What We Learn About Corporate Break-ups from Business Simulation Workshops (Part 2)
Please click the following if you missed part one of What We Learn About Corporate Breakups from Business Simulation Workshops
From a very practical business and financial perspective, there are several ways to determine business value. In many of our business acumen learning journeys and business simulations, we share that the ultimate value of a business is determined by the level of free cash flow from the business. The market value can be created or destroyed by future growth and the risk of what a company does with its cash flow.
To make the business case from a cash flow perspective that break ups enhance value, there are two financial tests. The first is to determine how a break up will impact cash flow, the value of growth, and the risk of the business moving forward. The second financial test, which is much harder, is to make the case that the consolidated parent company could not have made the changes without breaking up and back up that argument.
When a consolidated company is broken up, the value of the pieces created by the breakup have to show the general numbers and the specific cash flows and growth values of risk for there to be any value effects. Here are a few key things to think about:
Cash Flows
A break up theoretically can increase cash flows if the broken up business units have lower costs than the consolidated business (the efficiency rationale). However, what if there are now more profits? There could be an actual increase in taxes paid which would decrease cash flow. Some of the pro-break up proponents will argue that there will be a decrease in capital investments and R&D, which will improve cash flows, but, in our opinion, will impact long term value.
Focused Growth
A break up can theoretically increase the market value of the broken up units if the investments are more targeted to growth. For example, you can invest in the high growth products and business units, and decrease investments in core or mature products and business units. This also can decrease long term value.
Financial Risk Profile
A break up can theoretically reduce the cost of funding a business (the cost of capital) if the broken up business units are able to choose debt mixes that lower their weighted average cost of capital (WACC). However, in practical terms, one of the broken up businesses runs the risk of higher costs of capital because they don’t have the security of a bigger, more established entity behind them.
Skills and Human Capital
Separate from all of the presentations, calculations, cash flow analyses, and business jargon are the people who have to implement a break up and then run the broken up businesses. A serious question always has to be asked: “Do we have the talent and skills to actually make this happen?” One of the interesting things that typically happens during a break up is that the activist investors push very hard for the “strong talent” to go with the growth business units. Does that mean that the “not-so-strong” talent is left with the core, commoditized business units? If they don’t have the skills to create and execute a new strategy, then much more value will be destroyed than can ever be created in the growth company.
Our business simulation workshops illustrates that the corporate raiders – many of whom graduate from elite Ivy League MBA programs without ever working a day in a manufacturing facility or in the field as a sales professional – don’t understand the nuances of executing a value proposition to customers. When companies go through a significant change like breaking up, additional marketing is needed to create awareness and stability, more of a sales effort is needed to maintain relationships and trust with customers, more customer service and customer training is need to maintain consistency, and more capital is needed to duplicate things like warehouses and distribution facilities.
All of these real-world lessons are taken into consideration in the simulation workshop and almost inevitably drive down profits and value.
In summary, Advantexe is very wary about the hot new growth strategy of breaking up large companies in an effort to “unlock value.” Breaking up a company, just by itself, cannot increase value. It is what you do with that broken up units to change the fundamentals such as cash flow, growth, and risk that impact whether a break up is creating or destroying value. Our perspective is that there are only short term gains that only a few people such as activist investors can benefit from, but in the long term these tactics hurt customers, employees, and investors.
