breaking companies apart

corporate activism/raiding

Lots of activist hedge funds–or corporate raiders, as they used to be called–have been taking small stakes in publicly traded companies and then beating the drum for management either to articulate, or to change, corporate strategy.

Why do this?

…to make money for themselves and their backers, of course.  Also, the targets they’re attacking nowadays are very big.  So the prior tactic of taking control of the company through a takeover and forcing change isn’t possible.

How will change create value?

There are two main ways:

–a company may consist of several parts that have virtually no connection with each other.  A firm might, say, own office buildings and an airline, or make medical devices and lease airplanes.

Many times, these are family controlled firms that following the whims of the patriarch/matriarch.  They can also be small divisions whose growth had skyrocketed (think:  ESPN in Disney).  Or the firms might be holdovers from the 1960s, when, unlike today, the world believed there “pure” management skills could be applied to any field–and that, therefore, the best corporate form was the conglomerate.

People don’t think that way anymore.  We believe that the best companies are ones run by top management deeply skilled in one particular area.  Also, today’s professional stock market investors want to create a portfolio of stocks themselves.  They don’t like or want a corporate management that will create a portfolio of subsidiaries and offer it as a take-it-or-leave-it package.  The result:  a heavy discount applied in today’s world to conglomerates.

Put in a different way–n theory, and in practice, there are investors with differing investment styles and different investment objectives who will pay a higher price for some of the corporate components, provided they don’t also have to take the ones they don’t particularly want.  So breaking the package up creates value.

In the case of the airline/office building company I mentioned above (Swire Pacific of Hong Kong), announcement of plans for a separate listing for Cathay Pacific shot the stock price up by 40%.

–Sometimes companies are dysfunctional.  Internal political fiefdoms get created, preventing cash flows generated by operations from being reinvested sensibly.  Sometimes, companies are clueless about where their profits come from, so that some parts run horribly sub-optimally in order to make other parts look good.  This was the concept behind the activist interest in J C Penney–that the retail operations were being propped up by the property division, which was collecting below-market rents to the department stores.  The idea was to fix the retail and then break up the company into retail and real estate parts.

I once studied a publicly traded, family owned department store in Hong Kong.  I found the stores I visited to be completely unappealing, with dated merchandise at high prices–and stronger competitors a short walk away.  Yet the company, which owned all the property where its stores were located,  made a hefty profit each year.  How could that be?  When I began to work out how much rent the locations would command from third parties, I realized that profits would easily be 50% higher if the firm shuttered its stores and simply rented the properties to other.  But that would have meant that all of the relatives  who “worked” in retail would be out of jobs.  So the idea was a non-starter.

In most instances, management is unlikely to disturb the status quo without being educated/forced by outside parties.  That’s where the activists come in.

Sometimes activism doesn’t work, however.  That topic on Monday.

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