital while delivering only 4% for the revenues and 2% to the ebit. Cigarettes' business is the cash cow by a big margin. Good margins, great ROC, minimum capital required and as if that was not enough, serious barriers to entry.
ITC is demerging its hotel business in this SPIN OFF.
Now this demerger is slightly different. Usually, the demerged entity gets a mirror image of shareholding pattern as its parent but in this case ITC management has decided to keep 40% share with themselves and only the 60% remaining would be for the public. This has been done to ensure that there is no remote possibility of a hostile takeover attempt. Readers would do well to dig up old articles of GESCO demerger and Prof Sanjay Bakshi/Dalmia escapades where they pocketed a cool 9 crore profit in the process. https://www.livemint.com/Home-Page/jQkAyvlM9wDQO1Nhg7tLcN/The-untold-story-of-Great-Offshore.html
Our SOTP analyses conclude that this is a non event. 70% ITC share price comes from cigarette division valuation and another main chunk from FMCG.
Although the listed hotel business is expected to be debt free and with their drive for asset light model, the roce is expected to improve as well, it remains to be seen where it lists and if we will have something on the table.