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How companies are unlocking value by carving out pieces of their business.
Robert Stowe England, CFO Magazine
March 1, 1999
While market turmoil may have put a big dent in the number of initial public offerings last year, the equity carve-out IPO market continued on a roll, with several major high-profile deals.
Last year, in fact, 14 companies issued equity carve-outs--totaling a record $11.5 billion in net proceeds--despite the weakness in the overall IPO market.
An equity carve-out, sometimes called a partial spin-off, occurs when a parent company makes an initial public offering for a minority stake of a wholly-owned subsidiary-- usually less than 20 percent of the voting stock. The deals allow parents not only to raise needed capital, but also to retain firm control of the subsidiary before, typically, selling the remaining shares in a tax-free spin-off at a later date.
The list of 1998 deals included several high-profile names. For example:
* On October 22, at the height of the IPO drought, $45 billion, Wilmington, Delaware-based DuPont raised $4.4 billion in a public offering carving out roughly 30 percent of its oil subsidiary, Conoco Inc. of Houston. It was the biggest U.S. IPO and the biggest U.S. carve-out of all time, topping AT&T's $2.3 billion carve-out of Lucent Technologies in 1996.
* On November 11, Rupert Murdoch's News Corp. went public with 18.6 percent of Fox Entertainment, and raised $2.8 billion, the third-largest U.S. IPO.
* On December 10, CBS Inc. went public with 16 percent of Infinity Broadcasting and raised $2.97 billion, replacing Fox as the third largest U.S. IPO.
The trend shows no sign of abating. On February 5, General Motors Corp. went public with 18 percent of its Delphi Automotive business, and raised $1.7 billion. PepsiCo is planning to offer a stake in its $7 billion company-owned bottling operations this spring. And Viacom is set to part with a piece of its Blockbuster Entertainment unit. "In my opinion, this trend will continue because the theme of getting smaller has not run its course, and there are plenty of large, diversified businesses around that might be better off without some of their subsidiaries," says Joseph Cornell, president of Spin-Off Advisors LLC, in Chicago.
The idea of getting smaller may seem positively contrarian, as one giant merger after another tops the news. But companies are attracted to equity carve-outs for several reasons: First, says Andy Sanford, a director in the equity capital markets at Salomon Smith Barney in New York, "Carve-outs unlock the hidden value of one of the company's subsidiaries." In addition, says Douglas Squires, a managing director of investment banking at Merrill Lynch in New York, "Many of these transactions are motivated by investors' desire for investment clarity"--for both the parent and the subsidiary. The carve-out of Conoco, for example, allows the parent to exit the depressed oil business and focus on its core chemical business and its growth businesses, such as biotechnology. "This will make DuPont a faster-growing, less-cyclical, and more-profitable company," says Gary Pfieffer, DuPont senior vice president and CFO.
Still, carve-outs carry some risks. Some carved-out companies may not do well when the parent loads them up with too much debt. Others may not do well if they have not established a track record for growing revenues and profits. Ultimately, says Sanford, "It's important to position and structure the deal so each party--the parent and the subsidiary-- can operate and fund itself and reach a level of growth characteristic of its industry."
While carve-outs aren't new, recent research attests to their benefits. A 1998 working paper from Pennsylvania State University, for example, examined 83 equity carve-outs done between 1981 and 1990, and found that carved-out companies had significantly higher revenue and asset growth, higher earnings, and higher capital spending than the industry average during the first three years after the carve-out--achievements, the authors say, that are a direct result of 80 percent of the deals tying executive compensation to the share price of the carved-out company at the time it goes public. "It's a way of providing a stronger incentive for subsidiary executives to perform," says James A. Miles, one of the authors of the study, along with Heather Hulburt and J. Randall Woolridge.
Parent companies also benefit from a carve-out. The Penn State study, in fact, found that these companies had a higher return on assets in the first year after the carve-out. And a similar study by J.P. Morgan & Co., which examined 101 carve-outs between 1986 and 1997, documented that, on average, the share price of the parent rose between 3 and 4 percent in the 90 days following the announcement of a carve-out.
Such potential helped convince The Hartford Financial Services Group Inc. to carve out 18.6 percent of its Hartford Life subsidiary in May 1997, in a $735 million IPO, a move that David K. Zwiener, executive vice president and CFO of The Hartford Corp., says, "has surpassed all expectations."
Zwiener explains that the IPO was done to raise capital for the parent, provide stock-based incentives to Hartford Life employees, and unlock the hidden valuation of the rapidly growing business of Hartford Life, the largest seller of variable life annuities. "We felt strongly that the market was not giving us full valuation for 100 percent ownership of the Hartford Life business," he says.
The carve-out significantly contributed to the increase in The Hartford's valuation, which rose from approximately $9 billion at the time of the IPO to around $12 billion, despite carving out a portion of Hartford Life. In addition, Hartford Life's share price has zoomed, from 281/4 at the time of the IPO to 605/16 in early February, a growth rate more than twice the market average.
