A square peg in a round hole

Old Mutual is currently one of the biggest positions in our portfolios. From a valuation perspective the stock is attractively priced with many of its underlying divisions trading at a significant discount to their fair value. At a group level, the stock as a whole offers an attractive entry dividend yield and a compound annual growth rate in earnings of 12.5% p.a. Importantly, the entry forward PE of 9.9 times is significantly lower than the forward PE of the All Share Index at 16 times. This discount translates into a significant margin of safety which is crucial in the context of not overpaying for the asset.

Many businesses go through their life cycle making acquisitions and accumulating assets as they attempt to diversify into new markets and growth opportunities. Promises of ‘the creation of shareholder value’ through synergies, scale, and critical mass are often dangled like carrots in front of shareholders to justify this acquisitive process. However, the reality is many of these benefits turn out to be as elusive as holding a handful of sand and often result in added layers of central costs and unwieldy management structures with the potential to destroy shareholder value. In most cases the quality of the management team determines whether the acquisitions made over time are successful or not. The key determinant of success is the price you pay for the asset, if you get this wrong it tends to swamp many of the other strategic considerations.

Old Mutual plc like many other South African businesses has undergone a process of expanding their business through acquisitions, but most notably in their global franchise. Old Mutual first ventured offshore in 1986 with the purchase of Providence Capital in the UK and following the relaxation of exchange controls in 1993, they increasingly looked offshore to try and develop additional growth avenues for the business given their dominant market position in South Africa. Over the next 12 years Old Mutual concluded a series of acquisitions, many of which in hindsight were ill-timed resulting in significant destruction of shareholder value.

Post the global financial crisis under the new leadership of Julian Roberts, Old Mutual proceeded to clean up its offshore portfolio, selling-off its non-core insurance operations as well as removing legacy risks in the business. The new management team mapped out a new offshore strategy which was focused on building a market leading vertically integrated wealth management business encompassing the entire value chain. So despite having overpaid for many of its earlier offshore acquisitions, hard work from the new management team and a further handful of attractively priced acquisitions, it has transformed its offshore franchise into the highly attractive business it is today.

Compelling individual businesses 
All of the Old Mutual plc franchises listed below are strong businesses in market leading positions with good growth prospects. The businesses are run on an independent basis with their own clear strategy in their chosen markets. Importantly, they have very different capital requirements, legislative frameworks and risks associated with each franchise.

• Old Mutual Emerging Markets is a leading integrated financial services business with a unique mass market focus with operations principally across Africa but also with a presence in Asia and Latin America. 
• Nedbank Group, one of South Africa’s top banking groups which has carved out a niche in the corporate and commercial market. Old Mutual plc owns 54% of the Nedbank Group. 
• Old Mutual Wealth is a leading vertically integrated UK and continental Europe wealth management business which operates across the entire value chain with strong discretionary asset management, retail and platform propositions. 
• Old Mutual Asset Management, is a multi-boutique institutional asset business which has been developing a global distribution footprint and is listed on the NYSE.

The inevitable break-up 
We have for some time been highlighting that the share price of Old Mutual was not reflecting the underlying value of its individual business units. In addition we felt that the group could potentially be broken up to unlock this value, given the independent nature of its business units and the inefficient nature of the current structure.

Our thesis on why a breakup of the group was probable was based on the following facts:

• There is very little commonality or easily identifiable synergies between the different business units. 
• Potential cost savings, Old Mutual Plc runs a central head office to manage their subsidiaries at the cost of GBP 80million p.a. 
• Inefficient capital structure, any free capital surplus held in the South African operations cannot be counted towards the group solvency capital requirement. This is because the South African surplus assets are not fungible and available to be used to absorb losses outside of the country due to regulatory and exchange control limitations. 
• It would allow for better price discovery of the respective assets which would eliminate the conglomerate discount. 
• Alignment of investor with their target assets, given its make up, Old Mutual plc is neither a focused emerging nor developed market play. This often results in investors who have an emerging market focus avoiding the stock because it is not a pure play on emerging markets, with the same argument applying to developed market investors. This also contributes to sub-optimal pricing of the stock.

It therefore came as no surprise to us at the recent Old Mutual results presentation, where they announced that they intend to proceed with a ‘managed separation’ of the group, with the goal of unlocking significant value trapped in the current structure. However, despite their announcement they did not disclose much in the way of detail on the process to be followed, but they did disclose that most of the process will be completed by financial year 2018.

At the same time they also announced a reduction in the dividend payout ratio to retain more cash to pay down debt levels as the separation takes place. Despite the lack of clarity from management on the detail of the separation process we think they are likely to separate the businesses in the following order:

• Firstly we expect the Emerging Markets cluster together with Nedbank to be listed and then unbundled to shareholders. 
• Secondly, a portion of the Nedbank shares are likely to be unbundled to shareholders with Old Mutual Emerging Markets retaining a strategic minority stake. 
• Thirdly, we expect the process to run concurrently with the downscaling and eventual closure of the central head office. 
• Finally we expect the Old Mutual UK Wealth business to be sold or listed depending on which option offers the highest return for shareholders. We also expect the Old Mutual Asset Management business to be sold and the proceeds to be used to pay down debt.

The graph below compares the contribution to the current share price versus our assessment of intrinsic value. Depending on the extent of the value unlock discussed above, the upside may be slightly lower or higher than our base case scenario.

As can be seen from the graph, the biggest value unlocked from the separation will come from the sale or listing of the Wealth Management franchise. The Wealth Management franchise trades on an implied forward P/E multiple of 9.9 times while its competitors trade on an average forward P/E multiple of 18 times! Any sale to a private equity player or listing of this franchise will go a long way in unlocking value. The reduction in central costs and removal of the conglomerate discount should further sweeten returns. A further sweetener is the unbundling of a portion of Nedbank shares to shareholders as we receive them at the same implied conglomerate discount.

The announced separation of Old Mutual plc certainly gives us more confidence in our large overweight position in the portfolio. However, management still needs to successfully execute on their strategy and it will take time for all this value to be crystalised.