Friday, November 7, 2014

Focus Pocus: Is breaking up a cure for corporate attention deficit disorder?

I could start this post by telling you that some of my best friends are corporate strategists, but I would be lying. I do have a few strategists as acquaintances, but perhaps not after this post. In my cynical view, the primary contribution of corporate strategy seems to be to supply buzzwords that can be used by managers to distract investors and justify the unjustifiable. In an earlier post, I highlighted some of these words of mass distraction, including disruption, synergy and strategic considerations, and argued that the repeated usage of these words by a manager, analyst or investor is a signal that the numbers don't work. In this one, I want to add focus to that list of words, as it shows up with increasing frequency in the context of corporate break ups. In this post, I propose to put focus under the microscope, using EBay (and its proposed break up) as my illustrative example.


Focus, the new strategic buzzword?
As we go through another wave of companies breaking up, it is worth remembering that this is not the first time that we have seen this phenomenon, nor will it be the last. Each break up wave, though, comes with its own overriding rationale, that CEOs highlight and journalists then parrot in their news stories. The theme for this break up wave can be seen in the rationale offered by the CEOs of HP and EBay for breaking up:
“We’re in a better position to get focused companies who can respond more
quickly….
We felt like this was the right time to take advantage of setting up two scaled
 companies who will be a little bit more focused and a lot more nimble.” Meg Whitman, CEO of HP, on CNBC 
“ This transaction creates two industry leaders, each with significant reach and scale, and will allow us to continue our focus on customers, innovation and execution. …That will allow a greater level of strategic focus, greater strategic agility, and greater strategic flexibility. Simply put, we believe the premium on focus and agility will allow each business to compete and win in this exciting environment going forward. So we can move more quickly and make targeted, focused investments.. So I think, an independent PayPal unequivocally will have the focus and agility to play across the board in this fast moving payment space.” John Donahoe, CEO of EBay, on conference call with analysts
Notice that the “focus” shows up twice in Ms. Whitman’s brief statement and five times in Mr. Donahoe’s conference call brief. If you count in the use of the words “strategic”,“agility” and “innovation”, the Donahoe statement is strategy-speak, run amok. Taking both Ms. Whitman and Mr. Donahoe at face value, i.e. that breaking up into smaller units improves focus, there would be two questions that I would have for them.
  1. Until a few months ago, both Ms. Whitman and Mr. Donahoe were arguing, just as strongly as today, for keeping their companies as whole companies, using economies of scale and synergy as their strategic arguments. Were they wrong then or are they wrong now? Alternatively, if there were right both then and now, what’s changed? 
  2. If breaking up these companies is supposed to improve focus, these companies must have been unfocused before these break ups. If so, who was running these companies, what were causes for the lack of focus and how would breaking up deal with these causes?
By being opaque about focus, I think we are missing an opportunity to understand it better and perhaps deliver more value from it. I think that you can look at focus both the perspective of managers and from that of investors. You can look at what caused the lack of management focus before the break up and what will change in terms of fundamentals after the break up (with the resulting effect on value). Breaking up a multi-business company can improve investor focus on the businesses owned by a company and lead to a price effect (even if value does not change).

Management Focus and Value Enhancement
The first principles of corporate finance are universal and apply whether you run a single business or a multi business company. The company still has to pick good investments, i.e., investments that generate returns that exceed the hurdle rate, finance these investments with the right mix of debt and equity, i.e., a mix that finds the optimal trade off between the tax benefits of debt and the added default risk created by it and return cash to stockholders (in the form of dividends or buybacks). It is true, though, that putting these principles into practice is more difficult at some multi business companies, on each dimension of corporate finance:
  1. Hurdle rate hiccups: If the businesses owned by a multi business company vary on the risk dimension, it is critical that the hurdle rates used to make investment judgments vary across the divisions (businesses), depending on their riskiness. This fundamental proposition is violated at many multibusiness companies which choose to use one hurdle rate across all their businesses, justifying the practice on the (erroneous) arguments that that is what stockholders in the company demand or that division (business) level hurdle rates cannot be estimated. Not surprisingly, capital misallocation follows, with riskier businesses over investing and safer businesses under investing (and subsidizing the riskier businesses).
  2. Capital structure fuzziness: The capacity of a business to carry debt is determined in large part by its ability to generate cash flows (with higher and more stable cash flows resulting in higher debt capacity), the types of assets owned by the business (with tangible assets providing more debt capacity) and the tax rate that it faces (with higher marginal tax rates leading to more debt). If a multi-business company has businesses that vary on these dimensions, it will have trouble finding one composite debt mix that works across time and businesses.
  3. Dividend policy mismatches: The cash return policy for a business will be driven by its growth potential (with higher growth potential requiring more reinvestment and less cash returns) and the nature of the business (with siome businesses requiring more intensive investments than others). Again, if a multi business company has businesses that vary in terms of growth and reinvestment needs, it may not be able to find a dividend policy that meets its overall requirement. This problem is exacerbated if the company have attracted an investor base that has a particular preference in terms of dividend policy and that dividend policy is at odds with what a business can afford to pay out.
The argument that breaking up a company can improve capital allocation, allow for a more optimal capital structure and enable fine tuning of cash return policies to match the specifics of individual businesses will have the most resonance at those multi business companies, where the businesses vary widely in terms of risk, growth and asset characteristics. Thus, it will make more sense for a multi-business company that has a real estate division, a retailing unit, a financial service business and a manufacturing segment within its hold, and even more so, if these units are at different stages of the life cycle, than it will for a multi-business company that is in five mature, manufacturing businesses.

