Wednesday, September 21, 2011

Breaking up is easy to do...

Breaking up may have been hard to do for the Carpenters, but it seems to be easy to do for some companies. Here are just  a few examples of companies that have announced plans to dismember themselves, in the last few months:
  1. Kraft Foods: Kraft Foods split itself into two companies: a division that sells candy and snacks (Oreo, Cadbury, Tang) globally and a division that sells grocery brands in the US (Oscar Meyer, Jell-O). 
  2. McGraw-Hill: The company responded to demands by investors that it break itself up by dividing itself into two businesses: McGraw-Hill Markets, which includes the S&P rating and index businesses and McGraw-Hill Education, composed of the publishing and education businesses owned by McGraw-Hill.
  3. Netflix: Reed Hastings, the CEO of Netflix stated that the company would separate its DVD rental business (and give it the name Qwikster) from its streaming-only service (which will continue to be called Netflix). 
  4. Tyco:  Tyco announced its intention to break itself up into three separate companies: a residential security business (ADT), a unit selling valves and controls to energy, mining and water markets and a commercial fire and security business. This represents the closing salvo in a multi-year effort by Tyco to deconglomeratize (I know.. I know.. there is no such word... but there should be) itself.
What happens in a break up?
To understand the mechanics of breaking up a publicly traded company, recognize that  there are three dimensions on which break up can have varying effects, depending on how it is structured: 
  1. Control of the management of the business(es), where the effect can range from a complete separation of control (with each of the broken up businesses becoming independent companies, completely delinked from the parent company) to de facto serf status for the separated units (with the parent company exercising complete or near complete control over the separated businesses).
  2. Market pricing of the units, where the effect can range from the broken up businesses trading as independent units (with their own shares, market price and traded value) to no change in the status quo, with the parent company trading as a single company, composed as a holding company for the separated business units.
  3. A break up can have tax implications for the investors in the parent company. To the degree that a break up can be viewed as a transition from owning stock in one consolidated company to owning shares in multiple companies, tax authorities may assess capital gains taxes (relative to what was originally paid for the stock) or treat distributions as dividends (and tax them accordingly). Again, in the continuum, you can have break ups that create no tax consequences for investors and break ups that create large tax bills.
The good news is that the details of the break up ultimately have to be made public to investors, who can then assess the control, pricing and tax implications. The bad news is that the details may not be accessible at the time of the initial announcement of the break up.

