CORPORATE DIVESTITURE



Corporate Divestiture 556
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Divestiture involves the disposal of an ownership interest in a company or subsidiary in exchange for other forms of assets. Divestiture may be a voluntary act effected to raise money, stem operating losses, or reorganize a corporation. It also may be compulsory, where a government or regulator demands a divestment to achieve a public policy goal under the threat of legal action.

Companies usually divest themselves of subsidiary business units because the capital invested in that operation could be more wisely employed somewhere else. These disposals are frequently carried out under the authority of a board of directors, and usually do not require the express consent of shareholders.

Where the owner is not a corporation, but an investment trust, the investor may elect to divest the trust of a certain asset because that asset is performing poorly or is engaged in activities tat are opposed by the investor. Divestiture allows the owner to undertake a more beneficial employment of assets by making them transferable.

Corporate laws and regulations provide few barriers for divestment, except when it is related to fraudulent or anticompetitive activity. The ability to convert an investment into a transferable asset benefits owners tremendously by allowing their capital to be employed with optimal efficiency.

BASIC PRINCIPLES

The basic concept of divestiture is as old as trade itself, but corporate divestiture as a principle has a relatively brief history. This is because the procedures involved developed out of modern forms of legal incorporation. Any company endowed with a certain asset maintained an ownership right that entitled it to employ that asset any way it chose, including financial disposal or divestment.

For example, a railroad line might purchase a coal mining company to provide a direct source of fuel for its fleet of locomotives. But with development of more efficient diesel engines, the value of that mine becomes seriously eroded. As the railroad replaces its steam engines with diesels, it has no use for its coal, except to sell it to someone else. Thus, it faces a crucial decision of whether to sell the mine or hold on to it and enter the coal supply business.

If the company decides that it could not compete effectively with other coal producers, and should remain only a railroad, it might choose to divest itself of the mine. If this were the case, the railroad would begin negotiations with potential buyers.

As an operating subsidiary of the railroad, the mine may be worth $2 million. But one potential buyer, another coal company, offers $2.5 million for the mine. A second buyer, a steel mill, offers $2.8 million. This illustrates a necessary motivation for divestment: a difference in valuation among the parties. In this case, the steel mill wins the competition and agrees to take over the railroad's mine for payment of $2.8 million.

A somewhat more complex scenario arises if the coal company offers only $1.5 million for the mine, and the steel company's top bid is $1.8 million. Again, there is a difference in valuation, but the railroad would incur a loss from the sale.

Under these circumstances, it might choose to go ahead with the sale anyway, because it could employ the $1.8 million offered by the steel mill to increase its profitability in other ways. It could use the proceeds of the sale to upgrade its facilities and purchase new diesel engines. This might enable the railroad to derive additional efficiencies from its existing operation that might be valued at $1 million. Despite the loss of $200,000 on the sale of its mine, the railroad stands to gain a net profit of $800,000.

These examples demonstrate the most common reasoning behind the divestiture of certain assets where a justification lies in increased economies of scale and economies of scope. The steel mill clearly could make better use of its coal mine in its own operations than could the railroad, and this is reflected in the valuation.

Divestiture may result from instances where anticipated synergies do not result. Although related to the concept of economies of scale, synergistic combinations attempt to translate product-specific technologies to entirely different markets.

For example, a manufacturer of military aircraft may purchase a company operating at a loss whose primary business is building business jets and other civilian aircraft. The justification for such an acquisition is that the company's engineering expertise from building fighter jets could be applied to design better, and therefore more profitable, airplanes for the private market.

But in practice, the company discovers that its primary strengths with military aircraft, such as high-speed maneuverability and radar-evading designs, provide no marketable benefit to private aircraft. As a result, the company is unable to apply the benefits from its most valuable military technologies to the civilian aircraft market.

In this case, the company's military and civilian aircraft enterprises remain divorced, each with distinctly separate engineering requirements, cost structures, and markets. Since no benefit can be derived from the combination, the company may elect to divest the civilian aircraft operation. With the proceeds, it might purchase another company that will benefit more from an association with the core business.

