Learning Module 4: Corporate Restructuring

Learning Module 4 Corporate Restructuring EXAMPLE 1 Daimler AG to Split into Daimler Truck and Mercedes-Benz Until 2021, Daimler AG operated and reported in two business segments: Daimler Trucks & Buses and Mercedes-Benz Cars & Vans. In February 2021, Daimler AG announced that it will spin off Daimler Trucks & Buses into a separate Frankfurt-listed company and will rename itself (the remaining business seg ment) Mercedes-Benz, reflecting its focus on the car and van business that sells vehicles under that brand. The spin-off will be effected by Daimler AG paying a stock dividend of newly created Daimler Trucks & Buses shares to Daimler AG shareholders, who will then own two separate types of shares: Daimler Trucks & Buses and Mercedes-Benz. Ola Källenius, chairman of the Board of Management of Daimler AG, underlined that focus was the primary driver of the decision to split: "Mercedes-Benz Cars & Vans and Daimler Trucks & Buses are different businesses with specific customer groups, technology paths, and capital needs. Mercedes-Benz is the world's most valuable luxury car brand, offering the most desirable cars to discerning customers. Daimler Trucks & Buses supplies industry-leading transportation solutions and services to customers. Both companies operate in industries that are facing major technological and structural changes. Given this context, we believe they will be able to operate most effectively as independent entities, equipped with strong net liquidity and free from the constraints of a conglomerate structure. EXAMPLE 2 Novartis AG Divestments Like other major pharmaceutical companies, Novartis AG had a sprawling portfolio of healthcare businesses. In the years since the appointment of a new CEO in 2013, Novartis has made several large divestments: It divested its vaccines and over-the-counter pharmaceutical business to rival GlaxoSmithKline, sold its animal pharmaceuticals business to Eli Lilly, another rival, and spun off Alcon, its eye care business, as an independent SIX-listed company. Alcon was spun off, via a stock dividend payable to Novartis AG shareholders on 9 April 2019. At the time of the spin-off. Alcon equity was valued at over 30 times its EPS, while Novartis AG's price-to-earnings ratio (P/E) was half that amount. Two years after the spin-off, Alcon shares had appreciated by over 35% while Novartis AG shares were roughly flat, demonstrating that Alcon was more valuable outside of its parent than inside. Alcon was the market leader in eye care devices and supplies, a growing market that does not face significant patent expirations like biopharmaceuticals and that requires less R&D. EXAMPLE 3 Six Flags Inc. and Six Flags Entertainment Corp. Six Flags Inc., an NYSE-listed owner and operator of amusement parks, began to struggle financially in 2006, as revenues stagnated and EBIT fell by 50% from 2005 because the company's operating expenses were primarily fixed. Its share price fell by almost 50%, closing in 2006 around USD5 per share. Performance worsened in 2007, as revenues grew slightly but EBIT decreased by 34%, and the share price fell another 50%, closing around USD2.50. Standard & Poor's and Moody's downgraded the company's credit rating (though it was already speculative grade) because the company's net debt to EBITDA ratio increased to nearly 13x (see Exhibit 6). The United States, the company's primary operating region, entered a recession in late 2007, and credit markets seized, which was especially challenging for Six Flags because it was a highly leveraged company unable to refinance its debt and it faced a mandatory dividend payment on its preferred stock. The company implemented an extensive cost restructuring program in 2008, which did improve profitability despite a 24% fall in revenue, but the company defaulted on its debt obligations by missing interest payments and preferred stock dividend payments. By early 2009, Six Flags shares had fallen below USD1.00, which triggered a delisting of its shares on the NYSE. Six Flags declared Chapter 11 (reorganization) bankruptcy on 13 June 2009, seeking an agreement with creditors to eliminate a significant amount of its debt, though its theme parks continued to operate. EXAMPLE 4 LBO of Hilton Hotels Corporation by Blackstone Group In 2007, funds managed by the Blackstone Group acquired Hilton Hotels Corporation, an NYSE-listed global hotel and hospitality company in a transaction valued at approximately USD26 billion, with the Blackstone funds acquiring all outstanding shares of Hilton for USD47.50 per share, approximately USD20 billion in total, and assuming USD6 billion in existing Hilton debt. The Blackstone funds financed the cash portion of the transaction by borrowing USD14.5 billion and using 5.5 billion of equity. Upon closing the acquisition at the end of 2007, Blackstone replaced the management