So we know that it’s a lot harder for firms to grow as they reach megacap status. Megacaps would have a lot harder time to grow 10-15% annually compared to mid/small caps. So I’m thinking, would it be more efficient from a growth perspective for large conglomerates, say Kraft or JNJ for example, to slice themselves up into spinoffs of 5-10B market cap each? Any thoughts? Not including companies like Walmart which definitely benefit from logistical advantages of being a giant company.
I would lean towards no. investors like some revenue diversification to an extent. And then what happens to dividends? More importantly, it’s more of the business itself than the whole. That’s why you can see a large firm have an ultra fast growing segment.
What benefit would it be for Kraft and JNJ to split up? They are so dominant at what they do because of their breadth / scale – there are only a couple of companies that each competes with and the barriers to entry are enormous (R&D, scale in purchasing, brand, leverage on retailers, distribution, etc., etc.). It would destroy a lot of value for current shareholders to carve these up – now you would have less consolidation in a mature market, which would result in “creep” between the spin offs trying to grow by entering verticals occupied by their now competitors, the other spin offs. Not to mention the fact that the spin offs wouldn’t be as competitive against the other large congolmerates on a stand alone basis. This a no brainer to put in the “NO!!” category. These companies are basically “unseatable” and will both exist in more or less their current form 100 years from now pending something extremely dramatic (like the end of the United States, yada yada). You know their top lines are going to grow at roughly the rate of inflation + population growth + any overseas growth they may have. I haven’t looked at either of these for a long time, but that’s plenty growth to create value for shareholders if they use their balance sheets and cash flow intelligently. You are thinking too much like the run of the mill stock market noob re: top line growth being the main value driver of a company.
Fair enough. What would you say is the main value driver - stable to increasing FCFE/BV ratio?
So bromion was pretty harsh, but he’s kinda right. Company growth is something of a life cycle / product cycle phenomenon. Large companies may buy smaller firms to absorb and roll out the their products on a larger scale and thus boost their own growth, but as this develops, across the firm you develop an average where most of the company’s portfolio is mature and growth is lower, so the focus is on generating efficiency, often through cost scale across the enterprise. Breaking up the firm into smaller entities will not reverse this process any more than amputating an old person into a bunch of smaller body parts will not make those parts younger and prone to growth themselves. In fact, losing the cost synergies will often hurt the long term profitability of the parts if such a breakup were to happen. Occasionally you will get a non-synergistic conglomerate firm where the parts don’t share enough commonality and a breakup does improve the value, but this is not a life cycle phenomenon so much as reversing the effects of ill advised non-compatible empire building or a firm who’s parts have simply grown in different directions. There is an exception. In some large firms the organization has become top heavy, a non-efficient outcome of it’s own cancerous growth of internal bureaucracy. In this case a breakup is sometimes the best way to remove the cancer and rejuvenate the organization by as the new smaller parts may operate with less oppressive red tape. So in the end, it’s not merely a growth analysis that must be performed, but a cost / value analysis as well.
Just to clarify, my comment was not intended to be harsh – it was meant to be instructive while emphasizing how bad it is to be over reliant on top line and EBITDA growth assumptions. To answer Palantir’s question, it varies by company. In this case, it’s the scale & stability, as I mentioned – the products these companies make will always be in demand, and no one else can get into the businesses in question. Since these are not heavy asset businesses requiring a lot of additional capex, they will produce significant FCF over time, which can be reinvested or returned to shareholders. My point was that your proposal would destroy the value engine of the company, and should be avoided. Different companies will have different value engines, so trying to compare a retailer or a software company or a defense company to a staple wouldn’t make much sense. In the case of a manufacturer, their competitive advantages (if any), are likely to be low cost position, differentiation of product, or patents, or brand. Since you can’t patent food very well, it’s going to be one of the first two, and most of the products are basically commodities, so that narrows it further. The value engine here is the low cost position achieved through scale (in multiple ways, as noted above). In general though, the balance sheet is usually the best predictor of long-term value, not the P&L. Cash flow is important, but value is usually created or destroyed on the balance sheet for most companies – there are many permutations and I’m sure someone could point out an exception, but typically cash flow is the product of the decisions made on the balance sheet. People spend A LOT of time trying to guess what revenue or EBITDA will be next quarter and what that might imply for the stock in the next 10 minutes without actually understanding where & how the value of a specific company is generated – and this is the source of a lot of investment mistakes. The Michael Porter books are a really good source if you want to learn more about some of these topics (the very brief introduction in the CFA material isn’t sufficient).
