The case for a break-up

By Khairie Hisyam

Mired with issues on more than one front, Sime Darby seeks to ease the strain on its balance sheet amid turbulent market conditions for most of its divisions. The question remains however if listing its subsidiaries is a viable measure to consider at this time for this purpose.

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In late August 2014, Sime Darby president and group chief executive Mohd Bakke Salleh officially confirmed talk that the group is looking to list its Motors division, saying the “work-in-progress” will be completed “hopefully by early next year (2015)”.

This followed various reports, citing sources, that preparations for an initial public offering (IPO) are ongoing since July that year. While Mohd Bakke declined to reveal how much the group seeks to raise, the figure bandied about by various reports ranged between US$500-US$900 million, which at the time translated to RM1.6-RM2.9 billion.

However, that plan has since been shelved indefinitely as market conditions for Motors (the “overriding and most important element before we commit ourselves”, said Mohd Bakke) turned south.

Some may consider it an opportunity missed. Up to the official confirmation the Motors division had outperformed group revenue growth over the preceding five years, more than doubling its revenue contribution from RM7.5 billion in the financial year ended June 30, 2009 (FY09) to RM17.3 billion in FY13.

What is more, it would have been the first step in a long-term demerger process to restructure Sime Darby into what Mohd Bakke outlined as a flagship entity with several listed subsidiaries as opposed to a conglomerate structure.

“The next will be Property and maybe a bit later Plantation,” said Mohd Bakke in May this year while officially announcing the postponement of the listing for more ideal conditions to monetise the Motors business.

Perfect timing elusive?

The shelved listing of Motors presents a microcosm of the dilemma facing the larger break-up of Sime Darby: the window of opportunity to realise maximum valuation for each division may prove too fleeting to properly catch before they pass. And with a six-month deadline by Moody’s (see Part 1) to reduce borrowings substantially, the group may have to proceed regardless.

On one hand, it is only sensible to strive for maximum value creation – and IPO proceeds – for shareholders, which means going for as perfect an environment as possible for listing. However this is tempered by practicality concerns.

By nature Sime Darby’s two biggest divisions, Plantation and Industrial, operate in highly volatile sectors with nigh unpredictable cycles. Both face what seems a prolonged downturn and the timing of the next upcycle is anyone’s guess.

When asked by reporters in end-August for his predictions on the prevailing crude palm oil (CPO) prices for the long term, Mohd Bakke responded by asking for a crystal ball with which to make said prediction. Similar uncertainty goes for weak global coal prices, a major factor depressing the Australian mining sector which in turn is hurting the Industrial division, though it remains profitable.

This means any attempt to time the listing of these two divisions comes with inherent risk that the “perfect” window would pass too quickly with no telling of when the next would arrive. In other words, the risk lies in the potential time opportunity lost waiting for that perfect window.

It is not too different for Motors and Property, the latter of which is currently weathering turbulence in the Malaysian property market following various cooling measures by Bank Negara Malaysia over the past few years to put the brakes on an overheating market.

This consideration presents a case for pursuing expediency over maximum valuation. While this may not necessarily mean settling for any random valuation figure, the implication would be to set a lower threshold of acceptance vis-a-vis target proceeds.

However, this needs to be pondered together with Sime Darby’s prevailing issues at the moment (see Part 1).

Realistically, a spin-off for one or more of Sime Darby’s divisions may not completely solve its issues, especially the strain of borrowings, explored previously in this series, though it would certainly contribute much to that purpose by raising cash.

Rough calculations indicate this is a substantial avenue and may negate the need to explore other cash-raising options completely (to be covered in Part 3).

That said, starting the process now is also not without significant contributions to the cause in the longer term.

Reducing bureaucracy

Raising funds aside, a corporate break-up for Sime Darby in the mould of Mohd Bakke’s endgame invariably benefits the shareholders in various ways, especially in terms of governance, risk and transparency.

At the heart of it, the current structure promotes a bureaucracy whereby decision-makers at the divisional level are insulated from market scrutiny and shareholder expectations.

