eBay: Is Breaking Up A Cure For Corporate Attention Deficit Disorder? by Aswath Damodaran, Musing on Markets
I could start this post by telling you that some of my best friends are corporate strategists, but I would be lying. I do have a few strategists as acquaintances, but perhaps not after this post. In my cynical view, the primary contribution of corporate strategy seems to be to supply buzzwords that can be used by managers to distract investors and justify the unjustifiable. In an earlier post, I highlighted some of these words of mass distraction, including disruption, synergy and strategic considerations, and argued that the repeated usage of these words by a manager, analyst or investor is a signal that the numbers don’t work. In this one, I want to add focus to that list of words, as it shows up with increasing frequency in the context of corporate break ups. In this post, I propose to put focus under the microscope, using eBay Inc (NASDAQ:EBAY) (and its proposed break up) as my illustrative example.
Focus, the new strategic buzzword?
As we go through another wave of companies breaking up, it is worth remembering that this is not the first time that we have seen this phenomenon, nor will it be the last. Each break up wave, though, comes with its own overriding rationale, that CEOs highlight and journalists then parrot in their news stories. The theme for this break up wave can be seen in the rationale offered by the CEOs of HP and EBay for breaking up:
“We’re in a better position to get focused companies who can respond more?quickly….?We felt like this was the right time to take advantage of setting up two scaled? companies who will be a little bit more focused and a lot more nimble.” Meg Whitman, CEO of Hewlett-Packard Company (NYSE:HPQ), on CNBC
“ This transaction creates two industry leaders, each with significant reach and scale, and will allow us to continue our focus on customers, innovation and execution. …That will allow a greater level of strategic focus, greater strategic agility, and greater strategic flexibility. Simply put, we believe the premium on focus and agility will allow each business to compete and win in this exciting environment going forward. So we can move more quickly and make targeted, focused investments.. So I think, an independent PayPal unequivocally will have the focus and agility to play across the board in this fast moving payment space.” John Donahoe, CEO of eBay Inc (NASDAQ:EBAY), on conference call with analysts
- Until a few months ago, both Ms. Whitman and Mr. Donahoe were arguing, just as strongly as today, for keeping their companies as whole companies, using economies of scale and synergy as their strategic arguments. Were they wrong then or are they wrong now? Alternatively, if there were right both then and now, what’s changed?
- If breaking up these companies is supposed to improve focus, these companies must have been unfocused before these break ups. If so, who was running these companies, what were causes for the lack of focus and how would breaking up deal with these causes?
By being opaque about focus, I think we are missing an opportunity to understand it better and perhaps deliver more value from it. I think that you can look at focus both the perspective of managers and from that of investors. You can look at what caused the lack of management focus before the break up and what will change in terms of fundamentals after the break up (with the resulting effect on value). Breaking up a multi-business company can improve investor focus on the businesses owned by a company and lead to a price effect (even if value does not change).
Management Focus and Value Enhancement
The first principles of corporate finance are universal and apply whether you run a single business or a multi-business company. The company still has to pick good investments, i.e., investments that generate returns that exceed the hurdle rate, finance these investments with the right mix of debt and equity, i.e., a mix that finds the optimal trade off between the tax benefits of debt and the added default risk created by it and return cash to stockholders (in the form of dividends or buybacks). It is true, though, that putting these principles into practice is more difficult at some multi business companies, on each dimension of corporate finance:
- Hurdle rate hiccups: If the businesses owned by a multi business company vary on the risk dimension, it is critical that the hurdle rates used to make investment judgments vary across the divisions (businesses), depending on their riskiness. This fundamental proposition is violated at many multibusiness companies which choose to use one hurdle rate across all their businesses, justifying the practice on the (erroneous) arguments that that is what stockholders in the company demand or that division (business) level hurdle rates cannot be estimated. Not surprisingly, capital misallocation follows, with riskier businesses over investing and safer businesses under investing (and subsidizing the riskier businesses).
- Capital structure fuzziness: The capacity of a business to carry debt is determined in large part by its ability to generate cash flows (with higher and more stable cash flows resulting in higher debt capacity), the types of assets owned by the business (with tangible assets providing more debt capacity) and the tax rate that it faces (with higher marginal tax rates leading to more debt). If a multi-business company has businesses that vary on these dimensions, it will have trouble finding one composite debt mix that works across time and businesses.
- Dividend policy mismatches: The cash return policy for a business will be driven by its growth potential (with higher growth potential requiring more reinvestment and less cash returns) and the nature of the business (with siome businesses requiring more intensive investments than others). Again, if a multi business company has businesses that vary in terms of growth and reinvestment needs, it may not be able to find a dividend policy that meets its overall requirement. This problem is exacerbated if the company have attracted an investor base that has a particular preference in terms of dividend policy and that dividend policy is at odds with what a business can afford to pay out.
The argument that breaking up a company can improve capital allocation, allow for a more optimal capital structure and enable fine tuning of cash return policies to match the specifics of individual businesses will have the most resonance at those multi business companies, where the businesses vary widely in terms of risk, growth and asset characteristics. Thus, it will make more sense for a multi-business company that has a real estate division, a retailing unit, a financial service business and a manufacturing segment