21
tax free to P&G because it is an intracompany transfer. If the exchange offer had not been fully subscribed, P&G would have
distributed through a tax-free spin-off the remaining shares as a dividend to P&G shareholders.
The transaction agreement outlined the terms and conditions pertinent to completion of the merger with Diamond Foods.
Immediately after the completion of the distribution, the Pringles Company merged with Merger Sub, a wholly owned shell
subsidiary of Diamond, with Merger Sub’s continuing as the surviving company. The shares of Pringles Company common
P&G
Shareholders
Diamond
Shareholders
The Proctor &
Diamond Foods
Pringles Company
Merger Sub
Pre-Merger Structure
Separation Structure before Merger
P&G Shareholders
The Proctor &
Gamble Company
Pringle Company
(owns Pringle’s
assets and liabilities)
Merger Sub
Diamond
P&G
Sharehold
Stock
22
able to purchase Diamond common shares (flip-in poison pill) or those of any company into which Diamond is merged (flip–
over poison pill) at a price of $60 per share. Such rights would expire in March 2015 unless extended by Diamond’s board of
directors.
Discussion Questions:
1. The merger of Pringles and Diamond Foods could have been achieved as a result of a P&G spin-off of
Pringles. Explain the details of how this might happen.
Answer: By creating a wholly-owned shell subsidiary, P&G could have distributed the shares to its shareholders as a dividend
2. Speculate as to why P&G chose to split-off rather than spin-off Pringles as part its plan to merge Post with Ralcorp.
Be specific.
Answer: P&G chose a split-off rather than spin-off even though either would have resulted in a tax-free transaction for its
3. Why was this transaction subject to the Morris Trust tax regulations?
Answer: The U.S. Tax Code restricts how certain types of corporate transactions can be structured to avoid taxes. Specifically,
split-offs or spin-offs implemented as part of a merger must be structured to satisfy Morris Trust tax code rules if the
transaction is to be deemed tax free. The IRS’ concern is that a split–off or spin-off of a wholly-owned parent subsidiary could
4. How is value created for the P&G and Diamond shareholders in this type of transaction?
Diamond Foods
Merger Sub
Pringle Company (owns
Pringles assets/liabilities)
Diamond
Common
Shares
Answer: Ideally, the impact of taxes on investment decisions would be neutral, such that taxes would not impact how the free
market allocates capital. Resources would be transferred to those who can use them most efficiently, as they would be able to
offer the highest risk adjusted financial returns to attract investors.
5. Why did the addition of the shareholder rights plan by Diamond Foods following the merger with Pringles make sense
given the type of deal structure used?
Answer: The use of the split-off/reverse Morris Trust structure to acquire Pringles results in the transaction being tax-free to
The Anatomy of a Spin-Off—Northrop Grumman Exits the Shipbuilding Business
_____________________________________________________________________________________________
Key Points
There are many ways a firm can choose to separate itself from one of its operations.
Which restructuring method is used reflects the firm’s objectives and circumstances.
______________________________________________________________________________
In an effort to focus on more attractive growth markets, Northrop Grumman Corporation (NGC), a global leader in aerospace,
communications, defense, and security systems, announced that it would exit its mature shipbuilding business on October 15,
2010. Huntington Ingalls Industries (HII), the largest military U.S. shipbuilder and a wholly owned subsidiary of NGC, had
been under pressure to cut costs amidst increased competition from competitors such as General Dynamics and a slowdown in
orders from the U.S. Navy. Nor did the outlook for the shipbuilding industry look like it would improve any time soon.
