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Sales, spins and splits — what are the differences and why do they matter for investors like us?

Published

5 months ago

April 30, 2023

Johnson & Johnson (JNJ) — an iconic, 136-year-old American enterprise — will soon reshape itself, separating its division that makes Tylenol, Band-Aids, and other consumer health products into a standalone public company. The Club holding’s upcoming transaction highlights an advantageous tool that management teams can use to boost shareholder value: divestitures. In recent years, other Club holdings have gone through the process of divesting a unit, including Honeywell (HON) and Eli Lilly (LLY). Danaher (DHR) has completed them, too, with another one on the horizon this year. The motivations for divestitures, or business separations, can vary. But in many cases an overarching benefit for parent companies — the entities letting a unit go — is they can become a more focused, easier-to-manage organization, concentrating on doing fewer, high-impact things well. Over time, that can be good for their remaining shareholders because management teams marshal their energies and investments into core businesses. In some instances, the parent companies, or RemainCos as they are called, may be able to shake what’s known as the conglomerate discount — the idea that complicated firms with disparate businesses are worth less than the sum of the parts. To be sure, it doesn’t always work out well for shareholders in the RemainCos or the newly created entities, often referred to NewCos or SpinCos. Some separations can be misguided, complex or poorly timed, contributing to less-than-ideal stock market performance. Case in point, British drugmaker GSK’ s separation of its consumer-health unit, Haleon, started to gain traction after its completion last summer , but that took some time. The Club understands the specific circumstances surrounding divestitures matter when determining whether shareholders should rally behind management’s decision to pursue the transaction. In general, though, we like divestitures in situations when it’s clear the parent company will achieve a streamlined focus, enabling corporate leaders to lean into what’s best for their respective companies and maximize their potential without the added distractions of those prior units with diminutive synergies. Defining divestitures At a high level, the term “divestiture” broadly refers to when a company removes one or more of its existing businesses — whether a division or a subsidiary — from the larger enterprise. Sales are by far the most popular type of divestiture, accounting for roughly 95% of total activity, according to Wharton School management professor Emilie Feldman, whose research focuses on corporate restructuring. Spin-offs are the second-most common type of divestiture activity, according to Feldman. In a spin-off, the parent company establishes a standalone entity for a business unit, or units, and then distributes equity in that new firm to its existing shareholders on a proportional basis. Investors may get one share in the spun-out entity for every share of the parent company they owned. The distribution terms aren’t always one-for-one. Once a spinoff transaction is complete, parent company shareholders will see in their brokerage accounts that they now own pieces of two different firms. No action is necessary for them to obtain ownership of the SpinCo. For example, in October 2018, Club holding Honeywell spun off its home-technology unit and automotive equipment division into two distinct companies, Resideo Technologies (REZI) and Garrett Motion (GTX), respectively. In those instances, investors received one share of Resideo for every six shares of Honeywell stock they owned. For Garrett Motion, the distribution terms were one-for-10. Jim Cramer’s Charitable Trust owned Honeywell into both of these spin-offs, but opted to sell its Resideo and Garrett Motion shares upon receiving them due to a belief that the two companies had very low fundamental value. We would hold onto the SpinCo if we held a positive view of the newly created entity — that’s how you capture the upside of a spin. In the Honeywell case, we believed the spin-offs created more value for the parent than the children. Shares of Resideo and Garrett Motion have dropped nearly 40% and 50%, respectively, since they started trading in late 2018. Honeywell shares, meanwhile, have an annualized return of 9.5% over the past five years, according to FactSet. Conversely, in a type of divestiture known as a split-off, parent company shareholders get to decide about ownership. In split-offs, investors are given the option to exchange their shares in the RemainCo for shares of the new standalone entity. Hypothetically, an investor with 100 shares in the parent company can choose to own zero stock in the split-off firm, perhaps determining that its investment prospects are lacking and sticking with the parent is the best way to go. They can also choose a partial exchange – electing to receive, say, 20 shares in the split-off company and keeping 80 shares of the parent. The final possibility is relinquishing all their ownership in the parent for a 100-share stake in the split-off company. For the parent companies themselves, split-offs represent tax-efficient ways to reduce their outstanding share count. In both spin-offs and split-offs, the transaction does not generate money for the new standalone entity. However, parent companies can use what’s known as an equity carve-out to raise capital while divesting a business unit. In this kind of divestiture, the parent company will sell shares in its new standalone firm to investors through an initial public offering, generating proceeds that can be divided among the entities. In some cases, only a small piece of the new company will be sold in an initial public offering (IPO), with the parent firm retaining