Lawrence A. Cunningham’s Quality Investing: Why GE’s tax-free split could power the stock higher and reward patient investors
Shareholders should welcome the announcement that General Electric
will become three companies. Using a mechanism called a spinoff — a tax-free dividend to GE shareholders of new shares in the separated businesses — CEO Larry Culp pursues value creation modeled by corporate titans from John Malone to Bill Stiritz and by companies from ITT
which Culp used to run.
At GE, Culp is addressing a problem common to large corporations: a centralized command structure over multiple divisions. Such cultures offer limited incentives for creativity, adaptability and versatility. Spinning off a company liberates it from that culture, enabling managers to be more focused on their individual business and setting them up for increased chance of success.
One practitioner of multiple spin-offs is William Stiritz of Ralston Purina . When Stirtiz arrived at Ralston, the sprawling food products company famous for pet food, it had grown to include a variety of businesses, collectively called Ralcorp . They operated in many unrelated niche areas — infant formula, cereal, cookies, and ski resorts. Stiritz observed that such a wide array of business could not be managed efficiently and devised a plan to reorganize the company.
Stiritz embarked on a series of spinoffs, after which he saw a transformation in corporate leadership. Many Ralcorp managers who showed modest abilities beforehand became “incredible managers” when leading their own stand-alone businesses. Stiritz calls the spin “the ultimate form of reorganization for better results.” Those results were so strong at Ralston that Stiritz earned a chapter in Will Thorndike’s masterpiece, “The Outsiders,” and was awarded the Singleton Prize for capital allocation in 2019.
Perhaps the best-known practitioner of the corporate spinoff is John Malone of Liberty Media
Throughout its history, Liberty Media has been a relentless acquirer of a wide variety of businesses extending far beyond its origins in communications. But rather than creating a conglomerate of diverse businesses, the company has also been a relentless divestor. Spinoffs have been a favorite tool of divesture, including such prominent companies as Liberty Global/Discovery , DirecTV , Expedia
Starz , and QVC. All of these businesses prospered after their spins.
By constantly divesting, Malone avoids the problems of corporate suffocation that Stiritz referred to. It is as if the king parcels out earldoms, dukedoms, and other fiefdoms and locates them where their value will be best nurtured, to grow into new kingdoms.
The only other way to do that is to maintain an autonomous and highly decentralized business model, most famously done by Warren Buffett at Berkshire Hathaway
and also by such kindred companies as Amphenol Corp.
Illinois Tool Works
and Roper Technologies
Yet maintaining such a culture while operating at scale is difficult — and many such decentralized companies have also made spinoffs, including Constellation Software
(where I serve on the board), Graham Holdings
and Danaher Corp., Culp’s former company.
That’s why the conglomerate diminished in popularity in the 1990s, often dismantled by spinoffs. It was through spinoffs that ITT, for example, split into three in 1995, how AT&T
divested Lucent and NCR in 1996, and how Alleghany Corporation
— also highly decentralized — spun-off its Chicago Title Corporation business in 1998.
Others have used spins as part of a recurring process that involves both regular business expansion — whether acquired or organic—and later divestitures of some of them. An example is Sears Holdings
which from 1993 to 2014 spun off such powerhouses it had nurtured as Allstate, Dean Witter, Diehard, Discover, and Land’s End . Given the eventual fate of Sears as a retailer, it’s clear that those companies benefited from being spun out.
Such results explain why activist shareholders often prescribe spinoffs of excessively diversified businesses. In recent years prominent spins instigated by activist investors include eBay
spinning PayPal Holdings
(at the urging of Carl Icahn); EMC spinning VMware
(Elliott Management); and Timken
its steel business (Relational Investors).
Spinoffs also promote accountability to shareholders. Business divisions become opaque inside large organizations, making it difficult for investors to understand and evaluate a company. Spinoffs correct this problem — useful whether or not the business performs well.
Spins have become increasingly common in recent years as a way to increase focus and related capital allocation, whether at conglomerates or otherwise. As such, a strategy that includes spinoffs as a regular element can be a strong general deterrent to activists, as well as a source of shareholder value. Applying that strategy at an old conglomerate like GE is another reason shareholders will be listening closely to Larry Culp.
Lawrence A. Cunningham is a professor at George Washington University, founder of the Quality Shareholders Group, and publisher, since 1997, of “The Essays of Warren Buffett: Lessons for Corporate America.” Cunningham owns shares of Berkshire Hathaway, and Constellation Software. He is a director and vice-chairman of Constellation Software. For updates on Cunningham’s research about quality shareholders, sign up here.
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