Demerger – A Tool For Value Creation

Demerger – A Tool For Value Creation

What is a demerger?

In a normal commercial sense, a demerger means splitting of two or more business segments from its nucleus into separate individual existence. The business segment parting ways is incorporated as a separate corporate entity while the remaining business continues to operate under the demerged corporate entity.

A demerger can be seen as the opposite of a merger. With a merger, the object is created as synergy i.e. to take two separate business entities and combine them to form a new corporation that is able to accomplish more than the two former entities could ever accomplish on their own. While the demerger has also the same ultimate goal, however, the synergy is sought to be achieved by splitting off a portion of the existing company into a new and separate corporate entity, since the chances for success and profitability are greater than if the company remained one unit. This usually happens when the profits of a successful unit get sucked in by the inefficiency of the other and which is not immediately perceived as the two units function as one.

In India, the definition of demerger is not expressly defined under the Companies Act 1956 but the transaction is covered by virtue of arrangement as defined as per clause (b) of section 390 of the said Act. However, the definition of the term demerger is provided in the Income Tax Act by virtue of section 2(19AA).

Why do companies go for demerger?

There are many reasons why a company may undergo a demerger process. Let us look at some of them –

  • In some cases, the action may be necessary in order to comply with laws and regulations in place in a location where the company wishes to establish a presence.
  • At other times, a division may have reached a point where it would become more profitable if it were to become an entity that is separate from the parent.
  • The demerger may come about because the parent is changing direction and the division may be spun off as a way to continue meeting the needs of current clients while allowing the parent to focus on new markets.
  • Segregating assets with low operating performance potential helps in improving return on capital employed in the remaining business.
  • Another advantage of opting for a demerger is enhanced ability to leverage on equity account i.e. in a high growth phase, companies need funding an ongoing basis, as they focus on capacity expansions and acquisitions to achieve global size. There is a limitation on internal accruals and debt raising, which is a function of the equity base and that is where the demerger offers a solution. For example, a company with presence in the cement and sugar businesses will attract a larger set of equity investors once it segregates the businesses; also, it can choose to dilute equity only in a particular business.
  • A demerger assists in creating specific management focus on a particular business. For enterprises with businesses in different industry segments, a demerger can assist in segment-wise alignment and creation of focused entities.
  • Demerger as a concept is tax neutral in nature to the satisfaction of various conditions for instance specified under the Indian Income Tax, 1961 which may be used as tax planning device by corporate entities. Also additionally it is subject to lower stamp duty regime in various states in India that reduced the overall cost of the transaction.

In all cases, the general idea behind the demerger is to prove the action profitable for all parties concerned.

Spin – off by corporate through direct trade sale of their business segments is in substance a transaction of demerger. A trade sale is a standard, everyday corporate practice, a constant swapping of businesses as companies rethink their purposes and define and reinforce their ‘cores”. If the bought business does better, that merely means, that it’s found a more appropriate home. While the purchaser of your disposed business may be benefiting mightily, you should be doing likewise with your purchases of other people’s cast-offs.

It’s a two-way trade.Under Jack Welch, for instance, General Electric has bought businesses on a grand scale, ranging from modest units to record-breakers like RCA and Honeywell. But Welch has also been a heavy seller, even dropping the small appliances that had long been GE’s standard bearers. The appliance sale was bitterly opposed and resented by old-line managers who regarded appliances as the sacrosanct heart of the corporation.

The disposal, though, followed naturally from Welch’s famous strategic insistence that GE businesses which were not first or second in their markets would be revamped or sold. The strategy is central to any intelligent thinking on disposal, whether by sale or demerger. The intelligent strategist is juggling the corporate portfolio to serve strategic aims.

Nokia, for a spectacular example, exited from paper, tyres, metals, electronics (including PCs), cables and TV sets. The bold strategy was to concentrate on a single growth market, mobile phones – which duly rewarded the management with phenomenal success. Strategic considerations are crucial in opting for demerger. Will the strategic ends of the business concerned be better served as an independent, quoted entity than as a subsidiary? Then act: demergers unmake strange bedfellows.

