Financial engineering is a broad term, but one that worries me a great deal. I've been burned one too many times by a good story in which major corporate actions turn out to be little more than an effort to cover up, or make up, for larger issues. Which is why you need to think long and hard about big corporate shifts that take place at your investments. Sears Holdings (NASDAQ:SHLD) and McDonald's (NYSE:MCD) are two great examples right now that show both ends of the spectrum here, but there's a lot more in between-like Tesla (NASDAQ:TSLA)
Selling the silverware
It's not hard to figure out that Sears Holdings is in trouble today. The company's ailment goes back a long way and boils down to the fact that Sears and Kmart have both been left behind by a fast-changing retail world. Any action the company takes today pretty much has to be viewed from the perspective of this weakness.
So this is an easy one: Sears Holdings saying that it is exploring options for its Kenmore, Craftsman, and DieHard brands is a bad sign. These are brands that have storied histories and have long been a cornerstone of Sears' business. Some of the family's best silverware, if you will. If Sears is willing to part ways with Kenmore and the others, things have got to be pretty dire.
That's not a hard conclusion to come to, obviously. Sears is clearly a company desperate for cash as it struggles to live another day. This is a bit of financial engineering bad news, no matter how the company tries to position the story. So, too, was the company's choice to spin off properties in a real estate investment trust, Seritage Growth Properties (NYSE:SRG), an earlier move that spoke to a company using corporate actions to try to save the patient by cutting off appendages. Yes, that real estate move raised cash, but clearly not enough since Sears is back with another great idea.
At some point, there won't be any more to cut and the financial engineering taking place will box the company into a corner. Is there a chance that Sears Holdings can save itself? Sure, there's always a chance. It's not a bet that I'd be willing to take and the corporate moves Sears is making are, in my eyes, evidence of how bad things are.
They aren't all bad...
But what about McDonald's plan to sell its Chinese stores? China was once a bright spot in the world for growth and it's since cooled off - though it's important to note that slower growth is hardly the same as a contraction. A slowdown in China shouldn't be surprising, though. No tree grows to the sky. In the end, it makes sense that foreign companies with notable Chinese assets would, faced with a more difficult operating environment, be looking to make changes.
But what to make of McDonald's move? If you took a cursory look at the headlines, you might think that McDonald's was trying to cut and run via a big asset sale. But this corporate action, large and dealing with a key market, isn't what it seems.
McDonald's basic business is franchising, which is kind of like selling intellectual property for an ongoing fee. The franchisee gets to use the well-known brand and the systems that support it, and McDonald's get's paid for sharing. While the company does run restaurants, and always will, that isn't really the core of the business, which is where China comes in. The fast food giant owns most of its Chinese locations.
What McDonald's is really looking to do is sell the restaurants in a large transaction, or transactions, to companies willing to become McDonald's franchisees. McDonald's could raise some cash in the process, but more important will be that it aligns the company's Chinese business with the core of what it does. That will also reduce some of McDonald's risk, since the biggest operating risks reside with the restaurant owners.
In the end, this looks like a good move for McDonald's and not one to be worried about. It could even help boost growth, since its new Chinese partners, with their boots on the ground and focused on the country, might find new and inventive ways to push their own growth and, thus, benefit McDonald's top and bottom lines along the way.
Now what about Yum Brands' (NYSE:YUM) decision to spin off its Chinese assets? That's a harder call in my book. China quickly grew into a giant business at Yum, making up about half of the company's revenues in 2015. But the company has been hit by slowing Chinese growth and quality problems, both directly and on a public perception basis. That's not particularly different than what's going on with McDonald's.
The plan at Yum, however, is a little different. It's going to spin off its China business and then have that new company become a franchisee. That's the part that's the same and I'd expect the process to be relatively smooth. But is this new business going to be materially different from what's there already? No, not really, because the same folks who were there before will still be there. I'm a little more worried about the move at Yum because I'm not sure what's going to change that should make me believe that Yum's Chinese business will improve.
That's not to suggest that McDonald's will be the clear winner, there's no way to tell which effort will be the better choice at this point. Only that I see McDonald's move as less concerning from a corporate governance standpoint - it makes business sense beyond the headline story. Yum's move makes business sense in the headlines, but I'm not sure it does when I think about the goal of improving performance in China.
That icky feeling
Then there are other corporate actions that, for lack of a better term, smell bad. For example, DuPont (NYSE:DD) and Dow Chemical's (NYSE:DOW) plan to team up, cut costs, and then split into three companies. It's possible that this is a great idea and will work out in the end, but it seems like a huge amount of movement among two giant, and storied, companies that should be able to survive on their own without all of the drama. As an investor, I can't help but wonder if I'm going to get the raw end somewhere in this process. I'd rather wait for the breakup and then reevaluate what's been left after all the surgery than get involved in this special situation play. The parts may end up worth less than the sum...
And, more recently, there's the news of Tesla looking to buy its sister company SolarCity (NASDAQ:SCTY). The basic idea is that by putting these two together Tesla will become some sort of one-stop shop for the new all-electric world. But it looks like a struggling company getting a bailout from a larger company, with its own heavy debt load and cash flow issues. And with the somewhat incestuous relationships between the two companies, it's hard not to think that shareholders are somehow going to get taken for a ride. I just don't see how a solar panel company helps a car maker that still hasn't turned a profit. This corporate action isn't worth touching, in my book. And I'm not sure I'd be looking at Tesla after the move, either, since I think Elon Musk is making a less than friendly shareholder decision here.
Very often big corporate moves turn out to be no more than corporate engineering that does little for shareholders. But that's not always the case. You need to look past the headlines, understand what you own, and think about what's really going on. Sometimes it's easy to see, like with Sears' many seemingly desperate moves, and others times it's harder, like at McDonald's and Yum Brands. It's worth the time and effort to examine these changes, though, when your hard earned money is at stake. Just don't accept the storyline you're being fed - it might not be that simple.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.