Exam 16: Alternative Exit and Restructuring Strategies

Equity ownership changes in spin-offs, but it does not change in split-ups.

Voluntary bust-ups or liquidations by the parent firm reflect management's judgment that the sale of individual parts of the firm could realize greater value than the value created by a continuation of the combined corporation.

A parent firm rarely chooses to divest an undervalued business and return the cash to shareholders either through a liquidating dividend or share repurchase.

A split-up involves the creation of a new class of stock for each of the parent's operating subsidiaries, paying current shareholders a dividend of each new class of stock, and then dissolving the remaining corporate shell.

Both a divestiture and a spin-off generally generate a cash infusion for the parent.

After months of trying to sell its 81 percent stake in Blockbuster Inc., Viacom undertook a spin-off in mid 2004. Why would Viacom choose to spin-off rather than divest its Blockbuster unit? Explain your answer.

For financial reporting purposes, the parent firm should account for the spin-off of a subsidiary's stock to its shareholders at book value with no gain or loss recognized, other than any reduction in value due to impairment.

An equity carve-out is often a prelude to a complete divestiture of a business by the parent.

Inside M&A. Financial Services Firms Streamline their Operations During 2005 and 2006, a wave of big financial services firms announced their intentions to spin-off operations that did not seem to fit strategically with their core business. In addition to realigning their strategies, the parent firms noted the favorable tax consequences of a spin-off, the potential improvement in the parent's financial returns, the elimination of conflicts with customers, and the removal of what, for some, had become a management distraction. American Express announced plans in early 2005 to jettison its financial advisory business through a tax-free spin-off to its shareholders. The firm also noted that it would incur significant restructuring-related expenses just before the spin-off. Such one-time write-offs by the parent are sometimes necessary to "clean up" the balance sheet of the unit to be spun off and unburden the newly formed company's earnings performance. American Express anticipated substantial improvement in future financial returns on assets as it will be eliminating more than $410 billion in assets from its balance sheet that had been generating relatively meager earnings. Investment bank Morgan Stanley announced in mid-2005 its intent to spin-off its Discover Credit Card operation. While Discover Card generated about one fifth of the firm's pretax profits, Morgan Stanley had been unable to realize significant synergies with its other operations. The move represented an attempt by senior Morgan Stanley management to mute shareholder criticism of the company's lackluster stock performance due to what many viewed had been the firm's excessive diversification. Similarly, J.P. Morgan Chase announced plans in 2006 to spin off its $13 billion private equity fund, J.P. Morgan Partners. The bank would invest up to $1 billion in a new fund J.P. Morgan Partners plans to open as a successor to the current Global Fund. Because the bank's ownership position would be less than 25 percent, it would be classified as a passive partner. The expectation is that, by jettisoning this operation, the bank would be able to reduce earnings volatility and decrease competition between the bank and large customers when making investments. -In what ways might the spin-offs harm parent firm shareholders?

In deciding to sell a business, a parent firm should compare the business' after-tax value in sale with its pre-tax value to the parent as part of the parent.

Inside M&A. Financial Services Firms Streamline their Operations During 2005 and 2006, a wave of big financial services firms announced their intentions to spin-off operations that did not seem to fit strategically with their core business. In addition to realigning their strategies, the parent firms noted the favorable tax consequences of a spin-off, the potential improvement in the parent's financial returns, the elimination of conflicts with customers, and the removal of what, for some, had become a management distraction. American Express announced plans in early 2005 to jettison its financial advisory business through a tax-free spin-off to its shareholders. The firm also noted that it would incur significant restructuring-related expenses just before the spin-off. Such one-time write-offs by the parent are sometimes necessary to "clean up" the balance sheet of the unit to be spun off and unburden the newly formed company's earnings performance. American Express anticipated substantial improvement in future financial returns on assets as it will be eliminating more than $410 billion in assets from its balance sheet that had been generating relatively meager earnings. Investment bank Morgan Stanley announced in mid-2005 its intent to spin-off its Discover Credit Card operation. While Discover Card generated about one fifth of the firm's pretax profits, Morgan Stanley had been unable to realize significant synergies with its other operations. The move represented an attempt by senior Morgan Stanley management to mute shareholder criticism of the company's lackluster stock performance due to what many viewed had been the firm's excessive diversification. Similarly, J.P. Morgan Chase announced plans in 2006 to spin off its $13 billion private equity fund, J.P. Morgan Partners. The bank would invest up to $1 billion in a new fund J.P. Morgan Partners plans to open as a successor to the current Global Fund. Because the bank's ownership position would be less than 25 percent, it would be classified as a passive partner. The expectation is that, by jettisoning this operation, the bank would be able to reduce earnings volatility and decrease competition between the bank and large customers when making investments. -Speculate as to why a firm may choose to spin-off rather than divest a business?

