While there are arguably very few "sure things" when it comes to investing in the stock market, it would seem safe to assume that many value investors understand the forces at work during a demerger or spin-off situation.
Since listing in July this year, the share price of BHP Billiton Limited (ASX: BHP) spin-off South32 Ltd (ASX: S32) has slumped 18.5%. In comparison, BHP's shares are down 21%, while the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) has given up just under 10%.
It's certainly not what original South32 shareholders would have hoped for but in many ways it isn't surprising. Here's why:
Firstly, had the spin-off never occurred, original BHP shareholders would most likely be in roughly the same financial position as they are now particularly considering the downtrend in resource and energy markets.
Secondly, often spin-offs do underperform in the first few months post demerger as some shareholders are either forced to or choose to dispose of their shares. This selling pressure pushes the price down in the short term.
The stage could now be set for South32.
While there are initial forces which can cause underperformance, in the longer-term, a spun-off company which is free of the parent company and able to focus more intently of its own business model can excel.
The pro forma full year results and strategic initiatives being undertaken certainly suggest earnings could improve from here:
Operating revenue fell 7% to US$7.7 billion
Earnings before interest and tax jumped 52% to US$1 billion
Profit after tax slumped 56% to US$28 million
Net debt of US$402 million
Value?
With a market capitalisation of just under $8.9 billion, the enterprise value (EV) of South32 is approximately $9.3 billion. With EBIT of $1 billion, the stock is trading on an EV/EBIT ratio of 9.3x. That might not be a bad entry point for long-term value investors given where we are at in the commodity cycle and also considering the cost-out program currently underway in the streamlined South32.