As iconic companies including GE and Johnson & Johnson pursue collapse plans, the “sum of the parts if greater than the whole” argument is to get a new workout from the market.
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Everywhere you look in the market, across sectors, iconic companies are under pressure from activists to split, or make the decision to look within their own business and slim down.
GE̵[ads1]7;s failed conglomerate model resulted in the decision last week – a surprise to few – to split into three companies. In Asia, where the conglomerate structure is common, Toshiba said it would break up in talks with activist investors. Johnson & Johnson shares its consumer health business from its drug development. In sectors undergoing major economic and secular transitions where iconic companies are threatened by new technology, investors are pushing for breaks, from Macy’s in retail to Shell in energy.
It is an old and unscientific saying, popular in the press, that wood is a trend. If so, is the downsizing of iconic companies a new one, or are the latest headlines random when it comes to timing?
There are already predictions that “the conglomerate is dead”, but although GE “never had any meaning”, it is doubtful that Warren Buffett is overly concerned about the structure of Berkshire Hathaway, and there are very successful conglomerates, such as Danaher, who with The right combination of companies has a model that strengthens rather than detracts from shareholder value.
From many angles, the recently announced corporate restructuring is more of the same: companies always fail, always face pressure from activists, and often go on a fine line between internal companies that are more conservative and riskier, and as a result do not read on the same way for all investors, making it more difficult for “the whole” to receive a full valuation.
GE competitor United Technologies split many years ago and spin-offs are in the blood of the healthcare sector: Zimmer (spun from Bristol Myers in 2001), Medco (spun from Merck in 2003), Abbvie (spun by Abbott in 2013) , and Organon (spun out of Merck in 2021). In the health care system, there is always a distinction between more mature companies that can be attractive to value-oriented investors and the more risky biotechnological breakthroughs.
Spinoff activity over the past decade has been high in the United States, reaching $ 654 billion in new companies, according to FactSet Research Systems.
The hot deals market means more new companies
However, this wave in the capital markets, which is forcing companies to shrink, may lead to some new thinking in the world of restructuring. The more data that flows in about how well spinoffs perform, especially in a market with a strong appetite for new issues, the more inertia in the boardroom that has long been among the factors that stand in the way of breaking up companies, can disappear.
These agreements are not specific, according to Emilie Feldman, a professor of management at The Wharton School, University of Pennsylvania, who is studying a divestiture. While each company, be it GE or Fortune Brands – the liquor company that was also in golf and home security before being spun off ten years ago – can provide unique examples of why the value of keeping businesses together can be less than the value of breaking the company up, there is a more fundamental recognition that is taking place and pushing companies to focus on shareholder value creation through the formation of new companies.
“Right now there is a very hot market in terms of supply and available capital,” said Feldman.
And it’s structural changes happening across industries, such as the digital pressure that already led to Saks breaking up into separate physical and e-commerce companies and now the question for Macy’s, and the ESG investment trend and the impact of climate change on the market leading to massive gains for investment in renewable energy – it is Tesla that is now a trillion-dollar company, not Shell or GM.
This dynamic may lead more companies to look at what the data has always said: it may be difficult to break up, but it is good for shareholder value.
“My analysis is unequivocal. We definitely see these big profit improvements both in divesting companies, and when we look at the results of the companies that have been spun off, they tend to perform strongly after the completion of the separation from the former parent company.” said Feldman, whose book “Divestitures: Creating Value Through Strategies, Structure and Implementation” will be published next year.
Allocating capital is more efficient for a more focused business
One reason for the stronger performance has been mentioned in the case of GE: conglomerates are not necessarily the best allocators of capital. A newly independent entity has the ability to allocate to its own priorities and opportunities, free from any liability by the parent company, and by a diversified company, competition for capital that may be allocated between parts of the company. For this reason, more focused companies tend to be better at mergers and acquisitions.
“Decision making, including the allocation of capital, is faster without the need to receive approvals from multiple levels of management in the parent company,” said David Kass, clinical professor of finance at the University of Maryland’s Robert H. Smith School of Business. He has been following spin-offs for many years and said that the data going back several decades is clear about better results for companies that were singled out in relation to the total market.
Management’s performance incentive is also a major issue, with management teams at spinoffs receiving compensation based on their actual performance rather than related to the performance of a diversified company, a factor Feldman said shows in the research.
