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Everything you need to know about Demergers

Created on 04 Nov 2023

Wraps up in 7 Min

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Demergers - Meaning, Reasons, Benefits and Disadvantages | Insider by Finology

Let me start today's article by sharing a personal incident. Some time back, my family and I were gathered in the living room, tuning in to a news channel discussing the demerger of ITC, which had just been announced. As we were engrossed in the news, my father and I began discussing the future business prospects, exchanging our views. Meanwhile, my younger sister, curious about our conversation, interrupted us to ask the meaning of "demerger". 

Being a finance student, I found it challenging to break down the concept in a way that she would easily grasp. 🥲 But then, my father, in his own unique way, attempted to explain by asking my sister to imagine her favourite cake. 🍰 We both envisioned it instantly. He probed further, asking her to identify the cake's different layers. She promptly listed the sponge, the cream, and the icing.

At that point, I was quite puzzled, wondering how my dad would relate demerger to a cake. 🤔 Then, he cleverly added, "Think of a demerger as if you were separating these layers back into their individual parts." 

He drew a parallel from the cake analogy to the business world, explaining that a demerger is somewhat akin to a company deciding to split its different divisions or parts into independent businesses. Just like dissecting the layers of the cake, a company might divide into smaller, separate entities, each focusing on its own specialised area. And just like that, my sister's confusion dissolved.

However, there's much more to demerger than this simple explanation, which I'll delve into in this article. Let's begin by exploring...

What is Demerger?

A demerger is when a big company splits into parts that can work on their own or be sold separately. This helps the company:

  • Separate its different brands or units, which can be useful to avoid a takeover
  • Make money by selling parts that don't fit the main product line, or 
  • Create separate entities to manage different operations. 

If you want to know How Is Your Purchase Price divided after a Demerger? then click on the link to learn about it.

Does that make sense?

So…

Why exactly do companies decide to go through a demerger?

Companies opt for demergers for various reasons. It's a combination of factors, from financial strategies to internal reorganisation and even external influences, that drive companies to go through the demerger process.

Here's a breakdown:

  • Focus on Strengths: Sometimes, big companies want to concentrate on the parts that are performing well. By splitting off certain segments, they can give more attention and resources to those areas. 💪
     
  • Financial Gains: Selling off segments that don't align with the core business helps in raising money. It's like streamlining operations and getting rid of what doesn't fit. 
     
  • Internal Benefits: Employees and leaders in the company can benefit from these demergers, often resolving issues before they become public knowledge. It's a bit like fixing things before they go south, and it can be beneficial for both the company and its people. 

More like the business' way of saying, "It's not you, it's us... and we're better off apart!" 💔

  • Business Specialisation: Demerging enables companies to have experts handle specific business units rather than generalists. This specialisation can enhance the performance of these separate entities. 
     
  • Complexities and Benefits: Demergers might introduce complex accounting challenges but can also lead to tax advantages or other perks. 
     
  • Government Influence: Sometimes, a demerger might be a result of government intervention, like breaking up a monopoly. 

Shifting the focus to key considerations about demergers that one should be mindful of.

Key Must-Knows: The Inside Scoop Without the Snooze! 🫣

The Sum of Parts: Why a Company's Total Value Isn't Just a Simple Addition?

You know that many companies conduct business across different industries. Let us understand this with the help of an example. One such company which has subsidiaries in oil and gas, retail and telecom is Reliance Industries. Now, each of these subsidiary businesses has a different value because of their different profits, barabar? So, logic suggests the value of the parent company should be a simple sum of the values of all these businesses.


 
This brings us to ⤵️

Conglomerate Discount: Why the Parent Company Isn't Valued Like a Plain Total

The value of the parent company is not a simple sum of these businesses. This is especially so when you talk about company values through the price of its stock. Shares of such companies usually have a lower price in the market than their simple value. This is called a ‘conglomerate discount’. Now…

Why the Discount, Though?

