Big, it seems, is no longer beautiful. In recent weeks, markets have seen a flurry of high-profile moves by and calls for large companies to split or spin off their smaller divisions. Although the means differ, the goals are the same: free up capital, unlock trapped potential and wait for the share price to re-rate.
Conglomerates have led the charge. Within the past month, Johnson & Johnson (US:JNJ), Toshiba (Ja:6502) and General Electric (US:GE) – once America’s most valuable company – have each confirmed plans to break up. With one eye on rival Siemens (Ger:SIE) – which has itself gone through a similar carve up process –GE’s chief executive, Larry Culp, said his group’s move would “heighten focus and accountability”, to the relief of long-suffering activist Trian Partners.
So runs the latest leg in the long-running debate over conglomerate value. Proponents point to the benefits of diversification, industrial and operational synergies, and the ability to compete without becoming dominant (and potentially anti-competitive) in any one sector. Critics argue conglomerates lack specialisation, move slowly, and emphasise management above innovation.
Amid speculation of its own break-up potential, the sprawling UK engineering group Smiths (SMIN) was recently forced to defend its business shape. "The common denominator is not structure. It’s not multi-segment or pure-play,” said the FTSE 100 firm’s newly installed chief Paul Keel last month. “The common denominator is performance.”
As Keel knows, Smiths has fallen short on that count in recent years. Although cash profit margins have hovered at 20 per cent, sales have gone sideways and returns on equity have fallen heavily, leaving investors without a clear growth story. And when some tech-enabled businesses exhibit seemingly exponential growth, capital-intensive companies that fail to hit their potential will always be a target.
But just as a handful of stocks are recognised for their outsized contribution to equity indices, slower-moving firms are being pressed to carve out or highlight their most valuable parts and restrict capital to the rump.
Such pressure is only likely to grow amid diverging views on companies’ ESG credentials, and the market premiums that the greenest or most virtuous subsidiaries might attract. In the UK, for example, both SSE (SSE) and Royal Dutch Shell (RDSB) are facing activist calls to separate their clean and legacy energy divisions, so weak market sentiment toward the latter doesn’t suppress prices attached to the former.
Calls to break up a group can result in immediate paper gains for the investors who initiate them, which explains why they are often welcomed. But unlocking conglomerate discounts isn't as straightforward as activists sometimes make out. Take Prudential (PRU), urged in 2020 by hedge fund Third Point to spin off its US arm and reinvest the proceeds into its high-growth Asia business. Although the life insurer followed the advice, it was unable to find a buyer or receptive IPO market for the US business and had to raise the capital itself.
If the current vogue for break-ups suggests distrust in some executives’ capital allocation, it is notable how the world’s largest and most valuable businesses are left to get on with it. All the while, the likes of Apple, Amazon, Alphabet and Microsoft also increasingly resemble digital conglomerates. That they don’t draw similar break-up calls can be explained both by their phenomenal records, and because their parts are much harder to quantify.
Therein lies the use of such activist calls, that they at least concentrate investor minds. Below, we unpack two current calls for shareholder focus. AN
The green extraction process
Plenitude, the interestingly-named Eni (Ita:ENI) offshoot, will “accelerate the energy transition”, according to the Italian oil and gas giant’s boss Claudio Descalzi. More importantly for Eni, it will also attract new investors unwilling to buy into or lend to the parent company, which will hold a 70 per cent stake in the spinoff, Desclazi said.
For oil and gas companies that are amassing huge renewable energy portfolios, this type of divestment-lite transaction could make a lot of sense. Why leave desirable assets sitting behind a fossil fuels valuation when they could be out there boosting the balance sheet in a green wrapping and taking on cheaper debt?
Shell has faced similar calls in recent weeks from Dan Loeb, the billionaire founder of hedge fund Third Point.