Bromion, that’s actually a pretty interesting perspective, I do a lot of analysis on financial institutions, so balance sheet has been key there but I’ve never really applied balance sheet analysis very heavily to firms outside the financial sector before. Do you work a buy side analyst role? Also, do the porter books cover balance sheet analysis the way a buy side analyst might or more from a strategic management perspective. Any books along the analysis side you would recommend?
Great thread. Can you elaborate how non financial companies username balance sheet for competitive advantage here, and why the BS is actually more revealing than the P&L? You hint at it above, but it would help if you could say something about it head-on.
- Ask why am I on the right side of a trade? And where do I look for ideas? a. Stay away from lottery stocks b. People are overly averse to things that are ugly and cheap—go here c. Humans are constituted on certainty—good stocks are overbought and bad stocks are oversold. d. Ugly, disappointing, diseased securities 2. You want a better methodology for what these securities are worth. a. DCF is good in but terrible in practice i. Near term CFs are good but distant CFs are bad information; ii. They ignore balance sheets and this is the most solid information about a company; iii. Nobody knows the inputs to these models. b. Graham & Dodd—always start with the assets and then look at the earning power (what is meant by this) to see if the assets are protected. c. Growth is only worth paying for if the investment in growth is higher than the cost of capital 3. Barriers to entry: incumbent competitive advantage. a. Access to demand—customer captivity. Switching costs, tastes for uniformity. b. Technology—patents or a mine etc. c. Scale of operation, usually locally, that cannot be replicated.
Yes, I work in a buy side analyst role as a generalist covering all industries except airlines, utilities and financial services. I’m not sure if my first two posts were clear, but I was trying to say that every company has a different value engine, and those engines can be strong or weak (or even destructive) depending on the specific company, business model, industry, and capital allocation strategy in question. I’m not aware of any one source that covers this topic end-to-end or even really gets in depth with the overall, big picture logic. Michael Porter talks a lot about the drivers of the value engine, primarily from a qualitative (structural) perspective, but does not get into the specific accounting or quantitative aspects of the value engine. Schumpeter talks about some of this stuff by implication (creative destruction). Accounting books will go over some of the quantitative aspects, obviously. At the heart of it though is a pretty simple concept: The essence of capitalism is the outlay of capital for some purpose, and companies should be evaluated for their cash on cash production (cash returns on cash invested) to determine the efficiency of that capital outlay – i.e., a company deploys some amount of cash in the form of assets and expects to receive a cash return on those assets. This is covered in some detail by concepts such as ROIC, but my observation is that people seem to view the balance sheet as more of a static or lagging indicator than a leading indicator of value creation because they are overly focused on the P&L. In truth, for most companies, the balance sheet is a leading indicator, and the P&L (and hence operating and free cash flow) will be a function of the decisions made on the balance sheet (subject to industry dynamics and some macro factors, as noted). Companies such as internet or software based companies may have few tangible (non-human) assets, but for most companies, they are putting cash to use by purchasing assets, and a skilled analyst can predict (to some degree) what the likely outcome of that capital allocation will be. It’s tempting to assume that management always knows best, but that is simply not true. A few examples: - A little loved company with a boring business model that changed their strategy from strictly selling to selling and renting a particular product line, unlocking a previously unserved market with large latent demand, dramatically accelerating cash on cash returns with little additional capital outlay. The annoucement was initially ignored by the Street, but the stock eventually increased 6x over the span of ~5 years. - A company that was / is in denial about their industry positioning as the high cost producer of a commodity product in a shrinking market characterized by overcapacity. This company decided to expand capacity (wow?!), spending an additional $50M for a project that was destined to fail. Their P&L history was appealing with bullish guidance, and the stock was a darling of the Street. It’s down ~50% now and my guess is that it will probably go lower, though a lot of “value investors” like it because it looks “cheap” (low multiple of P&L earnings power). It’s not cheap if they are going to continue to destroy capital. - A company with aggressive P&L guidance but with negative balance sheet trends (large sequential DSO increases over a multi-quarter time horizon). Mgmt was evasive during questioning as to why the balance sheet was deteriorating. We went short, and it turned out the P&L was in fact lying. Many sell side analysts and investors (who apparently were only looking at the P&L) were crushed when the stock went from ~$30 to 4 as the fraud was revealed. There are lots of other examples, but the point is that over the long run, stock prices reflect the underlying economic engine of a company, and the balance sheet is often a better predictor of the future quality of that engine than the P&L. It’s of course valuable to look at the P&L, but looking at it in isolation is dangerous – you may think that sounds obvious, but this is the way the majority of people invest, including a lot of professional investors.
