071021 equity carve out

EQUITY CARVE-OUT (ECO) AS A FINANCIAL INSTRUMENT FOR CORPORATE RESTRUCTURING, WILL IT WORK FOR THE PULP AND PAPER INDUSTRY?

V.R. (PERRY) PARTHASARATHY, PhDWEYERHAEUSER COMPANYPORT WENTWORTH, GA 31407

2007 TAPPI Engineering, Pulping and Environmental Conference, Jacksonville, Florida, USAOctober 21 to 24, 2007

BREAKING UP IS GOOD TO DO. Restructuring through spin-offs and equity carve-outs can enhance Shareholder Value Creation (SVC)

o Restructuring usually eliminates diffusion of management goals, a problem that goes hand in hand with big, diversified companies. o When the aim is to focus on being the best at one or two things,

restructuring make sense. o Spin-Offs (SO) and Equity Carve-Outs (ECO) are used by large

corporations for restructuring purposes. Used judiciously, SO and ECO are important financial instruments that help corporations

increase value.

There are three types of corporate equity claims:

o Tracking (or Targeted) Stock (TS), o Majority-owned Equity Carve-Out (ECO) and o Spin-offs (SO).

CORPORATE EQUITY CLAIMS

The Tracking Stock (TS) is a class of common stock that is linked to the performance of a specific business group within the diversified firm.

Equity Carve-outs (ECO) are an IPO of a stake in a subsidiary. The parent usually keeps majority ownership.

Spin-offs (SO) occur when the entire ownership of a subsidiary is divested as a dividend to shareholders.

CORPORATE EQUITY CLAIMS

o The financial reporting is separate for the TS from the parent but the control remains in the hands of the parent company.

o TS is typically distributed as a dividend to shareholders of the parent company and can also take the form of an Initial Public Offering

(IPO).

o Even during its hay day, only two Pulp and Paper Companies had taken advantage of this instrument but that did not result in the enhancement of their corporate value.

o By 2006, the TS as a corporate restructuring tool had disappeared altogether and none was issued between 2001 and 2006.

TRACKING STOCK (TS)

o The ECO is different from TS in that equity partition creates well-defined equity claims on assets.

o ECO is the sale of a subsidiary by a publicly traded company by carving out a portion of its outstanding shares through IPO.

o While the parent firm usually retains a controlling interest in the partitioned subsidiary, each ECO, however will have its own

board, operating CEO, and will issue its own financial statement.

o Equity Carve-Outs (ECO) increase the access to capital markets, enabling ECO subsidiary strong growth opportunities while

avoiding the negative signaling associated with a seasoned offering (SEO) of parent equity.

EQUITY CARVE-OUT (ECO)

o In a twelve-year period between 1988 and 1999, the US stock market has seen 50 Carve- outs, or about 10% of the IPOs issued. o While the number of IPOs issued had increased at least three fold between the years

1997 and 2006, the IPOs for ECO were not that many (Exhibit 1). o Over the years, ECO as a corporate restructuring vehicle has shifted, for financial gain to strategic realignment.

EXHIBIT 1.

The Trend in Asset Disaggregation

Source: Bloomberg, Financial Executives Research Foundation Inc., Compustat SDC, BDCI Analysis

1988-1993 1997-20061994-1996 1988-1993 1997-20061994-1996

SPIN-OFF EQUITY CARVE-OUT (ECO)

100%

5012

88 50

17 26 83 10 15 7

80%

60%

40%

20%

42

58

Number of Events

Percent Strategic Reasons

Financial Reasons

Financial Reasons

Strategic Reasons

80 44 25

80 44 25


1988-1993 1997-20061994-1996 1988-1993 1997-20061994-1996

SPIN- OFF EQUITY CARVE- OUT (ECO)

100%

501212

88 50

17 26 83 10 15 7

80%

60%

40%

20%

42

58

Number of Events


Financial Reasons

Financial Reasons

Strategic Reasons

80 44 25

20 56 75


1988-1993 1997-20061994-1996 1988-1993 1997-20061994-1996


100%


1988-1993 1997-20061994-1996 1988-1993 1997-20061994-1996


100%

505012

88 50

12

88 50

17 26 83 10 15 717 26 83 10 15 7

80%

60%

40%

20%

42

58

80%

60%

40%

20%

42

58

Number of EventsNumber of Events


Financial Reasons

Financial Reasons

Strategic Reasons

80 44 25

80 44 25


1988-1993 1997-20061994-1996 1988-1993 1997-20061994-1996

SPIN- OFF EQUITY CARVE- OUT (ECO)

100%

5012 501212

88 50

12

88 50

17 26 83 10 15 717 26 83 10 15 7

80%

60%

40%

20%

42

58

80%

60%

40%

20%

42

58

Number of EventsNumber of Events


Financial Reasons

Financial Reasons

Strategic Reasons

80 44 25

20 56 75


One thing sure about ECO is the inherent assumption that the asset that is being carved-out could not derive its full asset value under the existing corporate structure and a carve-out will accurately value the subsidiary if, part of the equity is carved out and sold in an IPO (Exhibit 2).