Loeb said in his quarterly shareholder letter last month that the supermajor should split into multiple standalone companies to “match its business units with unique shareholder constituencies”. He said this should be a “legacy energy business”, including upstream, refining and chemicals, which would prioritise dividends, and a combined LNG and renewables business that could “combine modest cash returns with aggressive investment in renewables and other carbon reduction technologies”.
The company quickly rejected this idea, because its plan is to use upstream cash flow to fund green projects. “We're going to use wind power [from] the sea to [produce] hydrogen, to turn into molecules, and to turn into transportation fuels. All these things are only possible because we have the opportunity to integrate and we have the opportunity to treat our business as a network,” said Shell chief executive Ben van Beurden.
Bernard Looney at BP (BP.) had similar thoughts during the company’s September quarter analyst call. “We need cash flow to invest into the transition,” he said. “When I look at some renewable companies out there, I see some of them struggling to fund their growth.”
Third Point is not wrong about the valuations. Ørsted (Den:ORSTED), formerly Dong Energy, shifted to a renewables-focused business in 2017, and trades on a forward price-to-earnings ratio of 34. Shell’s forward PE ratio is seven times, with a five-year average of 12 times, while even a relatively green oil company like Equinor (Nor:EQNR) is valued at nine times forward earnings.
Plenitude is aiming to grow Ebitda from its assets from €600m (£508m) currently to €1.5bn in 2025. These are not just renewable assets, however. HSBC has forecast a valuation of €8bn-€12bn, with only one-third of that from the renewables business.
But even as a “conventional energy supply business with a low-carbon flavour”, as per HSBC analysts Kim Fustier and Gordon Gray, the new company would have a two-year forward cash flow multiple between 3.4 and 5 times higher than Eni.
Earlier this year, Fustier pointed out there were big downsides to shifting green assets into a new corporate structure. “For oil majors, growth in renewables is one of the few avenues available to meaningfully decrease carbon intensity,” she said, adding project-level farm-downs and better disclosures around individual assets could help the majors get more credit for green holdings.
A £50m London-listed oil and gas company has recently gone through this decision-making process, albeit on a smaller scale than Eni. President Energy (PPC) will soon spin out Atome Energy, a green hydrogen and ammonia company, which will join the Aim boards by the end of the year. It has two projects in the works, in Paraguay and Iceland, where renewable power will be used at yet-to-be-built plants.
Atome chief executive Olivier Mussat said financing considerations made spinning off the green company the obvious choice.
Mussat told Investors’ Chronicle there was a “huge amount of money out there” for renewable energy projects that have strong business cases. He also pointed to the valuation of a company like Equinor – which he described as “the greenest oil and gas company” – to show just why shareholders would benefit from spinoffs, and said opening Atome to green private equity money meant its prospects were much stronger than if President had tried to build hydrogen plants itself.
Funds like Third Point often are extremely influential, even if their initial gambits fail. Elliott Management finally got its unified BHP structure years after its campaign, for example.
Even if Shell (and BP) stick with their integrated models that recycle cash flows into renewables units, a downturn could change this thinking. If these new green assets are seen as being weighed down by upstream operations when oil is over $70 a barrel, what if it falls back to $40? Loeb’s plan could well look much more attractive in that scenario. AH
Will spin-off deliver Just Eat?
Through a series of mergers Just Eat Takeaway (JET) became the largest food delivery company by gross transaction value (GTV) outside of China. The company as we know it only came into being last February, through the £10bn merger between Just Eat and Takeaway.com. Jitse Groen, the founder of Takeaway.com and now CEO of JET, then quickly expanded the business into the US with a $7.3bn takeover of American group Grubhub.
In 2019, total revenue was £416m, by the end of 2021 it is forecast to be £5.21bn. In the food delivery business, scale is the holy grail and JET achieved it at high speed. The strategy now is to benefit from strong network effects – more customers means more restaurants and more customers again – it’s a virtuous loop. Once this is established, you can theoretically strip out the marketing costs and turn a healthy profit.
