The Demerger Craze
Corporate lemmings?
Corporate strategy seems to go in waves: consolidation, conglomerates, globalization, going private etc. And then something happens and the trends reverse, which seems to be happening now as a number of large conglomerates have decided to break-up into smaller more focused entities. Over the past few weeks we have seen “demerger” announcements from GE, J&J and Toshiba. And before that were similar announcements from Honeywell, Siemens and others. What’s going on? Why is this happening? And what does the future hold for these companies and their shareholders?
Strategic rationale. Each company that has announced a demerger has a somewhat different strategic rationale for doing so, but in each case the goal rightly seems to be “enhancing value” for their shareholders. In some cases, the restructuring seems to be precipitated by an underperforming share price or the unwanted appearance of activist investors. In others the announcement follows a change of management or a board shake up, often following years of underperformance. And in some cases, the motivation seems to be highlighting a component business the value of which seems not to be fully reflected in the parent company’s share price. But whatever the impetus, improving shareholder value seems to be the objective, or at least the mantra. But how does a demerger impact value?
Value impact. The fundamental value of a business is driven by various factors: corporate strategy, competitive positioning, operating performance, profitability, capital investment, growth and the cost of capital. But companies can grow profits while destroying value if their capital investment generates returns below the cost of capital. For these companies, the solution may be to scale back or reallocate capital investment if they cannot increase the returns. For other companies, who may be taking a pass on attractive investment opportunities due to financial or other constraints imposed by their troubled parent company, a demerger may facilitate increased investment, faster growth and enhanced value for shareholders.
This is basic EVA theory and it is widely employed in practice. Students who don’t yet understand EVA should read one or both of the classic McKinsey books on this topic: Value: The Four Cornerstones of Finance; or Valuation: Measuring and Managing the Value of Companies. If you just want the highlights, simply explained without too many numbers, get Value. If you want to go whole hog with lots of numbers and a bit of elementary math, get Valuation, which is the practitioners bible on this topic. Or do what I did and read them both, multiple times.
The key point here is that for a demerger to increase value, something needs to change with the fundamental performance of the underlying businesses: strategy, competitive position, operating performance, capital investment, financial returns, growth, etc. An improvement in cost of capital alone is unlikely to do the trick, although this too may contribute to value enhancement if the demerger facilitates a positive re-rating of the demerged business by lenders and investors. If the operating fundamentals of the underlying businesses don’t change, however, the intrinsic value of the business won’t change either, even if the stock market takes a different view for a brief period of time. (Very brief in the case of GE it seems.)
But how might a demerger cause or facilitate a value-impacting change in the fundamentals of a business? The simplest reason is focus. If GE separates the ownership and control of its aviation, energy and healthcare businesses, the senior management of each company will be freed up to focus on just that one business, without any distraction from the other businesses no longer part of the same corporate entity or from problems at the corporate parent. At least this is the theory, and there may well be empirical evidence to support it (I’m not sure).
But there is reason to be skeptical, in some cases at least. Think about GE, for example. Each of these three business units—aviation, healthcare and energy— are already run as separate units, by people who get paid in large part (but not entirely) for the performance of the individual businesses they run. And each of these separate business units are already quite large, consisting of many different individual businesses all of which still need to be managed by the same or new people. Are these executives really going to run the business differently now that they are not part of the conglomerates called GE?
Well, perhaps they will, if only because their compensation will now be tied 100% to the performance of the businesses they run, with no more disappointing GE stock options. Management of the demerged businesses will also be freed from the regular distractions and limitations associated with GE’s corporate baggage as a public company conglomerate. But keep in mind that each of these three business units is now going to become a public company in its own right, and the CEOs of these businesses will now have to think about all that public company stuff, including pesky investors, SEC reports, boards of directors with audit and executive compensation committees, and the performance of their own share prices. And of course each demerged business will require its own new stand-alone capital structure, since it can no longer rely on the corporate parent for funding. This is a good thing if it allows these companies to refine their capital structures and lower their effective cost of capital, but it is one more thing to manage independently.
Finally, a word on synergies, or the lack thereof, as a source of value. By announcing these demergers, the corporate parent companies are effectively acknowledging that any positive synergies or efficiencies between the various demerged business units—perhaps cited as value drivers at the time of acquisition—are no longer sufficiently large to offset the additional costs or negative synergies of the conglomerate structure itself. This is a big thing for some companies to admit, which is likely why demergers usually take place only after a change in personnel at the top.
