Breaking Up For Good

Dec. 21, 2004
Done for the right reasons and with effective execution, spinoffs can be surprisingly successful.
Alton Brann, chairman and CEO of Unova Inc., an industrial-technologies company, is no novice when it comes to corporate spinoffs. Brann's career has taken him from Litton Industries Inc. (many thousands of employees) to its spinoff Western Atlas Inc. (14,000 employees) and then on to its offspring Unova (7,000 employees). However, his latest spinoff departs a bit from the previous. In December, Unova's management sold the company's ritzy corporate headquarters in Beverly Hills, Calif. As of mid-April, employees will head for an unremarkable, albeit less expensive, office building about eight miles away in Woodland. The reason for the move? In 1997, after years of cutting and selling, Unova was ready to bulk up. During the last two years management has made several acquisitions, including the purchase last October of Cincinnati Milacron Inc.'s machine-tool business. The purchase added about $450 million in revenues to Unova's top line, along with Milacron's top-notch distribution system and global reputation for innovation. Selling the Beverly Hills headquarters netted the company $23 million, which will help pay down debt that was used in the purchases. Although the megamergers of the last year generated volumes of headlines, managers are finding that doing the opposite -- breaking a company up -- actually can be an effective means to profit, and even growth. Delta Consulting Group Inc., New York, reports that there were 77 major spinoffs in 1997, the latest year for which statistics are available. "It's interesting," says David Nadler, Delta chairman. "At the same time that we're seeing more mergers and acquisitions than we ever have before, companies also are doing more spinoffs and breakups." Behind the corporate pruning lie CEOs' expectations of a more focused strategy and improved operations. As Stanford University finance professor James Van Horne says, "Companies are looking for wealth creation and reverse synergy -- the notion that four minus three equals two." Disengaging from an ill-fitting or poorly performing division can result in a nice bump in stock price -- one reason analysts sometimes push companies to reinvent themselves as more of a "pure play," says Nadler. Often, the companies spun off also do better than one might expect. Steven Bregman, president of Horizon Asset Management Inc. and publisher of The Spinoff Report, says studies show that spinoffs during the last decade have beaten the market by about 10 percentage points annually. The reason? In many cases, executives with the new company have a real stake in the venture and are extremely committed to making it succeed, investing more time and resources than the former corporate parent would have. Of course, long-term success happens only when there has been some logic to the spinoff. "Some spinoffs make tremendous sense, and create strategic focus," Nadler says. "In other cases, you take big collections of companies that don't make sense and make smaller collections that don't make sense." Execution also matters. The operational challenge that is most overlooked, says Nadler, is simply the level of distraction created by the spinoff. "Deal fever is a common malady. The deal is a discrete event, it's highly leveraged, and has drama and excitement. You can get very worked up about it." Companies that do well after a spinoff have several things in common: a compelling strategy that is clearly articulated to stakeholders; leaders with the ability to rally employees around the new identity; and the management depth and breadth needed to run the new company. In its heyday, Unova's "grandfather" Litton boasted dozens of businesses that spanned a range of defense, aerospace, and industrial operations. By the late 1980s, it made sense to break up the company because of the differing rates of growth between Litton's defense and commercial divisions, says Dirk Koerber, Unova's vice president of investor relations. The first spinoff occurred in March 1994 and yielded Western Atlas, a new firm with two distinct businesses: oil-field services and the industrial-technology companies. By late 1997, a second spinoff looked promising; this time, the industrial-technology side (now Unova) split from Western Atlas. Unova competes in several markets, including machine tools, automotive-body assembly, industrial-grinding systems, and automated data collection. Before each deal, management took certain steps to ready the businesses for success away from their corporate parent. First, the operations had to have enough mass to compete on their own. For example, Unova's industrial operations supply the auto industry, and contracts easily run into nine figures. The operation had to be able to support business of that magnitude. Also on the to-do list was making sure that a management team was in place to run each of the new companies. Koerber says that under Western Atlas the company had (in a foreshadowing of events to come) maintained duplicate executive teams for several years -- one for the oil-field services side and one for the industrial side. Although this meant a small blip in administrative costs, Unova was able to hit the ground running once it was on its own. Customers had to know what was going on. To prevent confusion, Unova kept the product brand names it had been using before the spinoff, even though the corporate name had changed. Likewise, financial partners had to be informed of the changes. One factor that helped to convince Wall Street of the viability of the new companies, says Brann, was that the corporate management went with them, first to Western Atlas and then to Unova. Management's willingness to move to the new companies brings up a knotty issue: In most businesses, a manager's compensation correlates more or less with the size of the company. How do you ask your executive team to move to a smaller company if it means a cut in pay? You don't, says Brann. Instead, Unova's board agreed to a pay schedule that took account of the company's expected growth. Thus, Koerber says that while the pay ranges starting out for Unova's management are at the high end of the scale, the company's anticipated growth should help even things out. Indeed, Unova has been growing nicely. Revenues for 1998 were $1.66 billion, up 17% from 1997. Net earnings were $70 million, including the gain on the sale of the headquarters building. That compares with 1997's loss of $171 million, a result, in part, of $212 million in acquisition charges. It's not always easy being the offspring of a well-known corporate parent. When Lexmark International Group Inc. was formed via a leveraged buyout