United Parcel Service Goes Public in an Equity IPO On November 10, 1999, United Parcel Service (UPS) raised $5.47 billion by selling 109.4 million shares of Class B common stock at an offering price of $50 per share in the biggest IPO by any U.S. firm in history. The share price exploded to $67.38 at the end of the first day of trading. The IPO represented 9% of the firm's stock and established the firm's total market value at $81.9 billion (i.e., [$67.38 x 109.4 / .09]). With 1998 revenue of $24.8 billion, UPS transports more than 3 billion parcels and documents annually. The company provides services in more than 200 countries. By issuing only a portion of its Class B stock to the public, UPS was interested in ensuring that control would remain in the hands of current management. The cash proceeds of the stock issue were used to buy back about 9% of the Class A voting stock held by employees and by heirs to the founding Casey family, thereby keeping the total number of shares outstanding constant. The Class B shares have one vote each, whereas the Class A shares have 10 votes. In addition, the issuance of Class B stock provides a currency for making acquisitions. UPS had attempted unsuccessfully to acquire certain firms that had indicated a strong desire for UPS shares rather than cash. The beneficiaries of the sale include UPS employees from top management to workers on the loading docks. In a growing trend in U.S. companies to generate greater employee loyalty and productivity, UPS offered all 330,000 employees worldwide an opportunity to buy shares in this highly profitable company at prices as low as $20 per share. Before UPS, the largest IPOs included Conoco in October 1998 at $4.40 billion, Goldman Sachs in May 1999 at $3.66 billion, Charter Communications in November 1999 at $3.23 billion, and Lucent Technologies in April 1996 at $3 billion. -Describe the motivation for UPS to undertake this type of transaction.

To decide if a business is worth more to the shareholder if sold, the parent firm generally considers all of the following factors except for

Bristol-Myers Squibb Splits Off Rest of Mead Johnson Facing the loss of patent protection for its blockbuster drug Plavix, a blood thinner, in 2012, Bristol-Myers Squibb Company decided to split off its 83% ownership stake in Mead Johnson Nutrition Company in late 2009 through an offer to its shareholders to exchange their Bristol-Myers shares for Mead Johnson shares. The decision was part of a longer-term restructuring strategy that included the sale of assets to raise money for acquisitions of biotechnology drug companies and the elimination of jobs to reduce annual operating expenses by $2.5 billion by the end of 2012. Bristol-Myers anticipated a significant decline in operating profit following the loss of patent protection as increased competition from lower-priced generics would force sizeable reductions in the price of Plavix. Furthermore, Bristol-Myers considered Mead Johnson, a baby formula manufacturer, as a noncore business that was pursuing a focus on biotechnology drugs. Bristol-Myers shareholders greeted the announcement positively, with the firm's shares showing the largest one-day increase in eight months. In the exchange offer, Bristol-Myers shareholders were able to exchange some, none, or all of their shares of Bristol-Myers common stock for shares of Mead Johnson common stock at a discount. The discount was intended to provide an incentive for Bristol-Myers shareholders to tender their shares. Also, the rapid appreciation of the Mead Johnson shares in the months leading up to the announced split-off suggested that these shares could have attractive long-term appreciation potential. While the transaction did not provide any cash directly to the firm, it did indirectly augment Bristol-Myer's operating cash flow by $214 million annually. This represented the difference between the $350 million that Bristol-Myers paid in dividends to Mead Johnson shareholders and the $136 million it received in dividends from Mead Johnson each year. By reducing the number of Bristol-Myers shares outstanding, the transaction also improved Bristol-Myers' earnings per share by 4% in 2011. Finally, by splitting-off a noncore business, Bristol-Myers was increasing its attractiveness to investors interested in a "pure play" in biotechnology pharmaceuticals. The exchange was tax free to Bristol-Myers shareholders participating in the exchange offer, who also stood to gain if the now independent Mead Johnson Corporation were acquired at a later date. The newly independent Mead Johnson had a poison pill in place to discourage any takeover within six months to a year following the split-off. The tax-free status of the transaction could have been disallowed by the IRS if the transaction were viewed as a "disguised sale" intended to allow Bristol-Myers to avoid paying taxes on gains incurred if it had chosen to sell Mead Johnson. British Petroleum Sells Oil and Gas Assets to Apache Corporation In the months that followed the oil spill in the Gulf of Mexico, British Petroleum agreed to create a $20 billion fund to help cover the damages and cleanup costs associated with the spill. The firm had agreed to contribute $5 billion to the fund before the end of 2010. To help meet this obligation and to help finance the more than $4 billion already spent on the spill, the firm announced on July 20, 2010, that it had reached an agreement to sell Apache Corporation its oil and gas fields in Texas and southeast New Mexico worth $3.1 billion; gas fields in Western Canada for $3.25 billion; and oil and gas properties in Egypt for $650 million. All of these properties had been in production for years, and their output rates were declining. Apache is a Houston, Texas-based independent oil and gas exploration firm with a reputation for being able to extract additional oil and gas from older properties. Also, Apache had operations near each of the BP properties, enabling them to take control of the acquired assets with existing personnel. In what appears to have been a premature move, Apache agreed to acquire Mariner Energy and Devon Energy's offshore assets in the Gulf of Mexico for a total of $3.75 billion just days before the BP oil rig explosion in the Gulf. The acquisitions made Apache a major player in the Gulf just weeks before the United States banned temporarily deep-water drilling exploration in federal waters. The announcement of the sale of these properties came as a surprise because BP had been rumored to be attempting to sell its stake in the oil fields of Prudhoe Bay, Alaska. The sale had been expected to fetch as much as $10 billion. The sale failed to materialize because of lingering concerns that BP might at some point seek bankruptcy protection and because the firm's creditors could seek to reverse an out-of-court asset sale as a fraudulent conveyance of assets. Fraudulent conveyance refers to the illegal transfer of assets to another party in order to defer, hinder, or defraud creditors. Under U.S. bankruptcy laws, courts might order that any asset sold by a company in distress, such as BP, must be encumbered with some of the liabilities of the seller if it can be shown that the distressed firm undertook the sale with the full knowledge that it would be filing for bankruptcy protection at a later date. Ideally, buyers would like to purchase assets "free and clear" of the environmental liabilities associated with the Gulf oil spill. Consequently, a buyer of BP assets would have to incorporate such risks in determining the purchase price for such assets. In some instances, buyers will buy assets only after the seller has gone through the bankruptcy process in order to limit fraudulent conveyance risks. -In what sense were the BP properties strategically more valuable to Apache than to British Petroleum?

