Exam 16: Alternative Exit and Restructuring Strategies

The board of directors of a large conglomerate has decided that the investment opportunities for the firm are limited and that greater value could be created for the shareholders if the firm were divided into four independent businesses. Following approval by shareholders, the firm executed this strategy which is best described as a

A business that is rich in high-growth opportunities may be an excellent candidate for divestiture to a strategic buyer with significant cash resources and limited growth opportunities.

A spin-off is a transaction in which a parent creates a new legal subsidiary and distributes shares it owns in the subsidiary to its current shareholders as a stock dividend.

The Anatomy of a Spin-Off-Northrop Grumman Exits the Shipbuilding Business _____________________________________________________________________________________________ Key Points There are many ways a firm can choose to separate itself from one of its operations. Which restructuring method is used reflects the firm's objectives and circumstances. ______________________________________________________________________________ In an effort to focus on more attractive growth markets, Northrop Grumman Corporation (NGC), a global leader in aerospace, communications, defense, and security systems, announced that it would exit its mature shipbuilding business on October 15, 2010. Huntington Ingalls Industries (HII), the largest military U.S. shipbuilder and a wholly owned subsidiary of NGC, had been under pressure to cut costs amidst increased competition from competitors such as General Dynamics and a slowdown in orders from the U.S. Navy. Nor did the outlook for the shipbuilding industry look like it would improve any time soon. Given the limited synergy between shipbuilding and HII's other businesses, HII's operations were largely independent of NGC's other units. NGC's management and board argued that their decision to separate from the shipbuilding business would enable both NGC and HII to focus on those areas they knew best. Moreover, given the shipbuilding business's greater ongoing capital requirements, HII would find it easier to tap capital markets directly rather than to compete with other NGC operations for financing. Finally, investors would be better able to value businesses (NGC and HII) whose operations were more focused. After reviewing a range of options, NGC pursued a spin-off as the most efficient way to separate itself from its shipbuilding operations. If properly structured, spin-offs are tax free to shareholders. Furthermore, management argued that they could be completed in a timelier manner and were less disruptive to current operations than an outright sale of the business. The spin-off represented about one-sixth of NGC's $36 billion in 2010 revenue. Effective March 31, 2011, all of the outstanding stock of HII was spun off to NGC shareholders through a pro rata distribution to shareholders of record on March 30, 2011. Each NGC shareholder received one HII common share for every six shares of NGC common stock held. The share-exchange ratio of one share of HII common for each six shares of NGC common was calculated by dividing HII's 48.8 million common shares (having a par value of $.01) by the 298 million NGC shares outstanding. Since fractional shares were created, shareholders owning 100 shares would be entitled to 16.6667 shares-100/6. In this instance, the shareholder would receive 16 HII shares and the cash equivalent of 0.6667 shares. The cash to pay for fractional shares came from the aggregation of all fractional shares, which were subsequently sold in the public market. The cash proceeds were then distributed to NGC shareholders on a pro rata basis and were taxable to the extent a taxable gain is incurred by the shareholder. The spin-off process involved an internal reorganization of NGC businesses, a Separation and Distribution Agreement, and finally the actual distribution of HII shares to NGC shareholders. The internal reorganization and subsequent spin-off is illustrated in Figure 16.4. NGC (referred to as Current Northrop Grumman Corporation) first reorganized its businesses such that the firm would become a holding company whose primary investments would include Huntington Ingalls Industries (HII) and Northrop Grumman Systems Corporation (i.e., all other non-shipbuilding operations). HII was formed in anticipation of the spin-off as a holding company for NGC's shipbuilding business, which had been previously known as Northrop Grumman Shipbuilding (NGSB). NGSB was changed to Huntington Ingalls Industries Company following the spin-off. Reflecting the new organizational structure, Current Northrop Grumman common stock was exchanged for stock in New Northrop Grumman Corporation. This internal reorganization was followed by the distribution of HII stock to NGC's common shareholders. Following the spin-off, HII became a separate company from NGC, with NGC having no ownership interest in HII. Renamed Titan II, Current NGC became a direct, wholly owned subsidiary of HII and held no material assets or liabilities other than Current NGC's guarantees of HII performance under certain HII shipbuilding contracts (under way prior to the spin-off and guaranteed by NGC) and HII's obligations to repay intercompany loans owed to NGC. New NGC changed its name to Northrop Grumman Corporation. The board of directors remained the same following the reorganization. No gain or loss was incurred by common shareholders because the exchange of stock between the Current and New Northrop Grumman corporations did not change the shareholders' tax basis in the stock. Similarly, no gain or loss was incurred by shareholders with the distribution of HII's stock, since there was no change in the total value of their investment. That is, the value of the HII shares were offset by a corresponding reduction in the value of NGC shares, reflecting the loss of HII's cash flows. Before the spin-off, HII entered into a Separation and Distribution Agreement with NGC that governed the relationship between HII and NGC after completion of the spin-off and provided for the allocation between the two firms of assets, liabilities, and obligations (e.g., employee benefits, intellectual property, information technology, insurance, and tax-related assets and liabilities). The agreement also provided that NGC and HII each would indemnify (compensate) the other against any liabilities arising out of their respective businesses. As part of the agreement, HII agreed not to engage in any transactions, such as mergers or acquisitions, involving share-for-share exchanges that would change the ownership of the firm by more than 50% for at least two years following the transaction. A change in control could violate the IRS's "continuity of interest" requirement and jeopardize the tax-free status of the spin-off. Consequently, HII put in place certain takeover defenses to make takeovers difficult. -Speculate as to why Northrop Grumman used a spin-off rather than a divestiture, split-off or split up to separate Huntington Ingalls from the rest of its operations? What were the advantages of the spin-off over the other restructuring strategies.