and implemented a growth strategy, primarily through franchising. It also made several divestitures of highly-priced, flagship properties. In 2013, Hilton re-listed on the NYSE via an initial public offering. The trajectory of Hilton's long-term debt shows the effect of the leveraged buyout; long-term debt increased by a factor of 3 once it was taken private (see Exhibit 7). Blackstone funds used cash flows from operations to reduce indebtedness while Hilton was private, but it still returned to the public markets with a different capital structure. Exhibit 7: Hilton Hotels Debt Position through its LBO Blackstone funds did not sell any shares in the IPO; instead, Blackstone gradu- ally sold its stake over 2013-2018, which resulted in significant gains as Hilton shares appreciated over that time. By 2018, 11 years after its initial investment, the funds had realized a cumulative net profit of over USD11 billion on the initial equity investment of USD5.5 billion. EXAMPLE 5 Corporate Evolution and Actions 1. Explain what actions XYZ Ltd., a fictional company, might take in response to its declining revenue growth rates of 8%, 7%, 4%, 1%, and 1%, respectively, during the past five years. Solution XYZ Ltd. may make an investment in a faster-growing business, such as an acquisition, to accelerate its growth rate. If XYZ Ltd. operates multiple separate businesses with different growth rates, management may seek to divest those with growth rates below the consolidated rate to accelerate growth. 2. Instead of making an acquisition, a corporate issuer could invest internally via capital expenditures or R&D. Describe one possible advantage and one possible disadvantage of making an acquisition versus an internal investment. Solution A potential advantage of an acquisition over internal investment is time to market for a new product. Internally, developing and launching a new product, especially one with which the company lacks experience, may take significantly longer than acquiring a company already commercializing the product. A potential disadvantage of an acquisition is cost. Most companies are valued at prices greater than the replacement costs of their assets, and additionally, most acquisition values are greater than market valuations in the capital markets, reflecting a premium for control. 3. Identify which one of the following is least likely to be a motivation for divestment actions. A. Increase revenue 8. Increase focus C. Increase return on invested capital Solution A is correct. Divestment actions, including sales and spin-offs, reduce the size of a company and its revenues. B is incorrect because divestments, by shrinking the number or scope of businesses in the corporate issuer, do increase focus. C is incorrect because divestments are often motivated by the desire to reduce capital investment in areas of low returns. 4. Recommend a corporate restructuring action for each condition in the Conditions column by selecting one of the actions in the Corporate Restructuring Action column. Conditions 1. As a result of a significant downturn in commodity prices, an oil and gas producer faces negative cash flows from operations. The company has interest payments and debt maturities in the next 6 months. Corporate Restructuring Action A. Balance sheet restructuring Conditions Corporate Restructuring Action 2. Slowing revenue growth, owing to its products reaching market share saturation in most markets B. Reorganization C Acquisition 1. A company operates Segment A and Segment B. While Segment A is performing in line with expectations. Segment Breveme's growth has declined, because of changes in its regulatory environment. IX. Spin atf 4. A company owns and operates 245 physiotherapy and sports medicine clinics. While the clinics are performing well, the business is capital and labor-intensive because each clinic requires physical upkeep, capital equipment, and a skilled staff Solution B is correct. Reorganization is an appropriate action for companies facing significant debt levels that lack the financial wherewithal to service the debt. In reorganization, the company can negotiate adjusted debt payment plans with its creditors in an orderly fashion. C is correct. An acquisition is a likely course of action for a company with slowing growth as it reaches maturity. D is correct. Segments A and B have divergent performance and competitive landscapes. Unless there are significant synergies between the two, stakeholders may be better served if these businesses were separate rather than under the same ownership. A is correct. The company should consider balance sheet restructurings, such as franchising the clinics to third-party owner-operators with the corporate entity retaining such functions as quality control, billing, marketing, and so on or sale-leasebacks of the fixed assets. 