of the assets of IBM Corp.'s Information Products business in 1990, not all employees were thrilled with the change. Some were leery of giving up IBM's name recognition and reputation for lifetime employment to move to a relatively small, highly leveraged start-up. "For some employees, it was the most traumatic experience of their lives, other than a death in their immediate family," says Paul Curlander, president and CEO of the Lexington, Ky., printer company. A couple of moves helped to bring people on board. First, Lexmark's executive team had to develop a strategic direction for the new company. At the time Lexmark was spun off, printers actually accounted for less than half its revenues; the rest came from keyboards, typewriters, and other items. Given the anticipated growth in printers, management decided to focus there. In order to differentiate the company in a competitive environment, Lexmark aggressively targeted niche markets, such as health care and banking. All employees received stock options at the time of the split. Curlander says Lexmark was one of the first companies of its size (5,000 employees at the time) to offer options across the board. "The reception was outstanding. Now people had an interest in the future of the company." As a smaller company, Lexmark had to reinvent itself as a nimble competitor. To get there, management encouraged employee initiative and teamwork. Classes were offered on teamwork, and a suggestion program was put in place that rewarded team, rather than individual, performance. Both hard and soft topics were newly important. Given Lexmark's highly leveraged balance sheet after the buyout -- its debt-to-capitalization ratio was 72% -- making sure employees knew about cash management was critical, says Curlander. "People had to realize we were out of business if we had no cash." Lexmark also had to develop manufacturing procedures suited for a company with 5,000 employees and a handful of manufacturing locations, versus the hundreds of thousands of employees and global facilities of IBM. Product development was slated for some significant changes. For example, rather than slog through hundreds of iterations on working models, employees worked to optimize the performance of subassemblies before integrating them into a working model. More time was spent in the design stage of product development; previously, products moved more quickly through design to production. The company says the changes cut the development cycle by a third and slashed the amount of resources needed to launch a new product by half. Curlander notes one area in which the new company fell short in its transition efforts: communicating its new name. When Lexmark -- the name is a combination of "lexicon" and "marks," as in marks on paper -- was formed, the company moved slowly from the IBM to the Lexmark label. Such a drawn-out change made it difficult to establish the new firm's identity, says Curlander. However, Lexmark's strong financial results have helped it gain some attention. Revenue growth, which had been running about 10% per year since the spinoff, jumped to 21% in 1998, with revenues totaling slightly more than $3 billion. The bottom line has moved from red soon after the spinoff to black; net income was $149 million in 1997 and then jumped 49% to $243 million last year. The debt-to-capitalization ratio dropped from 72% to a more manageable 13% in 1997 before a stock repurchase increased it to 22% last year. The company went public in 1995 at $20; recently its share price hovered around $110. Not every spinoff is decided by the corporate parent. Example: Pervasive Software Inc., a $25 million developer of embedded database software located in Austin. Its original product was Btrieve, a PC-based database developed by Doug and Nancy Woodward in the early 1980s. In 1982 they formed Softcraft to sell their product. Novell Inc. bought Softcraft in 1987. As a unit of Novell, the division's potential seemed to be getting overlooked, says Pervasive's CEO Ron Harris. Managers wanted to exploit the markets they saw emerging for their turnkey database software. So in September 1993 Harris and the Woodwards approached Novell about a possible spinoff. By spring 1994 Pervasive again was an independent company, and management took it public in 1997. The new Pervasive had several things in common with any high-tech start-up: a lean staff (45 employees), a shoestring budget, rapid growth, and escalating customer demands. After the spinoff, employees immediately began work on the next-generation product, a relational database component for Btrieve. "We wanted to give them an opportunity to pour their hearts and souls into a project." Harris says. The demands were intense. "The transition was from a division employee to an entrepreneur carrying a very substantial load," Harris says. "The culture within the company had to change overnight. Employees had to be very decentralized in their decision-making and very entrepreneurial." Since leaving the corporate nest, Pervasive has grown its top line from $8.6 million in fiscal 1995 to $36.7 million in the fiscal year ended last June 30, a 50% increase from the previous fiscal year. The trend continued in the next six months, which showed a 60% revenue increase compared with the year-earlier total. Net income moved into the black in fiscal 1997, when the company earned $1.6 million, and jumped 71% to $2.7 million in fiscal 1998. When they're done for the right reasons and are soundly executed, spinoffs can be successful. Much of the catalyst for performance starts at the top. "Executives know they will never get this opportunity again," Horizon Asset Management's Bregman says.
Beyond The Break-Up
Delta Consulting Group offers advice about challenges to management and how to meet them head-on. Loss of identity -- Quickly create a new identity to offset the loss of identification with the core company. Recontracting with constituents -- Aggressively redefine relationships with both internal and external constituents. Downsizing -- Energize people about the start-up while capitalizing on opportunities for downsizing. Integration -- Create an "internal merger" of business units that were only distantly related in the core company. Start-up -- Seize the unique but narrow window of opportunity to boldly shape the technological and social elements of the new enterprise. Rebuilding the enterprise -- Begin the one- to three-year phase of reshaping the strategy, architecture, staffing, and operating environment of the new organization. Change management -- Implement a detailed transition plan focusing on personal involvement by senior management and widespread participation.

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