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Sime Darby’s own management is already considering spinning off some of its divisions, it appears, though perhaps not to the extent of completely breaking up the conglomerate. But how do you break it up for maximum benefit? In the second of an 8-part series KiniBiz examines the three options available.
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When merging Sime Darby, Guthrie and Golden Hope through Synergy Drive in November 2006, among the main objectives were to create the world’s largest listed oil palm plantations group, through which the group was eyeing greater economies of scale and cost synergies.
Additionally the merger would also have created a focused set of core businesses in the Asia Pacific region, and therefore be poised to benefit from population growth and economic development across the region, according to the merger prospectus.
However after six years these have not translated into increased value for the resulting entity that is Sime Darby Bhd, as examined briefly yesterday. The charts show that Sime Darby underperformed the FBM KLCI by about a third since the new entity was listed in end-November 2007. So what went wrong?
The question that needs answering is whether Sime Darby’s current structure is flawed and, if it is, what would be better. A simple analysis by KiniBiz yields three options going forward:
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Maintain the existing structure which puts businesses under divisions.
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Break up into independently listed sister companies held with Permodalan Nasional Bhd (PNB) as the major shareholder.
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A listed holding company which holds majority stakes in five listed companies, excluding healthcare.
KiniBiz uses six parameters — transparency, accountability, governance, independence, risk and valuation — and matches this against the three structures to see which is most suitable. We basically use three scales — three stars indicate the best result, two indicates moderate and one star weak.
On this basis, the indications are that the holding company structure is best (see table above). KiniBiz examines each in turn.
Transparency
A perennial problem with conglomerates is the question of transparency. With only the collective conglomerate face shown to the investing public, the divisions are somewhat shielded from open scrutiny.
Thus it becomes problematic to assess whether the conglomerate’s resources, talent and energies are fairly allocated across various divisions. Indeed it becomes problematic to accurately measure the individual performances of each division, too. Much can be hidden in the inherent structure of the conglomerate.
“(The conglomerate structure) opens room for camouflaging,” said one analyst to KiniBiz on the corporate structure model.
Both the other structures will give much more transparency as they will list the profits according to the business types. Investors would be able to examine the accounts of the individual businesses directly and evaluate their performances more accurately.
Therefore both these alternatives can be considered to be equally transparent.
Accountability and governance
The lessened transparency from the conglomerate structure naturally raises issues in terms of accountability and governance as well.
The independent sister companies structure addresses this problem by exposing the management of each business directly to market scrutiny.
But the holding company structure improves on this further. In terms of accountability there are two levels in the holding company structure — first to the holding company and then holding company to the ultimate shareholders.
The holding company is effectively the one that monitors the other companies to ensure performance and to oversee movements of assets and other resources between companies.
Independence
In terms of independence, this is greatest when each of the companies report directly to shareholders without having to report to an intermediate holding company and be governed by its imperatives.
This simply does not happen under the conglomerate structure, but would if Sime Darby were to be broken up into independently listed sister companies.
However, the disadvantage is that the companies may be too independent if PNB does not monitor the companies closely, which lends weight to the holding company structure where there would be a dedicated management team providing a check-and-balance mechanism for the listed companies.
Risk
The safety of the conglomerate’s collective balance sheet carries the risk of any one division overextending itself, a long-standing concern with conglomerates, by taking on business ventures that are actually beyond its individual capability but looks palatable for the conglomerate collective.
In other words, individual divisions may be tempted to bite off more than they can chew. And they may not even realise that they are doing so.
This has happened before with Sime Darby — in 2010 the conglomerate booked about RM1 billion in losses from cost overruns for the Bakun hydro-electric project. According to a news report, the government reimbursed the group some RM700 million, meaning the losses would have hit RM1.7 billion otherwise.
Prior to that, Sime Darby’s Energy and Utilities Division posted RM1.75 billion in losses in FY09, and in the late 1990s Sime Darby’s then-banking division Sime Bank recorded a pre-tax loss of RM1.57 billion for the six-month period ended Dec 31, 1997.
Past incidents of Sime Darby’s divisions going into business ventures only to end up losing money raises concerns about how well risk is managed under the current conglomerate structure.
Belgian economist Mathias Dewatripont wrote in a 2005 paper titled “Risk-taking in Financial Conglomerates” that as far as risk-taking goes, conglomerates are not necessarily more prudent than standalone companies.
“Conglomerates may … be extremely risky or extremely virtuous relative to stand-alone firms, with conglomerate behaviour going from one to the other extreme when a threshold in terms of bankruptcy cost is crossed,” concluded Dewatripont. “This means that the ‘stakes’ of supervision may be significantly raised by conglomeration.”
In terms of risk, the existing structure is the worst while a holding company structure gives one further layer of governance, making it the least risky.
Valuation
One advantage that has been put forward as far as conglomerates go is that it offers investors a diversification option by investing in one well-diversified entity for lesser overall risk and, again, earnings stability.
However the counter-argument is that investors can diversify on their own as easily if not more so, by choosing well-run standalone companies in the sector of their choosing. Arguably this presents a better option compared to being handed an arbitrary choice where sectors they seek to invest in are lumped in with industries that do not interest these investors.