EXHIBIT 2.

Equity Carve-Out (Pros and Cons)


o Common equity is the cheapest yet the largest value distribution in the Enterprise Valuation of a company with multiple business segments. o ECO gives a corporate parent an opportunity to get equity and at the same time

increase its market capitalization by virtue of restructuring one of the units as a

carved-out entity

EXHIBIT 3.

Valuation of an Enterprise with Multi-Business Segments

Source: “Valuation”– Measuring and Managing the Value of Companies: McKinsey & Company, Inc.,

Value of the Operating Units

750*

450

350

250

200 250

1750

400

200

1150

Corporate Overhead

TOTAL = 2000

Enterprise Value

Value Distribution

Common Equity Stock

Preferred Stock

Debt

Operation A

Operation B

Operation C

Operation D

Convertible Securities

*all values in million US$



750*

450

350

250

200 250

1750

400

200

1150

Corporate Overhead

TOTAL = 2000

Enterprise Value

Value Distribution

Common Equity Stock

Preferred Stock

Debt

Operation A

Operation B

Operation C

Operation D





750*

450

350

250

200 250

1750

400

200

1150

Corporate Overhead

TOTAL = 2000

Enterprise Value

Value Distribution

Common Equity Stock

Preferred Stock

Debt

Operation A

Operation B

Operation C

Operation D




o Thermo-Electron (TE) is the most successful company to leverage ECO to deliver high returns to its shareholders. o In 1982, TE was just a US $200 million company. By 1997, its market value was

$5200 million (a whopping 2500%) through frequent equity partition of business segments and owning controlled interest in the ECO subsidiaries

EXHIBIT 4.

Thermo Electron’s ECO Examples


March 1982 Market Value = $ 210 MM Thermo Electron March 1997 Market Value > $ 5,200 MM

Measuring and Controlling Devices

ECO Subsidiary(Business) (Year of ECO)

Parent’s % Ownership Market Value, in $ MM*

CAGR, % (3 Years)(2002-2005)

Thermomedics 51 683.1 38.0(Biomedical, 08/83)Thermo Instruments 86 3,033.1 14.3(Process Control, 08/86)Thermo TerraTech, Inc 81 165.2 20.7(Environmental Sciences, 08/86)Thermo Power Corp 63 84.3 -0.63(Refrigeration Engg, 06/87)Thermo Cardiosystems 55 88.5 21.0(Medical Device, 01/89)Thermo Voltaic Corp 59 102.5 21.8(Electromagnetic Devices, 03/90)ThermoTREX Corp 51 475.2 5.5(X-Ray Systems, 07/91)Thermo Fibertek 81 680.2 16.9(Papermaking Systems, 11/92)Thermo Remediation 69 99.5 9.8(Soil and Waste Engg, 12/93)Thermo Lase 65 554.5 12.3(Personal Care, 07/94)Thermo Ecolak Corp 83 396.5 27.6(Clean Fuels, 01/95)Thermo Spectra, Thermo Quest,TREX Medical 72,94,91 1,250.2 37.0 (Weighted)(Imaging, Analytical and X-Ray, 95&96)

*The MV is for year 1997 and in a ten-year period, the MV is tripled to US$ 15.7 billion.Source: The McKinsey Quarterly 1997, Volume 1, pp 165-172.

March 1982 Market Value = $ 210 MM Thermo Electron March 1997 Market Value > $ 5,200 MM

Measuring and Controlling Devices

ECO Subsidiary(Business) (Year of ECO)

Parent’s % Ownership Market Value, in $ MM*

CAGR, % (3 Years)(2002-2005)

Thermomedics 51 683.1 38.0(Biomedical, 08/83)Thermo Instruments 86 3,033.1 14.3(Process Control, 08/86)Thermo TerraTech, Inc 81 165.2 20.7(Environmental Sciences, 08/86)Thermo Power Corp 63 84.3 -0.63(Refrigeration Engg, 06/87)Thermo Cardiosystems 55 88.5 21.0(Medical Device, 01/89)Thermo Voltaic Corp 59 102.5 21.8(Electromagnetic Devices, 03/90)ThermoTREX Corp 51 475.2 5.5(X-Ray Systems, 07/91)Thermo Fibertek 81 680.2 16.9(Papermaking Systems, 11/92)Thermo Remediation 69 99.5 9.8(Soil and Waste Engg, 12/93)Thermo Lase 65 554.5 12.3(Personal Care, 07/94)Thermo Ecolak Corp 83 396.5 27.6(Clean Fuels, 01/95)Thermo Spectra, Thermo Quest,TREX Medical 72,94,91 1,250.2 37.0 (Weighted)(Imaging, Analytical and X-Ray, 95&96)

*The MV is for year 1997 and in a ten-year period, the MV is tripled to US$ 15.7 billion.Source: The McKinsey Quarterly 1997, Volume 1, pp 165-172.

