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The moves appear to reflect a widespread view that diversified companies should jettison business units that are not part of their “core” strengths so that all parties can focus on what they do best. The spun-off units, in turn, can also pursue their businesses in a more focused manner. In a reversal of the classic valuation metric, the parts are thought to be worth more than the sum.
Amid the breakup boom, a number of questions have arisen. Do spin-offs actually unlock value for shareholders? Do they make strategic sense? And on a practical level, how should investors approach the news that a stock in their portfolio has decided to divide? Sharing their insights on the trend are Lord Abbett Partners Rick Ruvkun, Director of Domestic Equity Research; John McMillin, Associate Director of Domestic Equity Research; and Justin Maurer, Portfolio Manager of Smid Cap Value; and Gregory Parker, Research Analyst for Lord Abbett’s Domestic Equity Research Team.
Spin-offs (also known as spin-outs or starbursts) occur when a parent company distributes shares of one or more subsidiaries to the parent’s shareholders, per the Securities and Exchange Commission’s definition.1 The shares are usually distributed on a pro-rata basis and the subsidiaries become separate companies that are owned by shareholders, rather than the parent company. Since the Tax Reform Act of 1986, a spin-off is generally the only way a company can distribute appreciated property to shareholders without incurring a corporate-level tax.2
The pace of spin-offs has quickened in recent years. According to research firm Dealogic, there were 19 completed spin-offs in the United States in 2011, versus 16 in 2010. The total deal value was $69.4 billion, versus $17.1 billion. Outside the United States, there were 63 spin-offs with a total deal value of $58.4 billion in 2011, versus 58 spin-offs with a total value of $36.6 billion in 2010.
And there could be many more to come. The Spinoff Report, a global research specialist that focuses on corporate breakups, has forecast a record 109 such deals worldwide in 2012. The increase is likely because more companies view the total value of their business units as potentially higher than that of the company as a whole, according to a mergers and acquisitions (M&A) attorney cited in a Wall Street Journal story.3 Paul Parker, global head of Barclays Capital’s M&A group, told the Journal he expects more spin-off activity in 2012 among industrial, consumer products, and healthcare companies, largely because investors don’t value big companies in those sectors as much in the current economic climate.
A Focus on Focus
According to a 2011 blog post by Howard Silverblatt, senior index analyst for Standard & Poor’s,4 over the past 25 years, member companies of the S&P 500® Index5 have accounted for 20% of U.S. spin-off distributions. (The largest of those was the $108 billion spin-off of Philip Morris International from Altria in March 2008.) Historically, consumer discretionary and technology sector companies have been the most common companies spun off, according to investment research firm Wolfe Trahan.
What’s behind the surge in demergers? “If you look at balance sheets and the ability to finance, [recent activity] is not out of financial necessity,” Mark Shafir, global head of M&A at Citigroup, told the Financial Times.6 “It’s about portfolio rationalization to improve efficiency and valuation multiples.”
New York Times finance blogger Steven M. Davidoff declared that “the days of conglomerates … are dead.”7 The former chief financial officer of spirits and consumer products conglomerate Fortune Brands, which split itself up in October 2011, told The Wall Street Journal that equity markets are moving toward an environment where “investors have more of a pure-play mindset.”8
Rick Ruvkun, Lord Abbett Partner & Director of Domestic Equity Research, said that companies going the pure-play route typically wish to focus on a business that has a high internal growth rate or some distinctive advantage, such as patents or a product with a differentiated niche.
There are a number of potential advantages for companies that take the plunge. For firms that have acquired a collection of businesses over time, and have amassed sizable gains on the value of those assets, a tax-free spin-off delivers value to shareholders “without having to pay as much to Uncle Sam,” said David Zion, accounting and tax analyst for Credit Suisse. While tax-free spin-offs may not make sense for every conglomerate, if a company has no immediate need for liquidity or access to cash, a spin-off can enable it to focus on its core business and deliver value to shareholders in a tax-efficient manner, he said. In many instances, spin-offs could be considered preferable to carve-outs, in which the unit’s shares are sold in an initial public offering, or an outright sale of the business. Both outcomes could result in significant tax bills for the parent company.9
Spin-offs may represent an attractive alternative to companies seeking buyers for parts of their business that have not received good offers from other firms, or from private equity buyers, according to a report in The Economist.10
Source: Wolfe Trahan Accounting & Tax Policy Research, Company filings, Bloomberg, Standard & Poor’s, and FactSet.
