Stocks could be multibaggers as they spin!

In the nedevour to identify multibaggers I had discussed How all multibaggers started with small caps, the link between first generation promoters and multibaggers and the effect of scale of opportunity on multibaggers. One of the least discussed ways of making money in the stock market is through buying conglomerates that are ready to spin off business. History shows that any company that has spun off a part of its business has made money for shareholders.The biggest example in recent times was Reliance Industries where shareholders gained 100% after the spini off. I provide some more evidence to back my claim.

1)      Larsen and Toubro was considered more of a cement business rather then a construction company. The construction business used to feed its bleeding cement division. Once the company spun off its cement division the stock went up 10 fold.

2)      In 2003 United Breweries de-merged itself into two companies United Breweries (the beer company) and UB Holdings (the property and investment play). In about three years the collective value of investment is up some 8 times.

3)      2003 was a great year for spin offs. At that time Aptech’s software development division was spun off as a separate company under the name of Hexaware and Hexaware went up 10 times after that..

These are just a few examples of how spin offs created shareholder wealth. I tried looking at the situation with a hypothetical example and then reworking the example to the actual sequence of events to explain the benefits of a spin off. The exercise requires a bit of arithmetic but is very very interesting!

I have assumed the following financial situation for a company that we shall call “Split up Ltd” that is into two businesses Cement (capacity of 1 million ton at Standard EV taken at US $ 100 per ton) and a full fledged construction business.

Workings:

Ø       Book value is Net worth divided by number of shares so we have Rs 900 crores/ 10 crores = Rs 90

Ø       EPS is Net profit/ No. of shares = Rs 100 crores/Rs 10 crores = Rs 10 per share.

Ø       RoE is Net profit/Net worth = Rs 100 crores/Rs 900 crores = 11.11%%

Ø       Since the RoE is at 11.11% we have assumed a PE of 12 for the stock.

Ø       Market price = EPS x PE = Rs 120 (Rs 10 x 12)

Ø       Market Capitalization is equal to number of shares x Market price = 10 crores x Rs 120 = Rs 1200 crores.

Now for “Split up Ltd” company we assume:

·         That capital is equally divided between the construction and Cement division

·         Companies are assumed to be debt free. In any case debt will not affect the calculations.

·         That the construction division (Net profit Rs 90 crores) is feeding the cement division (Net Profit Rs 10 crores)

·         The management after deliberation splits the company into two different companies with a equal share capitals and assets.

·         Two shares of the parent company were exchanged for one share each of the cement division and the construction division.

The share capital and book value will therefore be divided between the two companies.

Ø             Split up Construction Ltd  – Equity of Rs 50 crores

Ø             Split up Cement Ltd – Equity of Rs 50 crores.

 Let us first analyze the financials of Split up Construction Ltd after the split

Workings:

Ø       Equity share capital was halved so 50% of Rs 100 crores gives us 5 crore shares.

Ø       Net worth was halved so 50% of Rs 90 crores means that the net worth is Rs 45 crores.

Ø       Book value is Net worth divided by number of shares so we have Rs 450 crores/ 5 crores = Rs 90

Ø       EPS is Net profit/ No. of shares = Rs 90 crores/Rs 5 crores = Rs 18 per share.

Ø       RoE is Net profit/Net worth = Rs 90 crores/Rs 450 crores = 20%

Ø       Since the RoE is at 20% we have assumed a PE of 20 for the stock.

Ø       Market price = EPS x PE = Rs 360 (Rs 18 x 20)

Ø       Market Capitalization is equal to number of shares x Market price = Rs 5 crores x Rs 360 = Rs 1800 crores.

We now analyze the financials of Split up cement Ltd after the split:

Workings:

Ø       Equity share capital was halved so 50% of Rs 100 crores gives us 5 crore shares.

Ø       Net worth was halved so 50% of Rs 90 crores means that the net worth is Rs 45 crores.

Ø       Book value is Net worth divided by number of shares so we have Rs 450 crores/ 5 crores = Rs 90

Ø       EPS is Net profit/ No. of shares = Rs 10 crores/Rs 5 crores = Rs 2 per share.

Ø       RoE is Net profit/Net worth = Rs 10 crores/Rs 450 crores = 2.22%

Ø       In this case the stock will not sell for a PE determined price because the enterprise value will hold the stock up. This is so because companies that make losses do not sell for free.The enterprise value is  Rs 345 crores

Ø       Market price = Enterprise value/No. of shares = Rs  345 crores/Rs 5 crores = Rs 69

Ø       Market Capitalization is equal to Enterprise value = Rs 345 crores.

If you have lost everything please read back again from the beginning because the idea is very very interesting and important in making big money the unconventional way.

The value of the stock appreciated by 78.75% post the de-merger to Rs 429 from Rs 300 (150 x 2).Two shares of the parent company were exchanged for one share each of the cement division and the construction division.  The reasons attributable for this rise are:

n        The Cement business which was valued at negligible value as it contributed only Rs 2 to the EPS and was valued at Rs 2(EPS) x 12(PE) = Rs 24 per share  was suddenly valued at Rs 69 per share at an Enterprise value of Rs 345 crores.

n        The increase in share price attributable to the cement business was Rs 69 –Rs 48 (24 x 2) = Rs 21 per share

n        The PE of the construction business which was valued at Rs 8 (EPS) x 12 (PE) = Rs 96 expanded from 12 times to 18 times and the EPS went up from Rs 8 per share to Rs 18 per share thus giving it a value of Rs  Rs 360.= 18(EPS) x 20(PE). 

n        The increase in share price attributable to the construction business was Rs 168 per share Rs 360 – Rs 192 (96 x 2).

n        The total increase in share price was thus Rs 21 + Rs 168 = Rs 189

Thus spin offs in companies that have a division which is working below capacity or under a loss would make huge gains for investors. A few spin off candidates in today’s markets are:

Ø       Hinduja TMT (Technology and Media business)

Ø       TV 18  TV 18 and Network 18; at a later date Web 18 (the internet subsidiary)

Ø       GE Shipping (Shipping and Oil Drilling)

Ø       Pantaloon Retail (Central, Home Town etc)

More the losses the spin off division makes more the gains for the investor. Sounds very funny but that is the way it is.

Any suggestions?

I have listed the four potential ones since they should be spinning off in the next 6 - 9 months. Aditya Birla Nuvo wil be a multibaggers only when it decides to de-merge itself into seperate companeis for Insurance , Mutual Fund, Telecom etc