Fascinating writeup, I’ve always focused on the CF statement, more than anything else. The hard part about this is that there is zero feedback so you can’t really evaluate your thinking, except say 5 years down the line…
there’s a reason why Kraft is spinning off its snacks business from its grocery business, not because spinoffs are sexy right now and management got a glossy presentation talking about “unlocking shareholder value”. the value of synergies is more often than not way harder to realize than it looks in theory, and the benefits of ‘scale and stability’ are often completely lost when you adopt an ungly step child. with spun-off entities one can see a direct manifestation of ‘Will Rogers phenomenon’ - a low margin business which is depressing the profitability and the valuation of the consolidated operations, will often get a boost when it is divested and evaluated against its proper peers as a stand-alone entity. it can also result in higher margins and higher valuation for the parent, a win-win situation where the sum of the parts is worth more than the whole. not every spin-off is right and there are some big losers, but it is often the right move for a company whose management is not constrained by the narrow-minded ‘bigger is better’ mentality. i think it could work well for Kraft, for instance
Mobius Striptease Wrote: ------------------------------------------------------- > there’s a reason why Kraft is spinning off its > snacks business from its grocery business, not > because spinoffs are sexy right now and management > got a glossy presentation talking about “unlocking > shareholder value”. the value of synergies is more > often than not way harder to realize than it looks > in theory, and the benefits of ‘scale and > stability’ are often completely lost when you > adopt an ungly step child. > > with spun-off entities one can see a direct > manifestation of ‘Will Rogers phenomenon’ - a low > margin business which is depressing the > profitability and the valuation of the > consolidated operations, will often get a boost > when it is divested and evaluated against its > proper peers as a stand-alone entity. it can also > result in higher margins and higher valuation for > the parent, a win-win situation where the sum of > the parts is worth more than the whole. not every > spin-off is right and there are some big losers, > but it is often the right move for a company whose > management is not constrained by the narrow-minded > ‘bigger is better’ mentality. i think it could > work well for Kraft, for instance I haven’t looked at the specific spin offs as I said, but generally spin offs will destroy value unless they are clearly not a match for the core business (as you implied here). Bigger usually is better in branded consumer products companies as long as each segment meets some minimum threshold for return on capital. If you’ve ever worked at or looked in detail at the business model of a large retailer, this is self evident – most of these product lines and businesses are interlocking in the sense that they strengthen each other through scale and leverage over the retailer, distribution, and manufacturing costs. It’s infinitely better to have 100 or 200 product lines with a retailer where you are the go to supplier or one of maybe two go to suppliers, for example, than it is to have 1 or 2 product lines. There’s nothing narrow minded about that – it’s an economic reality. Same thing with Coca Cola. There’s value in the brand, but the real value of the company is the distribution network and scale. If everyone decided to stop drinking Coke, they would just sell whatever the new drink was and the business would still be inpenetrable to new entrants (or they just buy any company with a promising product, such as Monster, etc.). This is why you know that Coke will still be around in 100 years “no matter what.” I agree that though that management generally over promises on synergies.
i just think your statement that it is a ‘no brainer’ and that spinoffs generally destroy value is way too general to be true. there are several spinoff etf’s out there, and a spin-off index of divested businesses whose returns are no smaller than and often exceed the S&P’s. on average, spin-offs entities do outperform their parents - this is a fact. another recent example that is underway is Ralcorp’s pending spinoff of their branded cereals. Ralcorp is the largest private brand manufacturer in the US, a great position to be in especially as cost-conscious consumers are spending more and more on cheaper private brand substitutes during the recession. focusing on their leadership position in private brands is more optimal for the company than dabbling into branded cereals, a related yet very different market in which they are a follower behind the big boys. Post foods was lost under Ralcorp’s umbrella, it is a high-margin business which can shine on its own and attract more investors as an independent company. the spin off could be good for both if they dont mess it up by going crazy on the leverage!
