America’s Industrial Conglomerates are Breaking Up and this Activist Target Could be Next

Introduction:

America’s industrial companies have been actively managing their portfolios over the last few years through spinning off business segments. For instance, the largest industrial conglomerates such as General Electric, Honeywell, DuPont, and Danaher have each executed spin-offs of varying sizes. But the large guys aren’t the only ones reorganizing their portfolios. A handful of smaller industrial conglomerates such as Johnson Controls, Dover and Alcoa have done their own spin-offs as well.

Despite all the reshuffling over the past few years, these companies are far from finished. In fact, the spin-off pipeline is full of these same companies separating off additional businesses.

While all this activity has moved markets, one of America’s largest industrial conglomerates has been quiet. But this could be changing as they close on a major acquisition, finish a portfolio review, and count two prominent activist investors as major shareholders.

Industrial Conglomerates Continue to Execute Spin-Offs

  • General Electric plans to spin-off their Transportation segment and merge it with Wabtec as well as carve-out GE Healthcare.
  • Honeywell plans to spin-off both their Transportation Systems and Homes & Global Distribution businesses.
  • DowDuPont is in position to start spinning off their businesses in 2019 after the mega-merger and restructuring over these last few years.
  • Danaher plans to spin-off their Dental segment

 There have been a handful of key drivers that pushed and continue to push companies to pursue these transactions.

Key Factors Driving Industrial Conglomerate Spin-Offs

  • The market places a valuation discount on conglomerates
  • Activist investors sense the opportunity for operational and capital allocation improvements
  • Management teams want to focus on core operations to improve the consolidated growth rate and return on capital profile

Conglomerate Discounts

Valuing huge companies that generates billions of dollars of revenue through multiple segments and subsegments is difficult. It is tricky for investors to properly assess each segments’ key drivers and then roll all those individual segments up to analyze the consolidated company’s revenue growth, margins, capital requirements, and returns on capital. To account for this difficulty, the market values conglomerates at a discount to their “sum-of-the-parts”, or how each segment would be valued on its own. Therefore, value can be created by spinning off the different businesses as long as there is a sufficient difference between a conglomerate’s discounted valuation and the post-spin-off valuations. This is needed to account for the potential “dis-synergies” of splitting up the company.

Activist Investors

These types of investors are an important voice in communicating the opportunity to market participants after finding a conglomerate trading at a discount. Additionally, they could identify operational shortfalls within various segments relative to pure-play competitors and call for changes in capital allocation policies to more efficiently allocate cash flows to the highest returning opportunities. These efforts could allow them to obtain board seats and influence the company’s strategic direction.

Management Teams Refocusing

Over time, the business environment changes and strategies that were put in place either work or need to be refined. As a result, spinning off different segments is always an option for management teams who are looking to refocus the business.

Who Could Announce the Next Spin-Off?

United Technologies looks prepared to begin spinning off segments. The company is comprised of three separate, unrelated businesses that have different growth drivers, margin profiles, capital requirements, optimal capital structures, and natural investor bases.

  • Otis: the world’s leading elevator and escalator company
  • Climate, Control & Security (CCS): provides HVAC, refrigeration, fire, and security products.
  • Aerospace: includes the Pratt & Whitney aircraft engines business along with Aerospace Systems and the to-be-acquired Rockwell Collins

Currently, they are undergoing a portfolio review to determine if it makes strategic sense to separate any of the business segments. We think there is a high probability that they will ultimately announce spin-offs because they count two prominent activist investment firms, Pershing Square and Third Point, as large shareholders.

Both firms have called for the company to split itself up in letters to investors.

“UTC fits a pattern of many underperforming conglomerates where value is diminished by the ill effects of a “one size fits all” approach to corporate strategy, incentive compensation, and capital allocation…To reverse its years of underperformance and realize the full potential of its franchise assets, we believe UTC should split into three focused, standalone businesses: Otis, CCS, and an aerospace company (“Aerospace RemainCo”) encompassing UTAS and Pratt & Whitney.”

Third Point First Quarter 2018 Investor Letter

“…The review may result in a three-way separation of Aerospace, Otis, and Climate, Controls and Security. As each of these businesses has materially different capital requirements, competitive characteristics, and investor constituencies, we believe that they will be more likely to achieve fair value as independent companies. In a separation, management focus and alignment will also likely improve as compensation can be more easily designed to meet shareholder objectives, and entrepreneurial zeal is unleashed from the IPO-like nature of corporate spinoffs…”

Pershing Square Capital Management First Quarter 2018 letter to Shareholders

United Technologies will likely benefit from a breakup. Each of the businesses will be more focused, better able to align management incentives, improve capital allocation, and be much easier for investors to analyze and properly value.

Management expects to update investors on the results of the strategic review before the end of the year.

Conclusion

With a spin-off pipeline full of industrial conglomerates separating off different segments, it’s clear that the factors that drove these companies to spin-off subsidiaries over the last few years remain intact today. However, one of the few industrial conglomerates that haven’t undergone a major portfolio reorganization is United Technologies. This could change with the strategic review underway and a couple of prominent activist investors pushing for change at the company. Investors should keep an eye on this situation because the potential spin-offs at United Technologies display many of the unique characteristics that create compelling investment opportunities.

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2018-10-03T13:07:14+00:00