majority ownership; this is Johnson & Johnson’s approach with its consumer health unit Kenvue, which kicked off its IPO roadshow this past week . The RemainCo, which will keep the Johnson & Johnson name, will be made up of the pharmaceuticals and med-tech units. J & J aims to raise some $3.5 billion on that Kenvue IPO, and then possibly monetize its remaining stake over time by strategically selling shares to raise cash. It’s worth noting: That approach can be perceived as a negative overhang on the SpinCo’s stock because it means a big seller is lurking on rallies. Other ways to complete the separation include distributing shares in the new publicly traded entity to existing shareholders on a proportional basis, in a process that mirrors a standard spin-off or offer a share exchange, just like in a split-off. Club holding Eli Lilly’s divestiture of animal health unit Elanco utilized the latter strategy. In September 2018, the Indianapolis-based pharmaceutical giant sold just under 20% of Elanco in an IPO that raised $1.7 billion . The full separation was completed in March 2019, when Eli Lilly shareholders who took part in the exchange received roughly 4.5 shares of Elanco stock for each share of Eli Lilly common stock they owned. Shares of Eli Lilly notched a fresh all-time high Friday, breaking above $400 each intraday. Elanco shares have struggled since their debut. After finishing its inaugural session $36 each, the stock is down more than 70% as of Friday’s close. Rationale for spins, sales, splits As Eli Lilly sought to narrow its focus on human pharmaceuticals, the company considered an outright sale of Elanco before settling on the partial-IPO, share-exchange approach. Lilly chose that two-step transaction because it “maximized” the “after-tax value” for shareholders, CEO Dave Ricks said at the time. “In these situations where companies are likely to incur a large tax bill from the sale of one of their businesses, oftentimes they’ll use spinoffs instead because they can help mitigate some of that tax burden,” Feldman said, assuming several requirements are met including relinquishing at least 80% of voting shares in the transaction. A large tax bill could be incurred when the parent company has owned the subsidiary for a long time and, therefore, has a low tax basis. With Elanco, the animal-health firm had been inside Eli Lilly since its founding in 1954 — a classic situation where Lilly selling the company for cash likely would’ve led to a sizable capital gains tax bill. Feldman said the wave of spinoffs in the technology industry in 2015 are also prime examples in which tax considerations influenced the way businesses were divested. In that year, eBay (EBAY) spun off its payment processing unit, PayPal (PYPL), and then-Hewlett Packard separated its corporate software and hardware divisions into a new company called Hewlett Packard Enterprise (HPE) and kept its imaging and printing businesses in the renamed HP Inc. (HPQ). While taxes are a big focus on the financial side of divestitures, Feldman said the strategic considerations on a sale versus spin-off are a bit more nuanced. “Let’s say you have a company that just has a very well-defined business unit operating in one particular industry that just doesn’t fit with what the rest of the company is doing. Yes, you could sell it to another company but oftentimes – and especially if it’s of scale, if it’s big enough – that entity could stand on its own as an independent company. From that perspective, spin-offs become pretty appealing.” Club holding Danaher’s plans to separate its Environmental and Applied Solutions unit into its own freestanding company in the fourth quarter of this year — instead of searching for an independent buyer — reflects that thinking, Feldman said. Danaher’s EAS division, which will be called Veralto Corp., generated $4.8 billion in revenue in 2022 and has 16,000 employees of its own. Laura Born, a finance professor at the University of Chicago’s Booth School of Business, said the overall quality of the entity being divested may influence which type of transaction the parent company chooses. The broader state of capital markets activity also factors in, according to Born, a former investment banker who spent 16 years at JPMorgan and worked on numerous divestitures. In the current frosty IPO environment, Born said it seems that higher-quality assets are being spun off more than in years past. But, in normal market conditions, she said slower-growing entities that “aren’t as exciting” are prime candidates for a pure-play spin, referring to those transactions where 100% of the division is distributed essentially overnight. On the other hand, Born said faster-growing divisions – particularly those that could use additional capital to fuel expansion — are ideal candidates to be divested through an IPO. A classic example is McDonald’s (MCD) divestiture of its Chipotle stake in 2006, Born said. McDonald’s, once Chipotle’s majority shareholder, spun off a part of its stake in Chipotle in an IPO, then later completely divested through a share exchange. Chipotle Mexican Grill (CMG) and McDonald’s both hit all-time highs in Friday’s session. The fast casual burrito chain has a nearly $57 billion market value, while MCD’s market cap stands at around $219 billion. “We IPO things that are growing and can attract new capital, whereas a pure, 100% spin from Day One is usually a slower growth, or not core, asset,” Born said. At least from an investment banking perspective, she said, one phrase that’s been developed over the years is, “Spin the dogs. IPO the stars.” Resideo, for example, falls into the dog category. Chipotle stands out as a star. What shareholders should consider Now, let’s think about it from the perspective of a shareholder in a company that’s divesting a division or subsidiary. The Club is usually pleased to be in that position — as we are now with J & J and Danaher — and the general reason comes down to improving management’s ability to make the company more valuable in the eyes of Wall Street. In the case of both J & J and Danaher, this should occur as each management team is able to focus its time and resources on the more simplified companies with better growth profiles. In both instances, the businesses being divested are slower-growing assets.J & J’s consumer health products arm and Danaher’s water quality unit. What’s left of J & J will be focused on pharmaceuticals and medical technologies, which were responsible for over 84% of the company’s total 2022 revenue of $94.94 billion. Management says they make sense under the same roof because they serve similar end markets and operate in a similar competitive and regulatory landscape. Danaher is becoming a company even more concentrated on life sciences end markets, such as biopharmaceuticals, and its diagnostics business. In recent years, Danaher shed its industrial technology unit, executing a pure-play spin in 2016 to create a separate public company called Fortive (FTV), and completed a partial IPO, then share exchange of its dental business, Envista (NVST), in 2019. Ironically, Fortive was the other major bidder for National Instruments (NATI), which eventually completed a deal to be sold to Club holding Emerson Electric (EMR). It underscores that once free of the parent company tethers a divested company can chart its own destiny. Danaher’s playbook has usually been to raise cash through a partial IPO before completing the full divestiture. In the past, this has strengthened its financial position and often proceeded other major transformations. In February 2019 , Danaher announced its acquisition of GE Life Sciences , about six months after publicly embarking on plans to divest Envista. Wharton’s Feldman said it is difficult for management teams to manage multi-business firms with divisions “operating in, and moving in, potentially completely different directions.” The implication for investors in companies of that nature? The current corporate structure may leave shareholder value on the table. But after a hypothetical spin-off, “you have these business units that now can get what they need on their own. Business Unit A can operate freestanding and have its own operations, same with Unit B,” said Feldman, whose book, “Divestitures: Creating Value Through Strategy, Structure, and Implementation,” was published in late 2022. “There’s no internal competition between them within that same corporate household [over] what they have to get, perhaps, at the expense of the other.” In the context of Johnson & Johnson, its leadership has been required to weigh the competing interests of three divisions — which Jim and the Club believe has led to under-management in recent years. Perhaps smaller, yet beneficial deals for the consumer health business weren’t pursued because management preferred to focus its merger and acquisition (M & A) resources on medical devices while also investing in pharmaceutical research and development. This happened late last year when J & J agreed to buy heart pump maker Abiomed for $16.6 billion , looking to operate the company as part of its med-tech division. Those priorities may not have necessarily been wrong when considering J & J as the overall enterprise. But the upcoming separation is designed to eliminate that predicament altogether. Investors who believe management can more effectively lead streamlined organizations are likely to view a parent company more favorably after a divestiture, positively impacting the way they value its stock. At the core of that dynamic is what’s known as the diversification discount, or conglomerate discount. As mentioned earlier, this decades-old idea posits that the whole enterprise is worth less than the sum of its parts would be on their own. According to Feldman, research has consistently found that discount to be between 13% to 15%. This means that if those business units were all valued independently, that total value would be between 13% and 15% more than the current market value of the whole enterprise. Feldman’s own research has found the valuation gap to be even larger when a company’s disparate businesses have divergent financial characteristics, such as growth rates and profitability levels. “These companies where there is a diversification discount … are exactly the ones that should be doing divestitures to rectify this problem, or this discount that they’re experiencing,” Feldman said. Bottom line The Club agrees. Our overall understanding of those dynamics explains why we often view divestitures such as spin-offs favorably. Of course, a parent company that’s divesting a unit is not guaranteed to be a great investment. That hard reality has been on display with troubled Club holding Bausch Health (BHC) and the mismanaged equity carveout of its eye-care unit Bausch + Lomb (BLCO). But there are ample examples of addition by subtraction in the history of corporate divestitures. We believe J & J and Danaher are poised to deliver two more examples. If we had our way, once Honeywell’s CEO transition is finalized this summer, the industrial conglomerate would be next. Conglomerates were popular decades ago, but companies today have learned that being leaner and more agile is often a better way to go. Investors have come to similar realizations, which is why they are usually unwilling to pay top dollar for large, complex companies with businesses all over the map. While each transaction needs to be evaluated on its own merits, the Club has come to recognize that sometimes, less is more. (Jim Cramer’s Charitable Trust is long LLY, HON, BHC, DHR and JNJ. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

Johnson and Johnson hygiene products for sale in a supermarket in Madrid, Spain.

Cristina Arias | Cover | Getty Images

Source: CNBC

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