Describe how you as an analyst would estimate the potential impact of the Huntington Ingalls Industries spin-off on the long-term value of Northrop Grumman's share price?

AT&T (1984 - 2005)-A POSTER CHILD FOR RESTRUCTURING GONE AWRY Between 1984 and 2000, AT&T underwent four major restructuring programs. These included the government-mandated breakup in 1984, the 1996 effort to eliminate customer conflicts, the 1998 plan to become a broadband powerhouse, and the most recent restructuring program announced in 2000 to correct past mistakes. It is difficult to identify another major corporation that has undergone as much sustained trauma as AT&T. Ironically, a former AT&T operating unit acquired its former parent in 2005. The 1984 Restructure: Changed the Organization But Not the Culture The genesis of Ma Bell's problems may have begun with the consent decree signed with the Department of Justice in 1984, which resulted in the spin-off of its local telephone operations to its shareholders. AT&T retained its long-distance and telecommunications equipment manufacturing operations. Although the breadth of the firm's product offering changed dramatically, little else seems to have changed. The firm remained highly bureaucratic, risk averse, and inward looking. However, substantial market share in the lucrative long-distance market continued to generate huge cash flow for the company, thereby enabling the company to be slow to react to the changing competitive dynamics of the marketplace. The 1996 Restructure: Lack of a Coherent Strategy Cash accumulated from the long-distance business was spent on a variety of ill-conceived strategies such as the firm's foray into the personal computer business. After years of unsuccessfully attempting to redefine the company's strategy, AT&T once again resorted to a major restructure of the firm. In 1996, AT&T spun-off Lucent Technologies (its telecommunications equipment business) and NCR (a computer services business) to shareholders to facilitate Lucent equipment sales to former AT&T operations and to eliminate the non-core NCR computer business. However, this had little impact on the AT&T share price. The 1998 Restructure: Vision Exceeds Ability to Execute In its third major restructure since 1984, AT&T CEO Michael Armstrong passionately unveiled in June of 1998 a daring strategy to transform AT&T from a struggling long-distance telephone company into a broadband internet access and local phone services company. To accomplish this end, he outlined his intentions to acquire cable companies MediaOne Group and Telecommunications Inc. for $58 billion and $48 billion, respectively. The plan was to use cable-TV networks to deliver the first fully integrated package of broadband internet access and local phone service via the cable-TV network. AT&T Could Not Handle Its Early Success During the next several years, Armstrong seemed to be up to the task, cutting sales, general, and administrative expense's share of revenue from 28 percent to 20 percent, giving AT&T a cost structure comparable to its competitors. He attempted to change the bureaucratic culture to one able to compete effectively in the deregulated environment of the post-1996 Telecommunications Act by issuing stock options to all employees, tying compensation to performance, and reducing layers of managers. He used AT&T's stock, as well as cash, to buy the cable companies before the decline in AT&T's long-distance business pushed the stock into a free fall. He also transformed AT&T Wireless from a collection of local businesses into a national business. Notwithstanding these achievements, AT&T experienced major missteps. Employee turnover became a big problem, especially among senior managers. Armstrong also bought Telecommunications and MediaOne when valuations for cable-television assets were near their peak. He paid about $106 billion in 2000, when they were worth about $80 billion. His failure to cut enough deals with other cable operators (e.g., Time Warner) to sell AT&T's local phone service meant that AT&T could market its services only in regional markets rather than on a national basis. In addition, AT&T moved large corporate customers to its Concert joint venture with British Telecom, alienating many AT&T salespeople, who subsequently quit. As a result, customer service deteriorated rapidly and major customers defected. Finally, Armstrong seriously underestimated the pace of erosion in AT&T's long-distance revenue base. AT&T May Have Become Overwhelmed by the Rate of Change What happened? Perhaps AT&T fell victim to the same problems many other acquisitive companies have. AT&T is a company capable of exceptional vision but incapable of effective execution. Effective execution involves buying or building assets at a reasonable cost. Its substantial overpayment for its cable acquisitions meant that it would be unable to earn the returns required by investors in what they would consider a reasonable period. Moreover, Armstrong's efforts to shift from the firm's historical business by buying into the cable-TV business through acquisition had saddled the firm with $62 billion in debt. AT&T tried to do too much too quickly. New initiatives such as high-speed internet access and local telephone services over cable-television network were too small to pick up the slack. Much time and energy seems to have gone into planning