This article has been written by Anugrah Agnihotri, Chaitanya Bhatla, Garima Kumar, Krishna Kumar Rathi and Vinayak Lahoty - first-year students of the Business Management programme at XLRI, Jamshedpur.
Holding Company (HoldCo) Discount is a much sought-after investment philosophy that brings about opportunities to exploit discounted valuations in the case of listed Holding Companies. There are several reasons for which a Holdco trades at a massive discount to its intrinsic value with respect to a subsidiary/layers.
The factors that impact HoldCo discount are:
Leakage due to Capital Gains: If the underlying holdings are sold, capital gains tax on the profits will have to be paid by HoldCo, and the shareholder will pay tax on the dividend income. The capital gains tax leads to considerable tax leakage for HoldCo.
Poor Capital Allocation: Most of the time, Holdco is not just acting as a shell company. It either has its own business to run (operating Holdco), or it might have investments in other companies of its subsidiaries. In both cases, investors do not get access to capital gains. These capitals are usually reallocated to the businesses, which in some instances, might not generate the expected profits (poor evaluation of investment opportunities). This practice might force the investors to value the holding company at a discount.
Indirect control: The shareholders of the holding company do not usually exert direct control over its subsidiaries. When the goals and vision of the holding company shareholders and the subsidiary shareholders are aligned, this may not be an issue, but more often than not, this might not be the case. Under such circumstances, the holding company deserves a discount.
Total value: The total value is usually less than the sum of individual parts. The hold co could usually find itself traded at a discount to the sum of the parts of the various subsidiaries that it holds. The reason is that usually, the investors who invest in the subsidiaries find those sectors to be quite attractive and hence may value those subsidiaries more. But, once combined under the Holdco, all the exposure to these multiple sectors might not come out as attractive to the investors investing in the Holdco, leading them to value the Holdco at a discount.
Leakage due to Holdco's Expenses: In some cases, the holding company can incur additional administrative and even compliance costs. These expenses are a bit counter-intuitive as there are no operating revenues of the holding company. Still, since these costs are often relatively small as a percentage of dividends received, the effect on Holdco discount is minimal.
Bajaj Holding and Maharashtra Scooters - Opportunity or a Waiver for an Investor?
Maharashtra Scooters established in 1975 under the ownership of erstwhile BAL and Govt of Maharashtra holding stake through WMDC. It got know-how assistance from Bajaj and manufactured the 'Priya' brand of geared scooters.
BAL (entity before demerger) had expressed its interest in buying the stake of WMDC (27%) to consolidate Mah-Scooters in its books as early as the 2000s. But the pricing dispute had blocked the stake purchase for long, until in June 2019 when BHIL completed the 27% stake purchase under the court-ordered price.
Because of this court order, it had to pay 232 apiece (along with 18% interest from Jan 2006) for a deal that was earlier priced at 151.63 (that was ascertained upon arbitration on 14/01/2006).
The key question - What does MSL do? What is the value one gets?
Consumer preferences change, and a similar dimensional shift happens to the market for geared scooters; MSL finally stopped manufacturing geared scooters in April 2006. Currently, it operates as a holding company with the majority and minority investments in other entities. Less than 15% (as per FY 19 filings) of their total income comes from own manufacturing (casting dies, fixtures, and other automobile spares), and the rest is investment income.
We learn that the significant chunk of MSL's IC (Invested Capital) comes from their non-current investments, which means it's another kind of SPV/Investment Company for the Bajaj group (after WMDC's exit from the promoters front).
Hence it will be beneficial to unlock the investment value in MSL, which will provide shareholders of BHIL and other group companies with a positive outlook. That aims that greater access to funds and hence capital synergies. MSL is more of a sarkari company and can do a good overhaul at the management level.
BHIL can look to divest their business of manufacturing car-dies fixtures to existing vendors Bajaj Auto.
The drawback of this merger of MSL in BHIL is that though it is inconclusive, it is essential to highlight how a post-merger shareholding of the promoter group might be less than 51% due to the prevailing market cap differences and inter-company cancellation of shares.
The current dilution is on the assumption that the deal takes place at the CMP of both companies. Nonetheless, we can expect a minimum of 3% dilution unless public shareholding is bought in a buyback or scheme of arrangement provides preference shares to minority investors.
The merging process might even get easier after Sebi's latest proposition to allow the merger of listed Holdco's and their subsidiaries without triggering the delisting regulations.
With the MSL's market cap at 2058 crores (as on 31/03/2020) and investments valued at 7979.71 crores, we can expect theoretical gains of 3.83x times! This bonanza should be for both MSL and BHIL shareholders, given BHIL is also a Holdco and trades at >60% discount. We expect the part of its discount attributed to MSL investment to close and at least create a 5% imminent upside (45-50% of 2058 crores).
In conclusion, we feel that the existence of two holding companies in one group is futile, and hence the promoter group may take the stance of a merger between the two sooner or later. The pandemic can act as a catalyst to bring about this restructuring that's been outstanding for a long time and have something for both the promoter and shareholders to cheer about!