The common objective is to add ‘shareholder value’. Any disposal, including trade sale, will substitute cash and/or securities for assets. The special shareholder benefit of demergers depends on the reaction of the stock market. The classic situation is where the subsidiary is in a highly rated sector (highly rated by the market, that is) and the vendor is unfashionable. Demerger then unlocks the hidden value for shareholders who receive some of the demerged equity.

How does demerger create value for its shareholders?

According to Michael McKersie, assistant director of investment affairs at the Association of British Insurers whether it’s a merger or a demerger they must be done because they create value for shareholders and that’s got to be the bottom line. The value created for shareholders is positively reflected in the market price of the demerged and the resulting corporate entities where the split in businesses is clearer cut and better thought out.

Coming home the recent demerger of Asian Hotels Limited [AHL] [now Asian Hotels (North) Limited name changed with effect from April 16, 2010, Source NSE] Delhi-based and one of the largest players in the hospitality business is aiming in unlocking further value for its shareholders.

The deal in brief –

  • The Company would demerge into three separate entities and the three undertakings will own one property each in Delhi, Mumbai, and Kolkata. All the three entities would be separately listed and traded on the exchanges.
  • Asset Segregation –
    1. The Mumbai undertaking, along with investments and development options in Bangalore, would be transferred to its subsidiary Chillwinds Hotels.
    2. The Kolkata undertaking, along with investments and development options in Bhubaneswar and Regency Convention Centre and Hotels Limited, would be transferred to its subsidiary Vardhman Hotels.
    3. And the Delhi undertaking would form the residual Asian Hotels.

The three original promoters of AHL — the Jatia Group, the Gupta Group and the Saraf Group will thus part ways and now own three independent companies each charting its own growth path. This is good news for retail shareholders as AHL has put unofficial brakes on expansion plans due to the demerger process. Two unique advantages each promoter would have are the location and the ‘Hyatt’ brand name of all the three hotels. Asian Hotels has three 5-Star deluxe hotels in the three metros — Hyatt Regency in Delhi, Mumbai, and Kolkata.

All three metros are important and lucrative from the business point of view. The possibility of the three new companies growing through inorganic route cannot be ruled out either considering the metro location and the promoters’ aggressive intent of growing in the hospitality business.

The demerger may lead to tremendous value unlocking for investors as it had happened in the past with most corporate splits once the other two resulting companies are listed on the recognized stock exchange. However the market price of Asian Hotels i.e. the demerged company has gained approximately 3 times from April 1, 2009, trading at Rs 210. 10 per share to Rs 560.40 per share as on February 23, 2010.

Similarly in another recent case of demerger the wheel business of Enkei Castalloy Limited the demerged company is transferred Enkei Wheels (India) Limited the resulting company. The transaction of demerger here is also aimed at creating value for its shareholders and clear cut management focus on foundry and wheel businesses which would be operated by the demerged and the resulting company respectively. The result is evident in terms of the market response based on its perception of value unlocking through a demerger. The share prices of the demerged company have multiplied approximately 6 times from April 1, 2009, trading at Rs 21.05 per share to Rs 119.60 per share as on March 31, 2010. The same perception may be carried for the resulting company once it is listed on the stock exchange.

Another recent example can be considered is of Kirloskar Oil Engines Limited engaged in the business of manufacturing and sale of diesel engines, generating sets, bimetal bearings, bushes and bimetal strips. The engines and auto component business was demerged to Kirloskar Engines India Limited the resulting company. The disintegration was considered to enable management focus in creating values for the businesses separately. Fir instance with the current surge in automobile sector which is likely to grow at 10% to 12% in 2010 as per the global rating firm Fitch in its report titled ‘Indian Auto Sector Outlook’ [reported in India Today In dated January 19, 2010]. The report also points out increased competition between automobile players which in turn would also bring in stiff competition amongst auto component manufacturers and add to it many international OEMs are coming in either independently or in collaboration with existing players with the objective of reducing time to market and to take advantage of an established distribution network, the report said. Keeping in view the competition ahead it is very significant for management to have an undivided focus in conducting business. In this regard, the demerger of engines and automobile business would reap in benefits in creating value for its shareholders.

