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The disadvantages of Sime Darby’s current conglomerate structure outweigh the benefits — if any. Breaking it up, even if it is hard to do, is a much better path forward for the group, especially as such an exercise could boost the group’s value by some RM20 billion almost immediately.
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The biggest plus of all from a break-up of Sime Darby will be value creation of about RM20 billion — more than a third of Sime Darby’s current market value of RM56.2 billion.
This value creation would be more or less immediate upon demerger, but the figure could be much higher than that in the long term when operational focus sharpens and each company is under pressure to improve its performance.
There are two ways in which value can be created. The first is to increase cash flows, which arise from profits through operations. The second is to reduce the risk associated with a business which results in investors accepting a lower rate of return. That means the value of the investment rises.
The accompanying table which is an attempt to value a demerged Sime Darby by assigning historical price earnings ratios (PERs — the ratio of market value to net earnings) to the various divisions, is value creation along the second route.
Essentially, when Sime Darby’s divisions are individually listed, then their PERs should reflect those of comparable companies.
By doing this — and admittedly this is a very rough and ready way of doing it — indications are that the value of Sime Darby broken up could be as much as 35% higher or an increase of RM20 billion in absolute terms.
Reduce risk, add value
So where does the added value come from? Basically, once the divisions are restructured this way, each of them becoming a public listed company in their own right, they have to produce full accounts, have dedicated management teams and have every major move scrutinised by investors.
That inevitably reduces risk. Under the current structure, divisions hide behind a massive holding company which channels funds and resources behind an opaque veil with sometimes divisions handling jobs which are too big for them.
As was pointed out previously, this has resulted in massive losses in the past which has dragged the entire group performance down. Thus it is more than likely that Sime Darby has a conglomerate discount rather than a premium. KiniBiz’s own figures indicate that as well.
It is easier to remove this discount through a demerger than to attempt proper conglomerate management which is tough under the best of circumstances. It would need very close monitoring, some of the best management around, proper key performance indicators and exceptional corporate governance to do that. That’s simply not in enough supply not just in Sime Darby but in most major companies in Malaysia.
As for valuations following the demerger much will depend on the PERs assigned but here is our basis for assigning it the way we did.
Quality companies in the plantation sector such as Kuala Lumpur Kepong Berhad (KLK) and United Plantations have PERs in the range of 20 to 28. To be exact, KLK’s PE stood at 27.7 times yesterday and United Plantations at 20.6 whereas that for Felda Global Ventures (FGV), IOI and Genting Plantations are at 16.8 times, 15.5 times and 36.3 times. This comes to an average of 23.4 times. So a figure of 24 was considered reasonable for plantations, as Sime Darby is on the upper end of plantation companies which are well managed.
For industrial and motors, both of which have strong franchise businesses in many different countries we used motor-based conglomerate UMW (which also has franchise businesses mainly under Toyota), as a benchmark assigning a PER of 19 to both of the divisions.
Property was based on SP Setia’s PER and considering that our proposed structure foresees using SP Setia as the company which will hold the property assets, it is reasonable to do so. Considering that this will be a much stronger entity than SP Setia, the PER could even be higher that the 17 times PER KiniBiz assigned.
To be fair, however, KiniBiz also examined the PERs for other companies — E&O, UEM Sunrise and IJM Land — and along with SP Setia, the average PER comes to 18.8 times.
For E&U, that’s a tough one to call. If there are some gems in there, it may be possible to get a PER of 25 based on the ratings of some oil and gas companies.
Valuations for E&U could go even higher if Sime Darby has a strategy of getting some of the lucrative Petronas contracts, especially for the misnamed risk sharing contracts (RSCs) which are actually very lucrative for those who get them with little risk to boot.
A better path forward — two giants better than one
Following KiniBiz’s two-week analysis, the emerging answer is that breaking up the conglomerate represents a better path forward for the group.
Historically the conglomerate model requires much effort to pull off successfully as it requires a high degree of control from the top level in addition to very good monitoring systems.
By all indications, this is not present in Sime Darby at this time, and even for many conglomerates globally it is a tough challenge to continually address.
In contrast, a demerger is a much simpler way of achieving a desirable level of transparency and governance in each division, and based on KiniBiz’s rough analysis above, such an exercise actually boosts Sime Darby’s collective value — just not in a conglomerate form.
A demerger should be politically palatable because the plantation listed company will still be the largest in the world, only it will be much more focused on plantations and improving the plantations operations more than ever before.
And in property, we will see the rise of a property behemoth bigger than any other property company in Malaysia and will have the capability of becoming truly international, undertaking the RM40 billion plus Battersea project in London in which it will have an 80% stake and having significant other projects regionally and in Australia.
Better two different sector giants with focus and drive to maximise their potentials than one that is unfocused, defused and not living up to its potential.