This story isn’t currently wooing the public markets, though. Since the beginning of the year, JET’s share price has fallen around 40 per cent to just above £50. This is despite gross transactional value of orders increasing 37 per cent on an annualised basis during the first three quarters of 2021. This figure is even more impressive given it is compared against a period last year punctuated with strict lockdowns in JET’s largest markets.
Share price underperformance in the face of seemingly strong results is why activist investor Cat Rock Capital has publicly urged JET to sell Grubhub in the US and focus on the food and grocery delivery business in Europe. In July, it issued a statement claiming that JET had “completely failed to proactively communicate the costs of its logistics investments”, which Cat Rock claims led to analysts lowering their cash profit estimates from €400m in August to losses of €350m on the day of the announcement.
When asked to comment on Cat Rock’s statement at the time, a Just Eat spokesperson passed the buck to an October capital markets day, where investors would glean “increased visibility on how we will capitalise on the exciting, long-term growth opportunities”.
At the presentation, JET pointed towards Canada and Germany – countries in which it is profitable and nearly profitable, respectively – as examples of how the business model can work. “In Canada, the more orders we fulfil, the less variance you have. Once we reach a certain scale, orders in all zones are profitable,” explained chief operating officer Jorg Gerbig.
An issue for JET, which has been highlighted by Cat Rock, is declining market share in the US, where GTV only grew by 5 per cent in the third quarter of the year. This was significantly slower than the 23 per cent overall growth in the business.
Part of the reason is that fee caps on food delivery were introduced in 100 US cities during the pandemic. Many have now been removed but in New York, where Grubhub has a 50 per cent market share, they have been kept.
“Because of our leadership position in New York, the city with the most aggressive fee caps, we are affected disproportionately relative to our peers,” said Grubhub CEO Adam DeWitt.
It has also been losing market share to its competitors because it focuses its operations in city centres that have been largely vacant during the lockdowns. “Our competitors grew faster because the demand surge in online ordering came disproportionately in the suburbs,” explained DeWitt. JET has filed lawsuits to contest the price caps and hopes when customers return to the city it will be able to take back market share.
Cat Rock wasn’t impressed with the new strategy for Grubhub. In a public letter, managing partner Alex Captain welcomed “a clear, data-driven vision for the business”, but admonished JET for a “lack of tangible progress on asset sales or a formal commitment to near-term strategic action to unlock Grubhub’s value”.
In the 16 months since acquiring Grubhub, JET’s stock has underperformed the MSCI World Index by 69 per cent. In the four years prior to the acquisition it had delivered a 48 per cent return, against just 10 per cent for the MSCI World Index. “Grubhub is the root cause of the public market’s loss of confidence in JET,” according to Cat Rock.
The activist believes JET should spin off Gruhub to a business that needs last mile delivery service, such as Amazon, Walmart or Instacart, and estimates this would immediately drive an over 100 per cent re-rating in the stock value. With the cash from the disposal, Cat Rock then wants JET to focus on “the future of same-day delivery in Europe – where it operates the largest and fastest-growing same-day logistics network on the continent”.
The opportunities for last mile food delivery in Europe have been accelerated by the pandemic. Food and drink e-commerce sales grew 67 per cent in Western Europe, reckons market analyst Forrester, which expects the online share of the food and drink market to rise to over 14 per cent by 2025. As recently as 2019, it was just 3 per cent.
Since the capital markets day, Cat Rock says it has had “productive dialogue” with JET management and is on page with the “company’s intention to participate in the US consolidation and favour timely action that refocuses JET on its enormous European same day delivery opportunity”. The market remains unconvinced, and has pushed JET’s share price to a near all-time low.
Crunch time is 31 December. By then, Cat Rock has demanded JET announce a spin-off of 40 to 100 per cent of Grubhub or it will “take additional action to help JET realize its great potential”. The bad news for JET management is that Captain’s former firm, fellow activist investor Tiger Capital, is now the delivery group’s second-largest shareholder after building a £650m stake so far this year. Something is about to give. AS