Breakup!

Summary of

BREAK UP! How companies use spin-off to gain focus and grow strong

David Sadtler Andrew Campbell Richard Koch

Introduction $1 Trillion on table – Breakup experience till date shows that there will be an increase of share price by 20%. By breaking up 100 MBC’s (Multi Business Corporations) in US and UK, a value of $1 trillion can be created. Value Destruction is the reason for Breakup – First cause for value destruction by the corporate center. The second reason is from several frictions that happens. Breakup for the insiders – The chairman of the company can now become the chairman of multiple companies. CEO’s salary in many cases is linked with the share price and as the share price goes up, so will the salary. Senior managers can now be more focused. Sumantra Ghosal on MBC and FBC (Focused Business Corporation) – Atmosphere at most MBC’s is that of downtown Calcutta in summer. “Its oppressive. You feel drained of energy. New ideas all seem too difficult”. Whereas the atmosphere at FBC is that of woods outside Fontainebleau in France (INSEAD). “You feel spring is permanently in air. New ideas flow through you like electricity. Everything seems possible, You feel recharged”

Chapter 1: The epidemic breaks out Dollar value (in billion) of breakoff transactions in US – 1985 – 1.9, 1989 – 10.1, 1992 – 16.2, 1994 – 30, 1995 – 76.6, 1996 – 85.3. Dollar value (in billion) of breakoff transactions in UK –1989 – 3.9, 1992 – 7, 1994 – 0, 1995 – 2.9, 1996 – 5.9. It works!! – JP Morgan analysed the stock market performance of 77 companies that spun-off. Average spin-off performed 25% better in the next 18 months. The larger one’s performance went up by 13% and that of smaller by upto 45%!!13% and that of smaller by upto 45%!!

Chapter 2: What drives Breakup? 1. Managers genuine desire for increased focus Under-valuation arises when the company is viewed as too diversified for the following reasons •

More overhead is needed to manage the diverse portfolio

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Highly profitable business may subsidise dogs

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Management may too much for diversifying acquisitions where investors could buy them directly without paying a control premium

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Investors do not have the opportunity to invest directly in a business they want to be involved in

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Diversification makes it difficult to analyse them

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Analysts coverage is often restricted to the company’s primary business activity.

2. Management’s desire to see a “fair” share price •

Stock market prefers “pure play” than a company working on broadly defined industries

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More analysts follow the company after breakup!

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CEO’s sometimes see “pure play” as a disadvantage as this is likely to attract a bid. The bid might be good for the share holders, but not for the management.

3. Finding money to reduce debt 4. Fear of takeover •

Hostile takeover threat was a primary reason for breakup in the UK.

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Many time attempt for hostile take over is the result of the underperformance; but once spun-off, it releases lot of value and hence will be difficult for takeover.

5. Competitive conflict •

Vertical integration can backfire. Customers of one division might face competition from another division of the same company.

6. Poor performance 7. Pressure from regulatory and antitrust authorities 8. Quarantining a problem 9. Better tax efficiency of breakup compared to trade sale 10. Financial engineering fad Difficulty with Focus – It is an elastic concept linked with the concept of “core business”. Boundaries of core business are often reworded to stretch over a portfolio. What is Focus – Not just narrowing the scope of the portfolio. Key to focus is the existence of a match up between the needs of the portfolio businesses and the specific skills the center which can help to the business.

Chapter 3 – The real reasons why Breakup creates value Value Destruction – Not the fault of poor management or poor strategy. It is intrinsic and systemic to MBC’s. Business gets held back by the membership in the bigger corporate entity. According to Gary Hamel and Prahlad as written in Competing for the Future, “ the bottleneck is normally at the top of the bottle”. The easiest, fastest and most reliable way of removing it is to break the bottle, allowing the separate pieces to perform without constraints. Justifying Corporate Centre – If the grouping of 10 operating businesses under one center is to be justified on economic grounds, it must be on the basis that the business in aggregate will do better as a group than they would as 3 or 10 independent firms. To justify one company, the corporate center must add value to the individual operating companies. Every business after break up will incur more administrative and financing costs, still they perform better, because they are released from some constraints that existed in the group. Value Destroyers 1. Executive Influence a. Lack of fit between the owner and owned – There is a misfit between the center and the business it owns. Center doesn’t understand the business and may take worst decisions. In the mid 80’s all the oil majors like Atlantic Richfield, BP, Exxon, Shell and Standard Oil got into the minerals business. Soon they all had an average return on sale of -17% whereas the focused minerals companies had +10%. This drastic difference of 27% is what pays when a company is focused. Oil companies are conditioned by particular experiences. Applied in other fields, they can prove wrong. Even slight difference can be very expensive.