Investor Focus and Price Enhancement
Just as managers find it difficult to run multi-business companies, investors face challenges in pricing these companies. In particular, the standard rubric for pricing, which is to pick a pricing metric (earnings, book value, revenues), find comparable firms (by looking at the sector in which a company operates) and adjust for differences in growth or risk, is much more difficult to put into practice if you are valuing a multi-business company, with the magnitude of the challenge being a function of the following variables:
  1. Pricing Metric: A multi-business company that operates in businesses that should be valued using different metrics, it becomes more difficult to value the business. Thus, an infrastructure company (where EBITDA multiples may be the most widely used metric) with a financial service arm (where PE ratios or Price to Book ratios are more widely used) poses problems for analysts.
  2. Comparable firms: A related point is that pricing is always done relative to a group of comparable firms, usually defined as being other companies in the same business, with additional criteria added for size, growth and risk. With a multi-business company, finding a group of comparable firms becomes tricky, and especially so if the businesses range the spectrum.
  3. Controlling for differences: To price a company, you have to control for differences in growth, risk and cash flows across companies, and these comparisons sometimes require market or stand alone accounting information that may be unavailable or unreliable for a multi-business company.
In effect, investors are more likely to misprice multi-business companies than single business companies, though the mistakes can cut in both directions and the degree of misplacing will be greater, if the reporting is opaque and the pricing approaches vary widely across the businesses. In my view, this may be just as good an explanation for why there is a conglomerate discount as the more conventional operating inefficiencies story.

EBay: The History
EBay was founded in 1995 in San Jose, California. It is coincidence that its CEO during its early years was Meg Whitman, who is in the news as the CEO of HP, the other big company announcing a break up. As online commerce picked up in the late 1990s, EBay benefited from the boom, reporting exponential growth in revenues, but it also stood out from the crowd as one of the few companies in e-commerce that had found a way to be profitable. In the graph below, you can see revenues and operating income at EBay from its inception through 2014, with the operating margin for the company overlaid on the graph:
EBay: Operating History
It was to facilitate transactions on EBay that Paypal was initially created, as a payment processing system that allowed buyers and sellers in the auction market to reduce time involved in payment processing, while also reducing the risk of not getting paid. In fact, Paypal formed such a small part of EBay’s revenues in its early years that the company did not start breaking out revenues into its marketplace and payment processing units until 2006 and operating income until 2011. The table below summarizes the revenues and operating income at the two businesses, with revenue growth from 2006-14 and operating margins for each from 2011-14:


Looking at the evolution of the two businesses over time, they seem to be following different paths and operate in very different competitve spaces. The marketplace unit has seen slower revenue growth and higher operating margins that seem to be under pressure, dropping from 46% in 2006 to 35% in 2014. The payment-processing unit has higher revenue growth and while its operating margin is lower than that of the marketplace unit, it has also held up better over the last three years.

EBay: Valuing the break up
At the risk of stating the obvious, a break up can affect value, only if it affects the inputs into value, i.e., cash flows, expected growth, the cost of capital or the length of the growth period. In effect, if EBay breaks up into two units and the composite cash flows, growth rate, growth period and cost of capital for the two units remains the same as the consolidated unit, there will be no value created. In the table below, we start with this presumption, where we allocate the corporate costs across the two businesses, in proportion to revenues, and assume that the growth rates, growth period and debt ratios don't change for the broken up units.