Does breaking up make sense?
There are many reasons why companies may (or should) break themselves up, and here is a synopsis for each one:
  1. Market mistakes: The simplest rationale for a break up is that the market is mistakenly valuing the whole company at less than the sum of its pieces. Many analysts/ activist investors use this "sum of the parts" argument to push companies that they feel are being under valued to break up. While the story is intuitive, I would be skeptical of any argument that is premised entirely on "market mistakes", partly because most "sum of the parts" valuations are really "seat of the pants" valuations. Analysts will often take the earnings reported by division for a company, which are contaminated by accounting allocation and transfer pricing decisions made by the company, and apply sector-average earnings multiples (without correcting for differences between companies) to estimate the divisional or parts values.  (See the end of this post for a spreadsheet that will allow you to do your own sum of the parts valuation)
  2. Contaminated Parts: One division of a company may be saddled with actual, perceived or potential liabilities that are so large that they drag down the valuations of the rest of the company. This was the rationale for tobacco companies, faced with potential billion-dollar payouts on lawsuits brought by smokers, spinning of their non-tobacco businesses (See, for instance, the Kraft spin off from Altria (Philip Morris) in 2007). In the same vein, a company with a heavily regulated or constrained subsidiary may find that the regulations and constraints on that subsidiary spill over into its other businesses, rendering them less profitable. If restrictions on commercial banking are tightened (think of Dodd-Frank, with teeth...), it is conceivable that the large money center banks may want to spin off their investment banking arms to operate independently.
  3. The efficiency story: In the 1960s and 1970s, imperial CEOs  (Like Julius Caesar, they brooked no dissent and looked to no one for advice)  like Harold Geneen (ITT) and Charles Bludhorn (Gulf and Western) built up companies that spanned multiple businesses, arguing (with lots of help from strategists and consultants) that conglomerates would have significant advantages over their smaller competitors. Studies over the last three decades suggests that this optimism was misplaced and that conglomerates are often less efficient than competitors, earning lower returns and profit margins. In fact, markets responded by "discounting" conglomerates by about 5-15%, to reflect the inefficiencies. If conglomerates are less well run than the competition, perhaps because managers are spread too thin across business or because there is cross subsidization, then breaking them up into their individual businesses should increase efficiency, profits and value. The break up of Tyco, a company built on the conglomerate premise (and accounting gamesmanship), over the last decade can be a case study in deconglomeration.
  4. The simplicity story: Multi-business companies are not only more difficult to manage but they are also more difficult to value. With companies like GE and United Technologies, different businesses within each company can have very different risk, cash flow and growth characteristics and coming up with a consolidated number can be cumbersome. In my book, the Dark Side of Valuation, I examine why valuing their "octopus" companies is so difficult (you can just download the paper... you don't have to buy the book..)  and how to do a true sum of the parts valuation. In good times, investors may overlook the complexities of valuation, trust the managers and value these multi business companies highly. In bad times, they will not be as charitable and will punish complex companies by discounting their value. Breaking up the companies in bite size pieces that are easier to value and trade may therefore increase value, especially if you are in a "crisis" market.
  5. The tax story: When tax codes are complex (and when are they not?), companies may be able to lower their tax bills by artfully breaking themselves up. For instance, let us assume that the US government decides to take the populists' advice and tax all income generated by US corporations, anywhere in the world, at the US corporate tax rate in the year in which the income is generated (rather than when it is repatriated back to the US, as is the current law). Multinationals like GE and Coca Cola that generate a significant portion of their taxes in foreign locales, with lower tax rates, will be able to lower their tax bill by breaking up into independent domestic (US) and international entities, with different stockholders, managers and corporate governance structures.
On the other side of the ledger, there are costs to breaking up as well:
  1. Loss of economies of scale: Combining businesses into a company can create cost savings. Thus, a group of consumer product businesses may benefit from being consolidated into one unit, with shared advertising and distribution costs. Breaking up with result in a  loss of these savings. 
  2. Reduced access to capital (and higher cost): If external capital markets (stock and bond) are undeveloped or under stress, combining businesses into a consolidated company can provide access to capital. How? The excess cash flows from cash rich businesses can be used to finance reinvestment needs in cash poor businesses. 
  3. Lost synergies: I am generally a skeptic about synergy but it does exist. In some multi-business companies, businesses feed off each other's successes, thus making the whole greater than the sum of its parts. Disney is a good example, especially in its kid-oriented products: its movie business generates opportunities for its licensing businesses and increases revenues at its theme parks. Separating Disney into independent movie, toy and theme park businesses will result in a loss of these benefits.
If companies were rational, they would be looking at this trade off and making judgments on whether to break up, based upon the net effect. A rational explanation for the surge in break ups is that we are in a market phase, where risk is front and center, and complexity is being punished.

By focusing on sensible reasons for breaking up firms, we do miss the most important factor that explains corporate actions: herd behavior. Investment banks, consultants and corporations often get stuck on the same page in the value creation cookbook and dole out the same advice for each company that comes looking for help at a point in time. Break ups may be the flavor of the moment, and companies are jumping on the bandwagon, expecting stock prices to go up, even if the break up makes no economic sense.

