'Tis the season for Break-ups

With both local and global M&A business drying up in recent times - a function of the uncertainty about future economic conditions and management conservatism, investment banks have shifted their focus towards drumming up business from firm breakups. In recent weeks rumours have circulated about a number of possible breakups; including HP, and BP,  coupled with the announced breakup of McGraw-Hill. Locally, it was not so long ago where we witnessed the de-merger of Foster's, Tabcorp, and CSR. There has even been chattering that BHP should consider splitting up as a way of offering more value to shareholders. All this talk about breakups begs the following question.

What do breakups add in value? Is all this talk just a way for bankers to drum up business in go-slow market environments, or is there some real value added?

To begin with, let's begin by noting that not all breakups are the same. Breakups take on many different forms. For example, de-mergers and spin-offs are both breakups but are different in terms of the degree of retained control over an asset or divisional, and the the infusion of cash to the parent. The table below summarises (hence it is fairly general) the similarities/differences between the different forms of breakup.

Characteristics	Divestitures	Spin-off	Equity Carve-Outs	Split-ups	Split-offs	Bust-ups (Voluntary Liquidation)
Change in Equity Ownership	Yes	No	Yes	Yes/No	Yes	Yes
Parent Ceases to Exist	No	No	No	Yes	No	Yes
New Legal Entity Created	Yes/No	Yes	Yes	Yes	No	No
Cash Infusion to Parent	Yes	No	Yes	No	No	No
Newly Shares Issued	Yes/No	Yes	Yes	Yes	No	No
Parent Remains in Control	No	No	Yes	No	No	No
Tax-Free Transaction?	No	Yes	No	Yes	Yes	No

The are numerous reasons offered to explain why companies engage in breakups. They include: the desire to increase corporate focus, to exit under-performing businesses,  a lack of it, regulatory concerns, tax considerations, a need to raise funds or reduce risk, as well as discarding unwanted businesses from prior acquisitions, and increasing financial transparency.

If we take a look at some of mentions from above, the push for the BP breakup appears to be a function of the fact that the company is trading at a 100 billion pound discount to the sum-of-its parts (and also lagging its rivals). This is similar to the McGraw-Hill scenario, with suggestions that it is similarly trading at a 40% discount. McGraw-Hill which operates in a range of areas from textbook publishing, to rating government bonds, also appears to suffer from what is referred to as the 'conglomerate discount'. The S&P ratings debacle over the last couple of years has created some challenges for the rest of the business, for which management in its present outfit cannot reconcile. The HP scenario is not unlike the previous examples. A down-trending share price, poor acquisitions, and falling margins, compounded by the the cheapest valuation (at 5 times earnings) of more than 230 technology companies across the developed and developing world propels bankers to suggest that if a turn-around is to be on the cards, management need to deal with something a little smaller than a behemoth. When you think about the issues at News Corp in recent times, it is clear that isolated events can have a significant impact on firm structures.

The BHP scenario again rings around the issue of valuation. According to Morgan Stanley, "We see its EBITDA margin, gearing, and yield, as all being more attractive than those of ASX 200 Industrials, yet it trades at a 30% discount." But it is also that size appears to be causing real problems, with three failed merger deals in the past 24 months. These failed transactions suggest that future growth may be jeopardised by the current organisational structure of BHP who  will run into further antitrust roadblocks and be forced to pay higher than justified premiums for future acquisitions.

Getting back to our principal question, of whether or not breakups will create value, requires us not only to focus on what happens on the date of a break-up announcement (shares of McGraw-Hill advanced 7.4% on the date of announcement), which is typically an analyst's yardstick for value creation, but also to understand what it means for a firm and its shareholders long-term. Though firms like HP and McGraw-Hill have underperformed their peers in the current economic environment, we don't need to go back very far at all to find evidence of them trading at a significant premium to relevant market indices.

Although situations like the present call on management to 'strategically review' their operations, with almost everything up for debate, one must consider whether selling major assets/divisions in a depressed economic environment (even if it does yield some sort of premium) makes sense. When analysing the decision to issue equity (for an acquisition), we know that it rarely makes economic sense to issue when shares are trading below intrinsic value. The defining point whether or not to breakup a company, I believe should follow a similar chain of thought - if the selling price of an asset/division is below its intrinsic value (that is the price where neither the firm nor the market is in distress) then management should incur the short-term pain and consider a breakup when markets recover. Too often we see breakups (where there is a change in ownership) occur when businesses experience a decline in equity values and the market is engulfed in uncertainty. A more sensible approach may be to consider a scenario that allows a firm to retain an equity interest, which may be divested at a later point, but encourages the firm to pursue a strategy with a narrower focal point.

Whether the transactions mentioned will create value for shareholders is uncertain. We will have to adopt a wait and see approach. Although breakups may allow firms to write the wrongs of the past and unlock value not recognised by markets in a particular cycle, they are no panacea for creating long-term value; rather they are an adjunct to existing operational and financial policies.