Mobius Striptease Wrote: ------------------------------------------------------- > i just think your statement that it is a ‘no > brainer’ and that spinoffs generally destroy value > is way too general to be true. there are several > spinoff etf’s out there, and a spin-off index of > divested businesses whose returns are no smaller > than and often exceed the S&P’s. on average, > spin-offs entities do outperform their parents - > this is a fact. > > another recent example that is underway is > Ralcorp’s pending spinoff of their branded > cereals. Ralcorp is the largest private brand > manufacturer in the US, a great position to be in > especially as cost-conscious consumers are > spending more and more on cheaper private brand > substitutes during the recession. focusing on > their leadership position in private brands is > more optimal for the company than dabbling into > branded cereals, a related yet very different > market in which they are a follower behind the big > boys. Post foods was lost under Ralcorp’s > umbrella, it is a high-margin business which can > shine on its own and attract more investors as an > independent company. the spin off could be good > for both if they dont mess it up by going crazy on > the leverage! Spin offs do often outperform because investors often irrationally dump them immediately after the spin off for any number of reasons. My point was not referring to a specific spin off, but the concept of destroying part of the underlying value mechanism of a company. Are there examples of a spin off that can create value? Of course. That’s not the point though. For JNJ, it’s hard to see how spinning off a product line that makes cotton products (q-tips, cotton pads, etc.) is going to create value, for example. That business is not going to be as valuable to any other holder as it is right now to JNJ for all of the reasons I listed. That is a no brainer, and since the OP was talking about about carving these congolmerates up (as opposed to merely spinning of one division in a special situation), that was the relevant point.
Bebop and Rocksteady Wrote: ------------------------------------------------------- > 1. Ask why am I on the right side of a trade? And > where do I look for ideas? > a. Stay away from lottery stocks > b. People are overly averse to things that are > ugly and cheap—go here > c. Humans are constituted on certainty—good stocks > are overbought and bad stocks are oversold. > d. Ugly, disappointing, diseased securities > 2. You want a better methodology for what these > securities are worth. > a. DCF is good in but terrible in practice > i. Near term CFs are good but distant CFs are bad > information; > ii. They ignore balance sheets and this is the > most solid information about a company; > iii. Nobody knows the inputs to these models. > b. Graham & Dodd—always start with the assets and > then look at the earning power (what is meant by > this) to see if the assets are protected. > c. Growth is only worth paying for if the > investment in growth is higher than the cost of > capital > 3. Barriers to entry: incumbent competitive > advantage. > a. Access to demand—customer captivity. Switching > costs, tastes for uniformity. > b. Technology—patents or a mine etc. > c. Scale of operation, usually locally, that > cannot be replicated. Thanks for nothing.
we can agree that spinning off well-integrated divisions and slicing a conglomerate just to make it smaller and without an underlying thought process wouldn’t unlock hidden growth and is likely to destroy value. thats all in theory since in practice, one would like to think that management approaches each spinoff decision by analyzing the specific circumstances and formulating a strategic rationale that justifies the divestiture, something more thoughtful than ‘lets get smaller and leaner’. so in practice, while some spinoffs do fail because you cant predict the future, a lot of them end up ‘unlocking’ shareholder value.
Bebop’s list isn’t rocket science, but it is a handy little checklist of things not to forget. Bromion’s stuff is great. I learned a lot. I’m really enjoying this thread. Thanks and keep going!
it’s a very timely thread, 2011 has been the year of the spin-offs - such an expostion of divestitures. this site gives you a list of the bigger ones that are currenly in the works: http://www.stockspinoffs.com/upcoming-spinoffs/
Just have a minute, but one BS focused method I use often is a balance sheet recapitalization on smaller (non S&P 500) companies. With 7% HY rates, recapping and lowering the WACC is a way to see potential value unlocked through capital structure decisions. That is obviously just the method, and a thorough knowledge of management and business risks is essential to good execution. When using this, I also assume a very low growth rate typically: management has discretion over BS structure, but only marginal discretion over future growth.