Strategy

Corporate breakups: Grounds for divorce

The market loves breakups, and corporate Canada is getting the message.

As anyone: breaking up is hard to do. From divvying up assets to analyzing why the romance soured, it’s not Camelot. But the prospect of single life still carries sufficient promise to send some people rushing to sever ties. Same with corporations. Recently, behemoths such as EnCana (TSX: ECA), Motorola (NYSE: MOT) and Time Warner (NYSE: TWX) have announced their intention to split. These aren’t companies where rumours of infighting fuelled gossip of divorce. Instead, they are in pursuit of a common goal: a premium valuation.

For Randy Eresman, EnCana’s chief executive, the estimated $300 million the company will spend in breakup fees is just a means to an end. On May 11, he announced the split into an oil company — for now called IntegratedOilCo — and a gas company that’s likely to retain the EnCana name. “Individually, these two energy companies will have the ability to shine even brighter when contrasted against their industry peers,” he said at a news conference. So far, he seems to be right. The stock is down about 12% since the announcement, but analysts have hiked the 12-month target price in anticipation of longer-term windfalls. “Investors should like the restructuring, but it’s effectively the same company with better visibility in its operations,” Peter Ogden, analyst at National Bank Financial, wrote in a note to clients, where he bumped his target from $80 to $85 per share. Meanwhile, analysts at Credit Suisse, Blackmont and RBC bumped their targets by between $9 and $13 per share.

But why the sudden optimism? After all, as Ogden points out, it’s the same company. It might have something to do with history. In 1999, McKinsey & Co., the U.S.-based consultancy, published a report called Breaking Up Is Good to Do, which examined spinoffs between 1988 and 1998. The study came on the heels of one of the largest corporate breakups ever: AT&T’s 1996 split into three smaller companies. The study found shareholders were generally better off after corporate restructurings. Spinoffs, for example, offered a two-year annualized total return to shareholders of 27%, compared with the S&P 500’s two-year annualized return of 17%. In other words, the market showed a clear preference for a pure play rather than a conglomerate. McKinsey attributed the jump in value to four things: 25% more coverage by analysts two years after the spinoff, giving investors more exposure to the stocks; more investors being attracted to both stocks, with little overlap — just 19% owned both the parent and the spinoff; better operating performance of the companies; better governance.

Yet if spinoffs are a magical way to increase market value, why don’t all multi-line companies bust up their structures? A study in the mid-1990s found the strong performance of a few spinoffs, namely those that were taken over, skews overall results. That study, in the Journal of Financial Economics, found that in a sample of 160 companies, just one-third of the new spinoffs were acquired at a premium within three years.

So, when is the right time to break up? Like any relationship, it depends. EnCana’s chairman, David O’Brien, the former head of Canadian Pacific Ltd., helped orchestrate CP’s split into five companies in 2001. EnCana itself was created in 2002 with a merger between Alberta Energy and a CP spinoff, PanCanadian Petroleum. There had long been clues a breakup was in the cards. In 2003 and 2004, EnCana streamlined operations, including selling off a U.K. foreign holding for $2.1 billion. In 2006, when he took over from outgoing CEO Gwyn Morgan in 2006, Eresman acknowledged the virtues of a split and closed a deal for a joint venture with ConocoPhillips Co. Then, in early 2007, EnCana organized itself into six operating divisions — a signal at least one observer said was a sure sign the divorce was just a matter of time. Now, EnCana’s breakup is expected to be finished early in 2009.

The reasons for a corporate divorce are as varied as the reasons couple divorce: changes in regulation, a new innovation, a relationship gone sour, a new tax law. In May, when Time Warner announced it was spinning off Time Warner Cable, its chief executive, Jeff Bewkes, said that despite the bullish outlook for the division, the cable business was just too different from the rest of the company. The split of telecom giant AT&T in 1996 was fuelled by the decision of U.S. Congress to deregulate the telecommunications industry and force competition between long-distance and regional telephone companies. Much of Canada’s trust sector was born out of spinoffs. Companies such as BCE and Air Canada carved out divisions to create income funds, including Bell Nordiq, Jazz Air and Aeroplan.

Regardless of the reason for the split, the market typically reacts with affection. Investors are so positive because management is seen to be focused on a distinct strategy, says Steve Foerster, finance professor at the University of Western Ontario’s Richard Ivey School of Business. Spinoffs are also easier to value and compare to peers than are conglomerates. It’s like sussing out a potential spouse in a room filled with candidates who meet specific criteria, versus, say, searching for a partner by wandering down Main Street.

Spinoffs rid the company of the conglomerate discount — of typically between 5% and 12% — that arises out of assumed operational inefficiencies. There are two theoretical reasons why the corporate discount occurs, explains Thomas Lys, an accounting professor at Northwestern University’s Kellogg School of Management. The more traditional theory holds that management is too distracted and can’t concentrate on many different things at once. Another blames so-called corporate socialism, by which the conglom functions like a white-collar Robin Hood — taking from high-performing divisions and paying lower-performing ones. That is what happened at EnCana, where the cash-rich gas division invested in the cash-thirsty oilsands division. “A conglomerate lives a cozy life, as it’s less exposed to the market,” says Lys.

The transition from being part of a conglomerate to a sassy singleton comes with the risk — or the opportunity — of being a tasty takeover target. When CP split, four of its five divisions were swallowed, with Fairmont being taken out in 2006 by American and Saudi companies, and Fording being purchased by Teck Cominco this July. When Vancouver-based Lumina Copper Corp. split into four companies in 2005, two of the companies were acquired by foreigners. The takeouts wouldn’t have happened if Lumina hadn’t split up, says Cameron Belsher, a lawyer at McCarthy Tétrault LLP who was involved in the financing. But Belsher is quick to point out that Lumina split precisely because it wanted to unleash the value of its assets. The study by McKinsey examined the survival rate of spinoffs and found that five years after the restructure, 76% were still kicking; of those no longer trading, 25 were taken over and six were delisted.

Gwyn Morgan, EnCana’s inaugural chief, used to note that the company’s brawn would thwart takeover bids. Now there’s already speculation brewing that EnCana will tempt foreigners with its more digestible packaging. A natural acquirer for the IntegratedOilCo business is its 50% joint venture partner, Conoco. But Ian Nakamoto, director of research at MacDougall, MacDougall & MacTier Inc., says the split-up and possible foreign takeover of EnCana shouldn’t spark worries that a wave of corporate divorces is about to hollow out the nation. “Fads go back and forth,” says Nakamoto, who’s worked in the investment industry for more than 20 years. “In the ’80s, the big thing was to smooth out earnings with conglomerates.” And as for EnCana? “If oil was $30 a barrel,” Nakamoto says, “we wouldn’t be having this discussion.”