The bigger benefit from the demerger will come further out in time. Our preferred demerged structure is the one where there is a holding company which will hold stakes in the various companies representing Sime Darby’s previous divisions, which was examined in Part 2 of the series.
This is the one which gives the most amount of accountability and the greatest transparency. Without the extra layers of bureaucracy between business managers and investors, the overall results will be put to test by the market price and there is real pressure for the companies to perform.
That will inevitably force improvements, if not changes to get the improvements.
Throughout KiniBiz’s examination of Sime Darby’s individual divisions, the common theme that has emerged was the importance of improving risk management via more transparency, which can be achieved through independent listing of each division.
By separately listing each division according to the holding company structure which KiniBiz proposed in Part 2 of the series, each would gain more accurate valuations that reflect the risk profiles of their respective industries. Without being attached to other divisions in a conglomerate structure, each division can focus on its own sector, answerable only to shareholders.
Freed of the inherently cyclical Plantation and Industrial divisions, Motors and Energy & Utilities (E&U) can focus their energies towards addressing their own industry challenges, which in the former entails foreign expansion against the limitations of the Malaysian market whereas for the latter means mitigating dropping returns from the power generation business worldwide.
As for the Property division, Sime Darby’s majority shareholder Permodalan Nasional Berhad (PNB) would be presented a chance to create Malaysia’s largest developer through combining SP Setia, in which PNB holds nearly 70%, and Sime Darby Property, the country’s largest developer by land bank.
Is there benefit from the current structure?
The current structure, arguably, provides none of the benefits that were supposed to accrue from being a conglomerate entity which, in theory, provides a diversified risk portfolio which in turn provides stable earnings to investors.
Mohd Bakke Salleh
“Sime Darby Berhad is structured as a conglomerate and the strength of this model is widely known,” said Mohd Bakke in an emailed response to KiniBiz. “The inherent strength of the Group’s diversified portfolio of businesses in the Asia Pacific region provides us an earnings stability and a strong balance sheet.”
However, as examined in Part 1 of the series, earnings stability simply did not happen for Sime Darby. Worse, the misadventures of E&U division in FY10, posting RM2 billion in total loss impairments translating into RM1.75 billion in pre-tax losses, arguably cut the group pre-tax profits by half.
For the record Sime Darby posted RM1.7 billion in pre-tax profits in FY10, which is roughly the same amount that E&U posted in pre-tax loss.
Another benefit often put forward in argument for the conglomerate structure is cross-divisional synergy.
“One of the major synergies across the divisions of the Group is the potential for property development from the existing plantation landbank,” said Mohd Bakke in his email to KiniBiz. “However, this is done on an arm’s length basis and would not be affected if certain divisions are listed separately.”
However, that is as far as the synergistic relationships go, said analysts.
“What other synergies are there?” said one analyst to KiniBiz on condition of anonymity. “Even the Property-Plantation synergy is a one-way thing.”
Better focus through spin-offs
The emerging picture after analysing the divisional performances and prospects is that there is much more to be gained by separate listing. For one, improved transparency and better governance from being directly exposed to investor scrutiny can only mean improved overall performance in the long run.
In other words, independent listing leads to a do-or-die setting where tolerance for mistakes will be much lower. This in turn encourages better performance and more careful risk-taking.
Independent listing would also allow the divisions to build expertise as the top management of the listed entity is directly running the business — layers of oversight is removed with investors now directly providing a check-and-balance feedback.
This would be an improvement over the current structure where lumping all five divisions under a conglomerate stretches the group management’s energies and focus across five vastly different sectors.
When posed the question on whether the group management’s focus is blunted through the current structure, Sime Darby president and group chief executive Mohd Bakke Salleh points to the group’s two-tier board structure which he claims delivers the right level of dedicated oversight on the group’s businesses.
Set-up in January 2011, the two-tier board structure meant flagship subsidiary boards (FSB) were established in each division, comprising representatives from the main board at group level, from the group and division’s senior management as well as external industry experts.
“The FSBs oversee the operations of the Divisions, subject to the direction and counsel of the Main Board,” said Mohd Bakke in his emailed response. “This encompasses business strategy and performance, corporate governance and audit related matters, internal controls and risk management of the respective Divisions.”
“The new structure delivers the right level of dedicated oversight by having members of the FSBs focused on their core business. It also enables the divisions to leverage on the knowledge and expertise of independent directors drawn from diverse industries in tackling matters relating to governance and business excellence,” added Mohd Bakke.
While the efficiency of the structure is up for discussion, what is clear is a structure where all divisions were individually listed would provide similar, if not better, level of transparency and accountability — and with less cost too, given reduced layers of bureaucracy in a structure of separately listed divisions.
As discussed in Part 2 of the series, KiniBiz’s proposed holding company structure would mean each division has its own board as per normal listed companies, but these would in turn be supervised by the board of the holding company.
Therefore while breaking up Sime Darby may be hard to do, it is the best option for everybody.
Yesterday: Powering Energy & Utilities forward?
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