Extending that scenario, some investors may be eyeing a conglomerate’s particular division only but are either forced to take the whole package or worse shying away from investing in said conglomerate altogether.
In Sime Darby’s case, this means its market value may not be optimised, as higher risk in one division — real or perceived — may drag down another division in terms of overall valuation.
Mohd Bakke Salleh
When asked whether Sime Darby current valuation is inaccurate, Sime Darby president and group chief executive Mohd Bakke Salleh responded via email that as a publicly listed company, the value of Sime Darby’s shares are determined by market forces.
“The management focuses on improving operational efficiencies and achieving its strategic goals in an effort to enhance shareholder value,” said Mohd Bakke to KiniBiz. But that does not address the issue of structure versus valuation.
In terms of valuation, the one that gives the most choice is the holding company structure, where potential investors can choose to invest in any of the businesses or in all of them through the holding company or any other combination.
Choosing the right structure
After examining the six parameters, the emerging picture is Sime Darby would be better off broken up into separately listed entities from the current structure.
But which structure is the best fit for Sime Darby? One option is to separate all divisions into independently listed entities, linked only by common shareholders.
At present Permodalan Nasional Bhd (PNB) effectively holds 52.25% of Sime Darby through various vehicles, while Employees Provident Fund (EPF) has 10.95%.
Among others, this arrangement addresses the issue of inaccurate valuation brought about by lumping together different businesses with different risk profiles together. Separately listed on their own, each of Sime Darby’s current divisions would be more accurately valued given investors can now weigh the listed entity solely on its core business activity and assets.
With a clearer picture of the true value and risk profile of each separately listed business, investors would also benefit as they can choose the sector they want to invest in without having to put up with divisions they are not interested in.
However, a downside to this proposed structure is that investors who are so inclined would not have an option for investing into an entity with diversified businesses, especially if such an investor specifically prefers Sime Darby as a conglomerate.
Therefore while this proposed structure seems doable, it can be improved.
One way to address the downside of the second option above is by separating each of Sime Darby’s divisions into standalone listed entities with one crucial difference — creation of a listed holding company to retain interests in each listed entity.
This structure would be a win-win for investors as those who prefer a conglomerate structure to invest in can buy into the holding company whereas others eyeing a specific business can invest directly into the business.
In addition this second option also adds a second layer of oversight in the interest of promoting good corporate governance.
Under this structure, the senior management of the holding company can dedicate its energies and resources towards providing a check-and-balance mechanism for the listed entities. Investors would gain added confidence as the holding company’s management would scrutinise the listed entities from a shareholder’s perspective as opposed to a managerial standpoint under a conglomerate structure.
Another possibility in pursuing this option is that the holding company may not be an investment holding company per se but retaining one core business as its main business activity while retaining interests in other separately listed divisions.
The bigger picture
Arguably, breaking up Sime Darby would also unlock more value in divisions that have been overshadowed by larger arms such as plantations. And Sime Darby has been mulling the possibility of spinning off one or more divisions as well, along with other options.
“The management has been continuously assessing various possibilities and spinning off a unit is just one of the possibilities,” said Mohd Bakke via email to KiniBiz.
With bigger stakes tied to close supervision of the activities, performance and risk management of each division under a conglomerate model, the question then is whether Sime Darby group’s senior management is able to provide such focus adequately.
With each of its five core businesses carrying different risk profiles against varying industry headwinds, Sime Darby’s senior management’s energies and resources will always be split across the divisions.
This risk of over-stretching management resources was referred to by renowned investor Peter Lynch in his book One Up Wall Street, coining the term ‘diworsification’ in reference to businesses that diversify too widely that they risk destroying their original businesses because of this effect.
“(The conglomerate model) may not be the best in terms of focus,” said one analyst on Sime Darby’s current structure.
This raises concerns from an investing perspective — apart from the challenge of understanding a diversified conglomerate’s philosophy and direction, investors also need to be assured that each division is well managed, adequately supervised and performing up to par.
A proven model, says Mohd Bakke
Despite the problem of transparency inherent in the structure of a conglomerate, Mohd Bakke argues that the business model has been proven to work.
“It is worth noting that the conglomerate business model has withstood the test of time,” said Mohd Bakke in an emailed response to KiniBiz. However Mohd Bakke declined a face-to-face interview.
In presenting his case, Mohd Bakke makes reference to established conglomerates such as Mumbai, India-based Tata Group, Hong Kong-based Jardine Matheson Holdings, London’s Swire Group and Japan’s Mitsubishi, all born between 198 and 144 years ago.
“(The longevity of those groups) can be attributed to the strengths of the business model which embraces diversification to reduce risk,” added Mohd Bakke. “The size of a conglomerate also provides advantages such as cost efficiency, large investment opportunities and ultimately, earnings stability.”
While that seems to be the case for the multinational conglomerates he has referred to, in Sime Darby’s case the earnings stability has not materialised since the Synergy Drive merger six years ago, as highlighted in the first part of this series.
That indicates clearly that one should seriously look at whether Sime Darby should be split up.
Yesterday: Sime Darby loses value since 2006 merger
Tomorrow: Sime Darby Plantation, the big brother
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