Form of transaction. A so-called “demerger” can take various forms, but in the simplest form of transaction a publicly traded corporate parent company distributes or “spins off” 100% of the shares of a subsidiary to the shareholders of the parent company. The result of the share distribution is that both the former parent and the subsidiary are each now independent publicly traded companies. At the moment of he distribution the shareholders of both companies will be identical, but this will change quickly as existing shareholders and new investors trade shares.
Note that this type of demerger or spin-off transaction is structured differently from a divestiture, in which the parent company sells 100% of the shares of the subsidiary to an acquiror, perhaps another company in the same line of business (a “strategic buyer”) or to a private equity firm (a “financial buyer”). GE sold its insurance operations and its appliance business in divestiture transactions, but it is emerging or spinning off its healthcare and energy businesses.
A demerger or spinoff transaction can also take various forms. Perhaps the parent company first takes the subsidiary public via an IPO, either to raise new equity capital for the subsidiary (a “primary” offering) or to raise money for the parent (a “secondary” offering). In these cases, the IPO may be followed by a distribution of some or all of the parent company’s remaining shares in the subsidiary, usually in the form of a dividend to its own shareholders (as described above). In this transaction both companies eventually trade as independent public companies, but via a slightly different route than in the 100% spin-off scenario.
Or perhaps the transaction is structured as a merger of the subsidiary with another public or private company, with the merger consideration (shares or cash) retained by the parent company or distributed to its own shareholders.
In some cases the parent company may retain a large equity stake in the spun off subsidiary, possibly even a majority controlling stake. This may be a short-term thing, done for tax, legal or other reasons, but sometimes this situation continues indefinitely. When it does, public equity investors have the option of investing in either or both of the parent company or subsidiary shares, which often creates unwanted investor arbitrage activity in the two shares and may dilute the value impact of the transaction for the parent company shareholders as a result of the “holding company discount” which may arise. A good example of this is Softbank, which owns a large operating business (Japanese mobile) as well stakes in a large number of other public and private companies (including 25% of Alibaba). Softbank’s own shares currently trade at a price equal to only 50% or so of its sum-of-the-parts (SOTP) value. This is not an ideal outcome for the shareholders of Softbank, which has responded by buying back some of its own discounted shares, boosting the Softbank share price and increasing the ownership stake of founder Masayoshi Son.
Impact on shareholders. I have no doubt that there exists a plethora of academic studies of the impact of demergers on shareholder value, but I am not familiar with the literature. My guess is that these analyses purport to demonstrate that the shareholder value impact of demergers is mixed but on balance positive, particularly when compared with the impact of mergers on corporate buyers who typically must pay a “control premium” in the acquisition. (The value record of M&A for sellers is much better than it is for buyers.) The problem with all these studies, however, is that we can’t look at the counterfactual—what would have happened if the demerger (or merger) had not taken place. So in the end we don’t really know what impact the demerger had on value. And this will be true for GE, J&J and the others as well.
What I do know is that we should not accept short-term share price performance as an infallible predictor of future value creation. There is a lot of noise in public share prices and shareholder expectations of future value creation are often wrong. Tesla may (or may not) be a good example. Is Tesla really worth more than the other 10 largest auto companies combined? I doubt it, but the stock market obviously disagrees with me and Elon Musk seems to be laughing all the way to the bank, or more likely to the cryptocurrency exchange. But if he is selling Tesla shares (and he is), do you really want to buy?
Bottom line. Demergers often make great strategic sense and may well enhance shareholder value. But in the final analysis value creation is all about improved operating performance, not financial engineering smoke and mirrors. If the demerger results in improved management focus, a more disciplined corporate strategy, better capital allocation and increased operating cash flow, then fundamental value will almost certainly increase and improved share price performance will likely follow, over time if not immediately.
The value analysis is pretty much that simple and you don’t need an MBA to figure this out. But that doesn’t mean GE and these other companies won’t have paid a lot of money to high-priced consultants, lawyers and investment bankers to advise them on their demergers. They will have. And as a former banker, lawyer and (briefly) management consultant, I think that’s OK. I just wish I were still in the business to collect at bonus time.
Links
What Investors Need to Know about the GE Split, WSJ, 11.9.2021
GE was Once a Model for Siemens, but now Follows its Rival’s Path, WSJ, 11.11.2021
Toshiba, Like GE, Now Plans to Split in Two, WSJ. 11./12.2021
J&J to Split Consumer from Pharmaceutical and Medical Devices Businesses, WSJ, 11.12.2021
Honeywell to Spin Off Quantum Unit in Merger with Software Firm, Bloomberg, 6.8.2021