Maximizing the Potential of Resource-Driven Economies
Spinning off businesses can have real advantages in creating value—if corporate executives understand how.
December 2008 | by David Delaney
Company breakups through spin-offs date back at least a hundred years. Many of the earliest and best-known ones were mandated by courts to split up monopolies, including the 1911 breakup of Standard Oil into thirty-four separate companies, as well as the 1984 breakup of AT&T into eight companies.
After the AT&T breakup, spin-offs became a more common way for companies to change their strategic direction. American Express, for example, spun off Lehman Brothers in 1994, ending its strategy of becoming a financial supermarket. In 1993, as the historical links between chemical and pharmaceutical businesses became less relevant, the British chemical company Imperial Chemical Industries spun off its pharmaceutical business as Zeneca. Recent spin-offs have reflected similar shifts. In 2008, when the integration of the production and delivery of media content didn’t lead to the anticipated benefits, Time Warner announced that it would spin off its cable television business.
Some of the major conglomerates built in the 1960s and ’70s used spin-offs to break themselves up. ITT, one of the best-known conglomerates of that era, used a double spin-off in 1995 to split itself into three companies, ITT Sheraton, Hartford Financial Services, and the remaining industrial businesses, which kept the name. A fundamental principle of corporate finance holds that a business creates the most value for shareholders and the economy as a whole when it is owned by the best—or, at least, a better—owner.
It takes courage to break up a company. CEOs and boards of directors often fear that investors will view asset divestitures as admissions of failed strategy—that having certain businesses under the same corporate umbrella never made sense. Many worry that shedding assets will cost a company the benefits of scale, cut into the advantages of analyst coverage, or even damage employee morale. Spin-offs in particular draw scrutiny because they shrink the size of the parent company but, unlike sales, don’t generate cash.
Such assumptions rest errantly on a “sum of the parts” calculation. For each of a company’s businesses, analysts add up assumed earnings multiple based on the multiples of industry peers. If they find that the sum of the parts is greater than the market value of the company as currently traded, they assume the market hasn’t valued the business properly. Unfortunately, these analyses often are flawed—usually because the selected peers are not actually comparable in industry, performance, or both. Once truly comparable businesses are identified, the undervaluation typically disappears.