With the recently announced split of General Electric (GE) into three parts and Johnson & Johnson (JNJ) into two, it seems like a good time to discuss why some companies split up. It’s also a good time to discuss why companies merge in the first place.
The short answer is because their stock will go up.
The foremost job of the CEO of a public company is to maximize shareholder value, which results in an increased stock price. While that may sound cynical, CEOs are largely compensated via company stock and no CEO has ever been fired because the company stock price went up too much. In other words, if the stock price goes up, the CEO will both keep his or her job and make more money.
Why will the stock go up on the news of either a merger or split?
For a merger, it often comes down to synergies. For example, if company A (which makes widgets), buys company B (which makes fidgets), and both sell to the same customers, there will be synergies. Company A’s widget salesforce can now sell company B’s fidgets. This means the combined company no longer needs company B’s salesforce and can eliminate that line item from their profit and loss (P&L) statement. There would also likely be back-office synergies, e.g., only one company’s regulatory and compliance department is needed. Costs are saved and profits go up, which drives up the stock price.
When Jack Welch was CEO of GE in the 1980s and 1990s, he made over 100 acquisitions in the name of synergies. While the acquisitions were not necessarily part of a cohesive philosophy providing seamless widget/fidget synergies described above, they did enable GE to continually meet analyst quarterly earnings estimates. This pleased investors and analysts which resulted in a higher multiple and high share price for GE. Welch’s success at GE was a part of a larger trend during the 1980’s and 1990’s that saw several conglomerates created from mergers.
We are now seeing the reverse of this strategy as several high-profile break ups have either happened or are in the process of happening. In addition to GE and JNJ, the industrial conglomerates Siemens and United Technologies have already broken into more streamlined companies. AT&T spun off Warner Media this year, only five years after acquiring it. Former technology bellwether International Business Machines (IBM) is spinning off its infrastructure business.
The underlying reason for these moves?
Again, to improve the stock price, or really the total value of the newly created independent entities. Analysts will review a company and declare, after a sum of the parts (SOTP) analysis, that it is undervalued. For example, a company with 3 divisions trades at 15 times earnings. But when comparing each division to its direct public competitors, division A should be worth 20 times earnings, division B 25 times and division C 10 times. Assuming equal weights, the company is actually worth 18 times earnings, and is therefore trading at a nearly 20% discount to the SOTP. If the stock price of the company is underperforming, investors, activists and investment bankers will begin to agitate for a breakup to unlock this value.
Companies can also break up simply because the touted efficiencies are no longer in place. According to JNJ management, the synergies between the Consumer and Pharma & Device businesses no longer exist as the businesses have become too disparate. The Consumer business is also facing major lawsuits related to traces of asbestos in its baby powder. Management in the Pharma & Device segments may simply not want to deal with this potential liability. The synergies created during the AT&T and Time Warner Media merger were never clear in the first place.
Another reason is that a company or the investors may feel capital is not being properly allocated – the proper allocation of capital is key to operating any company. Prior to breaking up, United Technologies had four divisions including Carrier and Otis. Carrier was the second largest and Otis the smallest. These two were the most profitable and most likely deserved a greater share of the resources than they were getting as part of United. Since the breakup, both stocks have done well, Carrier in particular.
What does this mean for investors?
First, given the current political environment, the climate for meaningful mergers and acquisitions will likely be more challenging. For example, Visa tried to acquire fintech company Plaid in 2020 until the Department of Justice pursued litigation. We anticipate acquisitions, especially in the technology sector, will be more difficult going forward. This will make us wary of companies whose growth is driven by mergers and acquisitions. Second, any investor must be aware of how a company allocates its capital. Although management and investor interests are generally in line (both parties want to increase the value of the company), that doesn’t mean an investor always agrees with management. Management that continually acquires companies just to grow revenue and manage earnings (with little clear philosophy) will most likely not successfully drive long-term stock performance. We look for companies that can grow organically and, if they have a history of acquisitions, conduct ones that make sense. In other words, the synergies are apparent like in the widget/fidget example.