Why do businesses that have been spun off from their parent often immediately put antitakeover defenses in place?

In an equity carve-out, minority shareholders are eliminated.

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. -AT&Toverpaid for many of its largest acquisitions made during the 1990s? How might this have contributed to its subsequent restructuring efforts?

Empirical studies show that the desire by parent firms to increase strategic focus is an important motive for exiting businesses.

In a spin-off, some shareholders receive proportionately more shares than others.

What factors influence a parent firm's decision to undertake a spin-off rather than a divestiture or equity carve-out?

A substantial body of evidence indicates that increasing a firm's degree of diversification can improve substantially financial returns to shareholders.

How might spin-offs result in a wealth transfer from bondholders to shareholders?

What are the advantages and disadvantages of tracking or target stocks to investors and to the firm?

Which of the following is not true of an equity carve-out?

USX Bows to Shareholder Pressure to Split Up the Company As one of the first firms to issue tracking stocks in the mid-1980s, USX relented to ongoing shareholder pressure to divide the firm into two pieces. After experiencing a sharp "boom/bust" cycle throughout the 1970s, U.S. Steel had acquired Marathon Oil, a profitable oil and gas company, in 1982 in what was at the time the second largest merger in U.S. history. Marathon had shown steady growth in sales and earnings throughout the 1970s. USX Corp. was formed in 1986 as the holding company for both U.S. Steel and Marathon Oil. In 1991, USX issued its tracking stocks to create "pure plays" in its primary businesses-steel and oil-and to utilize USX's steel losses, which could be used to reduce Marathon's taxable income. Marathon shareholders have long complained that Marathon's stock was selling at a discount to its peers because of its association with USX. The campaign to split Marathon from U.S. Steel began in earnest in early 2000. On April 25, 2001, USX announced its intention to split U.S. Steel and Marathon Oil into two separately traded companies. The breakup gives holders of Marathon Oil stock an opportunity to participate in the ongoing consolidation within the global oil and gas industry. Holders of USX-U.S. Steel Group common stock (target stock) would become holders of newly formed Pittsburgh-based United States Steel Corporation, a return to the original name of the firm formed in 1901. Under the reorganization plan, U.S. Steel and Marathon would retain the same assets and liabilities already associated with each business. However, Marathon will assume $900 million in debt from U.S. Steel, leaving the steelmaker with $1.3 billion of debt. This assumption of debt by Marathon is an attempt to make U.S. Steel, which continued to lose money until 2004, able to stand on its own financially. The investor community expressed mixed reactions, believing that Marathon would be likely to benefit from a possible takeover attempt, whereas U.S. Steel would not fare as well. Despite the initial investor pessimism, investors in both Marathon and U.S. Steel saw their shares appreciate significantly in the years immediately following the breakup.: -Why do you believe U.S. Steel may have decided to acquire Marathon Oil? Does this combination make economic sense? Explain your answer.

Why would the U.S. Internal Revenue Service be concerned about a change of control of the spun-off business such that it might revoke its ruling that the spin-off satisfied the requirements to be tax-free?

Which of the following is a common problem associated with tracking stocks?

A spin-off is a transaction involving a separate legal entity whose shares are sold to the parent firm's shareholders.

Management may sell assets to fund diversification opportunities?

Spin-offs are generally immediately taxable to shareholders.