Equity Carve-Outs (ECO) out performed SO on three financial metrics, Total Shareholder Return (TSR), change in leading P/E ratio and Return on Invested Capital (ROIC).

EXHIBIT 5.

Comparison of Performance Metrics for ECO and SO


The Booz-Allen & Hamilton and SMU/The McKinsey Company studies which compared 78 merger deals between 1997 and 1998 and between 2002 and 2003 and worth more than $1 billion each, concluded that

o 48% of the mergers failed to deliver the promised cost savings over the two-year post-merger period.

o 52 percent of them had fallen short of achieving the revenue growth.

o Almost one-third of the companies delivered less than 40% of the cost-savings that were used as the basis for the mergers.

The previous pulp and paper industry mergers (and the premiums paid to acquire the companies) had been justified under potential cost savings rather than revenue growth put a big dent on their chance for success which came out to be true.


ECO on average has the strongest TSR or SVC performance of any restructuring vehicle and the track record of ECO on ROIC are far superior to Spin-offs (SO).

EXHIBIT 6.

Very Few Companies Achieved Success Through Mergers


-2

-1

0

1

2

3

4

-2 -1

0

-3

1 2 3

Post-Merger Revenue Growth

Pre

-Mer

ger

Rev

en

ue

Gro

wth

Great Earners Unfazed

Bad Remains Bad

Negative

Negative

Positive

Positive

Very Few Players Perform

Slow Down of Solid Performers

Sample of more than 160 acquisitions by 157 publicly traded companies across 11 industries. Revenue growth calculated for combined entity 5 years before and after mergers (1996-2005)

Source: The McKinsey Quarterly 2001, Number 4.

-2

-1

0

1

2

3

4

-2 -1

0

-3

1 2 3

Post-Merger Revenue Growth

Pre

-Mer

ger

Rev

en

ue

Gro

wth

Great Earners Unfazed

Bad Remains Bad

Negative

Negative

Positive

Positive

Very Few Players Perform

Slow Down of Solid Performers

Sample of more than 160 acquisitions by 157 publicly traded companies across 11 industries. Revenue growth calculated for combined entity 5 years before and after mergers (1996-2005)

Source: The McKinsey Quarterly 2001, Number 4.

o To deliver superior shareholder return, P&P industry can use, ECO as a corporate restructuring vehicle.

o For ECO to be successful, the parent company should have multi-segmented businesses and that the subsidiary can be separated easily from the parent without creating huge transfer-pricing issues and also the subsidiary should have good prospects.

o Out of the eighteen large U.S. and Canadian pulp and paper companies, only six are truly multi-segmented businesses and only these companies can do an ECO or spin-off.


The majority-owned ECO is the most appropriate for P&P industry because:

Out of the six P&P companies that are truly multi-segmented businesses, five of them have debt to equity ratio over 1.5 and therefore suffer huge capital constraints.

ECO will allow the parent companies to raise capital at a fair-price and to fund projects that might otherwise depress earnings.


The majority-owned ECO is the most appropriate for P&P industry because:

Certain businesses in pulp and paper companies, woodlands or lumber, for example, can readily be separated without involving transfer price problems.

Before the ECO, both the boards need to review contractual agreements, including those establishing transfer prices, and agree on sharing other supports such as R&D, sales and marketing, and certain manufacturing resources, etc.


CONCLUSIONS

Restructuring of corporations is usually carried-out to improve performance.

A majority-owned equity carve-out is one such equity claim that would allow the carved-out business units to improve performance by exposing them to the capital market and attracting new investors.

ECO brings a new management team into the organization. This usually results in improvement in operating performance, providing incentives for managers and increasing their strategic flexibility.


CONCLUSIONS

While mergers can be used as one of the tools to improve the performance of the pulp and paper industry, for companies with multi-segmented businesses, the ECO offers the best value-enhancing proposition

If judiciously applied, ECO can help corporate management to increase value of both the parent and the carved-out subsidiary.


Thanks.

071021 equity carve out

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