5. Identify the most likely reason for a corporate issuer to sell a segment of its business rather than spin it off. A. The issuer desires liquidity. B. The issuer operates capital-intensive, cyclical businesses. C. The issuer operates multiple businesses with varying revenue growth rates and risk profiles. Solution A is correct. A sale is the disposal of a segment in exchange for consideration, often cash consideration, while a spin-off generally raises less liquidity because control is transferred to existing parent shareholders rather than sold. B is incorrect because capital intensity and cyclicality generally have no bearing on the choice of sale versus spin-off. C is incorrect because this attribute is non-specific to sales or spin-offs; it is an attribute that makes both options more logical. What is the difference between a joint venture and an equity investment? Solution While the two share the same accounting treatment under IFRS and US GAAP, a joint venture is a specific type of equity investment, different from others in its formation, purpose, and governance. Formation Joint venture Equity investment Investor acquires shares in existing investee company New legal entity formed when agreement is reached, and joint venture is financed Purpose Specific launch in new geography, new technology, etc. Controlled by participants by varying degrees General investor.com pany seeks exposure to investee Governance Investee maintains control over investee operations 7. Tyche, a fictional company, owns and operates 140 retail stores, including the real estate. As a result of a pandemic. Tyche's revenues and cash flows have declined severely, which may result in the inability to make interest and principal payments on its bonds and credit facility. Tyche management is considering selling the real estate for 40 of its stores to a commercial real estate investment fund and immediately leasing them (operating lease) for their remaining economic lives. Explain this type of action and its potential benefits and costs. Solution This is a balance sheet restructuring specifically, a sale-leaseback transaction. If completed, Tyche would receive cash from the sale and recognize a liability equal to the present value of future lease payments. Depreciation expense would be replaced with lease expense, which would include interest expense charged by the lessor. Potential benefits and costs of the sale-leaseback versus asset ownership are as follows: Benefits Costs Receive cash up front, to use for debt service Lease expense includes interest expense, generally resulting in higher overall costs Reduce costs of ownership, such as obsolescence and disposal Increased indebtedness 8. Empirical research suggests that at least two-thirds of acquisitions fail to create meaningful value for acquirers. Explain why this might be the case. Solution The following are three common explanations for the failure of acquisitions to deliver meaningful value for acquirers: 1. Overpaying: While the target business and synergies associated with the acquisition may perform well, paying too great a price simply results in a negative net present value (NPV) transaction. In effect, value is transferred to the seller. 2. Under-realization of expected synergies: Acquisitions are often done with the assumption of greater revenue or greater profitability (lower costs) for the combined entity than for the two entities alone. Expected synergies are reflected, in part, in the acquisition price. These synergies can be overestimated, perhaps due to unrealistic assumptions. 1. Integration issues: Acquirers often change the business processes and resources of targets to match their existing processes. Additionally, target management is typically replaced. Such changes can result in the deterioration of the performance of the target. AstraZeneca plc, an LSE-listed pharmaceutical company, announced its acquisition of Alexion Pharmaceuticals, a NASDAQ-listed biotechnology firm focused on therapeutics for rare diseases. AstraZeneca will pay USD60 in cash and 2.1243 AstraZeneca American Depositary Shares for each Alexion share, for a total consideration of USD39 billion, based on share prices just prior to the announcement. AstraZeneca expects to realize annual recurring cost synergies of USD500 million (pre-tax), primarily from commercial and manufacturing efficiencies as well as savings in corporate costs. The achievement of the full USD500 million in synergies is expected by the end of the third year after the acquisition closes. AstraZeneca expects to incur cash costs in the first three years following the close of the transaction, reaching USD650 million in Year 3. Prior to the acquisition announcement, expectations for revenues and total operating expenses for AstraZeneca and Alexion for the next three years are as shown in Exhibit 8. EXAMPLE 6 Farfetch Ltd. Acquires New Guards Groups Farfetch Ltd. is a UK-based, publicly traded