To be fair, since 2011 Sime Darby has established a two-tier board structure which sees flagship subsidiary boards (FSBs) are set up in each division to oversee operations subject to direction and counsel of the main board.

The subsidiary boards comprise representatives from the main board, senior management from the divisional level and external industry experts, said Mohd Bakke to KINIBIZ previously.

“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 structure may provide some efficiency, however, Sime Darby can achieve even greater accountability and transparency through a break-up. A separate listing would reduce the bureaucracy not insignificantly while sharpening operational focus.

The creation of a two-tier board structure was, presumably, driven by the point that managing a conglomerate would mean the group management’s energies are consistently split between five different core businesses. It is fair to assume that the two-tier board structure is a response to the need to have final decisions be cleared at the group level, who is the one picking up shareholder calls.

Separate listing simplifies matters. First, it removes the additional group layer and exposes a dedicated management team to market scrutiny directly. The stakes rise as tolerance for mistakes lessen.

This adds pressure to perform and make good decisions, encouraging more sensible risk-taking especially as most of Sime Darby’s core sectors are navigating a slowdown at present.

The second effect is sharpening focus. Without the need to have the subsidiary board defer to the main board on pressing matters, the buck now stops with the divisional management who calls the shots. Decisions can be made without constant deferral which takes up additional time.

This results in more nimble outfits that would be on better footing to weather turbulence in market conditions as opposed to a more ponderous behemoth pulled in different directions in terms of management attention and energies.

Meanwhile the group level management shifts from operational oversight to providing check-and-balance and monitoring performance. This reduces the strain of managing five different core businesses to overseeing measurable performance indicators.

Lessening risk

Another benefit of a break-up is reduced risk for investors – simply put, separate listing status adds clarity to investors in respect of how the business is doing and how the dedicated management at divisional level is performing.

The current structure promotes opacity. Only group-level accounts are published the consolidation of five different core businesses into one set of accounts means relatively little details, especially the bigger businesses such as Plantation and Industrial, are available to shareholders.

This creates some measure of uncertainty, which forms one basis for the conglomerate discount (see Part 1) which has shackled Sime Darby’s value creation for years.

And history provides a grave lesson of what can and has gone wrong with this sort of opacity as seen in FY10 when the group incurred some RM2 billion in losses which in turn dragged down profits by 43% year-on-year.

The losses came from massive cost overruns at Sime Darby’s Qatar Petroleum (QP), Maersk Oil Qatar (MOQ) and Bakun dam projects, handled by Oil & Gas and Engineering units which were major businesses under the Energy & Utilities (E&U) division at the time.

In terms of pre-tax losses, the red for E&U that year came to RM1.75 billion, though restated to RM687.2 million in subsequent annual reports. To add perspective, removing the provision for this loss would have doubled Sime Darby’s pre-tax profit that year from RM1.75 billion to RM3.5 billion.

While taking cognisance of the benefit of hindsight, the immediate question was – and still is – whether the financial disaster would have been prevented had E&U been a separately listed entity with the increased transparency and scrutiny that entails.

Another question is whether E&U at the time had overestimated its capacity to undertake the projects by leveraging on collective muscle at the group level as opposed to its own standalone capacity.

Such overextension in risk-taking and other potential problems can be averted going forward by introducing direct market scrutiny on business decisions. By spinning off divisions to be listed separately, each division would have to produce its own set of accounts for shareholder scrutiny.

The ensuing transparency ensures shareholders get a deeper look at how the businesses are being operated and have access to more detailed accounts, which promotes both good governance and investor confidence – value rises.

Is it worth doing now?

All things said, however, the concern of selling Sime Darby shareholders short when it comes to reaping as much value as possible from corporate spin-offs should not be dismissed.

What it comes to is this question: is there a sufficient threshold of value to be unlocked even as turbulent market conditions depress valuation of the core businesses?

This necessitates a rough analysis of how much value the core businesses might command as a separately listed entity, which KINIBIZ explores further in the next article.

Yesterday: To break up or not?

Thursday: Billions to unlock via demerger