Why more iconic companies like GE and J&J may be about to get smaller
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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 that you look on the market or in different sectors you will see iconic companies being pressured by activists to separate, or to make the tough decision to shrink their businesses.
GE‘s failed conglomerate model resulted in the decision last week — a surprise to few — to break up into three companies. Toshiba in Asia where conglomerates are common declared that it will disband in spite of activist investor calls. Johnson & JohnsonIt is separating its consumer healthcare and drug development businesses. Investors are pushing for the dissolution of iconic businesses in sectors that are undergoing significant economic and secular transformations. Macy’sIn the retail sector Shell in energy.
An old, unscientific, and widely quoted saying states that “three makes a pattern.” Are the headlines recently synchronized or new?
Already, there are predictions. the “conglomerate is dead,”Even if GE was not possible “never made any sense,”It’s unlikely Warren Buffett cares too much about the structure of his company. Berkshire HathawayConglomerates that are extremely successful include DanaherWith the right mix of businesses, you can create a business model that enhances rather than degrades shareholder value.
Many aspects of the recent announcement on corporate restructuring are the same. Companies always fail, are under constant pressure from activists and sometimes walk a fine line among internal businesses that tend to be more conservative or risky. This makes it difficult for investors to see all the details, and therefore, harder to give a complete valuation to the entire group.
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). There is always a division in healthcare between mature companies that are more attractive to investors who value innovation and those with higher risk.
According to FactSet Research Systems, the U.S. has seen a lot of spinoff activity in the last decade, with new businesses generating $654 billion.
Market for hot deals means new businesses
The capital market wave that is pushing smaller companies may result in new ideas in corporate restructuring. More data is available on spinoff performance, particularly in markets that are keen to acquire new securities. This could lead to more inertia in boardrooms that have been preventing companies from being disintegrated.
Emilie Feldman is a Professor of Management at The Wharton School of Pennsylvania. She studies divestitures. While each company, whether GE or Fortune Brands — the liquor company that was also in golfing and home security — 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.
Feldman explained that the market is “ferociously hot” in terms of capital availability and offers.
There are also structural changes happening across industries. For example, Saks has already been forced to split into physical and digital retail businesses. 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 ShellGM.
These dynamic might lead companies to look more closely at the data and see that while it can be difficult for some, it will benefit shareholders.
My analysis is clear. These big improvements in performance are evident both when divesting companies occur and also when looking at performance after separation. Companies spun off tend to perform strongly,” Feldman said. Feldman’s book, “Divestitures” will be out next year.
For a business that is focused, capital allocations are more efficient.
One of the reasons for GE’s stronger performance was that conglomerates don’t always have the best capital allocators. An independent new entity can allocate their resources to the priorities they choose, without the interference of the parent company. In the case of a multi-company, there was competition for capital. Focused businesses are better at mergers or 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. Since many years, he has been following spinoffs and says that data from decades back shows the superior performance of companies spun off in comparison to the general market.
The issue of management incentive is also a major one. Spinoff executives receive compensation based upon their performance, rather than being tied to the overall performance of the diversified company. Feldman says this factor shows up in Feldman’s research.
It is a topic that concerns how CEOs are paid.
Senior managers and CEOs have an interest in keeping the company together. They may even want to add value by making additional deals. Managerial compensation is strongly linked with size, scope and number of companies and acquisitions. Feldman’s research shows that spinoffs decrease the size and scope of a company, and this doesn’t help its compensation self-interest. But, Feldman suggests that it may be foolish thinking.
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 conglomerates can be bad or good. It’s hard to believe that. However, I think that conglomerates need to be motivated by real reasons. This means that they should focus on similar businesses to ensure that capital can be allocated in an efficient and consistent manner.
Danaher was cited as an example, and it has done well.
Feldman stated that the one thing that stands out in her recent news is inertia, which has often impeded these types of deals.
According to her, “there is an amazing amount of inertia that prevents divestitures from happening,” and she suggested companies divest much more frequently and far sooner.
There are many reasons why boardroom resistance is caused by the stigma surrounding divestiture. It’s a signal of incompetence or an admission that the executives can’t handle the operation or resolve the issues that prevent better performance.
Feldman stated that at the CEO level there is a lot of this.
Death of large-cap 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. The market currently has a lot of activity, including significant acquisitions and high levels of divestitures. However, there are reasons to think that the former may be experiencing 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.
According to Nick Colas (co-founder DataTrek Research), the current market supports spinoffs and “a reequitization corporate assets.” The U.S. equity stock market’s number has seen a steady decline over the years, although it looks like the situation is changing in recent months, thanks to IPOs, spins, and SPACs. He said that some of it was due to the large amount of liquidity that’s been put into the system. It’s also due to longer-term equity returns that have been excellent (10-year compound annual growth rates of the 13% range), which has led to increased retail interest in equity investment.
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.”
This thinking was related to many reasons that academic experts have cited for spinoffs continuing to be a hot topic. These include management incentives and activist pressure.
How do you attract new talent to your company if there isn’t a challenge that offers a lot of pay and a great opportunity for you? If you don’t challenge the status quo, how can you convince investors to look at your stock? He was curious. He asked.
The old way of doing business was that strong companies would subsist poor businesses and thus endanger their unlocked potential. Colas explained that the current situation is quite different.
Provocative thinking is what happens when that stops. There are some iconic companies who may be under pressure from the hot public offering market, the discounts that apply to famous names, and the industrial transformation pressures.
Colas claimed that Ford and GM were the best.Rivian“The success of this project screams for the dissolution of all EV/non-EV operations.”
Although it might be difficult to achieve, corporate boards will find it more challenging to argue against it.
Colas said that “I covered this space for a decade” about his years as an autos analyst in Wall Street. “Back when research analysts were basically investments bankers.” There were endless presentations made to the Big Three about how companies could be sliced and diced to increase value. Although very few managed to get through the process, every manager implicitly recognized that conglomerate discounts are a problem. The EV and ICE operations are now available. When it was Tesla, the board might have said “Oh, that’s Elon premium.” This explanation has been lost.”
Shell countered activists’ calls to dismantle its fossil fuels exploration business and its production business by renewables in the energy sector, saying its entire business model rests on the balance sheets of today and tomorrow. Colas however says that this market is not convincing and Rivian is also not.
“Not with a +$10Billion IPO/spin, and access the capital markets for additional,” he stated.
More operational issues are involved – maintaining dealer networks and financing operations. R&D and assembly plants could all be carved out.
When ESG ratings become stricter about greenhouse-gas emitting products, boards should consider the impact on their equity cost of capital.
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