Corporate simplification has accelerated in Europe, presenting compelling investment opportunities across many industry sectors
Within Europe, we have noticed a particular phenomenon gaining traction – a heightened focus on corporate simplification. Over the past 18 months, strategic M&A activity has picked up against a backdrop of strong corporate earnings growth, increasing business confidence, buoyant valuations, historically low volatility and easy financing conditions (Figure 1).
With an abundance of cash-rich buyers, firms across multiple sectors are using the M&A boon to restructure and simplify their operations. Divesting or spinning out non-core and underperforming assets on later-cycle multiples and refocusing on the core can crystallize significant shareholder value. Meanwhile, ensuing share price strength of the parent company can be attributed to the potent combination of rebounding earnings growth and / or multiple re-rating.
In the first quarter of 2018, European asset divestments and spin-offs have accelerated. At J.P. Morgan Private Bank we expect this trend to continue – with disruption and shareholder activism key catalysts for progress. Using bottom-up analysis, we identify compelling investment opportunities in European businesses that can:
The rate of technological change continues to increase and disruption is affecting companies across all sectors. Technology is disrupting profit pools, creating greater differentiation between the most successful businesses and the rest of the competition. It is more imperative than ever before that company executives focus their business strategies and unwind complexity that has steadily crept into portfolios over the past decade. Improved management bandwidth and capital allocation decisions can follow.
There has been a resurgence of shareholder activism around the world in the past 12 months across multiple sectors. Typically, activists agitate for change with the ultimate goal of creating financial value, often through seeking out potential buyers for the business, in whole or in parts. With leverage for listed businesses in Europe significantly reduced over the past decade, activists often view balance sheets as a further source of shareholder value release. More recently, active shareholders have also promoted non-financial agendas, seeking to influence a company's corporate governance structure as well as its environmental and social performance.
Activists are no longer intimidated by larger companies. Indeed, many activist situations in the past year have involved household names with big market capitalizations. Campaigns have also been increasingly high-profile in nature. While activist tactics can range from being friendly to hostile, we believe a more co-operative approach is evolving – between the activist and both management and other institutional shareholders. We expect the trend towards large-cap activism and engagement to continue, particularly in Europe, where there is still much catch-up potential versus the US.
The rise of shareholder activism in Europe should encourage company managements to proactively consider measures that can be taken to avoid activist interest. A genuine focus on shareholder value, and transparent communication with existing shareholders, is a good place to start.
Our analysis, using a sample of European corporate actions announced over the past 18 months, shows that buying stocks on the day that a significant divestment or spin-off is declared, and holding this company for up to six months, generated on average 2.4% of outperformance relative to the Stoxx600. Buying ahead of the catalyst has historically proved even more lucrative. Investors who owned the same stocks 12 months before the announcement, and continued to hold them for up to six months following the announcement of the corporate action, would have enjoyed an average of 14.6% alpha relative to the European benchmark over the total holding period. The analysis of corporates undergoing material simplifications also showed the stocks consistently delivered alpha relative to their sector.
When a business has diverse operations, it may not be appropriate to apply standard valuation methodology using group earnings, balance sheet and cash flows. A more accurate measure of intrinsic value may be achieved by aggregating the standalone value of each business unit in order to arrive at a total enterprise value, from which the company's net debt and corporate expenses can be deducted. This technique is commonly referred to as the sum-of-the-parts (SOTP) or break-up value.
A holding company or conglomerate may trade at a discount to its implied SOTP – the "conglomerate discount" (Figure 3). Herein lies the opportunity to crystallize shareholder value through corporate simplification.
Spinning out an asset from the conglomerate creates two distinct catalysts which allow this revaluation to occur:
Critically, to maximize shareholder value creation, the separate valuations of the spun-off entity and the remaining parent should be greater than before the corporate action. As such, value creation may be most significant when the spin-out releases a "diamond in the rough" (a high-growth division that could achieve a materially superior multiple alone) or exposes a lower growth division, the removal of which allows the virtues of the core to shine.
A business does not need to be a conglomerate or holding company in order to benefit from corporate simplification and refocusing.
Simple divestitures can enhance a business’s core growth and returns profile. Again, we see two potential paths to value creation, although a combination may be employed:
In almost every sector across Europe, we are seeing a heightened corporate focus on pursuing value maximization through simplifying business operations. For example,
Looking forward, opportunities abound, across sectors, geographic regions and market capitalizations. To pull out a few specific examples:
What do managers on our platform think?
Och-Ziff Capital Management Group, Co-Chief Investment Officer and Head of Global Credit
“For the first time in a generation Europe is showing a real appetite for corporate change – begetting a wave of breakup, consolidation and M&A activity. In our view, this makes it a very target-rich environment for our style of investing.”
Chief Investment Officer, AllianceBernstein
‘’We have seen increased activity of shareholder activism in Europe over the past 12 months. This has translated in some cases to realization of value but more than that is putting corporates on alert. Management and boards appreciate that if they don’t improve their businesses, there is a fair chance that others will.’’
Chief Executive Officer and Chief Investment Officer Asset Value Investors (AVI)
’Activity levels at many of our European holding companies remain high, as family shareholders and managers continue to agitate for change by, for example, listing private businesses and improving engagement and communication with shareholders. Such actions help the market to uncover the extremely attractive core businesses that are at the heart of many of our companies and, consequently, narrow the discount to net asset value (NAV) at which many of these companies trade.
Identifying catalysts is, we believe, one of our core strengths and provides us with the opportunity to generate above-average risk-adjusted returns (‘alpha’) for our clients.’’
During the first half of 2018 we have observed corporate simplification become an increasing focus for European companies. Portfolio changes can significantly impact on a company’s market value, helping stocks outperform both relative to the sector and the broader European equity index. The presence of activist shareholders in Europe could further motivate managements to take action when a company’s market value falls short of its intrinsic value. At J.P. Morgan we expect portfolio simplification to be an enduring alpha-generating theme and are excited by the many bottom-up opportunities to crystalize value across Europe.
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