Note: Market data as of Januar y 11, 2012.
Some observers think the trend is also being driven by deal-hungry investment bankers. Davidoff asserted that “Wall Street bankers are pushing spin-offs to compensate for declining takeover volume … [in] the frenzy, every company with even remotely divergent businesses is a target.”11
The trend also may reflect corporations’ efforts to counter stock valuations that continue to trail historical levels. Valuations for U.S. equities have been stuck below the five-decade average for the longest period since Richard Nixon’s presidency, according to a Bloomberg News report.12
Clamoring for Change
Corporate boards may also be feeling external pressure to split up their companies. “Management boards across all markets and capitalizations are seeing their outlook strategies being challenged by increasingly vocal investors seeking greater shareholder growth, said Ryan Mendy, chief operating officer of The Spinoff Report.
Hedge funds are among the activists pushing for split-ups. One approach is for a fund to take a position in a company and try to bolster returns by agitating for a spin-off of an underperforming or divergent business. Bill Ackman, who runs New York-based hedge fund Pershing Square Capital Management, bought a large stake in Fortune Brands in late 2010, and then lobbied the board to split up Fortune’s disparate business lines.13 The company divested its golf products business and split up its home-security and liquor businesses in October 2011. (Fortune Brands’ former finance chief told The Wall Street Journal that the company had decided to split itself up prior to Ackman’s approach.) In February 2012, John Paulson, head of hedge fund Paulson & Co., pressed Hartford Financial Services Group Inc. to split up its life and property-casualty insurance businesses.14
Ralcorp Holdings, facing a hostile takeover bid from ConAgra, decided to split its private-label foods and branded cereals businesses in July 2011.
Split-ups create numerous issues for investors. One important consideration is where management of the parent company will land after the split-up, noted Mendy. “Who’s keeping their job?” he asked. S&P’s Silverblatt noted that, with spin-offs, “there is … an old saying to follow senior management—that’s where the money is (or is going).”15 “The current CEO always tends to become head of the most coveted business in the spin-off,” noted John McMillin, Lord Abbett Partner and Associate Director of Domestic Equity Research.
And with the new management structures in place, investors should look at “who’s getting what performance-based equity options to make the separation work over time,” noted Mendy.
Investors also may wish to closely examine the competitive and financial standing of the spun-off companies, the payment of special dividends, and other factors. Among other key questions, according to Mendy: “Where’s the debt or cash going ... how much, and to whom or what entity?”
Considerations regarding management compensation may provide additional incentive to split up a company. If a stock has slumped and management holds incentive equity options to buy company shares that are priced above the current stock price, a spin-off may allow them to “shuffle the deck,” according to McMillin, giving them two or more stock holdings instead of the single, depressed equity. Shareholders, like management, have the chance to make money since there are “two [or more] horses in the race instead of one,” he said.
Ruvkun said management will try to give investors incentive to buy the stock based on the characteristics of each unit. Some conglomerates may structure a spin-off in which one company that has faster growth is positioned with moderate debt levels while the other spun-off unit, with the slower-growing business, may be more highly leveraged. “The pure-play will trade at a premium price-to-earnings ratio,16 while the slower-growing company, although it may have a higher degree of leverage, may attract more value-oriented buyers because it has good cash flow or recurring revenue,” he said.
The desire to “roll up” companies into conglomerates—and the urge to tear them apart into “pure-play” components—appears to run in cycles, noted McMillin. During the 1950s and 1960s, for example, corporations sought to broaden their lines of business via massive diversification programs.17 This effort reached full flower with the merger wave of the 1960s and the rise of the modern conglomerate, exemplified by telecommunications equipment maker ITT Corp., which snapped up 350 businesses during 1959–77, encompassing everything from snack cakes to hotels to rental cars. (See sidebar on page 33.) Other major names followed suit, with unlikely pairings including PepsiCo owning North American Van Lines and cereal titan General Mills buying toymaker Parker Brothers.