The decision to retain majority ownership, however, may limit the upside to the deal. The J.P. Morgan study found a distinct difference in the share price performance of carve-outs that later became spin-offs and carve-outs that did not. In the case of 12 carve-out companies in which the parent announced there would be a later spin-off, the share price of the carve-out performed 11 percent above the market 18 months after the initial public offering. The shares of all other carve-outs--those without an announced spin-off later--actually underperformed the market by 3 percent.
There are other advantages to following up a carve-out with a spin-off or split-off, says Rick Escherich, managing director in the M&A group at J.P. Morgan. "It creates more shareholder value, since spin-offs preceded by a carve-out usually perform better than straight spin- offs," he says. In a spin-off without a prior carve-out, the parent company basically "gives the shares away and they have to find a home," Escherich explains.
Most spin-offs are shares given as a dividend to the shareholders of the parent company's shares. Some of the shareholders don't want the shares, and dump them on the market, depressing the share price, he says. "With a carve-out, you have to market the shares through road shows," says Escherich. "This leads to a more-stable home," and a more- stable share price.
The ability of the carve-out to capture more value ahead of a spin-off or split-off is also why DuPont chose to do it ahead of its split-off of Conoco. The carve-out, which was priced at $23 a share, is to be followed by a split-off later this year. In a split-off, shareholders who want Conoco shares will have to trade their DuPont shares for them.
Despite the jump start carve-outs give to stock prices, "they need to be based on overall business strategies if they are to succeed," says Peter Grittner, principal in management consultancy Towers Perrin, in Providence.
For example, a CFO might want to consider a carve-out if a subsidiary is valued by the markets "on a different basis than the parent company," says Merrill Lynch's Squires. By this he means that the market might value the parent's business on a multiple of earnings per share, while the parent might value the subsidiary on multiples of gross revenues or cash flow.
Such is the situation with New York-based Barnes & Noble Inc., which is considering a carve-out of part of its online subsidiary, barnesandnoble.com, later this year. The parent is in an industry that is valued on earnings per share, while online booksellers are valued by investors on revenue growth.
"It's a different investor base that may look at the online business differently," explains Marie Toulantis, executive vice president of finance at the parent company. The barnesandnoble.com IPO, originally slated for November, was postponed after Barnes & Noble announced that it was selling 50 percent of the business to Bertelsmann AG for $200 million.
Another valid business purpose for a carve-out is to allow the subsidiary to sell its product or service to a broader market than its parent company, Grittner says. Telephone deregulation, he says, prompted AT&T to carve out and then spin off Lucent Technologies--a move that has allowed Lucent to sell equipment to competitors of AT&T.
Similarly, the globalization of the auto business drove General Motors to carve out Delphi Automotive, so that it, too, can sell to competitors of GM. "It's now a corporate necessity for Delphi to sell to others besides GM," says Towers Perrin's Grittner.
Of course, the tax advantages of carve-outs can't be underestimated. By spinning off less than 20 percent of the company as a taxable entity, parents are able to follow it up with a tax-free split-off. That's because under tax law, a company must have 80 percent of the voting stock and 50 percent of the economic value of its stock in order to have a tax-free divestiture. DuPont, however, was able to sell 30 percent of Conoco, by issuing two classes of shares in the company: Class A shares, which were sold in the IPO, have one vote; Class B shares, which were retained by the company, have five votes each.
The different voting stock levels allowed DuPont to sell more than 20 percent of its economic value in the IPO, and still have a tax-free split-off. The company retained 92 percent of the voting power.
There is a downside to carve-outs, however. Tom Wilson, president of Allstate Life Insurance Co. and former CFO of Allstate Insurance Co., both based in Northbrook, Illinois, warns there can be operational conflicts between the parent and the subsidiary after a carve-out. "I am not a big fan of 80 percent ownership," says Wilson. "It creates friction between the companies."
The problem arises because the managers of the carved-out company have a new group of financial stakeholders, the public stockholders, "who don't have the same interests as the 80 percent shareholders," the parent, he says. This can create divided loyalties and "complicate" the life of the parent and the carved-out company. For this reason, Wilson would not contemplate a carve-out for Allstate Life and Savings.
Such friction can be avoided, however, if there is a complete break--a carve-out and a spin-off or split-off. This is what happened when Sears carved out Allstate and then spun it off, says Wilson. It's also what's happening with DuPont and Conoco, where the decision to part ways was mutual, according to Conoco CFO Robert Goldman.
After several analyses, both inside and outside Conoco, "we came to the conclusion that our ability to grow the company beyond the year 2000 depended on more access to capital and greater flexibility in managing the business," Goldman says, adding that this required its separation from DuPont. Conoco's senior management has delivered their own vote of confidence in the carve-out, Goldman says, by converting 100 percent of their DuPont stock options to Conoco stock options. "The compensation alignment is a critical aspect in this whole thing," Goldman says.
Whatever the strategic business reasons for a carve-out, the appeal of the technique is expected to grow among larger, diversified companies, experts say, as long as companies continue to search for new ways to unlock value and clarify investing options.
"It's been a very powerful focus for us," says Zwiener. "We've moved the entire company to even-more accountability on a business-by-business level." What's more, he adds, it has inspired other businesses at The Hartford to continue to build the kind of consistent growth and profit results that have been achieved by Hartford Life.
Robert Stowe England is a freelance writer based in Arlington, Virginia.