Investors usually benefit from companies splitting up because the total market value of the separate parts is usually more than the single combined firm. Managers tend to resist splitting up companies. This misalignment of interests should make investors skeptical of hypothetical sum-of-parts plays. Instead, investors should look to management teams that have a track-record of executing spin-offs or which have announced spin-off deals to the public.
Spin-offs Avoided by Management
More often than not, management does not want to sell or otherwise cede control of a business segment. It's too much like giving up or admitting defeat for most managers, and, as a group, they tend to fight asset disposal. Executives may refuse to give up control because having more assets under their control helps justify high salaries and lofty egos. This perspective would view a CEO of a $3 billion company as having more clout than a CEO of a $2 billion company. Hence, the benefit to shareholders is not enough to coax management into executing a spin-off.
Alcoa (AA) and Hewlett-Packard (HPQ) were recently featured as sum-of-parts plays without any nod from management or board members that either firm is considering a break-up. But investors interested in profiting from spin-offs should wait for an executive to announce such intentions or for investor activists to accumulate shares and press for restructuring.
Let's consider how UBS analysts concluded that Hewlett-Packard ought to separate business solutions division from its personal computers and printer operations. Hewlett-Packard shares would be worth $20 or more per share if the businesses were separated, substantially higher than the roughly $14 price of shares today. The analysts led by Steven Milunovich stated, "HP, with its fully developed enterprise and consumer businesses, should split up in order to realize greater value." Any loss in purchasing power would be more than made up for by an increase in management focus. Hewlett-Packard refuted that it would break up. According to spokesman Michael Thacker, Hewlett-Packard is stronger together than it would be apart and the customers believe in one HP. However, the UBS analysts suggest that HP could break up if "prompted by activists or private equity." Whitman said the enterprise business and the software business would be the only growth engines for HP. Milunovich believes that at current share prices HP investors are actually getting the printer and PC business for free.
Such hypothetical scenarios are great fodder for analysts, but without a management decision a spin-off or business sale will not happen. The value of a company's parts cannot be unlocked without consent from those who control the firm.
A similar study turned to Alcoa and investigated whether the firm as a whole is worth more than its parts. Bloomberg averaged the work of four different analysts who each used a sum-of-the-parts valuation of Alcoa's four divisions as separate businesses. Their average value per share for the parsed entity would be $14.82. This is almost twice the value of Alcoa shares, which trade near $8.70 today.
More likely than not, this analysis will not matter any time soon. Not surprisingly, Alcoa CEO Klaus Kleinfeld said the following:
…We have to prove for every business that we have that we are a better parent to that business than anybody else…In principle, you see it coming in through technology. You see it in through procurement. It comes in through customer intimacy, customer reach, the talent management that we have, through the operating system.
That's how we can generate value…in the performances that we have been able to generate in the downstream as well as the midstream business and how we are performing against bringing the upstream business down on the cost curve.
On a personal level, I sympathize with these executives. If I had worked hard to become the leader of a giant corporation I wouldn't want to carve it into pieces either. However, in the end, I would do what is best for shareholders.
Better Spin-off Candidates
ING Group (ING) recently announced the sale of its Malaysian insurance unit for 1.3 billion euros to AIA Group. This transaction would increase AIA's profit percentage to 13%. This deal is likely to go through. Mark Tucker, AIA's Chief Executive Officer took it upon himself to re-imagine the company's future after it had suffered a huge setback during the financial crisis after its parent company American International Group (AIG) was bailed out in 2008. Tucker said that AIA is so strong now that it can grow while simultaneously acquiring new assets calling it an "excellent strategic fit."
Some announced spin-offs either don't happen or may fetch lower valuations than the market anticipates. Abbott Laboratories (ABT) and its partner Reata Pharmaceuticals will be forced to review their options after the trial of bardoxolone methyl, a drug for kidney failure met a dead end. The drug that was in the final stage of testing was disqualified for adverse complications and the possibility of causing death.
Bardoxolene methyl was meant to better the functioning of damaged kidneys, a multi-billion dollar opportunity to serve millions of people with some form of chronic kidney disease. Days after the announcement, Abbott's market value declined by about $9 billion and the company's development pipeline now relies on its line of Hepatitis drugs.
This setback makes Abbott's planned spin-off pharmaceuticals business, AbbVie, less attractive. Sanford C. Bernstein analyst, Derrick Sung observed, "This is obviously disappointing news for Abbott as investor excitement around Abbott's late stage pipeline had been growing in anticipation of the split off of the AbbVie branded pharmaceuticals business." It was also recently announced that AbbVie would be subject to increased taxes to repatriate funds.
The valuation multiples of these companies reveal that ING and Safeway are particularly attractive:
Investors looking to play corporate events for profits should consider ING and Safeway as potential buy candidates. On a price-to-book basis, ING is arguably cheaper than Alcoa or Hewlett-Packard, and yet is vastly more likely to sell any business unit. Similarly, on a price-to-sales basis, Safeway is much more attractive than any other company on this list, and yet it is much more likely than Alcoa or Hewlett-Packard to actually go through with an asset sale.
Abbott trades at richer multiples than the other firms on this list and may find its spin-off has become less attractive based on its drug development setback. Thus, it is less attractive as a buy candidate than ING or Safeway.