Friday, October 24, 2014

Corporate Breakups: Value and Pricing Effects

As HP and EBay announce break-ups and longstanding market players like GE and IBM make moves to narrow their business focus, it seems like corporate strategy has come full circle. In fact, as I watch strategists, consultants and analysts tell me how breaking up companies will make them more valuable, I cannot but be cynical, because it was not so long ago that these same strategists, consultants and analysts were selling me on the wondrous benefits of building “all-in-one” companies, where synergies and economies of scales were the mantra. The best cure for that cynicism is for me to take a deep breath and look at the possibility that this time these experts mean what they say and to give the story a fair hearing. In keeping with a theme that I have pushing on my blog, I will first look at how and why a break up can affect value and then examine whether there may be a pricing rationale for break ups.

The value effect of a break up
I may sound like a broken record but the value of a business is determined by the level of its cash flows from existing investments, the value that can be created (or destroyed) by future growth and the risk in both these components. To make an argument that break ups enhance value, we have to meet two tests. The first is to show how a break up can affect cash flows, the value of growth and risk and that is relatively straightforward. The second, and this is the tougher test, is to make the argument that the consolidated company could not have made the changes without breaking up and to back up that argument.

When a consolidated company is broken up, the value of the pieces created by the breakup have to show up in the numbers, in general, and in the cash flows, growth value or risk of the business, in specific, for there to any value effects.
  1. Cash flows: A break up can increase the cash flows, if the broken up units will have lower costs than the consolidated company (efficiency rationale), is expected to pay less in taxes than the consolidated unit (a tax payoff) or can reduce the amount it invests in maintenance capital expenditures & working capital to maintain its existing operations (a working capital story). 
  2. Value of growth: A break up can increase the value from growth if the broken up units invest more than the consolidated unit (if you are in good businesses), redirect investment from one business to another (if one business is good and the other is not) or invest less than the consolidated unit (if both businesses are bad).
  3. Risk: A break-up can reduce the cost of funding the businesses (cost of capital) if the broken up units are able to choose debt mixes that lower their cost of capital or are able to alter the type of debt they use to better reflect their asset characteristics. In some cases, a break up can also reduce the overall risk of failure, if one of the units of a consolidated company faces a potentially catastrophic risk (from a legal or regulatory event), by separating the rest of the company from it.
The picture below brings all of these possibilities into perspective.

Looking at the picture, it is easy to portray break ups as value creating, but there are two caveats to keep in mind. First, note that with a little tweaking this same picture can be used to show the value of synergy in a merger, with the only difference being that the consolidated unit is the one that has the advantage in that case, with lower costs, higher value to growth and less risk. Second, the tougher test to meet with both break ups and mergers is showing that you could not have created these value-enhancing changes, without breaking up or merging. Thus, if your argument is that breaking up can create cost savings, it also behooves you to follow up and explain why the consolidated company could not have cut these costs on its own. In general, the following table summarizes reasons why breaking up may be necessary for the changes to occur, with examples (and feel free to add your own):

Example (s)
Regulatory restrictions
If you are a regulated company, with an unregulated (& growing) business, regulatory restrictions may prevent you from investing as much as you would like to in that business.
In the early (and growth) days of the cell phone business, some established phone companies (which faced regulatory constraints) separated their cell phone businesses. (AT&T spinning off its wireless holdings in 2001)
Legal constraints
If one part of a consolidated company faces legal jeopardy (from a class action lawsuit or government action), its other businesses may be viewed as contaminated, and thus constrained in their operations.
At the height of the tobacco lawsuit wars, tobacco companies separated themselves from their non-tobacco holdings. (RJR Nabisco split up in 1999)
Debt/Bond Covenants
If the consolidated company is bound by covenants in past bond issues/bank debt from changing its financing mix or type, it may benefit from breaking up and relieving itself of those covenants.
These break ups, when they are announced, are almost always contested by bondholders and banks, who have lent to the consolidated company. They still do occur.
Tax Code
If a consolidated company faces a higher tax rate than its broken-up parts will face, breaking up will make sense.
While this is undoubtedly a motive in some break-ups, no sensible management will ever mention it, since it is sure to draw fire.
Corporate culture/history
A company with a long history and an entrenched culture may be unable to change its business practices, but its broken up parts (or at least some of them) may not feel as constrained.
The older and more set in its way a company is, the more likely it is that a break up will be needed to shake up practices. (Kraft's break up and rebranding)
Dividend clientele
A company accumulates investors who like its dividend policy. To the extent that this dividend policy is no longer sustainable, the company may need to be broken up to institute change.
Most likely to be the case when a business that used to be stable/mature changes characteristics to becomes higher growth/riskier. (AT&T IPO of  Bell Labs (as Lucent))

There is one final possible explanation for why a break up may sometimes be needed for value creation and it relates to the well-discussed and much over-used notion of disruption. If you buy into Clayton Christensen's thesis that disruption is more likely to come from upstarts that have nothing to lose than from the establishment entities that have to weigh in the lost profits from existing products, a company that has a disruptive business unit, with the disruption aimed at one of its existing (and perhaps more profitable) businesses may find its value enhanced by separating the disruptive unit from the company (and giving it the resources to continue on its disruptive path).

