Divestitures, Who, What, Why and What Happens?

One of Joe's previous posts, The Power of Subtraction,  discussed the value that can be created by divestitures.  This leads to several interesting questions: Which firm divests?  When a firm divests, which division is sold?  What are the important factors in selecting that division?  How important are financial constraints in the divestiture process? And How well do divesting firms perform?  The abstract below describes a paper two colleagues and I wrote to analyze these issues. 

Asset Liquidity and Segment Divestitures

Frederick P. Schlingemann

University of Pittsburgh - Finance Group; Rotterdam School of Management (Erasmus University)

Ralph A. Walkling
Drexel University – Executive Director, Center for Corporate Governance, Lebow College of Business; Professor Emeritus, Ohio State University

Rene M. Stulz
Ohio State University (OSU) - Department of Finance; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

      
Abstract:      
We investigate a sample of firms whose number of reported segments falls by one or more for the first time in their reporting history. The firms in our sample have a significantly larger diversification discount, underperform, and underinvest relative to comparable firms. Firms are more likely to divest segments from industries with a more liquid market for corporate assets, segments unrelated to the core activities of the firm, poorly performing segments, and small segments. The liquidity of the market for corporate assets plays an important role in explaining why some firms divest assets while others stop reporting them without divesting them, and why some firms divest core segments while others divest unrelated segments.

The final version is published in the Journal of Financial Economics.  A slightly earlier version of the complete paper can be downloaded here.

All the best,

Ralph

PE Magic

One of the merger motives touted during the 1960's was PE Magic.  The concept was simple: you have Firm A with a PE of 20 acquiring Firm B for cash with a PE of 10.  Suppose both firms have an EPS of 1 and 10 shares outstanding.  The market price and market value of firm A is 20 and 200, respectively.  The corresponding values for Firm B are 10 and 100.  So without synergy, if the firms joined, the market value should be 300.  

Here is where PE magic comes in.  According to PE magic, when firm A acquires firm B the market attributes Firm A's superior PE of 20 to the combined EPS of 2.  Hence the market value of the merged firm is 40 and the total market value is 400.  Voila!  100 of market value by PE magic!

This concept was used to explain the conglomerate merger wave of the 1960s.  You know, when a cement company acquired an ice cream manufacturer - not much synergy there unless you can use the cement trucks to mix the ice cream!

Ahem.  There are obvious problems with PE magic.  There are reasons that firms trade for various PEs.  The PE of firm B is only 10 for reasons related to risk, managerial talent, growth and all the factors that relate to future projected cash flows and the variability of those cash flows.  Unless Firm A is able to alter those factors there is absolutely no reason to believe the PE of the combined firm will not settle somewhere in between 10 and 20 to reflect the realities of the new firm.  If nothing  changed after merger, the combined market value would be 300, the combined EPS would be 2 and the PE would be 15.  If you adjust for the costs of integration, the PE and market values would be reduced.

Now, Firm A may  be able to alter the characteristics of the cash flow stream - but that is synergy, not magic.  The moral of the story is to beware of any explanation for merger that implies something for nothing.   See our related posts on merger motives, synergies and the power of subtraction.

All the best,

Ralph

When the Whole is Worth Less Than the Sum of Its Parts

A long time ago, at a university that I won't name,  I attended a faculty meeting where each department head gave a report on their department.  The leaders of each of the five departments (e.g. marketing, accounting, etc.) stood up and demonstrated how their group was, by some convenient statistic, ranked among the top ten departments of the country.  A colleague pointed out that 'It is interesting that each and every department believes it is in the top ten but the U.S. News rankings put the college 27th!' 

Now in the case of the university, the disparity was obviously the result of selective reporting, but the same thing happens in business.  Sometimes the whole is worth less than the sum of its parts!  Joe wrote about this in a previous post The Power of Subtraction.  This week's Wall Street Journal gives two additional examples:

First, Consider Amazon's Jeff Bezos buying the Washington Post.  In an interesting WSJ post, (After the Sale: Unfolding the Washington Post's Inner Value) Miriam Gottfried notes the various parts of the Post enterprise.  The Post was sold for $250 million whereas the entire Post enterprise is valued at $4 billion consisting of TV Broadcasting, Cable TV and Education in addition to Newspaper Publishing.  The article goes on to note the different trading multiples typical of the various business sectors and suggests that continuing to focus the Post (perhaps by spinning off the educational arm, Kaplan) might 'release further value'.  I agree, not because of PE magic (which we'll warn about in a subsequent post)  but because of substantial evidence the companies increase value by focusing  on the core units with the best chance for a sustainable, competitive advantage. 

