Earlier this week Origin Energy announced their decision to spin off the company’s portfolio of conventional oil and gas assets in a move designed to repair the company’s balance sheet and restore it to profit growth. This action will create two companies a $1.5 billion conventional oil and gas company and the rump energy utility business tacked onto the Queensland APLNG export project. Interestingly Origin Energy was itself spun off from building materials company Boral in 1999!
Whilst many in the market have pointed to the rising oil price as a motivation for this move by Origin Energy; more cynical investors may look at the performance of high profile BHP spin-off S32 that closed today (8/12/16) at an all-time high of $3.00, compared with its listing price of $2 in May 2015.
In this note we are going to look at the rationale behind spinning out assets to form a new company.
The Ignored Child gets a New Lease of Life
The most common reason cited for a company demerging or “spinning off” a division into a separately listed vehicle is that the previously unloved or lower growth division will now be run by management totally focused on it. The theory goes that, because of this increased love and focus and not having to compete with other larger divisions for management attention and capital, the demerged division begins to prosper. Furthermore, management at the parent company benefit, as the more attractive “core” business is now re-rated upwards by the market and valued on a higher multiple. The sum of the two parts becomes greater than the original whole.
In Origin’s case, it would be hard to imagine that management attention has been predominately concentrated on the $25 billion APLNG project and keeping the utilities business humming along to support the capital calls required to build this project. Understandably given the falling oil price and rising debt burden, the conventional oil and gas have seen very little growth capital over the past five years.
Recent examples of this can be seen in Orica’s 2010 spin-off of their paint division Dulux and Woolworth’s spin-off in 2012 of a portfolio of shopping centres into Shopping Centres Australasia Property Group and Brambles’ demerger of its underperforming data management business Recall in 2013. These three spin-offs have proved to be very successful with all three outperforming the parent since they were listed.
It was evident for those who met with the new management teams of the spin-offs post their demergers, these management teams exhibited a great deal of pride in the results of their own smaller companies. Furthermore, as stand-alone companies both Dulux and Shopping Centres were able to make acquisitions to grow their businesses, moves that probably would not have been approved if they were still competing with Orica and Woolworth’s much larger Australian grocery and global mining services for capital.
Not all that Glitters is Gold!
Whilst the above more recent spin-offs have all outperformed their parents, it would be wrong to think that all spin-off result in large boosts to shareholder value. BHP has previously spun-off divisions in the past that they viewed as less desirable.
In 2000 BHP demerged their long steel division (Arrium née Onesteel) and in 2002 their flat steel division BlueScope. This was motivated by the view (which proved to be correct) that greater returns could be made from digging ore out of the ground and directly shipping it to China, rather than in manufacturing commodity steel in Australia. Furthermore, BHP was able to “spin-off” the industrial relations headaches that are present in the heavily-unionised steel manufacturing sector. Additionally, BHP shareholders are now no longer on the hook for the clean-up and redundancies of Arrium’s Wyhalla steel mill. Similarly, the 2015 S32 spin-off removes from BHP the political risk of a meltdown in South Africa.
These BHP spin-offs performed very well in the years post the spin-off, with Onesteel’s market capitalisation rising from $400 million to $6 billion and BlueScope from $2 billion to $9 billion. During those heady years, BHP was criticised for letting go of their steel manufacturing businesses as it may face for spinning-off South32, however often the genius behind this course of action does not become apparent for several years.
In the period up until 2007, these two newly separated steel companies enjoyed the benefits of a low AUD and more importantly supernormal profits from being able to fix their material costs (iron ore and metallurgical coal) annually in a period of steadily rising steel prices. The breakdown of the annual iron ore contract system that had been in place since the 1960s in 2010 and the move to short-term prices has permanently removed this source of profits for the steel mills. Further as a result of dilutive share issues in the period between 2009 and 2012, BlueScope is now 18% below its initial 2002 issue price and Arrium 100% below its 2000 issue price in nominal terms!
The most consistent winner from spin-offs are the investment banks that are advising the companies to make these corporate changes. BHP paid US$115M in fees to create South32, though we would expect a slightly lesser amount for the Origin Energy spin-off to accrue to UBS and Macquarie Bank. Additionally, the investment banks also wet their beaks during the four major capital raisings that Arrium and BlueScope have made since 2009!
Whilst the above suggests that spin-offs can unlock hidden value for shareholders, there are downsides. Two separately listed companies results in the additional costs of maintaining two separate listings on the ASX such as two separate boards and management teams. From years of looking at Origin’s conventional oil and gas assets, the spin-off company will own a range of interests in projects in Victoria, South Australia and New Zealand. These are steady, not particularly low cost operations with minimal exploration upside. For new purchasers of stock it is hard to see significant upside, given the continued impact of US shale oil on global energy markets.