Divestiture also may be advantageous where business cycles are involved. For example, a paper and lumber company gradually diversified its operations to include certain types of specialty chemicals. This sideline provided the company with a valuable source of income from an operation that was well-insulated from the business cycles in the paper and lumber markets. When paper and lumber were unprofitable, the successful chemicals enterprise provided earnings stability, and by the time chemicals declined, paper and lumber had recovered to take its place.

But two dissimilar business cycles will not always coincide so conveniently. At one point, assume chemical operations became unprofitable well before demand for paper and lumber could recover. The company might decide to divest the chemical operations to stem its financial losses and even provide capital to pay off whatever debt it may have incurred to keep the company solvent.

If the company simply cannot afford to run the division any longer, its only option is to divest quickly. The paper company would be forced to sell the chemicals division at a substantial loss, because the chemicals market is at the low point of its cycle.

As a result, the purchaser of the chemical division can assume control of it at a very low cost. Eventually, the demand for chemicals will recover and the division will become profitable again. Accordingly, the value of the operation increases. If the valuation continues to grow, the new owner may elect to sell the operation, if only to realize a profit before the cycle turns down again.

Both instances illustrate the motivation behind a divestment due to circumstances solely attributable to business cycles. The same dynamic also applies to the cycles that govern individual products and product lines.

In some cases, a company may choose to divest itself of completely unrelated divisions because the parent company's management believes it can no longer administer them efficiently.

For example, a manufacturer of aluminum diversifies into a variety of final products, including outdoor structures, automotive assemblies, household appliances, and missiles. The only thing that each of the four divisions has in common is that its products are constructed of the parent company's aluminum. As a result, each division builds unique administrative organizations and cultures based on their different markets. In effect, they function as completely different enterprises.

These differences would be amplified if the parent company were to lose its competitive advantage in aluminum production. In this instance each of its units would be better off purchasing aluminum from competitors. If the parent company were to exit the aluminum business, it would remain in charge of four functionally disparate companies.

Management at this point might ask whether this represents an appropriate distribution of its assets. It might identify one or two business units for divestment, based on which unit would provide the lowest earnings, relative to its worth. The company then could use the proceeds of the sales to make additional investments in the remaining businesses it felt it could operate best.

Divestment, coupled with acquisition, provides an effective means for a company to discover unanticipated economies and synergies through trial and error. A company whose core skills lie in financial control and administrative consolidation might strive to assemble a fully diversified conglomerate.

In this case, the company's mission is to assemble unrelated businesses, in the hope that their profitability can be restored through restructuring or that their combination might provide some unforeseen benefit. When a division fails to deliver such benefits, its parent company might choose to divest itself of the operation and try again with another type of company.

Some companies may not feel compelled to divest underperforming divisions because there is inadequate pressure from the company's owners to maximize the company's profitability. The primary motivating factor in this resistance lies in the financially irrational concept of empire building, where sheer size and diversification feed the egos of management.

This situation usually persists until a group of activist shareholders can persuade the company's management—usually through proxy battles—to consider divestiture of these assets.

The awarding of substantial stock options to company management serves to more closely align the interests of management with interests of shareholders. In addition to merely drawing a salary from the company, these managers would become significant shareholders who would benefit from the greater profitability that a divestiture might create.

During the 1980s, the concept of the leveraged buyout (LBO) was propelled by the potential value of divesting undervalued operations. Several corporations progressed to a point where each operating unit was unable to compete efficiently in its respective markets. This depressed the value of these corporations and made them targets of raiders who financed, or leveraged, bids for these companies with the companies themselves as collateral.

These raiders understood that such companies were comprised of several divisions that, if sold separately to others—even their own competitors—could exact a total selling price well in excess of the total company's market value. By divesting certain operations, the raiders could raise funds to pay off the often substantial loans that were needed to launch the LBO in the first place.

