As iconic companies including GE and Johnson & Johnson pursue breakup plans, the “sum of the parts if greater than the whole” argument is getting 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 up, or are making the decision to look within their own operations and slim down.
GE‘s failed conglomerate model resulted in the decision last week — a surprise to few — to break up into three companies. In Asia, where the conglomerate structure is common, Toshiba said it would break up in the face of calls from activist investors. Johnson & Johnson is splitting its consumer healthcare business from its drug development. In sectors undergoing major economic and secular transitions where iconic companies are threatened by new technology, investors are pressing for breakups, from Macy’s in the retail sector to Shell in energy.
There’s an old and unscientific saying, popular in the press, that three makes a trend. If so, is the downsizing of iconic companies a new one, or the recent headlines coincidental in timing?
There are already predictions that the “conglomerate is dead,” but even if GE “never made any sense,” it’s doubtful Warren Buffett is overly concerned about the structure of Berkshire Hathaway, and there are highly successful conglomerates, such as Danaher, which with the right combination of businesses have a model that is reinforcing rather than detrimental to shareholder value.
From many angles, the recently announced corporate restructuring is more of the same: companies are always failing, always facing pressure from activists, and often walking a fine line between internal businesses that are more conservative and riskier, and as a result don’t read the same way to every investor, making it harder for the “whole” to receive a full valuation.
GE competitor United Technologies already split up years ago and spinoffs are in the healthcare sector’s blood: Zimmer (spun off from Bristol Myers in 2001), Medco (spun off from Merck in 2003), Abbvie (spun off from Abbott in 2013), and Organon (spun off from Merck in 2021). In healthcare, there is always the division between more mature businesses that may be attractive to value-oriented investors and the riskier biotech breakthroughs.
Spinoff activity within the past decade has been high in the U.S., reaching $654 billion in new companies, according to FactSet Research Systems.
Hot deals market means more new companies
This wave in the capital markets pushing companies to get smaller might, though, result in some new thinking in the world of corporate restructuring. The more data that pours in on how well spinoffs perform, especially in a market with a strong appetite for new issues, the more boardroom inertia that has long been among the factors standing in the way of breaking up companies may dissipate.
These deals are not idiosyncratic, according to Emilie Feldman, professor of management at The Wharton School, University of Pennsylvania, who studies divestitures. While each company, whether GE or Fortune Brands — the liquor company that was also in golfing and home security before spinning off entities a decade ago — may offer 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 taking place and pushing companies to focus on shareholder value creation through the formation of new companies.
“Right now it is a ferociously hot market in terms of offerings and capital available,” Feldman said.
And there are structural changes occurring across industries, like the push to digital which already led Saks to break up into separate physical and e-commerce retail companies and is now the question for Macy’s, and the ESG investment trend and climate change influence over the market leading to massive gains for renewable energy investments — it is Tesla that is now a trillion-dollar company, not Shell or GM.
These dynamics may lead more companies to look at what the data has always said: breaking up may be hard, but it is good for shareholder value.
“My analysis is unequivocal. We definitely see these big performance improvements both in divesting companies and then equally when we look at the performance of the companies spun off, they tend to strongly perform 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 cited in the case of GE: conglomerates are not necessarily the best allocators of capital. A newly independent entity has the ability to allocate to their own priorities and opportunities, free of any encumbrance from the parent company, and in the case of a diversified company, competition for capital that had to be allocated between parts of the company. For that reason, more focused companies tend to be better at mergers and acquisitions.
“Decision making, including allocation of capital, is quicker without the need to receive approvals from additional levels of management at the parent corporation,” said David Kass, clinical professor of finance at the University of Maryland’s Robert H. Smith School of Business. He has followed spinoffs for many years and said the data going back decades is clear on the outperformance of companies that were spun off relative to the overall market.
Management performance incentive is a big issue as well, with the executive teams at spinoffs receiving compensation based on their actual performance rather than tied to the performance of a diversified company, a factor Feldman said shows up in the research.
How CEOs get paid is an issue
CEOs and senior managers have a self interest in keeping a company together, and even adding to it through additional deal making, with managerial compensation strongly correlated with firm size and scope, the number of businesses, and any acquisitions. Spinoffs reduce size and scope, which doesn’t benefit the parent company management’s compensation self-interest, but that may be penny-wise and pound-foolish thinking, according to Feldman’s research.
