Chicago Tribune: Heller College of Business professor weighs in on significance of spin offs

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Outside Opinion: The strategy behind spinoffs

Recent spinoffs have heads spinning: Why split a company in two?

By Kristin Samuelson, Tribune reporter
 
October 23, 2011

When a company seems to be performing well, why break it up? That question came up again last week, when Abbott Laboratories, which has seen double-digit bottom-line growth the last three years excluding the second quarter of 2009, announced that it is splitting into two publicly traded companies: one to focus on its branded pharmaceuticals such as rheumatoid arthritis drug Humira, and the other for its diversified medical products, which include generic drugs, diagnostic tests and baby formula.

Abbott's move puts it in the company of Kraft Foods Inc., Motorola Inc., Sara Lee Corp. and Fortune Brands Inc. — local companies that have recently decided to split up.

What is the strategy behind such a spinoff? Is it an accounting maneuver or does it create more value for the companies?
We asked Damien Conover, Abbott analyst at Morningstar Inc., and Henry I. Silverman, assistant professor of finance at the Heller College of Business at Roosevelt University.

Q: What are the pros and cons of a spinoff?

Conover: You potentially get the ability to unlock value. It provides clarity of individual units for the market to see. It opens up the strategic direction for the company. The company could lose some synergy. By having units together, they wouldn't have to endure some of the costs they will when the companies are separate. For example, certain functions that will be duplicative such as IT, executive boards, investor relations, legal teams, to some extent, and physically speaking, some geographies where the company might have to split up a building. You lose some strategic synergy, as well. A big trend right now is to develop drugs in tandem with diagnostics. So for Abbott, specifically, the new pharmaceutical group can do that, but they'll have to partner with the diagnostics team rather than have them in house.
All in all, I think the pros outweigh the cons.

Silverman: The reasons for a spinoff are usually aimed at adding value for shareholders: creating two entities that have a value greater than the original one. Companies typically do a spinoff when divisions have significantly distinct business models in terms of product mix, markets, cost structure, risk and/or prospects, with these differences limiting growth. Spinning off a division or creating a new company and depositing assets into it is intended to allow each to focus on what it does best, unencumbered by the operational, financial, investing and, possibly, management constraints of the other. That maximizes market opportunities, profits and, ultimately, shareholder value. If investors feel that business prospects are enhanced by the spinoff, they will typically bid up the price of the shares (of both companies).
There may be other financial or legal reasons for a spinoff, such as stripping underperforming or at-risk assets from an otherwise successful company, but this is not likely the case with Abbott. In the case of Kraft for example, it divided its grocery and snack businesses; the former was seen as impeding growth of the latter. An example of a spinoff for legal reasons was when Monsanto transferred liability related to PCB contamination by spinning off its industrial chemical division in '97.
Possible drawbacks are a reduction in economies of scale, including borrowing capacity (Abbott's debt has been downgraded by some rating agencies); increased risk due to lessened diversification; loss of strategic synergies; and costs to other stakeholders (for example, employees). Of course, the main risk of a spinoff is that management will have miscalculated, and one or both of the resulting companies will not perform as well as expected.

Q: In general, how successful are spinoffs?

Silverman: It depends how you define "successful." Research suggests that spinoffs are accompanied by what academics call "abnormal" positive stock market returns for the companies involved; that is, returns in excess of what one would expect given the risk, particularly immediately after the announcement of the spinoff. Longer term as well, the shares of these firms tend to outperform on a risk-adjusted basis. In this sense, spinoffs have increased the value of the company/companies. There is also evidence to suggest that firms created through spinoffs grow more consistently than other new companies.

Q: Why would a company initiate a spinoff in this economy?

Conover: There's been this growing interest by the investment community to see some assets broken off. I think as Humira has grown to be so disproportionate compared to Abbott's other assets, it has become more distracting for other assets to be noticed by investors. Also, Abbott management mentioned that the pipeline for the company four or five years ago wasn't in a great position for a pharmaceutical firm to be on its own because Humira wasn't as big then — it needed more time to develop and mature. Now the pharma firm is in a better position. By the time the pharmaceutical company is spun off, which is expected by the end of 2012, it's likely to have a strong pipeline to help complete the overall story and outlook for that firm versus just being focused on Humira. As Abbott has grown, it has put more resources behind developing the other products, so there are more diversified elements that you wouldn't have had two or three or years ago. With the spinoff, you'll see the reallocation of capital from certain product lines being reinvested.

Silverman: There is never a bad time to try to create value for shareholders, particularly when many firms are sitting on a lot of cash and see investable opportunities. The stock market has been recovering, albeit slowly, so there is the opportunity to capture productivity and profitability gains via higher share prices achieved through a spinoff.

Q: The local spinoffs tend to be consumer product companies — Kraft, Motorola, Sara Lee. Why that segment?

Silverman: Spinoffs are popular among conglomerates, which have become very large and where growth prospects are limited by their size, operating inefficiencies, internal interests competing for investable funds and sometimes legal constraints. Product manufacturers tend to have many divisions or lines, some of which are in an early stage, some mature, some profitable, others not. This creates the dynamic for a spinoff.

Q: What happens to management style after a spinoff?

Conover: The medical products group will probably retain a lot of the culture and strategy Abbott has always taken, which has a very Midwest feel to it: hardworking, innovative, and transparent communication. The pharmaceutical company will probably go down a different path.

I think the diversified Abbott will take a similar path that Abbott has taken in the past: a diversified approach, and a focus on its growth area and improving margins. In the pharma company, the pipeline's better than three years ago, but could still improve. They'll expand the pipeline and will address some of the challenges (albeit minor) it has with some patent losses. It will push through some head winds, and continue to support the Humira growth.

There will probably be further consolidation in the pharma industry, so strategically, both firms will most likely look to acquire other companies. On the pharma side, it will look to acquire in order to build up its pipeline; and on the diversified side, Abbott will look at where they're entrenched right now, so it will not be a big strategic shift.
I think this mirrors what other firms are doing that have spun off.

Silverman: As in the case of Abbott, those teams retained or hired to manage each of the companies will typically have experience and a performance record in the sector where they will be operating. In the case of repositioning existing managers, they will likely have developed their own management "style" and strategic goals in the original company and fully exercise these in the new entity.

ksamuelson@tribune.com

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