Summary
Many a successful business leader has created value for their shareholders. In their drive to grow the business and sustain value, those same leaders are eventually confronted by a market that no longer appreciates all that they have done. Quarterly earnings calls once dominated by research analysts are instead punctuated by the demands of new investors calling for action. It is time to realize the value that is now locked within a sprawling business enterprise. The accompanying analysis goes well beyond the article’s subject matter to identify the factors that stand in the way of value realization and suggests the ways to address them.
Analysis
Value Realization: When Value Creation Just Isn’t Enough
Creating Value
Many an entrepreneur or business founder has slaved to create and execute a successful business plan. It started with an innovative idea for a product or service. Next came the detailed plan to produce and market the idea. And finally came the usually exhausting and almost always frustrating process of financing the idea where the creator must now share ownership in his or her big idea.
By then, the execution of the plan should have been the easy part. But it is no secret that the vast majority of new business launches fail. Perhaps the introduction was under resourced. Perhaps the market research was wrong or misinterpreted. Perhaps the positioning was misdirected or the message was misunderstood. Perhaps the timing was inappropriate. Perhaps the launch was just poorly managed. Perhaps we will never know.
For the handful of truly expert (and sometimes lucky) business strategy executions, the idea takes off. Customers are satisfied. Their expectations are fulfilled or even exceeded. They are willing, able and actually pay fair value for the product or service. The business model is confirmed. Customers are retained. New customers are added. Revenues grow and profits accelerate. Value has been created.
Sustaining Value
Success usually breeds more success. Growth requires investment. The public markets clamor for such opportunities. A broader shareholder base can also be appealing to business founders. Potential liquidity for management, investors and the founders themselves adds to the allure of taking the company public.
The capital provided by the initial public offering and subsequent follow-on offerings provides the fuel for business growth. However, once the obvious exploitation of new demographic and geographic markets has occurred, further growth requires the generation of new ideas. These new ideas often lead to business diversification through merger, acquisition, licensing or internal development.
The capital provided by going public comes with only a few strings attached. These include required compliance with (i) the rules and regulations of the Securities and Exchange Commission; (ii) the listing requirements of the chosen stock exchange; and (iii) Acts of Congress (e.g., Sarbanes-Oxley). To satisfy these requirements, one needs to follow only a few simple rules. First, tell everyone the truth at the same time. Second, keep all required filings current and comprehensive. Third, don’t buy or sell company shares when in possession of insider information. Lastly, don’t steal company assets or cheat the shareholders in any way. Handle all that and you will endure the drudgeries of being a public company.
Of course, not everyone takes theses drudgeries in stride. The company founders often leave. Perhaps they do not have the tolerance for being a public company. Perhaps they are bored by the tasks of managing an increasingly larger and more complex organization. Perhaps they enjoy better the task of creating versus maintaining a business enterprise. Perhaps the more vocal shareholders and the board of directors have lost confidence in the management that brought the company this far. For whatever reason, the founders leave or otherwise relinquish their leadership responsibilities.
Business professionals are brought in and charged with the task of enhancing shareholder value. The growing and increasingly far-flung enterprise they inherit will require even more professionals and specialists to manage businesses in different stages of their life cycle – some mature; some growing; and some in various phases of earlier development.
One day, management wakes up to a perplexing and growing problem. The market no longer appreciates all that the company is doing for its shareholders. In fact, despite all the progress – the growth, the expansions and the diversification – the value of the company is depreciating versus appreciating. Road shows are organized to rekindle investor enthusiasm. PowerPoint presentations are prepared, printed in vivid color and spiral bound for leave-behinds. The market responds with a thundering silence. The “Street” just doesn’t get it.
This problem impacts upon companies large and small. Most of the press focuses on companies such as the giants Microsoft (WSJ, “Gates Should Weigh Microsoft Breakup”, June 17, 2006), Time Warner (WSJ, “Time Warner’s Malaise Persists”, June 23, 2006) and, most recently, General Electric (WSJ, “GE’s Caged Peacock Should Be Set Free”, July 29, 2006). But many a small-to-mid-cap company CEO has also seen his list of investors migrate from focused, long-term, industry-specific mutual funds to short-term, vocal hedge funds and private equity investors. Quarterly earnings conference calls once dominated by industry research analysts may now be punctuated by the demands of these new investors. What are the CEO and the rest of senior company management to do? What can the CEO of a company under siege by its investors do to settle the rising tide before the fatal tsunami hits shore?
Realizing Value
The increasing role of activist shareholders, as noted in the accompanying Wall Street Journal article “Investor Activism Grows Globally, But Wins Are Rare”, July 3, 2006, highlights the failure of company managements to address, among other matters, the issue of value realization. It is not sufficient to create value for shareholders, that value must also be realized.
Many a CEO has accused “the market” as having an increasingly shorter-term focus. Hedge funds and private-equity investors are oftentimes at the focal point of the criticism. However, the criticism may be exaggerated. These activist shareholders are, in a sometimes back-handed manner, supporting management’s success in the creation of shareholder value. Now they are merely asking for them to find the ways and means to realize it for their current shareholders. So how do we address this pressing demand?
