By Toby Sterling
AMSTERDAM (Reuters) – The days of the European conglomerate may be numbered, as activist shareholders are pressing diversified groups to spin off secondary businesses and focus on doing one thing well.
Many investors and analysts – and some managers – say that in a world where good returns are hard to come by, breaking up businesses that don’t belong together can be profitable.
In theory, spinning off business divisions allows the parent company and the spin-off alike to focus better on their respective strategies, while investors tend to value both more highly due to greater transparency.
“I think demergers and the destruction of conglomerates is the next major trend in the M&A market,” said Christer Gardell, co-founder of Cevian, a Swedish-based activist investment fund.
“The trend has already started, it’s going to run for the next 10 years,” said Gardell, who is pushing Swiss-Swedish engineering giant ABB <ABBN.S> to spin off its power grid equipment division from its robotics and other operations.
While some conglomerates such as ABB are trying to hold their businesses together, others are embracing the trend either under pressure from investors or even willingly.
A wave of spin-offs through initial public offerings (IPOs) among energy and industrial groups is already underway. Philips <PHG.AS> of the Netherlands, Fiat Chrysler <FCHA.MI> of Italy and Germany’s biggest energy groups E.ON <EONGn.DE> and RWE <RWEG.DE> have all floated major divisions this year. German engineer Siemens <SIEGn.DE> has announced similar plans.
Companies with many business lines are “mostly too complicated, too bureaucratic, too slow, and they usually suffer from poor capital allocation and poor performance”, Gardell told Reuters. “Obviously for investors to invest in these complicated structures, they require a discount, and usually it’s a significant discount.”
Remove these obstacles, and the need for a discount will fade, Cevian argues. It says ABB shares, which are below 21 Swiss francs, would be worth 35 francs if its separate business arms traded in line with listed peers.
ABB disagrees that it power grids business should be spun off. “As part of the strategic review process, we examined all options for the division. The outcome of the review was clear that the most value would be created through the continued transformation of Power Grids under ABB’s ownership,” spokesman Saswato Das said.
Not every spin-off works out for shareholders. However, a JPMorgan study in 2015 of spin-offs in the United States, where the trend began earlier than in Europe, appears to support Gardell’s arguments in general.
It found that U.S. shares typically rose a relatively modest 2-4 percent against the S&P 500 average when a spin-off was announced. But over the next two years, the combined value of the parent company and its spin-off rose 15-20 percent – with the relative values of both usually rising.
Marc Zenner, one of the study’s authors, said this U.S. data would show activist investors that there is also potential across the Atlantic to create value through spin-offs. “In Europe one reason why you could see more in the future is that there are more conglomerate companies there,” he said.
Conglomerates have lasted longer in Europe due to a mix of factors that can insulate managers from unhappy shareholders. These include “poison pill” rules to discourage hostile takeovers and higher levels of family ownership.
Some countries also have laws stipulating that managers must consider the interests of employees and other groups along with those of shareholders.
Some firms are willing to accept limited change. One such is German industrial group ThyssenKrupp <TKAG.DE>, which is in talks to merge its struggling European steel business with that of India’s Tata Steel <TISC.NS>.
However, ThyssenKrupp has so far resisted calls to isolate its most profitable business, making elevators. It also sells car parts, and engineers military ships and chemical plants. The company announced worse than expected profits for 2016last week and a gloomy outlook for 2017, which analysts said strengthens the case for a breakup.
MANAGEMENT FOCUS OR INVESTOR TRANSPARENCY?
Advocates argue that spin-offs do better because smaller companies have a stronger focus and their chiefs have a greater incentive to succeed than division heads. But for investors, the biggest benefit seems to be increased transparency.
“When (spin-offs) do work, it is more often the market valuing the standalone business more accurately than a stronger clarity of focus by management,” said Drew Dickson, managing director of Albert Bridge Capital.
Dickson doesn’t look for breakup candidates as a strategy. But he said revaluation paid off for one of his firm’s investments, Fiat Chrysler, after the group floated its Ferrari sportscar division in October 2015. “The market knew that Ferrari was valuable, but only could answer the question (of how valuable) once it was standalone,” he said.
Under the deal, Fiat Chrysler shareholders were handed an 80 percent stake in Ferrari <RACE.MI> <RACE.N> in January. While the parent company’s shares are down 13 percent year to date, the value of their Ferrari stock is such that investors who held onto both have made a gain of roughly 60 percent.
However, the jury is still out on strategies adopted by the German power companies, which are under pressure from government-subsidized wind and solar electricity.
E.ON spun off its fossil fuel operations into Uniper <UN01.DE>, while RWE carved out its green energy operations as Innogy <IGY.DE> in an IPO, while still holding a controlling stake.
Both parent companies have lost around 60 percent of their value over the past five years. Uniper and E.ON, if still regarded as one unit, would be up 1.2 percent since they started trading separately in September. RWE is down 12.5 percent since Innogy listed in October.
Philips CEO Frans van Houten is an example of a manager who has embraced the spin-off trend. In May, the group floated Philips Lighting <LIGHT.AS>, its original business dating back to 1891, allowing the parent to focus on healthcare equipment.
Both divisions were “great opportunities with a lot of room to grow (but) both required investment; the commonality was minimal other than the Philips brand,” Van Houten told Reuters.
Proceeds from the IPO will be reinvested in the high margin health operations while the spin-off, the world’s largest lighting company, hopes to have greater access to capital markets to fund M&A.
During his career Van Houten has seen Philips eclipsed in value by not one but two former divisions it has spun off: semiconductor equipment maker ASML <ASML.AS>, and computer chip maker NXP <NXPI.O>. He left Philips to oversee NXP’s restructuring after it was sold to private equity investors in 2006, returning to Philips in 2011. NXP, which had a new IPO in 2010, is now in the process of being acquired by Qualcomm <QCOM.O> for $38 billion.
“Definitely my learning there helped me in my thinking,” VanHouten said.
After lackluster performance for most of Van Houten’s tenure, Philips shares are up 17 percent year to date.
For a graphic on Europe’s spinoffs, click http://fingfx.thomsonreuters.com/gfx/rngs/EUROPE-SPINOFFS/010030NE1EV/EUROPE-SPINOFFS.jpg
(Additional reporting by Maiya Keidan, Thomas Escritt, John Revill and Georgina Prodhan; editing by David Stamp)