“The trend toward conglomerates tends to start when [single-] focus companies realize they are not growing, and can justify building a conglomerate because of perceived synergies among business units. But the real reason may be that they are not growing,” said McMillin.
After the 1960s’ diversification boom, companies had second thoughts about the value of a widely varied portfolio of businesses, noted McMillin. Amid a period of lackluster economic growth in the 1970s and 1980s, companies began to spin off units that were not considered essential to their core businesses. (The 1984 breakup of AT&T into seven regional Bell operating companies was sui generis because it was stipulated by an antitrust settlement with the U.S. Department of Justice.)
The 1980s and 1990s brought a renewed focus on diversification, as mergers and acquisitions again took center stage. Another upturn in spin-offs occurred in the late 1990s, with the number in the United States reaching a cycle peak of 28 in 1998, according to data from Wolfe Trahan. (See Chart 1.)
Source: Wolfe Trahan Accounting & Tax Policy Research and company filings.
Merger and acquisition activity picked up again in the 2000s, but with the sluggish economic conditions of recent years, companies’ desire for scale has given way to the need to focus on operations, said McMillin. With the current spin-off boom, “the focus companies are winning the argument.”
Some of the food companies McMillin follows illustrate the trend. Kraft Foods, for example, announced in August 2011 that it intended to split its faster-growing global snacks business apart from its North American grocery operations. In January 2011, Sara Lee announced plans to divide its international coffee and tea business and its North American retail, foodservice, and specialty meats operations.
The activity has triggered speculation about another major name in the sector. A Bloomberg News story reported that PepsiCo’s struggles with slow growth have led analysts to suggest that the company’s beverage and snacks businesses would be worth more as separate units than together.18
Apart from two high-profile examples—ITT Corp. and Tyco Industries—one group that has proved relatively immune to the trends has been diversified industrial companies, said Gregory Parker, Lord Abbett Research Analyst for U.S. Large & Mid Cap Equity. “The management teams for these firms prefer being diversified because, like investment portfolio managers, they like to have something in their business mix that can grow in every part of the economic cycle, as it limits the overall financial volatility of the company.” Parker noted that the ITT and Tyco breakups were not particularly in response to current market conditions; for Tyco, the move is part of a longer-term strategy, while ITT is trying to remedy a failed strategy that left the company significantly overweight in the weakening U.S. defense segment.
Diversification: A Drag on Value?
Ultimately, companies with diverse lines of business that decide to break apart may be waving the white flag in the face of the “conglomerate discount,” in which the market values a company as less than the sum of its parts.
Researchers Philip G. Berger and Eli Ofek studied the effects of diversification on a company’s value by estimating the value of a diversified firm’s segments as if they were operated as separate firms.19 Their finding is that diversification reduces value. The authors estimated that the average loss of value was 13–15% over the sample period of 1986–91, occurred for firms of all sizes, and was mitigated when the diversification was within related industries. Berger and Ofek said their study confirmed evidence documenting a significant loss in value in corporations that followed a diversification strategy during the 1980s.
On the surface, the conglomerate approach appears to have many desirable features. Berger and Ofek noted the potential benefits of operating different lines of business within one firm included combining businesses with imperfectly correlated earnings streams, leading to a “coinsurance effect” that could help cushion against cyclical economic downturns. The scale afforded by diversification gives conglomerates greater borrowing capacity than single-line firms. Increased debt capacity can create value by increasing the firm’s ability to write off interest on its taxes.
Why, then, do investors value some companies at less than the sum of their parts? The answer may rest in how effectively diversified companies allocate capital. The researchers identified overinvestment in segments from industries with limited investment opportunities as one source of the value loss. They cited studies showing that managers of firms with unused borrowing power and free cash flows—typical attributes of a diversified conglomerate—are more likely to undertake value-decreasing investments.
An additional source of value loss can be found in the subsidization of poorly performing divisions by better-performing divisions. A March 1993 Wall Street Journal story cited by Berger and Ofek provides a telling example: “When Michael Walsh was preparing to take over as CEO of Tenneco, he discovered that ‘Tenneco’s profitable auto-parts and chemicals divisions didn’t strive as hard as they might for higher earnings because their surplus was routinely dumped into the company’s money-losing farm-equipment operation.’”