While every company situation is unique, there are some approaches that are common to most situations. Here are a few thoughts.
- The Message
First and foremost, we need to check the company message. Is the mission clear and meaningful? Does it distinguish itself in any way from the mission of the company’s key competitors? Does the business model and related finances convey a clear path to sustained profitability that is understood by those inside and outside the company? For pre-revenue companies such as many biotechs and other development-stage companies, are the milestones critical to the companies’ future success clear, communicated to all stakeholders and updated regularly? For those same companies, is it understood by the stakeholders what the potential gain might be if the company succeeds? Assuming that value is created, what are the plans for realizing it?
- Fact & Fiction
Find out what investors, former investors, analysts and others familiar with the company story understand with respect to the company’s business. How well does their perception of the business match up with your reality? Where there are differences, try to determine how they originated and why. Revisit the corporate story and company presentations. Do the differences arise out of the failure to disclose the facts? Are assumptions taking the place of undisclosed facts? Is there an important reason why the information is not disclosed? If the information is disclosed, why is it not understood by others? Where the perceptions of the company story differ from the realities, consider adding or changing content in the company presentation then find every opportunity to communicate the newly enhanced message. Sometimes the presentation merely requires “freshening” to get an old and tired message through to the intended audience.
- Always Do Right
In this exceedingly complex business environment, mistakes will occur. The rules and regulations binding companies today, particularly the smaller and more thinly staffed ones, make it nearly impossible to get it right every time. For some companies, the cost to ensure compliance with complex rules such as those promulgated by Senators Sarbanes and Oxley may be prohibitive. Accept the fact that sometime, someplace a mistake will occur. When it does, remember the advice of Mark Twain: “Always do right. This will gratify some people, and astonish the rest.”
The most frequent infractions require the restatement of previously issued financial statements. These usually benign changes typically involve revenue recognition with respect to oftentimes complex, multi-part contracts. The restatements are almost always non-cash in nature and have little or no economic effects. If acted upon quickly, they are soon forgiven and forgotten by shareholders. State the facts. Make no excuses. Get the matter behind you.
Even if the mistakes are more serious and more damaging, the advice remains the same. The consequences, however, could be more lethal to the near-term realization of shareholder value. The integrity and trust that took years to establish will likely take years to re-establish. Again, get the matter behind you and take the actions necessary to ensure that the issue does not re-appear.
- Know Your Investors
Who is investing in the company? How does that compare to those who invested 3 months ago, 6 months ago, a year ago or more? Have there been significant shifts in the investor base? These shifts can have profoundly negative effects on the company share price for a number of reasons. For example, has there been a shift away from mutual funds and institutional investors to retail holders? Reductions in mutual fund and institutional holdings can impact upon the liquidity of a company’s stock. Lower liquidity makes the company shares less attractive to fund managers who need the flexibility to get in and out of their sometimes significant positions without significantly impacting the share price.
Changes in the “style” of the investors can also impact upon the share price as expected returns can vary significantly from one style to the next including:
- Index
- Sector specific
- Aggressive growth
- Growth
- Core growth
- Growth at a reasonable price (GARP)
- Momentum
- Income
- Deep value
- Value
- Core value
A comparison of the investors and investor types to those of peer companies, particularly those whose stock is performing better in the market, can also provide insights into factors that may be negatively impacting your company’s share price.
Lastly, the growth of hedge fund ownership in company shares can signal further trouble. Their shorter investment horizons and oftentimes open criticism of management’s failure to lead an effective path to value realization may become the incentive for long awaited change.
- Expand Coverage
While the role of research analysts has changed significantly over the last decade, they continue to provide a valuable service to retail and professional investors who do not have the time to evaluate the potential for each company investment. Companies with little or no analyst coverage may find it difficult to get on the radar of many fund managers. This reduces the market and demand for those investments. Taking the time to introduce your company to relevant research analysts and following up on a regular basis to update your story may someday get the desired coverage. This takes time, persistence and consistency in the performance of the company but is well worth the effort.
- Pure & Simple
Growth through diversification can lead to unintended consequences. Diversification takes the company further away from its pure-play roots. Fund managers, particularly small-to-mid-cap investment managers, do not like and, in some instances, will not invest in diversified enterprises. Their preference is for clear, distinguishable, pure-play investments. Their portfolio of pure plays provides the diversification they need to manage investor risk. An otherwise satisfactory investment comes off the list for consideration by many fund managers simply because it is not a pure play. This, of course, limits the demand for the shares of the diversified company which further penalizes the company share price. This issue is at the heart of the complaints by activist shareholders in many diversified companies. They call for their breakup to unlock the value imbedded in their divergent businesses.
