To break up or not?

By Khairie Hisyam

Eight years after a mega restructuring into the conglomerate it is today, Sime Darby is now at a crossroads. Can the group manage its heavy borrowings to avoid a rating downgrade while addressing a long-term devaluation issue?

________________________________________________________________________

As conglomerate Sime Darby’s results for the financial year ended June 30, 2015 (FY15) were released in end-August, the emerging picture was abundantly clear: the behemoth, having posted arguably its worst full-year performance since relisting as the new entity in 2007, is facing a crunch.

On one front, the group is grappling with prolonged downturn in terms of its major core businesses, which have dragged earnings down heavily. In addition, the turbulence came at a time when the group is trying to manage a substantial spike in borrowings over the past year, which has put a strain on its balance sheet and putting it at risk of a rating downgrade.

A more long-term problem is that Sime Darby, nearly eight years after returning to Bursa Malaysia on Nov 30, 2007, has been losing value. Its closing price of RM7.50 per share on Sept 2, 2015 put its market value at RM46.6 billion, 21% lower than its initial public offering (IPO) valuation of RM59.5 billion in 2007.

To be fair, however, a substantial part of this decline can be attributed to selling pressure pervading the stock exchange in recent months.

Combined, these issues pose a difficult question: how does Sime Darby address them going forward?

At a media briefing to present its 4Q15 numbers on Aug 26, group management affirmed that the group will continue managing costs closely on all fronts to weather the storm. In particular, president and group chief executive Mohd Bakke Salleh reaffirmed that the group is exploring ways to pare down its debts, which had been speculated as potentially involving a rights issue of up to RM6 billion.

One interesting note however was the mention of further monetisation of assets towards this purpose. This in turn gives fresh rise to a question that has been hanging over the group for some time – breaking up the conglomerate to unlock the value within.

But this is a tricky proposition because in the end the group management team led by Mohd Bakke may end up working themselves and a number of employees out of their jobs, depending on how a demerger goes. On the other side of the equation is, however, the duty to pursue the best course of action for the group. This is explored further later in this series.

When KINIBIZ reached out to Sime Darby to explore the matter further, however, the group declined to add anything to previous statements. “Sime Darby will make an announcement on any measures undertaken at an appropriate time.”

A conglomerate in chains

For years, Sime Darby’s overall valuation had been held back by a discount owing to its conglomerate structure, which in turn makes it difficult to push for a sustained earnings growth trajectory as different divisions had experienced differing fortunes in their respective sectors.

While it is difficult to pinpoint the exact quantum of undervaluation, especially considering the recent selling pressure in the market – which some analysts feel had been overdone – as well as the complexities of evaluating each division’s value, a cursory attempt on the Plantation division, the biggest single contributor to earnings, sheds some light.

On Sept 3, 2015, Sime Darby was trading at a price-earnings (PE) ratio of 20 times, according to Bloomberg. This is the second-lowest ratio among a number of major plantation counters surveyed by KINIBIZ, with only United Plantation trading lower at 19 times.

It is a perplexing state of affairs as Sime Darby’s earnings capacity from its plantation business, as well as the level of governance, does not fall short compared to its peers – in some cases even standing taller.

And the discount extends to Sime Darby’s other divisions as well, with risks and potential volatility in other component sectors giving pause to investors who are only interested in one core sector or another.

The net result is a depressed valuation which may indicate that the group is currently valued less than the sum of its individual parts, had these parts been listed separately at present.

The most straightforward way to negate this discount is to spin off Sime Darby’s core businesses into listed entities in their own right. This would provide investors direct exposure to the respective sector of interest and, in turn, allow each core business to be properly benchmarked against its peers vis-a-vis market valuation.

Volatile earnings trajectory

In terms of overall financial performance, the group had not seen earnings stability which is traditionally associated with the conglomerate structure. This owes much to the volatility in the sectors that drive most of its income – Plantation and Industrial.

Both divisions traditionally make up about half group revenue and two-thirds pre-tax profit. While in previous years swings in these divisions had largely offset one another, the past couple of financial years had seen both grapple with downturns simultaneously.

This was reflected in group financial performance in FY15, which saw the lowest pre-tax profit recorded since 2007 with the exception of FY10. However, FY10’s abnormally low numbers were due to a one-off RM2 billion loss from a now-defunct Engineering division which was a scandal unto its own at the time.

For Plantation, a downturn in crude palm oil (CPO) prices is a major challenge while the Industrial division is struggling with a prolonged depression in the Australian mining sector – owing to weak global coal prices – as well as weakening demand in its other markets due to dampened global market conditions.