Parker noted that this is a key concern of operating a conglomerate. “How,” he asked, “do you allocate capital? Are businesses within the conglomerate structure seeing their growth being stifled?” Parker said the effectiveness of capital allocation often depends on the degree to which the company’s management structure is centralized or decentralized.
Justin Maurer, Lord Abbett Partner and Portfolio Manager of Smid Cap Value, said that while a desire to focus a company’s operations is understandable from a business perspective, there are instances when a multi-industry portfolio can help a company deal with periods of economic weakness. Maurer said a properly configured conglomerate could provide inherent diversification of business lines and income streams, providing a way to cushion against cyclical downturns in the economy.
After Division, Do Returns Multiply?
Let’s say that a company’s board tires of a perpetual conglomerate discount and follows through with a spin-off of one or more units. Does such a move typically unlock shareholder value?
Researchers Chris Veld and Yulia V. Veld-Merkoulova looked at the wealth effect created by spin-offs in a 2008 study.20 Their analysis of 26 studies (known as a meta-analysis) on spin-off announcements published from 1983 to 2008 showed that spin-offs are “unambiguously associated with positive abnormal returns on the day they are announced.” On average, announcing a spin-off increases the value of company equity by about 3%.
Their research found that returns are higher for spin-offs that lead to an improvement of industrial focus—the degree to which a company becomes a “pure play”—confirming the idea that dispositions involving assets outside the core business of a firm are viewed by the market as value-increasing. They also found that larger spin-offs were associated with higher abnormal returns, as the divestiture of a large nonrelated subsidiary is likely to be received more favorably than one involving a smaller unit outside the core business.
When the authors assessed research as to whether the wealth effects of spin-offs are limited to the announcement returns or whether they persist in the long run, the results were mixed. A 1993 study found a significant long-run abnormal performance in the one-, two-, and three-year periods after a spin-off date for U.S. firms. Later studies incorporating more refined statistical tests indicated no gains over and above stocks in similar industries.
Spin-offs can unlock some value in certain circumstances, but they are not “a layup to make money” over the longer term, noted McMillin. He said that while there are some success stories among the consumer products companies he has followed—Coach Inc., for example, split off from Sara Lee in April 2001, and since has prospered—other deals have turned sour. He pointed to Campbell Soup’s March 1998 spin-off of pickle producer Vlasic Foods. Vlasic was saddled with debt and simply was not strong enough to stand on its own, said McMillin. The company filed for bankruptcy protection in January 2001, and its operating businesses were acquired by Pinnacle Foods later that year.
Bracing for a Breakup
If a stock in an investment portfolio has separated into two or more distinct equities, what comes next? Silverblatt said the separation “leaves investors with the decision of keeping or selling the issues, since the new entities need to be evaluated separately.”21
For some portfolio managers, the challenges are clear. Ruvkun likens the situation of contending with newly split-up companies to “speed dating,” where in some cases “everybody has to change partners … and quickly.” He noted that for some fund managers, the presence of a smaller, spun-off company in their portfolio may pose an issue as its market capitalization may fall below a fund’s stated parameter.
While post–spin-off portfolio moves can vary based on a number of conditions, Maurer’s experience with the October 2011 split-up of Fortune Brands provides some insights from the perspective of a value manager. The stock was a holding in the Lord Abbett Value Opportunities Fund that he co-manages. He said that initially he was surprised when the company’s board announced the move, noting management’s previous statements that strength at its spirits business had helped mitigate weakness at its consumer products business, which had exposure to the housing downturn.
After the split-up in October 2011, the Value Opportunities Fund held on to both of the resultant stocks: spirits producer Beam Inc. and consumer-products company Fortune Brands Home & Security. Maurer said the steady cash flow from the spirits business helped Fortune Brands accelerate its investment in brands and infrastructure, and international distribution prior to the spin-off to position Beam for solid earnings growth and margin improvement. Meanwhile, Fortune Brands Home & Security received a favorable response from investors amid some tentative early signs of stabilization in the housing market.