Given the limited synergy between shipbuilding and HII’s other businesses, HII’s operations were largely independent of
3 The share–exchange ratio of one share of HII common for each six shares of NGC common was calculated by dividing HII’s
48.8 million common shares (having a par value of $.01) by the 298 million NGC shares outstanding. Since fractional shares
24
The spin-off process involved an internal reorganization of NGC businesses, a Separation and Distribution Agreement, and
finally the actual distribution of HII shares to NGC shareholders. The internal reorganization and subsequent spin-off is
illustrated in Figure 16.4. NGC (referred to as Current Northrop Grumman Corporation) first reorganized its businesses such
that the firm would become a holding company whose primary investments would include Huntington Ingalls Industries (HII)
between HII and NGC after completion of the spin-off and provided for the allocation between the two firms of assets,
liabilities, and obligations (e.g., employee benefits, intellectual property, information technology, insurance, and tax–related
assets and liabilities). The agreement also provided that NGC and HII each would indemnify (compensate) the other against
any liabilities arising out of their respective businesses. As part of the agreement, HII agreed not to engage in any transactions,
50% for at least two years following the transaction. A change in control could violate the IRS’s “continuity of interest”
requirement and jeopardize the tax-free status of the spin-off. Consequently, HII put in place certain takeover defenses to make
takeovers difficult.
Discussion Questions
1. Speculate as to why Northrop Grumman used a spin-off rather than a divestiture, split-off or split up to separate
Huntington Ingalls from the rest of its operations? What were the advantages of the spin–off over the other restructuring
strategies.
Answer: Spin-offs may involve businesses which are first transferred to a newly formed wholly–owned subsidiary corporation,
with the stock of that corporation then distributed to the shareholders of the parent firm. Other times, the stock of a pre-existing
subsidiary is distributed. Section 355 of the U.S. Tax Code permits the division of a corporation tax-free, including a spin-off,
aggregation of all fractional shares, which were subsequently sold in the public market. The cash proceeds were then
distributed to NGC shareholders on a pro rata basis and were taxable to the extent a taxable gain is incurred by the shareholder.
25
2. What is the likely impact of the spin–off on Northrop Grumman’s share price immediately following the spin-off of
Huntington Ingalls assuming no other factors offset it?
3. Why do businesses that have been spun off from their parent often immediately put antitakeover defenses in place?
4. Why would the U.S. Internal Revenue Service be concerned about a change of control of the spun-off business such
that it might revoke its ruling that the spin-off satisfied the requirements to be tax-free?
Answer: The IRS is concerned that a spin-off may be used for tax avoidance rather than for a sound business purpose. A sound
.
5. Describe how you as an analyst would estimate the potential impact of the Huntington Ingalls Industries spin–off on
the long–term value of Northrop Grumman’s share price?
Answer: An important stated motivation for the spin–off by Northrop Grumman’s management is to simplify the corporation,
Figure 16.4 Spin-off Illustration.
26
Kraft Foods Splits Up in Its Biggest Deal Yet
Current Northrop
Grumman Corp
(CNGC)
New Northrop
Grumman Corp
Public
Shareholders
Public
Shareholders
27
_____________________________________________________________________________________________________
Key Points
Investors often evaluate a firm’s performance in terms of how well it does as compared to its peers.
Activist investors can force an underperforming firm to change its strategy radically.
In 2010, the firm made what at the time was viewed by top management as its most transformational move by acquiring
British confectionery company Cadbury for $19 billion. While the firm became the world’s largest snack company with the
completion of the transaction, it was still entrenched in its traditional business, groceries. The company now owned two very
6% ownership interest.
To avert a proxy fight, Kraft’s board and management announced on August 4, 2011, its intention to restructure the firm
radically by separating it into two distinct businesses. Coming just 18 months after the Cadbury deal, investors were initially
stunned by the announcement but appeared to avidly support the proposal avidly by driving up the firm’s share price by the end
of the day. The proposal entailed separating its faster-growing global snack food business from its slower-growing, more
United States–centered grocery business. The separation was completed through a tax-free spin-off to Kraft Food shareholders
of the grocery business on October 1, 2012. The global snack food business will be named Mondelez International, while the
North American grocery business will retain the Kraft name.
Management justified the proposed split-up of the firm as a means of increasing focus, providing greater opportunities, and
giving investors a choice between the faster-growing snack business and the slower-growing but more predictable grocery
operation. Management also argued that the Cadbury acquisition gave the snack business scale to compete against such
competitors as Nestlé and PepsiCo.
