Why invest in restructuring opportunities?

In the Schroders European Equities team, we look for stocks that have been mispriced by the market. That means we look at why the market valuation of a company may be wrong, and the factors that could lift a share price up to our estimate of fair value.

Restructuring is one of several factors that can boost share prices and is often missed, or misunderstood, by the wider market.

Why is restructuring important?

Restructuring is sometimes referred to as “self-help”. It is something a company can do of its own initiative to add value.

Many stocks find themselves buffeted by broad economic or sector trends over which they have little control. Restructuring is a way for companies to put themselves in the driving seat and optimise the performance of their business.

Companies often restructure during a downturn, so that they are best-positioned to take full advantage of any future improvement in business conditions.

What do we mean by restructuring?

Corporate restructuring can take many forms. It could be that a company has made an acquisition which it now needs to integrate with its existing operations. Or perhaps it is looking to reorganise its internal operations to cut costs, improve efficiency and enhance growth.

We have listed the main forms of restructuring below:

• Cost restructuring
• Mergers & acquisitions
• Divestments
• Capital allocation changes
• New organisational structure

How does this work in practice?

An example of a company undertaking restructuring recently is lifts and escalators manufacturer Schindler. Our interest was piqued in late 2014/early 2015.

The industry has high barriers to entry and we saw Schindler as a high quality firm with a solid balance sheet. However, its profit margins persistently lagged behind those of its peers. We identified several restructuring measures being taken by the company that could cause that profit margin gap to close.

• New organisational structure - Schindler was in the process of creating two global business areas: New Installations & Supply Chains and Service Business. The idea was that this would streamline the supply chain, improve internal reporting, and increase the efficiency of the business.
• Rationalised product offering - One issue Schindler faced was that it had a broad range of products, which meant it was unable to operate a standardised manufacturing platform. However, the company refreshed its product offering and switched to three global product lines, which we felt should improve efficiency.
• Moderating investment - Clearly companies do need to invest in their businesses but this can weigh on returns in the short-term. At the time we were looking at the stock, Schindler had already completed construction of four out of six new production facilities. That investment would then become productive over the coming years as production ramped up at the new sites.
• Cost cuts - Schindler announced its “Fast Forward” cost-cutting programme in 2015, again with the aim of improving operating efficiency across the business.
• Strong balance sheet - Schindler had a very strong balance sheet with a net cash position. In the past, this cash has been used to buy back shares, and the option remains for this to be restarted or for the company to announce a special dividend.

Life cycle of a restructuring investment

It is worth adding that we won’t necessarily continue to hold our investment in a stock while the entire restructuring story plays out.

In many cases, once the restructuring path becomes clear, the share price will respond accordingly.

If the shares rise to our estimate of fair value then it makes sense to sell and recycle the proceeds into a new opportunity.

Is this the same as recovery investing?

Recovery investors often look at companies in the process of restructuring but there are important differences. Firstly, recovery investing is about finding companies where the share price has fallen to low levels and where there is a prospect of the shares recovering to their historic valuation levels.

By contrast, we look for transformational restructuring. We aim to find opportunities where a company can restructure to such a degree that its historic valuation is no longer relevant. We’re looking for restructuring that can deliver a dramatic increase in the valuation that the market is prepared to pay for a company.

For this reason, we do not simply look for companies that are undervalued compared to their own history, or to the wider market. A company that on paper may seem expensively valued may still be an interesting opportunity for us, as long as we can identify the restructuring catalyst that should propel the share price higher.

How does restructuring fit into a portfolio?

Clearly restructuring opportunities carry an element of risk. It is hard enough for a company to identify the right strategy to restructure and improve returns, and it is harder still to execute that strategy effectively.

In the Schroder European Equities Team we will only invest in a restructuring opportunity if we have confidence that the management has the ability to see the restructuring through. We are fortunate to count on the support of an experienced team of analysts who are experts in their sector and work to identify the best investment opportunities.

Meanwhile, simply identifying an opportunity for restructuring will not on its own be enough for us to invest. Our starting point for any investment is valuation, and whether we think there is a mispriced opportunity. If the prospect of restructuring, and consequent improved returns, is already captured by the share price then there is no reason for us to invest.

Securities and sectors mentioned are for illustrative purposes only and not a recommendation to buy or sell.