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A different spin
Not long ago conglomerates carved out, and sold to the public, parts of subsidiaries to capture hidden valuations. The carve-out strategy still remains popular, but the motivations have changed.
Not long ago conglomerates carved out, and sold to the public, parts of subsidiaries to capture hidden valuations. For example, Philip Morris Cos. sold off 16 percent of its food group for $8.7 billion last year. The new public entity, Kraft Foods, sells at 32 times trailing earnings, while Philip Morris sells at a price-earnings ratio of just 13. But in December 2000, before it announced the carve-out of Kraft, Philip Morris stock was selling at 38. These days it trades at about 53.
The carve-out strategy still remains popular, but the motivations have changed. Now big companies go to the equity markets to focus their businesses and , you guessed it , create transparency. Nowadays, carve-outs are often the first step in spinning off the business altogether. One prominent example: Tyco International. After a decade of agglomeration, CEO L. Dennis Kozlowski, under fire for Tyco's opaque accounting, proposed splitting the company into four public operating units. When investors hammered Tyco's stock, the company scaled back its plan. For now, it will carve out only CIT Group, its financial services business.
Carve-outs make up 71 percent of the dollar volume of initial public offerings thus far this year, according to Dealogic. That compares with 31 percent of dollar volume in 2000 and 51 percent in 2001, according to Lehman Brothers.
Recent big carve-outs include multibillion-dollar deals for Alcon Laboratories, a U.S.-based Nestlé subsidiary, and Citigroup,s Travelers Property Casualty Corp. According to Dealogic, more than $14 billion in carve-outs have been done or are on the runway so far in 2002; carve-out volume for all of 2001 was $25 billion. "Last year was a great year, and this year is moving just as fast," says James Rossman, head of equity restructurings at Lehman. "So far carve-outs are dominating the calendar, and we are on pace for them to make up an even greater percentage of deals."
Driving this trend, in part, is pressure on companies to create accounting and balance-sheet transparency for investors, while improving earnings. Executives at DuPont hope that a carve-out of its synthetic textiles business, DuPont Textiles & Interiors, will help the parent company's growth plans. DuPont has set targets of top-line revenue growth of 6 percent per year for the parent company, earnings per share growth of more than 10 percent and return on invested capital in the high teens. "If the unit weren,t separated out, it's unlikely we,d be able to support those corporate aspirations," says Ray Anderson, director of investor relations for DuPont.
Mark Hantho, co-head of North American equity capital markets for Morgan Stanley, says that carve-outs help create research coverage before the rest of the unit is spun off to stockholders. That's probably why Merck & Co. will carve out Merck-Medco Managed Care, which Carl Seiden, pharmaceuticals analyst at J.P. Morgan, says it plans to spin off later this year. "There's no question that Medco drags down the margins on Merck," says Seiden. The gross margin on Merck is about 30 percent, compared with the teens for Medco, a pharmaceuticals management provider. "When the numbers are averaged together, it is difficult for investors to see what's really going on with the companies," Seiden says. A spokesman for Merck declined to comment on the company's plans.