Note that in this valuation, the earnings and growth rates of the units aggregate to the earnings and growth rate of the consolidated company and that the units stick with the debt ratio that the consolidated company has. Not surprisingly, if you assume no fundamental changes in how the units are run or financed after the deal, there is no value created from the break up. So, what are the potential value enhancers? I can think of four possible changes:
  1. The corporate cost story: If the corporate costs, currently $1,819 million for the consolidated company could be lowered by a hundred or two hundred million dollars, there will be an immediate value effect. If the annual operating costs are cut by $100 million, for instance, the value of the combined firm will increase by $2.2 billion. Absent detailed information, I am in no position to argue for or against this possibility but EBay does not strike me as an excessively bloated company with significant (and easy) cost cuts for the taking and news stories like these don't seem to indicate belt tightening ahead.
  2. The unleashed growth story: If the broken up units can have a composite growth rate in revenues and operating income that exceeds that of the consolidated unit, there will be a value increase that comes with that higher growth. Of the two units at EBay, the one that seems most likely to benefit from being cut adrift is Paypal and using a 20% growth rate for the next few years, instead of 15.49%, increases the value of the combined firm by $13.6 billion. There is an argument to be made that the corporate tie between EBay and Paypal has made it both more difficult for Paypal to aggressively go after the payment processing business (especially if doing so will hurt the market place of the business) and for some competitors to adopt Paypal as a payment mechanism.
  3. The competitive advantage story: If the broken up units can improve their competitive advantages, relative to the consolidated unit, the higher return on capital and longer growth period that result will increase the value of the broken up units, relative to the consolidated company. Are EBay or PayPal, as stand alone units, likely to have stronger competitive advantages than EBay does has a consolidated company? I don't see a reason why but I am open to suggestions. 
  4. Lower cost of capital: If the broken up units are able to adopt financing mixes that better reflect their standing as businesses, it is possible that the costs of capital will decline at the broken up units, relative to the consolidated unit and increase value. This argument would have more basis, if either of these businesses had the capacity to carry substantial debt on their own but not as a consolidated unit. In fact, changing the debt ratio for the units to 20% (while increasing the cost of debt to 4.5%) from the current debt ratio of 10.71% increases value only by $479 million, increasing it to 30% (with a cost of debt of 5%) leads to an increase in value of $655 million and increasing it beyond 30% actually lowers value.
The spreadsheet that I attach can be used to tweak each of these numbers, to see the impact. I remain skeptical on the cost-cutting, am open to the possibility of higher growth, but I don't see much of a basis for the increased competitive advantage or cost of capital stories.

EBay: Pricing the break up
It is possible that the motives for this break up have nothing to do with management focus and value enhancement and have more to do with investor focus and price enhancement. EBay has two very different businesses in its consolidated unit that should be priced relative to different sectors and using different multiples. It is possible that investors (and analysts) are comparing EBay to the wrong set of companies, using the wrong metrics, and are thus mispricing it. 

To assess the pricing impact, I tried a very simple analysis, where I broke the company down into two businesses, the market place business and the payment processing business and priced each relative to what I thought were more relevant comparable firms: online retail firms for the former and payment processing companies for the latter.  Using information on firms operating in each of these businesses, I arrived at the following estimates for the multiples within each sector:


The pricing effect of the break down will depend in large part on the comparable companies used to value each unit, the pricing metric used in that unit and any adjustments made to the multiple to reflect EBay's unique qualities. For instance, applying the median EV/Sales ratios for each sector to the revenues of the two EBay units would have yielded a  value of $47.8 billion for the company,  much lower than the consolidated company's current enterprise value of $68 billion. Using the median values of the EV/EBIT multiple to the stated operating income of the two EBay units would have resulted in a value of $113.3 billion for the equity, much higher than the current enterprise value.

The wide variation in value can be attributed partly to the fact that EBay's units vary from the comparable companies in significant ways:
  • Bay's marketplace business model keeps its revenues low, since it reports only its cut of the price of items sold as revenues rather than gross revenues, giving it a much higher margin (24.47%) than the typical online retail firm (where the median is 3.71%). 
  • Like many of the companies on the comparable firm list, PayPal derives its revenues from transactions, but its profits are a function of how a transaction is funded, with its highest profits coming when it is funded with a PayPal account balance and its lowest profits from a (non-PayPal) credit card transaction.

To adjust the enterprise values for both businesses, for these margin differences, I ran regressions of the EV/Sales ratio against operating margin within each sector and arrived at the following results:

  • In online retail: EV/Sales = 2.53 + 10.51 (Operating Margin) R squared = 51%
  • In payment processing: EV/Sales = 0.24 + 15.8 (Operating Margin) R squared= 84%

At the bottom of the figure above, I used these regressions to estimate margin-adjusted EV/Sales ratios for the two businesses and arrive at an cumulated enterprise value for the two units of $69 billion, very close to the current value. (You can download the comparable data in this spreadsheet and check out or modify the regressions.)