The share prices of the demerged company have multiplied approximately 3 times from April 1, 2009, trading at Rs 56.15 per share to Rs 164.85 per share as on March 31, 2010. The same perception may be carried for the resulting company once it is listed on the stock exchange.

Demergers staging a come back globally

Spin-offs at Cable and Wireless and Carphone Warehouse have underlined a shift in the deal cycle – the return of the demerger. Not since the start of the last decade has the trend for splitting up businesses particularly in Europe, had such momentum, say investment bankers and analysts. With corporate buyers and private equity short on the ground, the comeback of such deals is no surprise as demergers are often seen as the less risky cousin of mergers and acquisitions, and have a better track record of boosting shareholder value.

The stock market debut of Carphone Warehouse’s newly demerged retail and telecoms interests unlocked additional value for shareholders, writes Andrew Parker Financial Times. The combined market capitalization of the demerged companies was 10 percent higher than the old Carphone group. Charles Dunstone, Carphone’s founder, said he was considering a demerger in 2008 after investors pressed him for a separation of the company’s retail and telecoms interests.

According to Daniel Still it, a special situations analyst at UBS, who published research looking at demerger activity over the past decade shows of 75 European demerged companies since 2000 showed spin-offs outperformed Europe’s top-300 groups by 16 percent a year on from deal completion. Mr. Stillit believes there will be a “flurry” of spin-offs in the coming months. But he points out that not all demergers do equally well. Some of the best performers are those spin-offs that are used as “bait” for potential buyers. “Carving the business out can make it more saleable. If you do the spin-off, shareholders can still catch a takeover premium later,” Mr. Stillit says.

Similar research from Deloitte, the accounting firm, and the London School of Economics indicate demergers were largely beneficial for shareholders. In a still nervous economic environment, companies in a demerger have the advantage of tending to perform well regardless of the way the overall market is moving, UBS and Deloitte research shows. Nevertheless, the spin-off part of the business often performs better than the larger parent, according to research from Thomas Kirchmaier of the London School of Economics. One reason for this is the demerger throws light upon parts of the business that were hidden to investors beforehand.

Neil Sutton, head of corporate finance at PwC in the UK, says the logic of a successful demerger must be that the valuation of the “sum of parts will be more clearly seen by the various different investor group than as a conglomerate”.

Companies that take longer than nine months to plan their demerger generate at least two times more value than those that take less time, achieving an average 20 percent increase in their share price, according to Deloitte.

Source : Financial Times published March 29, 2010

Demerger scenario in India

Coming back home India Inc has been bitten by a demerger bug. A large number of listed companies have announced plans to hive off a part of their business to unlock value, attract investors and take tax benefits ahead of proposed changes in taxation rules. According to stock exchange data, companies that have announced demerger plans since the beginning of this year include Transport Corporation of India, Triveni Engineering & Industries, Dalmia Cement Bharat, Texmaco, Biopower, Harrisons Malayalam, ETC Networks and Rain Commodities.

Many old listed entities are only holding companies created to ensure the promoter holding remains at comfortable levels. Investors of such companies are dependant on dividend income. Demergers help companies create operational entities wherein potential investors can invest,” said Kapoor. Harrisons Malayalam plans to demerge its investment undertaking into Sentinel Tea and Exports.
Pankaj Kapoor, managing director, Harrisons Malayalam, said demerged units gave investors an option to invest in operational companies rather than purely holding ones.

Another reason for a surge in such instances is the proposed changes to Section 56 of the Income Tax Act which, once implemented, will make the consideration received in kind by a company from its parent or a subsidiary taxable as income from other sources. One view held by tax experts is that this may cover demergers, although this is debatable. Market participants are quick to point out the advantages of demergers from a tax perspective and also from an investor point of view.


Though demerger as an approach is adopted by a corporate to boost shareholders value in the long run but it must proceed with a clear carve out of businesses to be operated separately. But here remains a concern among investors that companies do not rush to demerge simply because they have become the flavor of the month in a sluggish merger market where bankers are looking for new sources of fees. They must be done for the benefit of all stakeholders of the corporate entity.

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