Cumulatively in FY15 this led to a couple of interesting firsts for Sime Darby since the relisting in 2007: collective contribution from both divisions to group revenue fell short of 50% while collective contribution to group pre-tax profit fell below 60%.

Against this backdrop of earnings turbulence, Mohd Bakke stated in the Aug 26 media briefing that the group will continue to control its costs closely to weather the volatility in Plantation and Industrial sectors.

Part of this effort had been underway for a while in Australia, where its Industrial division is weathering a prolonged storm amid a weakening mining sector. For instance, in February this year Mohd Bakke stated that the group’s workforce in Australasia had been slashed by a fifth and that the cost-cutting measures are an ongoing process.

Gearing surge

However, an additional issue also weighs down on the group going forward: a surge in the group’s debt level over the past year due to its RM6 billion acquisition of New Britain Palm Oil Ltd (NBPOL).

As FY15 concluded, the group’s gearing ratio stood at 58%, according to group chief financial officer Tong Poh Keow on Aug 26, compared to 38% a year ago. A more desirable level, said Mohd Bakke at the same briefing, is in the 30%-35% range.

The surge is mainly attributed to the NBPOL deal, which was concluded in March this year. While there are arguments that Sime Darby overpaid for the deal, Mohd Bakke had consistently defended the acquisition as fairly priced and too good to pass up, going on to say that consolidation after a merger is a normal part of corporate growth.

In hindsight, the acquisition came at an inopportune time considering the challenges the group is grappling with. And the strain is visible. According to unaudited figures for FY15 released in end-August, some RM4.86 billion of Sime Darby’s RM18 billion borrowings are in short term revolving credits and trade facilities.

This raises the spectre of a ratings downgrade for Sime Darby, something the management is keen to avoid – it is currently looking at ways to strengthen its balance sheet and bring gearing down to a “more palatable” level, presumably below 35%, though nothing had been concretely decided according to Mohd Bakke.

Already the group is under pressure from ratings agencies to do this. In April Moody’s Investors Service warned that Sime Darby’s leverage position needs “swift reduction” after falling outside its “A3” rating limits, though the “A3 stable” rating was retained.

On May 28, Standard & Poor’s Ratings Services (S&P) downgraded the group from “A” to “A-”, citing among others the RM6 billion NBPOL deal as well as weakening cash for outlook and ringgit depreciation.

While Moody’s reaffirmed its A3 rating in early September, it changed Sime Darby’s outlook to negative as the A3 rating is not sustainable at the current leverage. “The company… indicated that over the next six to nine months gearing – as measured by debt/equity – could fall to around 35%-40% from 58% currently. On that basis, and given the company’s long track record, the rating action has been limited to a negative outlook at this time.

“However, failure to deliver on the de-gearing within six months could lead to further erosion in SDB’s ratings,” said Moody’s.

A report by The Star in the final week of August said Sime Darby is mulling a rights issue to raise some RM6 billion. And the figure may not be too far off either.

Essentially a measure of debt against equity, the gearing ratio is calculated by dividing total borrowings over total equity. To bring gearing ratio down from 58% to 35%, Sime Darby’s RM18 billion in borrowings would need to be reduced by roughly RM7 billion, presuming total equity remains fixed at RM31.37 billion.

One option, despite what would seem a less-than-favourable environment, remains spinning off one or more core businesses to raise some funds towards this end.

Mohd Bakke’s endgame

The separate listing of Sime Darby’s core businesses, however, is not a new idea. In fact Mohd Bakke himself had previously stated a long-term goal of having several listed subsidiaries under a flagship entity.

However, the situation has come to a point where Mohd Bakke must decide whether this desired endgame must be pursued immediately despite less than ideal circumstances, especially with a six-month deadline imposed by Moody’s. While this may be extended with substantial show of progress on Sime Darby’s side, the clock is ticking.

Many other questions arise. Among them, apart from timing concerns, is how far a break-up would solve Sime Darby’s immediate woes, how the group might go about pursuing Mohd Bakke’s endgame and what the eventual structure may look like.

Such a long-term demerger process carries many benefits. For one, it would remove the conglomerate discount attached to the group’s value over the years, a shackle that has constrained value creation since the 2007 mega merger.

In addition, it would improve transparency and governance while, in the more immediate term, raising cash for the group to pare down its borrowings or any other purpose.

KINIBIZ explores these concerns and more in subsequent articles.

Tomorrow: The case for a break-up