While large industrial conglomerates have always been active in acquiring new companies and divesting legacy businesses, their tendency to focus on a select few or even just one key end market has increased in recent years.
To find examples of this trend, investors do not need to search far and wide. Nearly every single large U.S. industrial conglomerate has pruned their portfolio in one way or another. Furthermore, it appears that spin-off transactions have become the preferred method for separating off a large subsidiary rather than selling the business outright to a competitor or financial buyer.
Nearly every large industrial conglomerate in the U.S. has completed or announced plans to focus their business through an asset sale, spin-off, carve-out, or split-off.
- Honeywell spun-off their Resins and Chemicals business in 2016 and recently spun-off their Turbochargers and Building Technologies/Distribution businesses.
- DowDuPont is splitting into three companies. Additionally, DuPont spun-off their Performance Chemicals segment as Chemours in 2015 and sold their Performance Coatings business to Carlyle in 2012 which has since returned to public markets as Axalta Coatings Systems.
- General Electric carved-out their private label credit cards business as Synchrony Financial in 2014 and recently announced transactions to spin-off both their Transportation and Healthcare businesses.
- United Technologies recently announced they are splitting up into three separate companies.
- Danaher split-off their Communications business in 2015 (merged with NetScout), spun-off some of their legacy industrial focused assets as Fortive in 2016, and announced plans to spin-off the Dental business in the future.
In addition to these mega capitalization companies, there have been portfolio moves in recent years by Johnson Controls, Dover, Ingersoll-Rand, ITT Corp, Air Products, Emerson Electric, Alcoa, Masco, and many others.
In order to better grasp the investment landscape today, investors need to understand why corporations are making these decisions. From our perspective, it boils down to two main drivers: Conglomerate Discounts and Activist Investors.
Large industrial conglomerates typically generate billions of dollars in revenue through multiple segments. Each segment can have very different revenue drivers and business economics (margins, capital requirements, returns on capital, etc).
These dynamics can be helpful to the conglomerate because the diversity enables them to weather a downturn in one of their end markets. It also allows them to reinvest capital across all their different businesses in a tax efficient way. However, this same diversification makes it very difficult for investors to value the consolidated company.
As a result of these business complexities, focused businesses generally doing better than widely diversified businesses, and Corporate America’s notoriously poor track record of allocating capital, investors typically value conglomerates at a discount to a sum-of-the-parts.
In fact, Greg Hayes, the Chairman and CEO of United Technologies, said in an interview with CNBC that one of the key factors that went into the spin-off decision is that United Technologies doesn’t get a favorable valuation for the business’ diversity like it has in years past. This is a very telling statement and one that investors should note.
Activist investors can be an important voice for shareholders as they work with the board and management to optimize the business’ portfolio as well as communicate the investment opportunity to market participants.
They can also identify operational shortfalls within the disparate business segments and push for changes in capital allocation policies to more efficiently allocate cash flow to the most attractive opportunities.
Through communicating with the management team and board of directors, activists can influence the company to look at alternative paths and weight those potential outcomes versus the current strategy. These discussions can result in the company reevaluating their direction and potentially decide to separate off a segment.
Once the conglomerate has decided to separate off a segment and focus the company, they need to determine the most effective transaction structure.
While some companies have historically been more inclined to spin-off businesses rather than sell them outright, it seems like more and more companies are favoring spin-off transactions in recent years. There could be a few reasons why today’s conglomerates are choosing spin-offs:
- Becoming More Sensitive to Tax Implications
- Low Return on Reinvestment / Capital Distribution
- The Segments Being Separated are Larger than in Prior Years
Becoming More Sensitive to Tax Implications
When a company sells a business, it must pay taxes on the difference between the tax basis and the proceeds from the sale. While the Tax Cuts and Jobs Act of 2017 lowers corporate tax rates and makes a sale relatively more attractive, the tax bill can still be quite large if the company has a low tax basis.
Furthermore, depending on what the company plans to do with the proceeds, shareholders could be taxed again (see below for additional details).
On the other hand, spin-offs are typically structured as a tax-free distribution to shareholders. This minimizes the tax leakage associated with an outright sale of a subsidiary.
Low Return on Reinvestment / Capital Distribution
If a company sells a business, it then needs to decide what it’s going to do with the cash proceeds. In general, a company use the cash in five different ways:
- Special Dividend
- Share Buybacks
- Internal Investment
- Debt Paydown (or Build Cash)
As discussed below, it is difficult for a company (or its shareholders if paid out as a special dividend) to generate a higher after-tax return on the proceeds from an asset sale than the returns investors could generate through continuing to own the business through a spin-off.
If the company elects to pay a special dividend out to shareholders, then many investors will be taxed on that distribution. This means that investors will be taxed twice. Once for the sale of the business at the corporate level and then again with the distribution from the company. As a result, the proceeds from the sale must be that much higher (significant premium to where the business would trade as a spin-off in the public markets) to account for this double taxation.
In order to offset at least a portion of the dilution from the sale, a company can repurchase shares so that the per share impact is not as pronounced. Based on the company’s valuation, redeploying the proceeds into shrinking the share count may or may not be a better use of capital than shareholders owning the segment via a spin-off.
The company could use the proceeds to reinvest in their remaining businesses. However, companies typically do not underinvest to the extent where they could deploy a very large lump sum at an attractive rate of return into their remaining businesses. Furthermore, the company is already likely reinvesting as much as they can currently for profitable, organic growth.
With a large pile of cash sitting on the balance sheet, a company could go out and find an acquisition. Yet, it is a difficult task for the company to successfully redeploy that capital into an acquisition that generates an attractive return. They would need to find something at a more attractive price and that is a better business than the one they just sold (to make up for the tax leakage on the sale).
This is an especially difficult task in the current market environment when take-private acquisition multiples are elevated.
Pay Down Debt / Build Cash
While paying down debt can certainly be a great option for companies that are highly levered, in highly cyclical industries, or have upcoming maturities, debt financing remains cheap so there is not a huge benefit to completely deleveraging the balance sheet.
Also, interest rates are currently very low so cash on the balance sheet doesn’t generate significant returns for investors.
The Segments Being Separated in Recent Years are Larger than in the Past
If a mega capitalization company is separating off a very small segment, it simply might not be very efficient to spin-off the business. This is because of the additional public company costs and the time drain on management.
However, with the large industrial conglomerates making massive changes in their portfolio composition, the segments being separated off are plenty large to be public companies. Also, it is well worth management’s time and attention to manage the separation in the most efficient manner possible. Lastly, there might not be any buyers out there for these large businesses because of their sheer size (nobody has or can raise enough capital) and/or antitrust reasons.
Not every large industrial conglomerate has made transformational portfolio moves over the last few years. Companies that have been able to generate revenue growth well in excess of GDP and find attractive investment opportunities (both organic and acquisitive) have been rewarded with a premium valuation. In these cases, there hasn’t been pressure on the conglomerates to make any large changes as the current portfolio is serving the company well.
Over the last few years, there has been a massive shift in the make-up of the large, U.S. industrial conglomerates as they become more focused companies. The key drivers pushing companies to become more focused, namely conglomerate discounts and activist investors, look like they are here to stay for the foreseeable future.
In some cases, the companies spun-off by these conglomerates demonstrate the characteristics of the most successful spin-offs. Yet, in other circumstances, the parent company is offloading a business they don’t want and loading it up with significant financial leverage. Investors need to be aware of these tides shifting across Corporate America and its implications on the investment landscape.
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