The managers of the spun-off entity frequently own a substantial stake in the shares of the newly formed company, providing them with additional incentives to maximize shareholder value and align their interests with those of shareholders.
“I think it’s tough to generalize and say conglomerates are bad vs. good. I’m reluctant to say that. But I would say that if you are a conglomerate you need to have a real reason for what you are doing … super-focused on businesses that have similar underlying structural characteristics that makes it possible to allocate capital in a clear and consistent way.”
She cited Danaher, which has performed well, as an example.
Feldman said that one finding from her research that makes the recent headlines notable is the inertia that has typically stood in the way of these kinds of deals.
“There is an incredible amount of inertia against divestitures, and companies should divest way more and way sooner,” she said.
The reasons for boardroom resistance include the stigma that accompanies divestiture, that it is an admission of failure or a signal that the executive team couldn’t manage the operations or fix the problems standing in the way of better performance.
“At the CEO level, we tend to see lots of that,” Feldman said.
The death of the large-cap value stock
M&A and divestitures do tend to move in cycles, with big waves of M&A and growth and expansion into new industries followed by big pushes to divest. Right now, the market is a bit of an anomaly in experiencing both significant acquisition activity and a high level of divestitures, but there is reason to believe the latter may experience even more momentum.
“Consolidation (acquisitions) may be more likely to occur during a bull market that is not yet perceived to be fully valued. However, in later stages of bull markets, divestiture may be a very effective approach to maximizing shareholder value,” Kass said. The “conglomerate discount,” he added, is removed when individual businesses can trade on their own and be more easily valued by the market.
The current market is making the case for not just spinoffs, but “a re-equitization of corporate assets,” said Nick Colas, co-founder of DataTrek Research. The number of stocks in the U.S. equity 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 that has to do with the mountain of liquidity that’s been pumped into the system, for sure,” he said. But it’s also because longer run equity returns have been good (10-year compound annual growth rates in the 13% range) and that’s has contributed to new retail interest in equity investing.
He thinks there is a growing awareness in boardrooms of companies like GE and Johnson & Johnson which comes closer to the thinking of activist investors about spinoffs specifically, that “being a large-cap value stock is a very bad thing.”
And that thinking related back to many of the reasons the academic experts cite for why spinoffs will continue to prove a hot topic, from management incentives to activist pressure.
“How do you get fresh blood in the door if you can’t offer talent a big, interesting challenge with a direct payoff for addressing it? How do you get investors to pay attention to your stock if you aren’t disrupting status quo business models?” he asked. “Equities have turned into a have and have-not market, and the same goes for talent acquisition.
“It used to be that you broke up a company because strong businesses were subsidizing poor ones and breaking up that dynamic unlocked value. It feels like what’s going on now is different,” Colas said.
Where that ends leads to some provocative thinking. Among iconic companies that may have a target on their back given the backdrop of a hot market for public offerings, the discount applied to iconic names and the pressures taking place across industries related to industrial transformations:
“Ford and GM,” Colas said. “Rivian‘s success screams for a breakup of EV/non-EV operations.”
While it would be very hard to do, it will get harder for corporate boards to defend not doing it.
“I covered that space for a decade,” Colas said of his time as an autos analyst on Wall Street, “back when research analysts were basically investment bankers. We did endless presentations to the Big Three back then about slicing and dicing up the companies to unlock value. Very few went through, but every management implicitly understood the inherent conglomerate discount problem. This time around it is having an ICE operation and an EV operation. Back when it was just Tesla in the mix, a board could say ‘Oh, that’s an Elon premium.’ Now that explanation is gone.”
And while in the energy sector Shell has countered activist arguments for a breakup of its legacy fossil fuels exploration and production business from renewables by saying its entire business model is predicated on the balance sheet of today funding the business of tomorrow, Colas says this market and the Rivian deal suggest that isn’t going to be a convincing argument in some cases.
“Not with a +$10 billion IPO/spin and access to capital markets for more,” he said.
The issue is more operational – maintaining access to the dealer network and finance operations. R&D and assembly plants could all be carved out.
And boards need to consider what happens to their equity cost of capital when ESG rankings become more stringent about producers of products that create greenhouse gasses.
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