I also think that two big news stories from the last two months may have also prompted EBay's separation of PayPal. In September, Alibaba went public to acclaim and saw its stock price pop on the offerting date, drawing attention to the fact that Alipay, their payment processing system, would not be bundled with the company. A short while later, Apple announced Apple Pay, a payment mechanism for iPhone users, accepted for the moment by a handful of retailers. With both Alipay and Apple Pay, though, there was talk about their capacity to disrupt the credit card business and the profits that disruption would deliver. As the most established and widely used digital payment processing system in the world, PayPal may very well have resented the fact that they were not spotlighted and blamed their association with EBay for the treatment. Thus, one reason for the timing of the EBay break up may have been the rise in market interest (and valuations) for companies in the digital payment space.

Bottom line
In an earlier post, I argued that there was little reason to believe that HP’s break up would lead to higher value or higher price for the individual units, and based my argument not the fact that they are too similar in their fundamentals, with flat and declining growth, and shrinking margins for either value enhancement (from more focused managers) or price enhancement (from more focused investors) to pay off. I have a more optimistic take on EBay’s break up, though it is tempered by my suspicions on motives and timing. Ebay’s market place (the new EBay) and payment processing (the new PayPal) are different enough that managing them as a combined company must have posed head aches for managers. There is also a pricing rationale that comes to the surface, especially with Apple Pay and Alipay being viewed as disruptors in the financial services business, where a stand alone PayPal may attract more attention and perhaps a higher price from investors.

Attachments:
  1. EBay Valuation and Pricing
  2. Corporate Breakups: Value and Pricing Effects
  3. HP Break Up: Value Enhancement, Pricing Game or Management Hype
  4. Focus Pocus: Breaking up as a cure for corporate attention deficit disorder

15 comments:

Anonymous said...

This is absolutely golden but the timing of publishing is unfortunate (to maximize exposure & readership). Perhaps you should have pushed the release to Monday morning?

Anonymous said...

Good article, again, Aswath. CEO are more political than finance analyst. You can not believe in whatever they say. The 10k and 10Q are our best friends.

The Contrarian Individual Investor said...

Perhaps they believe an independent Paypal will attract an open market take over bid. Their are plenty of cash rich, flagging sales, tech companies looking for a way to stay in the game, not to mention a few financial companies that want to be in the game.

Aswath Damodaran said...

On the timing of the post, I did think about it for a moment, but it was done, there is nothing I will be learning over the weekend and EBay will still be breaking up on Monday morning. So, I decided to post on Friday evening. If nothing else, it will be an experiment in whether timing matters.
On the possibility of PayPal being a target for an acquisition, perhaps, but why could that not happen when PayPal is part of EBay? Unless you believe that the acquisition is going to be hostile, I don't see why a break up is needed for the acquisition to go through.

Abhay Vig said...

Looking from a perspective of ebay(market place + payment processing) :

1. Having pay pall+ ebay may pass the better off test , due to existing synergies and growing business and revenue potential.

2. It however doesn't seem to pass the ownership i.e , if ebay is driving its competitiveness through synergies with having paypall in its fold , it can continue doing so , by having a contractual relation with paypall , and thus increasing competition between paypall and other payment service providers.

3. Since the paypall is growing at 20% rate and is in the industry which is essentially very attractive to be in at this point of time , it should continue to keep it in its fold.

4. On cost of corporate coordination needed , since a payment processing service would have essentially its own technology and resource backbone and essentially operating independent the conglomerate discount could be essentially very less.

It should break off paypall only if ebay has realized that paypall has reached its maximum growth potential and it is operating at maximum efficiency , which is clearly not the case.

Henry said...

I don't understand how a CEO can go on national television and say they will absolutely not break up the company. Then next thing you know it, there's a break up announced. I wonder if management compensation is tied creating a higher stock price rather than growing the business.

Ian said...

Aswath,

Would it make sense to use your spreadsheet value the converse, in which a company is consolidating business units rather than spinning off divisions?

Thanks,
Ian

Aswath Damodaran said...

Ian,
It should work in that direction to.

Wonni said...

Hi Aswath,
In your bottom line you said:
"Especially with Apple Pay and Alipay being viewed as disruptors in the financial services business"
Can do you call Apple Pay and Alipay as disruptors?
regards

Aswath Damodaran said...

If Apple Pay and Alipay are not disruptors of how we pay for stuff, what exactly do they hope to accomplish?

Wonni said...

Hi Aswath,
I am sorry, but I don´t understand your question.
Could you please formulate your question differently?
Regars

Aswath Damodaran said...

The definition of a disruptor is that they plan to change the way an existing business is run. Using that definition, Alipay and Apple Pay qualify in my book.

Wonni said...

Hi Aswath,
sorry but I dont´t understand what you mean when you say "Alipay and Apple Pay qualify in my book." What do you mean by "qualify"? and what makes Apple Pay and Alipay to disruptors?
I'm curious
regards

Anonymous said...

Hi Prof
dod you mean the EBAY could be a "good" value to buy?

Anonymous said...

Do you think that using linear regressions on seemingly non linear issues poses a problem to investors and students of finance?