Assessing break ups and potential break ups...
As investors, the breaking up of a company can be good, neutral or bad news. In assessing either announced or potential break ups, here are some things to consider:
a. Past performance: I know.. I know.. I have read the disclaimers too, but if you are performing well (both in terms of earnings and stock prices), why mess with a winning formula? A firm that is performing well (both in terms of profitability and stock price measures) should therefore be less inclined to consider breaking up than a firm that is under performing its competition.
b. Separate and independent businesses: The benefits of breaking up increase and the costs decrease if the businesses that are being broken up are stand alone, independent businesses, with few or no cross business links. Conversely, companies with interlocked businesses that have synergies should be wary of break up plans.
c. Management rationale and consistent actions: A break-up is more likely to succeed if  the managers of the parent company are  clear about their objectives and structure the break up consistently. For instance, if the rationale for a break up of a company is that one business is contaminating the remaining businesses, the break up makes sense only if it creates separate legal entities that operate independently.

So, how do the break ups in the news measure up?
  • The Tyco break up makes the most sense: the businesses are separate and independent and managers seem clear on the rationale. It is also part of a long term plan and is not a knee-jerk response to market developments.
  • The McGraw-Hill merger also makes sense, since there is little overlap between S&P and the education businesses. These firms operated independently until a few years ago and the transition back to independence should be easier. Finally, the current legal and public relations problems with the ratings agencies could hurt the rest of McGraw Hill. (In fact, a surprising number of break ups are reversals of acquisitions done in prior years, an admission that the acquisitions did not work.)
  • The Netflix break up seems like a clumsy solution to a pricing problem: the cost of maintaining a DVD customer is higher than the cost of a streaming customer and that cost difference will widen as fewer people use DVDs. But do you have to break up a company to accomplish this? 
  • I am at a loss on the Kraft break-up. The businesses that are being divided have more in common than they are different. Oreo, Cadbury, Jell-O and Oscar Meyer are all strong brand names with a global presence. The fact that the latter two may get more of their revenues from US grocery story sales does not strike me as a big difference. Perhaps, there are differences in growth prospects, but the costs of breaking up (lost economies of scale and synergies) seem to vastly outweigh the benefits. In short, this break up seems to fit into "action is better than inaction" rationale for break ups.
Finally, are there other companies that meet the criteria for "good" break up candidates? There are plenty, but let me suggest three high profile candidates:

  1. Time Warner: Time Warner is a company with tentacles in every aspect of entertainment. Unlike Disney, which does get significant cross business synergies, Time Warner has less overlap across businesses. The company has had trouble on both profitability and stock performance measures and a management that will never outlive the consequences of having made the worst acquisition in history.
  2. GE: In the days of Jack Welch, GE was a case study of a large company that seemed to have found the fountain of everlasting growth. Not only have we discovered in hindsight that this growth (mostly from acquisitions) was more expensive than it seemed at the outset, but GE Capital has taken on an outsized role in determining the value of GE as a company. As one of the largest financial service companies in the world, with its own share of costly mistakes, GE Capital is an impediment to valuing GE and an brake on its stock price. Unlike other captive financing arms (Ford Capital, GMAC), where the bulk of the revenues come from within the company and separation is difficult, GE Capital derives a significant portion of its revenues outside GE and should be easier to separate from the company.
  3. Citigroup/Bank of America/ JPM Chase: The strategies that the big money center banks embarked on, a decade or more ago, of being financial supermarkets, with business interests in banking, real estate, portfolio management and housing finance has blown up in their faces. Instead of the diversification helping the company, one or two portions of each bank (with bad lending practices or toxic assets) is threatening to bring down the rest of the institution. Perhaps, it is time to break up.. or in the case of Bank of America, put one of its businesses into bankruptcy..
So, embark on your proactive exercise of looking for potential break up candidates: if you can get ahead of the curve, you should profit, even if only a fraction of these companies do break up. Just to help you along, I have attached a very simple spreadsheet for assessing the effect on value of a break up, in both intrinsic and relative valuation terms. Have fun with it! 


Anonymous said...

Thnx, Prof. >:D<.

French Translation said...

Thank you Professor. I am really grateful to you.