Investors often point to the conglomerate discount as a market inefficiency and view the discount as a way to buy undervalued stocks. Maurer concurs. “We have owned several companies that have been part of spin-offs,” he said.
What happens when a fund manager finds out that spun-off stocks do not conform to the fund’s investment parameters? Maurer noted that as a value manager he had no minimum market capitalization restriction. For stocks that cross over a fund’s market capitalization parameters, there is “no hard and fast rule to sell,” as long as the managers still consider the stock a good value and its fundamentals are solid. [Although the Fund’s investment strategy requires that, under normal market conditions, the Fund invest at least 65% of its assets in small and mid-sized companies, the Fund does not have any restriction with respect to the capitalization of any particular company.]
Maurer gave the theoretical example of a high-tech growth company that is spun off from a larger conglomerate in a value-oriented fund and is assigned an above-market valuation multiple by investors. “Does it still fit the value process, even if it is beyond [the fund’s] valuation parameters?” he asked. The answer: The fund may choose to continue to hold the shares if managers are comfortable with other fundamentals of the stock.
Investors may realize value from spin-offs in unexpected ways. Ruvkun cited the purchase of Motorola Mobility Inc. by Google Inc. in August 2011. While Motorola Mobility—which was spun off by Motorola Inc. in January 2011—was hobbled by a slowing handset business, Google recognized that the company’s prize asset was its trove of technology patents. Google’s offer represented a 63% premium to Motorola Mobility’s share price at the time of the acquisition announcement.
Split-Ups: Summing Up
What should investors ultimately take away from the current breakup trend? While there can be opportunities surrounding a company’s decision to split itself into pieces, the investment benefits from the spin-off process itself appear to be short-term in nature.
“The jury’s still out on the effectiveness of spin-offs,” said Maurer.
Ruvkun asks: “How many examples [of spin-off deals] represent companies declaring defeat—basically saying they shouldn’t have bought these businesses in the first place, and now have to dismantle?”
McMillin said he’s skeptical of “financial engineering” moves by companies without a strong strategic rationale, adding that spin-offs are “not necessarily a shot of penicillin” for slow-growing companies. Investment professionals have to “see past” the reshuffling of a company’s assets to uncover the inherent fundamentals of the stocks that are left standing.
“It’s our job,” he said.
—Reported by Will Andrews
The Go-Go Years
To bolster growth, the company began to cast its net wider. From 1960 to 1977, ITT, under chief executive Harold Geneen, developed into the very model of a major modern conglomerate. It acquired more than 350 companies, including such staggeringly diverse businesses as Sheraton hotels, Hartford Insurance, and Continental Baking (maker of Twinkies). The buying blitz boosted ITT’s sales from $760 million to $17 billion.
The Great Unbundling
Facing sluggish growth in the late 1970s, Geneen’s successor, Rand Araskog, restructured ITT through a series of divestitures and acquisitions. (The company divested its signature telecommunications assets in 1987.) The coup de grace was delivered in 1995 when ITT split into three separate, independent companies: ITT Corp., which housed its hotel and gaming businesses; insurance giant ITT Hartford; and diversified manufacturer ITT Industries. The hotel unit was acquired in 1998, while Hartford changed its name to The Hartford Financial Services Group in 1997. That left only one company to carry on the original ITT name, and ITT Industries changed its name to—what else?—ITT Corp. in 2006.
The Final Breakup?
After the split-up, ITT snapped up a number of companies to expand its operations in water and fluids management, global defense and security, and motion and flow control. Fast forward to 2011: With its defense segment weakening amid U.S. government cutbacks, and wishing to free up its faster-growing water treatment business, chief executive Steven Loranger engineered another breakup of ITT into three companies in October 2011, spinning off its water-related businesses (Xylem) and its defense unit (ITT Exelis). But it looks like some habits die hard. The surviving ITT Corp., which participates in the energy infrastructure, electronics, aerospace and transportation markets, calls itself a “diversified” manufacturer.
Diversification does not guarantee a profit or protect against loss in declining markets.This is not intended to be a recommendation or offer to buy or sell any securities or to adopt any investment strategy. Investors should not assume that investments in companies, securities, and/or sectors described were or will be profitable.