Discussion Questions
1. Speculate as to why Kraft chose not to divest its grocery business and use the proceeds to either reinvest in its faster
growing snack business, to buy back its stock, or a combination of the two?
Answer: Many of Kraft’s grocery brands were quite old and the firm’s tax basis was probably quite low. A divestiture
would have resulted in a huge tax liability to the firm and have significantly reduced the after-tax proceeds available
28
2. How might a spin-off create shareholder value for Kraft Foods shareholders?
Answer: Spin-offs create value for shareholders in a variety of ways. First, if properly structured, they are tax-free to
3. There is often a natural tension between so-called activist investors interested in short-term profits and a firm’s
management interested in pursuing a longer-term vision. When is this tension helpful to shareholders and when does it
destroy shareholder value?
Answer: If a firm’s current strategy is faltering, activist investors can force a change in direction. While the firm’s
share price did grow in excess of the S&P 500 index since 2010, it is unclear if activist investors gave the Kraft
GENERAL ELECTRIC DOWNSIZES
ITS FINANCIAL SERVICES UNIT
_____________________________________________________________________________________
Key Points
• Exiting a business can take many forms ranging from an outright sale to an initial public offering to a split-off.
• The exit can take place at a moment in time or be phased over a period of time.
• The choice of the appropriate restructuring strategy reflects an array of factors including the parent firm’s need for
cash, the availability of potential buyers, and tax considerations.
______________________________________________________________________________
Long synonymous with the word conglomerate, General Electric had skillfully managed for years its highly diverse business
portfolio profitably. GE Capital had been a major profit generator for General Electric Corporation for decades, often
contributing more than one–half of the parent firm’s operating profits. The firm’s exposure to the financial services industry
had provided sustained growth and had tended to offset some of the cyclicality of its industrial businesses. GE Capital had been
managed as a cash cow to generate new funds to finance the parent’s forays into new businesses.
All that changed with the collapse of the global financial markets in 2008. GE shares plummeted immediately following the
bankruptcy of mega investment bank Lehman Brothers, as investors expressed concern about the conglomerate’s ability to
support its financial services businesses. Huge holdings of commercial loans whose value was questionable along with its
substantial risk exposure as a subprime residential home loan lender raised the prospect that GE Capital would be forced into
bankruptcy.
Recognizing the key role played by the business in the U.S. economy, U.S. regulators declared it as a “systemically
important financial institution.” This meant that the government could take over the business in an effort to wind it down in an
orderly manner if it were declared to be insolvent in an effort to blunt any ripple effect that the demise of such a large
institution might have on global financial markets. The net result would be huge financial losses for GE shareholders. To
minimize this potential outcome, GE decided to reduce substantially its vulnerability to the financial services industry.
Despite efforts in recent years to downsize the operation by divesting in 2010 its commercial real estate business for $251
billion, GE Capital remained a major revenue generator for General Electric. In 2013, the unit’s annual revenue totaled $44.1
billion, about 30% of the parent’s consolidated revenue.
To accelerate its efforts to restructure GE Capital, the unit’s retail finance operation was renamed Synchrony Financial and
taken public through an initial public offering in late 2014. Synchrony processes credit card transactions for major retailers
such as the Gap and Walmart. The IPO represented 20% of Synchrony shares. By issuing only 20% of its shares, GE would be
able to consolidate the unit’s financials for tax purposes. The IPO enabled GE to establish a value for the business and to
create a liquid market for the unit’s stock, a factor that was to make the second half of GE’s exit strategy for this business
29
possible. The proceeds of the IPO were used to pay certain intercompany loans owed to General Electric Corporation and to
add to the new company’s capital base.
In 2015, GE will completely exit the remaining 80% of its retail finance business through a so-called transaction consisting
of a tax-free distribution of its remaining interest in Synchrony to GE shareholders willing to exchange their shares of GE
common for Synchrony Financial shares. Any remaining shares in Synchrony not disposed of through the share exchange will
be paid out as a dividend to GE shareholders. In doing so, GE will be totally rid of its retail finance unit.