and acquiring what were viewed as key building blocks to the strategy. However, there appears to have been insufficient focus and realism in terms of the time and resources required to make all the pieces of the strategy fit together. Some parts of the overall strategy were at odds with other parts. For example, AT&T undercut its core long-distance wired telephone business by offers of free long-distance wireless to attract new subscribers. Despite aggressive efforts to change the culture, AT&T continued to suffer from a culture that evolved in the years before 1996 during which the industry was heavily regulated. That atmosphere bred a culture based on consensus building, ponderously slow decision-making, and a low tolerance for risk. Consequently, the AT&T culture was unprepared for the fiercely competitive deregulated environment of the late 1990s (Truitt, 2001). Furthermore, AT&T created individual tracking stocks for AT&T Wireless and for Liberty Media. The intention of the tracking stocks was to link the unit's stock to its individual performance, create a currency for the unit to make acquisitions, and to provide a new means of motivating the unit's management by giving them stock in their own operation. Unlike a spin-off, AT&T's board continued to exert direct control over these units. In an IPO in April 2000, AT&T sold 14 percent of AT&T's Wireless tracking stock to the public to raise funds and to focus investor attention on the true value of the Wireless operations. Investors Lose Patience Although all of these actions created a sense that grandiose change was imminent, investor patience was wearing thin. Profitability foundered. The market share loss in its long-distance business accelerated. Although cash flow remained strong, it was clear that a cash machine so dependent on the deteriorating long-distance telephone business soon could grind to a halt. Investors' loss of faith was manifested in the sharp decline in AT&T stock that occurred in 2000. The 2000 Restructure: Correcting the Mistakes of the Past Pushed by investor impatience and a growing realization that achieving AT&T's vision would be more time and resource consuming than originally believed, Armstrong announced on October 25, 2000 the breakup of the business for the fourth time. The plan involved the creation of four new independent companies including AT&T Wireless, AT&T Consumer, AT&T Broadband, and Liberty Media. By breaking the company into specific segments, AT&T believed that individual units could operate more efficiently and aggressively. AT&T's consumer long-distance business would be able to enter the digital subscriber line (DSL) market. DSL is a broadband technology based on the telephone wires that connect individual homes with the telephone network. AT&T's cable operations could continue to sell their own fast internet connections and compete directly against AT&T's long-distance telephone business. Moreover, the four individual businesses would create "pure-play" investor opportunities. Specifically, AT&T proposed splitting off in early 2001 AT&T Wireless and issuing tracking stocks to the public in late 2001 for AT&T's Consumer operations, including long-distance and Worldnet Internet service, and AT&T's Broadband (cable) operations. The tracking shares would later be converted to regular AT&T common shares as if issued by AT&T Broadband, making it an independent entity. AT&T would retain AT&T Business Services (i.e., AT&T Lab and Telecommunications Network) with the surviving AT&T entity. Investor reaction was swift and negative. Not swayed by the proposal, investors caused the stock to drop 13 percent in a single day. Moreover, it ended 2000 at 17 ½, down 66 percent from the beginning of the year. The More Things Change The More They Stay The Same On July 10, 2001, AT&T Wireless Services became an independent company, in accordance with plans announced during the 2000 restructure program. AT&T Wireless became a separate company when AT&T converted the tracking shares of the mobile-phone business into common stock and split-off the unit from the parent. AT&T encouraged shareholders to exchange their AT&T common shares for Wireless common shares by offering AT&T shareholders 1.176 Wireless shares for each share of AT&T common. The exchange ratio represented a 6.5 percent premium over AT&T's current common share price. AT&T Wireless shares have fallen 44 percent since AT&T first sold the tracking stock in April 2000. On August 10, 2001, AT&T spun off Liberty Media. After extended discussions, AT&T agreed on December 21, 2001 to merge its broadband unit with Comcast to create the largest cable television and high-speed internet service company in the United States. Without the future growth engine offered by Broadband and Wireless, AT&T's remaining long-distance businesses and business services operations had limited growth prospects. After a decade of tumultuous change, AT&T was back where it was at the beginning of the 1990s. At about $15 billion in late 2004, AT&T's market capitalization was about one-sixth of that of such major competitors as Verizon and SBC. SBC Communications (a former local AT&T operating company) acquired AT&T on November 18, 2005 in a $16 billion deal and promptly renamed the combined firms AT&T. -Was AT&T proactive or reactive in initiating its 2000 restructuring program? Explain your answer.