The idea is that when investors buy stocks, they want exposure to a single industry. Instead, they are unwittingly exposed to the dynamics of other industries. Moreover, there's a good chance that the company may be a dominant business in one industry but a small player in another. In such a case, the investor is compromising. 

They could have instead bought the shares of that dominant company. As a result, they are willing to pay a lower rate than the conglomerate's true value. Moreover, investors can also find it hard to understand the company's business model because of the large structure. In short, more often than not, transparency gets compromised in a conglomerate structure. 

Moving on to…

How Demerging Can Make Things Better

Share prices of companies often perform better after they cut off one or more of their businesses into a separate entity. Investors then have the option to choose which businesses to invest in. It could so happen that the demerged company operates better for reasons like better debt/corporate rating. 🤷‍♀️

For example, suppose a profitable company can end up paying higher interest rates on its debt simply because its parent company and sister businesses have high debt on their books. In this case, the company could cut down its costs by being demerged into a separate entity. 🫡 

Sab achaa bolne ke liye paisa toh mila nahi hai mujhe, toh… 

The Not-So-Good Side of Demergers

So, while demergers have their perks, they're not all sunshine and rainbows. Let's take a look at the downside:

  • Business Fragmentation: When a company splits, each piece doesn't need to work effectively on its own. You know, just like measuring the performance of individual players as compared to the ability of the whole cricket team. Sometimes, they just don't perform as remarkably without the whole squad.
     
  • Complex Transition Phase: During a demerger, there's a lot of reorganising, paperwork, and change. It's like shifting homes but for a business. Things can get pretty chaotic for a while.
     
  • Customer Confusion: What if your favourite store suddenly changed its name or the way it does things? It will leave you puzzled for a while, and people might take time to adjust, and some might even wander off to other places, right? The same is true with the case of demergers if the company changes its identity. 🤔
     
  • Uncertain Future Direction: After a demerger, both the new entities might not have a clear path ahead, similar to setting off on a road trip without a GPS. They need to figure out their direction and strategies, which can take some time.
     
  • Investor Scepticism: Investors might get a bit jittery during a demerger. Some people might not like the new arrangement and decide to play their hand elsewhere.
     
  • Costs and Risks: All this restructuring and setting up new operations can be expensive. It costs money, and there's always a bit of risk involved.
     
  • Legal and Regulatory Hassles: Just like how rules and regulations can make life a bit difficult, demergers also face their fair share of legal and regulatory challenges.

My Vishesh Tippani

So, when a company splits up its business, they often hand out shares of the new company to the current investors. Sounds good, right? But here's the catch- the original company's stock price usually drops. I mean, think about it: they just let go of a chunk of their business. The thing is, you can't predict exactly how much the price will fall. That uncertainty makes the stock all jittery for a while after the split.

And get this: when analysts see a company with a bunch of different parts or subsidiaries, they sometimes get a bit wary, so they might knock down the value of the main company by 15% to 30%. It's kind of like giving them a lower score. So, next time you see an analyst not too keen on a company with lots of branches, that could be one of the reasons why.

The Bottom Line

Sure, demergers can pump up shareholder value in the long run, but let's break it down. It's gotta start with a super clear separation of businesses to make it work. Investors, though, they're a bit jittery. They worry some businesses might split just to follow the trend and not because it's best for everyone involved.

And hold up, there's more. It's not all sunshine and rainbows. Demergers can hit snags. Sometimes, things just don't click as planned, causing a bit of a ruckus.
Want the full scoop on demergers?

Check out 'What is the Impact of Demerger on Shareholders?' for the lowdown on the types and all the other nitty-gritty details. Remember, in the corporate world, it's not always a guaranteed win. But hey, that's what keeps it spicy, right?

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Sakshi Dhakre

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Sakshi is an adventurous spirit who enjoys both the intellectual stimulation of Finance and the sensory experiences of good food and nature’s beauty. She has a passion for delving into complex financial topics and distilling them down into easy-to-understand insights. When she's not poring over financial reports, you might find her exploring a new corner of the city, trying out new restaurants and cuisines or admiring the beauty of the night sky.

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