And speaking of spinoffs, note that TripAdvisor, spun off from Expedia in December 2011 now exceeds the parent in terms of Market Cap.  (See Out of Nest, TripAdvisor Soars Past Expedia).  

All the best,

Ralph

The Power of Subtraction: When 2-1=3

Difficult economic and industry conditions have depressed operating results for many firms. This has stimulated changes in corporate strategy and structure. Fusion based mergers and acquisitions are a means to implement such changes. They are based on the premise of 1+1=3, largely through synergy based improvements. The other side of the merger coin is the less well know fission-based de-mergers approach where 2-1=3. The focus of this post is on voluntary as opposed to imposed de-mergers due to financial distress or bankruptcy issues.

De-merger activity, like its merger related cousin, runs in waves. Currently, the wave is in an upswing. For example:

1)     Smithfield: the friendly acquisition to a Chinese firm is challenged by an activist shareholder claiming a de-merger of the vertically integrated pork producer would create one-third to two-thirds value increase over the acquisition alternative.

2)     Sony: activist investor Daniel Loeb is seeking a 15-20% equity carve-out (partial public offering) of Sony’s entertainment division to unlock value and fund the turnaround of its lagging electronics unit.

3)     Media Industry: McGraw-Hill split of its publishing and ratings units and the Fox spinoff of its print from electronic media just to name a few.

De-mergers, unlike mergers have a surprisingly positive value impact. Despite this, it is not something that comes naturally to most managers. It is seen more as a mark of failure-shrinking versus growing- than as a natural process in portfolio management reflecting changes in market conditions and the firm’s life cycle. Consequently, most firms engage in de-mergers only after being prodded by activist or frustrated shareholders signaling their displeasure with disappointing performance. Also, de-mergers appear to be more about financial engineering than value creation. This is partly true as de-mergers are about releasing trapped value inherent in multi-divisional diversified firms than creating something new.

Typically, such firms suffer from a conglomerate discount, which reflects the difference between the values of the separate individual business units on a standalone basis in a conglomerate from the market value of the parent. This difference is in effect a negative synergy or management as an off- balance- sheet- liability. The negative synergy can result from increased overhead expenses, capital misallocation, cross subsidies, and suboptimal incentives. These suggest that the current parent is not the best owner of the division.

The major de-merger methods include among others:

1)     Divestment: usually taxable sale to a third party. An example is McGraw-Hill’s sale of Business Week to Bloomberg. Getting an acceptable price depends on finding a natural buyer (best owner). As Warren Buffett notes, divestment is not Gin Rummy where discard your worst cards. As you are unlikely to get much for losers. Rather, it is about selling good businesses to someone who pays more to you than the assets are worth to you as a continuing operation.

2)     Spinoff: frequently a tax free distribution of subsidiary shares to the parent shareholders - similar to a stock dividend. They continue to own the same operations, but in a separate form. It can be faster and more assured than a divestment - especially, when no natural buyer can be identified. Can be both leveraged and un-levered. In a leveraged spin-off, the subsidiary borrows to fund a special dividend to the parent before the spin.

3)     Split-off: related to a spinoff, whereby parent shares are exchanged for direct ownership in a subsidiary.

4)     Equity Carve-out: portion (typically 15-20%) of a subsidiary’s shares are sold to the public as a partial public offering. Carve-outs, like spin-offs, can be either leveraged or un-levered.

5)     Tracking Stock: separate classes of parent stock whose dividends depend on the performance of an individual subsidiary.

The relative merits of each method vary are beyond the scope the scope of this post. Nonetheless, it illustrates some of the many ways to unlock trapped value in underperforming diversified firms. The key is to recognize that subsidiaries come with different “sell-by” dates. Management needs to watch and act on these dates as part of it on-going portfolio management process.

J