b. 10 percent Vs. 100 percent paradox – How can group CEO’s in their 10% time see better ways forward than energetic managers who devote 100% time to do their business?!?!?! c. The truth possession and Perversion Paradox – To take better decisions, the center must be well informed about the operating companies. But most of the information is with the Business Managers of individual operating companies. d. The Alienate Syndrome – Many a time one has to go that extra mile with the customers to get the business. A corporate center which is never with the customer cannot do this and hence the danger of alienation is ever present. 2. Linkage Initiatives – This is the process of encouraging interactions between the businesses in the portfolio. Linkage initiatives start with hopes of finding and exploiting synergy. Synergy is many times a trap. There are cases when linkage initiatives is successful – in case of joint purchasing or coordinated manufacturing etc. 3. Central Staffs –Good center staffs can add value, but quite often they are not. 4. Portfolio Development – Involves acquisitions, divestments, corporate venturing initiatives etc. Seller the gainer - Most of the value released from acquisitions goes to the seller and not the buyer. In most cases, before buying, the buyer will have to project his plans on the buying company. When there are multiple buyers bidding, then the buyers will have to offer more in terms of plans. Hence they end up not just paying premium for the buy, but also will have to invest a lot in the plan charted out. Corporate Ambition – When buying out, one needs to know what the company is worthy of, what it can earn etc. Then it depends on how one runs the company, the actions of competitors etc to know how well it actually does. Experience shows that it can vary +/- 50% making the future very uncertain.

Research shows that the corporate center destroys at least 10% of the value of each standalone component. Hence it can destroy even more than 50%!!

Chapter 4 – Do You need to Break Up? 1. Identify the natural clusters in the portfolio. Final clustering is based on two facts: a. How similar are the critical success factors and how easy is it avoid value destruction? b. How similar are the improvement opportunities and hence how easy will it be to develop the skills and resources to exploit them. 2. Does the center fit with the Cluster(s)? a. Success and failure Analysis b. Opinion of Business Managers 3. Is there a logic for keeping the clusters together? 4. Does the multi-cluster logic stand up to challenge? a. Will investors buy it? b. Does the past performance support it? c. What hard evidence can be provided?

Chapter 5 – Anatomy of Breakup 1. Pressure for Breakup a. Breakup is always the result of some kind of a pressure. No breakup is proactive. Reasons are i. Conviction of insiders and investors that the stock is undervalued ii. Outsiders and commentators suspect company’s strategy has failed or is inadequate iii. Managers hear the heavy footfalls of predators and see the shadows of suspected stalkers iv. Pressure from powerful customers who are also corporations competitors v. Bankers and preferential shareholders apply squeeze arguing debt is too high. vi. Company needs to raise extra cash vii. Pressure from industry regulators 2. Resistance and Acquiescence 3. Breaking Up 4. ReBirth

Tips for Successful Breakups •

Expect emotional resistance

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Sell the positive aspects if breakup Alternatives to breakup – rationalizing the portfolio, downsizing the corporate center, restructuring divisions – are more evolutionary, but less attractive. They basically don’t eliminate the problem

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Treat financial costs and outcomes as one input only

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Create a breakup “Credo” Closed door meetings always lead to untold anxiety. Communicating intentions will facilitate decision making

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Take positive managerial control of the project

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Move as fast as you can

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Communicate, Communicate and Communicate

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Expect it to be a huge task.

Chapter 6 – Profiting from Breakup There are 4 generic investment strategies to take advantage of breakup: 1. Speculate ahead of breakup 2. Avoid breakup candidates – Invest in those low value breakup candidates because they are likely to be more focused. Bigger ones (MBC’s) will probably breakup to form yet another MBC. On the contrary, FBC’s are liable to diversify. They can get dissatisfied with tightly focused business and can get excited with growth, new adventures etc. 3. Invest in broad portfolio of breakups – Invest in all breakups immediately after they are announced. Then subsequently sell those which are broken up to form another MBC. 4. Selectively invest in Particular breakups – Invest only in those which are likely to increase the value most.

Chapter 7 – Breakup: The Future Emergence of FBC – Focus can be on different things. For instance, Canon is good in a number of related technologies than competitors, that they will pursue skill-based competition in more than one line of business. Unilever is a much better marketing company! Warren Buffet and Jack Welch can be considered as magicians for holding on to so many businesses simultaneously. These MBC’s are likely to breakup after these leaders departure.

Breakup is a way of achieving greater simplicity. It is a step back from the black hole of complexity. Where it is needed, breakup is an act of great managerial courage and wisdom