e-commerce company that primarily operates an online marketplace for branded luxury products. Luxury brands list their products and connect to consumers through Farfetch's website and mobile app but retain control over most of the sales process, such as product selection, pricing, promotions, and so on. Farfetch earns revenue through commissions on each sale. In July 2019, Farfetch announced the acquisition of the privately held New Guards Groups, an apparel company that sells exclusively licensed luxury streetwear under the brand Off-White, for total consideration of USD704 million, which amounted to approximately 8% of Farfetch's total enterprise value just prior to the announcement. Despite being relatively small financially, the acquisition was seen as a problem by investors for two reasons: (1) It meant that Farfetch would start competing with sellers on its own platform by selling products itself, and (2) it represented a shift in business model away from an "asset-lite" online marketplace connecting third-party sellers to consumers towards an online retailer selling products under its own brands, with inventory risk and higher operating costs. Farfetch shares, listed on the NYSE, fell 45% the day after the acquisition was announced. EXAMPLE 10 Dilmun Inc. and Spina Ltd. Dilmun Inc., a fictional company, makes and sells traditional combustible cigarettes and cigars. Over the last 10 years, its sales volumes have declined annually by a mid- to high-single-digit rate, as the number of smokers in its major markets has dwindled, but strong pricing power has enabled the company to maintain stable revenues. Dilmun is the market share leader in its geographies and remains highly profitable, with operating margins exceeding 35% and returns on invested capital exceeding 30%. In recent years, two trends have emerged that have challenged Dilmun, beyond the impact of declining volumes: 1. Some lawmakers have advocated limiting nicotine in tobacco products to non-addictive levels and banning menthol and other flavorings. 2. The proliferation of ESG-focused strategies by asset managers has pressured Dilmun's share price because Dilmun's business model scores low on social metrics. Additionally, shareholders have engaged with the company's board and management to change its products or business model to better align with ESG goals. At the end of 20X3, Dilmun made the following announcement by press release: Dilmun Inc. today announces it signed and closed a USD1.2 billion investment in, and service agreements with, Spina Ltd., a market leader in e-vapor. The investment and service agreements will accelerate Spina's strategy to switch smokers of traditional cigarettes to e-vapor products, Dilmurn's investment represents a 30% interest in Spina equity, valuing the company at USD4.0 billion on an enterprise value basis. Spina will remain fully independent. As part of the service agreements, Spina will have access to Dilmun's sales and marketing infrastructure, including premium shelf and display space at over 225,000 retail locations worldwide, up from less than 75,000 today, and marketing material inside of Dilmun-branded cigarette packs and access to contact information from customer loyalty programs. While public health authorities recommend against the use of vapor products or any tobacco product, they have acknowledged their increased safety over traditional cigarettes. "We are taking significant action to prepare for a future where adult smokers choose non-combustible products over cigarettes by investing in Spina, a market leader," said Dilman's chairman and chief executive officer. "Lower-risk products are a promising way forward for all stakeholders. Today, we are making a significant investment toward that goal." EXAMPLE 11 Opone-Hapalla Automotive Alliance SA Opone SA, a fictional company headquartered in Brazil, designs, manufactures, and sells vehicles. While it sells some vehicles under its own brands, most of its business is a joint venture with Hapalla AG, named Opone-Hapalla Automotive Alliance SA (OHAA). OHAA was formed in 20X1 to make and sell Hapalla-branded vehicles in Latin America. Besides its participation in OHAA, Hapalla AG operates only in select European markets. OHAA has increased its annual vehicle sales volume from less than 10,000 in 20X1 to 1.5 million in 20X7. The joint venture has a contractually agreed-upon term of 25 years. Opone SA and Hapalla AG disclose summary financial results and positions for OHAA in the notes to their financial statements and share equally in the joint venture's profit and loss, as well as any dividends paid. Exhibit 27 and Exhibit 28 (also in the Example 11 worksheet in the downloadable Microsoft Excel work- book) show summary financial data from Opone SA's 20X7 annual report and consensus forecast figures for 20X8E. OHAA is the only joint venture Opone SA has an investment in.