Anatomy of a Spin-Off On October 18, 2006, Verizon Communication's board of directors declared a dividend to the firm's shareholders consisting of shares in a company comprising the firm's domestic print and Internet yellow pages directories publishing operations (Idearc Inc.). The dividend consisted of 1 share of Idearc stock for every 20 shares of Verizon common stock. Idearc shares were valued at $34.47 per share. On the dividend payment date, Verizon shares were valued at $36.42 per share. The 1-to-20 ratio constituted a 4.73% yield—that is, $34.47/ ($36.42 × 20)—approximately equal to Verizon's then current cash dividend yield. Because of the spin-off, Verizon would contribute to Idearc all its ownership interest in Idearc Information Services and other assets, liabilities, businesses, and employees currently employed in these operations. In exchange for the contribution, Idearc would issue to Verizon shares of Idearc common stock to be distributed to Verizon shareholders. In addition, Idearc would issue senior unsecured notes to Verizon in an amount approximately equal to the $9 billion in debt that Verizon incurred in financing Idearc's operations historically. Idearc would also transfer $2.5 billion in excess cash to Verizon. Verizon believed it owned such cash balances, since they were generated while Idearc was part of the parent. Verizon announced that the spin-off would enable the parent and Idearc to focus on their core businesses, which may facilitate expansion and growth of each firm. The spin-off would also allow each company to determine its own capital structure, enable Idearc to pursue an acquisition strategy using its own stock, and permit Idearc to enhance its equity-based compensation programs offered to its employees. Because of the spin-off, Idearc would become an independent public company. Moreover, no vote of Verizon shareholders was required to approve the spin-off, since it constitutes the payment of a dividend permissible by the board of directors according to the bylaws of the firm. Finally, Verizon shareholders have no appraisal rights in connection with the spin-off. In late 2009, Idearc entered Chapter 11 bankruptcy because it was unable to meet its outstanding debt obligations. In September 2010, a trustee for Idearc’s creditors filed a lawsuit against Verizon, alleging that the firm breached its fiduciary responsibility by knowingly spinning off a business that was not financially viable. The lawsuit further contends that Verizon benefitted from the spin-off at the expense of the creditors by transferring $9 billion in debt from its books to Idearc and receiving $2.5 billion in cash from Idearc. -Do you believe that it is fair for Idearc to repay a portion of the debt incurred by Verizon relating to Idearc's operations even though Verizon included Idearc's earnings in its consolidated income statement? Is the transfer of excess cash to the parent fair? Explain your answer.

A parent firm's decision to sell or to retain a subsidiary is often made by comparing the after-tax equity value of the subsidiary with the pre-tax and interest sale value of the business.

The board of directors of a firm approves an exchange offer in which their shareholders are offered stock in one of the firm's subsidiaries in exchange for their holdings of parent company stock. This offer is best described as a

In a spin-off, the board of directors is the same as the board of directors of the parent firm.