For example, an underperforming company with ten divisions might be acquired for $500 million, financed by banks or other investors. Six of these divisions are sold for $350 million. These funds are immediately transferred to the lenders, reducing the debt to $150 million, and cutting the amount of payments on the company's debt by 70 percent.

However, the remaining four divisions have a market value of $300 million. The raider can sell the company at this amount and take a $150 million profit, or use the profits from its remaining operations to pay down its debt over a period of, say, three years. At the end of that term, the company might be sold for $300 million, all of which would be profit.

Often the managers of potential takeover targets recognize the precarious position their companies are in and initiate divestments to raise the market value of their companies. This, it is hoped, would discourage others from launching LBOs that could cost them their jobs. They do exactly what a raider would do, but they do it before losing control of their company to a raider. In both instances, the owner benefits, whether the owner is a corporate raider or a group of shareholders.

Because managers often are in the best position to understand the state of their company, they themselves may opt to purchase the company from shareholders, in effect, launching their own LBO. These management buyouts take many forms: they may involve the entire company, or just a single division of it.

To illustrate this, assume a group of managers arranges financing to offer shareholders $600 million for the same underperforming ten-division company. At this price, shareholders may realize an immediate 20 percent premium on the market value of their shares. If the shareholders can be convinced to sell at this price, the managers would take control of the company and initiate the same divestments described earlier. Again, the managers are acting the same way as a raider, only it is they, as owners, who benefit from the divestiture.

But if a group of managers within one of the company's ten divisions believes it can administer the operation more efficiently than the parent company, they might arrange financing to purchase only that division from the parent company. If the managers can offer a price for the division that is greater than the company's valuation of it, the company may elect to divest the operation.

TYPES OF DIVESTITURES

Divestitures take several distinct forms, based on the nature of the exchange of assets and the relationship between the buyer and seller. Because these forms have subtle differences, the terms used to describe them are frequently used incorrectly.

The most common term, used to describe the most common form of divestiture, is the sell-off. Here a company agrees to sell one of its divisions, as an individual enterprise, to another company. The defense industry has provided several examples of sell-offs in recent years.

General Dynamics, a maker of nuclear submarines, battle tanks, and aircraft, decided to exit the military aircraft portion of its business in 1993. This operation was centered at a single plant, the Convair works in Fort Worth. It found a buyer in Lockheed, a military aircraft manufacturer that was better structured to profitably operate the Fort Worth facility. In exchange for the plant, Lockheed paid a single amount in cash to General Dynamics. Lockheed eventually merged with Martin Marietta in 1995, but in another divestiture sold its interest in Lockheed Martin to Martin Marietta in 1996. This action by Lockheed allowed Martin Marietta to use the stock to make additional acquisitions.

A second type of divestiture is the spin-off. Here, a company divests itself of a part of its operations by replacing its existing shares with two or more classes of shares, representing the new, independent operations.

Morton Thiokol, a manufacturer of chemicals, salt, and rocket motors, executed a spin-off when it divided its operations into two companies in 1990. Shareholders exchanged shares in Morton Thiokol for an equivalent value of shares in the two new companies, Morton International and Thiokol, Inc. Thiokol's performance since the split has improved, partially due to its 1995 acquisition of a majority interest in Howmet, maker of blades for jet engines and gas turbines. In May 1998 Thiokol was renamed Cordant Technologies Inc.

The most celebrated spin-off occurred in 1984 when, under antitrust pressure from the U.S. Department of Justice, AT&T was forced to divest its 22 local Bell operating companies. Shareholders were issued new shares in AT&T, which retained its long distance, manufacturing, and research divisions. As of the late 1990s, those shareholders also held stock in eleven new companies, including Ameritech, Bell Atlantic, BellSouth, Lucent Technologies, Pacific Telesis, Nynex, Southwestern Bell, SBC Communications, and US West as a result of that spin-off.