Business diversifications can come in many forms. Consider development-oriented companies such as those in the biotechnology industry that elect to take the plunge to commercialize their own discoveries. Sales forces are hired. Marketing teams are put in place. Support infrastructures are established. But the risks that are taken on are enormous and the odds are stacked heavily against the company’s success. While success is still possible, the wait-and-see market will attach a significant diversification penalty to the company shares. Avoiding diversifications and the diversification penalty can save precious time and preserve hard-earned company value. If you have survived the probabilities and vagaries of product research and development, why take on the additional and equally vague risks of the market place? Far better to partner the opportunity and realize the value already created.
- Taxes & More Taxes
In assessing the ways and means to realize value, one must always give consideration to the tax consequences. In the end, the value realized is the value received free and clear of any federal, state or foreign taxes. In choosing from among the options, consideration must be given to the tax consequences for both the corporation and its shareholders.
The after-tax proceeds from a corporate transaction that is later distributed to the shareholders can result in a second tax bite from an increasingly smaller pie. Holders of the shares of tax-free spin-outs or IPOs can avoid taxes all together thus significantly improving the value realized. In contrast, the dividend of the after-tax proceeds from the sale of a business with a low tax basis subjects the corporation to a tax on the gain and the shareholders to a tax on the dividend.
- Structure & Analysis
Think carefully and thoughtfully about the structure of any transactions. Remember that the objective is to simply separate the businesses of the diversified firm to realize their pure-play valuations. The ways and means to do this are many and varied. Mergers, outright sales, spin-outs and IPOs each have their advantages and disadvantages from a corporation and a shareholder perspective.
It is important to understand how shareholders will handle the potential outcomes of any action taken. For example, would the holders of a bricks and mortar manufacturer be likely to retain the shares of that same corporation’s spin-out of an Internet subsidiary? If they are likely not to retain the shares, we may incur two unanticipated consequences. First, the shareholder will be taxed on any gain realized upon the disposition of the newly issued shares. Second, the wholesale dumping of the shares could negatively impact the pricing of those shares in the after market. One option to potentially overcome this issue is to give the shareholders of the parent corporation the choice as to which of the two companies’ shares they wish to hold post separation. Under this scenario, each shareholder would have the right to retain shares in the parent corporation or to swap them for shares in the spin out. To be fair, this is a somewhat unusual and rarely used transaction structure. It is provided here simply as an example of the type of unrestricted thinking that should occur before a choice is made as to the structure of any transaction.
Another consideration in evaluating the options for separating businesses are the one-time and ongoing costs of potential transactions. The cost of investment bankers, brokers, accountants and other advisors must be deducted from the amounts to be realized. In addition, in estimating the potential value of a newly spun-out public company, the cost of being a public company must be considered as well. Conversely, in a merger with another company (hopefully a company in the same or similar business), there are likely to be synergies post-merger that will add value to the new enterprise.
The bottom line here is to carefully evaluate all the options and their impacts for the corporation, its shareholders and the surviving entities.
- Time For Action
Finally, fretting about your share price dilemma will get you no where with your problem or your shareholders. Over the long haul, the market always gets it right. Accept the problem as your problem – not the markets – and take action.
·Confirm that your company message is clear and meaningful.
·Confirm with your stakeholders that their understanding of your business is accurate.
·Ensure that the company culture and all governance matters embrace an “always do right” philosophy to help weather the effects of inevitable mistakes and setbacks.
·Analyze the changes in your shareholders over time and as compared with your more successful peer companies to better understand the challenge ahead of you.
·Begin the courtship of influential research analysts to increase the marketability of your company stock.
·Avoid diversification and the diversification share price penalty.
·If you have already diversified, conduct a sum-of-the-parts business valuation to confirm the amount of the diversification penalty implicit in your company share price.
·Devise the plan to realize the value implicit in those businesses through mergers, outright sales, spin-outs and IPOs with full consideration of the tax consequences, transaction structures and transaction costs/benefits.
·Lastly, communicate constantly with all company stakeholders.
Take these actions and your frustrations with the market will be rewarded through the realization of the value you and those that may have preceded you worked so hard to create.
Lawrence (Larry) Gyenes has played a significant role in creating and realizing value in both public and private pharmaceutical, consumer brands and technology-based businesses. He has spent over 20 years in pharmaceuticals serving as the CFO or top finance executive at three of those companies (Searle, Reliant and Savient). He has served as CFO of three public companies (Helene Curtis, CompuServe and Savient), taking CompuServe public in 1996. While at Lorex Pharmaceuticals, a joint venture between Chicago-based Searle and Paris-based Synthelabo, he led the process to develop, approve and commercialize the blockbuster drug, AmbienÒ. He has been at the center of the launch of such well-known brands as NutraSweetÒ, EqualÒ and Pearle Vision CentersÒ. His extensive deal-making experience includes the multi-billion dollar divestitures of DuPont Pharmaceuticals, CompuServe and Helene Curtis as well as multiple acquisitions, co-promotion agreements, joint ventures and strategic alliances. Larry has a bachelor of science in Accounting from the University of Illinois and an MBA from the University of Chicago. He is a CPA and a past nominee for the New Jersey Technology Council’s CFO Hall of Fame.