How CEOs get paid is a problem
CEOs and top executives have a vested interest in keeping a company together, and even adding to it through further agreements, with management compensation strongly correlated with the company’s size and scope, number of companies and any acquisitions. Spinoffs reduce the size and scope, which does not benefit the parent company management’s compensatory self-interest, but it can be crown-wise and pound-foolish thinking, according to Feldman’s research.
The managers of the separated entity often own a significant stake in the shares of the newly formed company, which gives them additional incentives to maximize shareholder value and coordinate their interests with the shareholders.
“I think it’s hard to generalize and say that conglomerates are bad versus good. I’m reluctant to say that. But I want to say that if you’re a conglomerate, you have to have a real reason for what you do … super -focused on companies that have similar underlying structural characteristics that make it possible to allocate capital in a clear and consistent manner. “
She mentioned Danaher, who has performed well, as an example.
Feldman said that a finding from her research that makes the latest headlines remarkable is the inertia that has usually stood in the way of this type of agreement.
“There’s an incredible amount of inertia towards disposals, and companies should sell much more and much sooner,” she said.
The reasons for boardroom resistance include the stigma that comes with divestiture, that it is an admission of error or a signal that the management team could not control the operations or fix the problems that stand in the way of better performance.
“At the CEO level, we tend to see a lot of that,” Feldman said.
The death of the value share with large share capital
M&A and divestitures tend to go in cycles, with big waves of M&A and growth and expansion into new industries followed by great pressure to sell. Right now, the market is a bit of an anomaly in experiencing both significant acquisition activity and a high degree of sales, but there is reason to believe that the latter may experience even more momentum.
“Consolidation (acquisition) may be more likely during a bull market that is not yet fully valued. However, in later stages of bull markets, divestments can be a very effective approach to maximizing shareholder value,” Kass said. The “conglomerate discount,” he added, is removed when individual companies can trade on their own and are more easily valued by the market.
The current market is arguing for not just spin-offs, but “a re-equitization of corporate assets,” said Nick Colas, co-founder of DataTrek Research. The number of stocks in the US stock market has been in secular decline since the 1990s, but it seems to have turned the corner in the last 18 months through a combination of SPACs, IPOs and spins. “Some of it has to do with the mountain of liquidity that has been pumped into the system, of course,” he said. But it is also because the long-term return on equities has been good (10-year compound annual growth rates in the range of 13%), and it has contributed to new retail interest in equity investments.
He believes there is a growing awareness in the boardrooms of companies such as GE and Johnson & Johnson that comes close to the mind of activist investors about spinoff specifically, that “being a value share with big companies is a very bad thing.”
And that thinking was linked back to many of the reasons the academic experts cite for why spinoffs will continue to be a hot topic, from management incentives to activist pressure.
“How do you get fresh blood in the door if you can not offer talent a big, interesting challenge with a direct gain to take it up? How do you get investors to pay attention to your stock if you do not disrupt the status quo business models?” ” he asked. «Shares have become a have and non-market, and the same applies to talent acquisitions.
“It used to be that you broke up a company because strong companies subsidized the poor and broke up the dynamic unlocked value. It feels like what’s happening now is different,” Colas said.
Where it ends up leads to a bit provocative thinking. Among iconic companies that may have a goal on their backs given the backdrop of a hot market for public offerings, the discount applied to iconic names and the pressure that is taking place across industries related to industrial transformations:
“Ford and GM,” Colas said. “Rivian’s success screams after a breach of EV / non-EV operations.”
Although it would be very difficult to do, it will be more difficult for corporate boards to defend not doing so.
“I covered that area for a decade,” Colas said of his time as a car analyst on Wall Street, “when analysts were basically investment bankers. We held endless presentations for the big three at the time about cutting and cutting up companies to lock in. very few went through, but every management implicitly understood the inherent conglomerate discount problem.This time it is to have an ICE operation and an EV operation.When there was only Tesla in the mix, a board could say “Oh, it is and Elon Premium. ‘ Now that explanation is gone. ”
And while Shell in the energy sector has opposed activist arguments to break up its old fossil fuel exploration and production business from renewable energy by saying that the entire business model is based on the current balance sheet that finances tomorrow’s operations, Colas says this market and the Rivian agreement suggests that it will not be a convincing argument in any case.
“Not with an IPO of +10 billion dollars / spin and access to capital markets for more,” he said.
The problem is more operational – maintaining access to the dealer network and financial operations. R&D and assembly plants can all be cut out.
And boards need to consider what happens to their cost of equity when ESG rankings become stricter when it comes to manufacturers of products that create greenhouse gases.