The Price Effect of a Break up
I believe that much of what companies do is directed at increasing price rather than value. Thus, the simpler explanation for break ups is that they are actions designed to either correct what companies perceive to be market mistakes in how they are being price or in some insidious cases, to create market mistakes in their favor. The pricing effect rests on the presumption that investors may price a consolidated company differently than they price its pieces. At the risk of repeating myself, the pricing process is based upon three choices that investors make:
  1. Pricing metric: You can price based upon revenues, earnings, book value or a revenue driver, and you either look at just equity value or the value of the business. That is the essence of a multiple, whether PE, EV/EBITDA or EV/Revenues. 
  2. Comparable firms; All pricing is based on a comparison to a set of firms that you believe are comparable to the one that you are trying to analyze. 
  3. Control factors: Since the multiples will vary across the firms because of differences in fundamentals (growth, cash flows and risk), you have to control for those differences, either subjectives (story telling) or objectively (by bringing them into the multiple or statistically).
To capture the effect and lay the foundations for why it may exist, consider the following picture:

Note that the pricing metric used, the comparable companies that are chosen and the control variables/processes are all subjective and that breaking up the company may change all of these choices. Thus, an IBM or GE may be valued relative to other large market cap, mature companies by analysts tracking them, but if broken up into parts, they may be compared to individual businesses that are priced differently (on different metrics and with different values, for the same metrics). Not surprisingly, the kinds of companies that gain the most in pricing from breaking up are firms that have one or more of the following characteristics:
  1. Opaque financials: In theory, you should be able to price a consolidated company as the sum of its pieces but to do so, you will need operating details at the unit level. While many consolidated companies report operating metrics for each unit, those values can be difficult to read for many reasons. The first is if there are significant intra-company transactions, transfer pricing may affect reported revenues. The second is that many corporate expenses have to be allocated across businesses and those allocations reflect accounting judgments and may not fairly capture costs at the unit level. Finally, if there are significant corporate costs that are unallocated, they become a wild card in valuation, since ignoring them will lead you to over value consolidated companies. (Much of the  academic work done on the conglomerate discount, in my view, reflects not only pricing but very sloppy pricing, at that.)
  2. Diverse businesses: The possibility of mis-pricing also increases as the diversity (on both operating and financial dimensions) of businesses within the corporate umbrella increases, making it more difficult to find a metric and comparable firms for the consolidated company.  After all, who really can come up with the right metric or comparable firms, if you are pricing a GE, Siemens or United Technologies?
  3. Hot "sector": The potential pricing effect of breaking up is much greater if there is a part of the consolidated business that is in a hot sector (where the market is attaching high market value to potential) but that part is being obscured by the details of the rest of the company. Thus, if Microsoft has a booming social media presence (I am not saying it does), would you even notice that presence?
It is worth noting, though, that the nature of pricing is that the price effect of a break up may reflect game playing and cosmetics more than reality. In other words, it is just as likely  that the market was pricing the consolidated company correctly and that it is the broken up pieces that are being over priced as it is that the market was under pricing the consolidated unit and that the break up leads to a correct pricing.

Bottom line
Breaking up a company, by itself, cannot increase value. It is what you do (not say that you will do) with the broken up units to change the fundamentals (cash flows, growth or risk) that determine whether a break up is value creating, value neutral or value destroying. However, breaking up a company can have a price effect, for good reasons and bad ones. As an example of the former, a company that is sorely misunderstood and misclassified by investors and analysts can see its market value go up after breaking up. At the same time, though, some break ups can be motivated by the desire to fool some investors some of the time, with most of the price increase coming from either a n accounting sleight of hand (a reshuffling of expenses and earnings across business units) or from a sector being over priced. I will be looking at the HP and EBay breakups in my next post to see where they fall on both value and pricing dimensions.

Posts on corporate break ups

  1. Corporate Breakups: Value and Pricing Effects
  2. The HP and EBay Breakups: More or Less than meets the eye?


Unknown said...

I really learned from this article . I am not trained in accounting, and this sort of nuanced discussion really helps me to better understand the numbers. THANK YOU! :-)

Apprentice of Agamas said...

Dear Prof,
What about the yang piece to this yin story? How does one gauge (foretell maybe) if corporate mergers are going to be successful ?
I don't have numbers but it seems almost certain that taking two large companies (and their associated ceo personalities) and merging into one is almost certain to create a value loss for share-holders in the near future
(eg: Time Warner, Comcast+AT&T Broadband etc)
Your thoughts ?

Andrew Nolan said...

First off thank you for all the content you provide to the online community. I very much enjoy your articles.

Regarding break ups enhancing value. What about break ups that create top line growth by unlocking access to markets that were otherwise implausible to enter as one company? It may be you considered this in your article and it went over my head.

I am thinking of the case of eBay/Paypal. It seems to me that some online retailers (e.g. Amazon) do not accept Paypal as a payment method because it is a subsidiary of their competitor, eBay. But by becoming its own company that barrier to entry may be removed.

Aswath Damodaran said...

I like that rationale of top line growth and I am going to use it as one possible justification for eBay/Paypal being potentially a value additive break up.