In both examples, there were no buyers and sellers. Shareholders were compensated with new shares, and no money changed hands. In 1998 Michael Noer speculated in Forbes that the same type of spin-off could happen at Microsoft if the U.S. government won its antitrust case against the software giant.

In some cases, a company may choose to create a divestment by offering partial equity in its subsidiaries. For example, General Motors Corp. offers two classes of stock shares—Class A for its core automotive operations and Class H for its GM Hughes Electronics group.

The company maintained a majority stake in Hughes but allowed a minority of those shares to trade independently of General Motors Class A. If at some point, for example, GM elected to divest most or all of its interest in Hughes, it could merely sell its shares in that company to a buyer or to the general population of shareholders. The exchange would be made between GM and the buyer on the basis of money for shares.

Another form of divestment, described earlier, is the management buyout. Union Carbide, a diversified manufacturer of industrial chemicals and plastics, operated a small consumer products group. In 1989 Union Carbide announced its intention to sell the consumer group in order to focus on improving the performance of its core operations. A group of managers organized financing, some of which was provided by Union Carbide, to make the division an independent company, now called First Brands Corp.

In this instance, the buyer was a group of managers, and the company was compensated with both cash and shares. Union Carbide gradually reduced its equity interest in First Brands by later selling its shares in the company.

Asset trades constitute a fifth form of divestment. Telephone companies have been known to divest of certain service territories with asset trades. For example, a company that has operations centered in Louisiana, but which operates telephone franchises in Ohio, might benefit from trading its operations in Ohio to a company whose business is stronger in that state. In return, the Ohio telephone company offers operations it has in Louisiana as payment.

In this case, both companies are buyers as well as sellers. Payment is in the form of barter, where each company's divestment is the other's acquisition.

The final form of divestment involves total liquidation, where all of a company's divisions are sold off or its operations are wound down and the assets sold for cash. In 1990 Eastern Airlines fell into such a deep financial morass that it was forced to close down. The company's debts far outnumbered its assets. A court ordered the liquidation of the company to provide at least partial settlement for its liabilities.

The company's aircraft, facilities, routes, and even its venerable name were divested. A shell corporation remained in place only to administer the divestiture of assets. In this case, there were many buyers, and payment was strictly in cash.

Regardless of the form or the specific motivations behind it, a divestiture is almost always undertaken to do one thing: maximize the value of invested capital. It provides an exit mechanism to convert invested capital back into a negotiable form of assets, usually cash, shares, or some other debt instrument. These assets, freed of their previous application, can then be applied to some new form of investment.

SEE ALSO : Divestment

[ John Simley ,

updated by Wendy H. Mason ]

FURTHER READING:

Baumol, William J., and Alan S. Blinder. Economics: Principles and Policy. 2nd ed. New York: Harcourt Brace Jovanovich, 1982.

Chakravarty, Subrata N. "Thiokol Needed a Booster." Forbes, 21 September 1998, 204.

Cornell, Joseph W. Spin-off to Pay-off: An Analytical Guide to Investing in Corporate Divestitures. New York: McGraw-Hill, 1998.

General Dynamics. Fort Worth Division. Continuing the Tradition: 50 Years of Building the Best. Fort Worth: General Dynamics, 1992.

"Morton Thiokol Completes Spinoff." Journal of Commerce, 6

July 1989.

Noer, Michael. "Breaking Windows." Forbes, 2 April 1998.

Sadtler, David, Andrew Campbell, and Richard Koch. Breakup!: How Companies Use Spin-Offs to Gain Focus and Grow Strong. New York: Free Press, 1997.

Smith, Rod. "Lockheed to Sell Its Majority in Martin Marietta." Feedstuffs, 26 August 1996, 8.

Vogel, Todd, and Leah J. Nathans. "First Brands: Anatomy of an LBO that Worked." Business Week, 4 December 1989, 104.

Von Brachel, Jessica Skelly. "A High-Stakes Bet that Paid Off." Fortune, 15 June 1992, 121-22.



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