On Monday, Hewlett-Packard announced that it was dividing itself into two companies: HP, Inc., which will make personal computers and printers; and Hewlett-Packard Enterprise, which will provide hardware, software, and services to businesses.
Everyone cheered. HP’s stock gained almost 5 percent. Ralph Whitworth, an HP investor and former chairman, said, “HP’s board and management have made a brilliant value-enhancing move at the perfect time in the turnaround.” Breaking up is in vogue. Activist investors are pushing every company from Sony to DuPont to split up into pieces—even though, as anyone with any sense of history will tell you, this is just the latest swing of the pendulum since the rise and fall of the conglomerates in the 1960s and 1970s.
I teach corporate finance. I believe that big investors are mostly rational most of the time. And that makes it hard to explain why corporate breakups should be such a great thing.
The value of a company is supposed to be the discounted present value of its expected future cash flows. Actually, the value of a company is the discounted present value of its expected future cash flows. So it follows that a breakup should only create value for shareholders if it increases future cash flows or lowers the discount rate. Most breakups don’t obviously do either.
One story you hear a lot is that breaking up a company will allow a higher-multiple business to escape the shadow of a lower-multiple business. This was one of the justifications for eBay’s spinoff of PayPal: eBay’s valuation as a retailer was supposedly holding back PayPal’s valuation as a high-growth leader in digital payments. But to believe that story, you have to believe that the stock analysts and institutional investors who determine stock prices were somehow unaware that PayPal was part of eBay — or that they are unable to create a spreadsheet that applies different multiples to two parts of a company.
Another possibility is that a breakup will attract investors who might be interested in one part of a company but not in the whole thing. Philip Morris’s spinoff of Kraft could fall into this category: investors who wouldn’t buy stock in a cigarette company might buy stock in a mediocre food company. There might be something to this, but it presumes a certain amount of investor irrationality. For Philip Morris’s stock price to be depressed because of investors’ aversion to tobacco, it must be the case that Philip Morris’s fundamental value (the discounted present value of its expected future cash flows) is greater than the total amount of cash available to all investors who are willing to buy its stock. If a share of Philip Morris is worth $100 on a discounted cash flow basis, but it is trading for $90, then anyone willing to hold the stock who can gain access to $91 by any means — inlcuding selling other assets — will buy a share, bidding up the price. That will be true until the price is $100 or all of those people have exhausted their credit lines.
For a breakup to make fundamental sense, the sum of the cash flows of the resulting companies must exceed the cash flows of the former company. That can happen in one of two ways. One is if there are tax or accounting shenanigans involved — which is quite possible in this case, given HP’s history as a tax avoider, but generally absent from media stories about the breakup. Otherwise, the breakup must somehow affect the actual operating businesses of the companies involved. And this is where things start getting tricky.
As you invariably hear when one company buys another, there are synergies in combining organizations — most commonly, laying off the smaller company’s marketing, HR, finance, and legal staff; using greater buying power to get bigger discounts from suppliers; and reducing capacity and increasing prices. Break a company up, and the opposite should happen. There’s no particular financial reason to believe that two companies will be better off than one; not only do they have to pay twice as much for everything from search engine optimization to investor relations, but they’ll have twice as many overpaid executives and twice as many board meetings.
Instead, you always hear some story about “focus,” like HP CEO Meg Whitman saying each new company will have the “independence, focus, financial resources, and flexibility they need to adapt quickly to market and customer dynamics.” But what does that mean? Clearly Meg Whitman could have combined personal computers and printers into a Printing and Personal Systems Group and given it the autonomy to operate as its own business. Wait — actually, she tried that.
With rare exceptions, everything that a company does after a breakup (launch products, enter markets, outsource manufacturing, lay off employees, create marketing campaigns, etc.) is something that it could have done before the breakup. A corporate breakup is ultimately an admission of failure: a concession that the mother company’s management wasn’t doing a good job and that their business was too big and complicated for them to handle. HP’s stock went up because investors recognized that the management team was underperforming — so much that it made sense to pay for a whole second set of managers. If investors had thought that HP’s management was doing a great job maximizing the value of its assets, then the breakup should have caused the stock to go down.
Of course, it’s better for management to recognize that fact than not to recognize it, and for that Meg Whitman deserves a measure of credit. Jamie Dimon, Michael Corbat, and any other CEO of a bloated, unmanageable megabank under investigation for yet another scandal would be wise to bear that in mind. The hierarchical, bureaucratic structure of the modern American mega-corporation is generally not fertile ground for the kind of innovation and agility that businesses need to succeed. The current wave of breakups is an implicit acknowledgment of the failings of corporate management today.
Photo credit: Wikimedia Commons (public domain)