GE decided to undertake this staged divestment of its retail finance unit because of its huge size and the inability to find a
buyer for the entire business. The obvious potential acquirers are other large financial institutions which continue to find
themselves capital constrained and as such unlikely to be permitted by regulators to undertake such a large acquisition.
Consequently, GE’s options for exiting this business were limited.
The Warner Music Group is Sold at Auction
_____________________________________________________________________________________________________
Key Points
In selling a business, a firm may choose either to negotiate with a single potential buyer, to control the number of potential
bidders, or to engage in a public auction.
The auction process often is viewed as the most effective way to get the highest price for a business to be sold; however, far
from simple, an auction can be both a chaotic and a time-consuming procedure.
Auctions may be most suitable for businesses whose value is largely intangible or for “hard–to–value” businesses.
____________________________________________________________________________________________________
In early 2011, the Warner Music Group (WMG), the third largest of the “big four” recorded–music companies, consisted of two
separate businesses: one showing high growth potential and the other with declining revenues. Of WMG’s $3 billion in annual
revenue, 82% came from sales of recorded music, with the remainder attributed to royalty payments for the use of music
owned by the firm. Of the two, only recorded music has suffered revenue declines, due to piracy, aggressive pricing of online
music sales, and the bankruptcy of many record retailers and wholesalers. In contrast, music publishing has grown as a result of
In 2004, Warner Music’s parent at the time, Time Warner Inc., agreed to sell the business to a consortium led by THL
Partners for $2.6 billion in cash. The group also included Edward Bronfman, Jr. (the Seagram’s heir, who also became the
CEO of WMG), Bain Capital, and Providence Equity Partners. Having held the firm for seven years, a long time for private
equity investors, its primary investors were seeking a way to cash out of the business, whose long-term fortunes appeared
30
For bidders, the objective is to make it to the next round in the auction; for sellers, the objective is less about prices offered
during the initial round and more about determining who is committed to the process and who has the financial wherewithal to
consummate the deal. According to the firm’s proxy pertaining to the sale, released on May 20, 2011, the subsequent bidding
was characterized as a series of ever-changing alliances among bidders, with Access Industries submitting the winning bid. The
sale appears to have been a success from the investors’ standpoint, with some speculating that THL alone earned an internal
rate of return (including dividends) of 34%.4
Motorola Bows to Activist Pressure
Under pressure from activist investor Carl Icahn, Motorola felt compelled to make a dramatic move before its May 2008
shareholders’ meeting. Icahn had submitted a slate of four directors to replace those up for reelection and demanded that the
wireless handset and network manufacturer take actions to improve profitability. Shares of Motorola, which had a market value
of $22 billion, had fallen more than 60% since October 2006, making the firm’s board vulnerable in the proxy contest over
director reelections.
Signaling its willingness to take dramatic action, Motorola announced on March 26, 2008, its intention to create two
independent, publicly traded companies. The two new companies would consist of the firm’s former Mobile Devices operation
(including its Home Devices businesses consisting of modems and set-top boxes) and its Enterprise Mobility Solutions &
Wireless Networks business. In addition to the planned spin-off, Motorola agreed to nominate two people supported by Carl
Icahn to the firm’s board. Originally scheduled for 2009, the breakup was postponed due to the upheaval in the financial
markets that year. The breakup would result in a tax-free distribution to Motorola’s shareholders, with shareholders receiving
shares of the two independent and publicly traded firms.
The Mobile Devices business designs, manufactures, and sells mobile handsets globally, and it has lost more than $5
billion during the last three years. The Enterprise Mobility Solutions & Wireless Networks business manufactures, designs, and
services public safety radios, handheld scanners and telecommunications network gear for businesses and government agencies
and generates nearly all of the Motorola’s current cash flow. This business also makes network equipment for wireless carriers
such as Spring Nextel and Verizon Wireless.
By dividing the company in this manner, Motorola would separate its loss–generating Mobility Devices division from its
other businesses. Although the third largest handset manufacturer globally, the handset business had been losing market share
to Nokia and Samsung Electronics for years. Following the breakup, the Mobility Devices unit would be renamed Motorola
Mobility, and the Enterprise Mobility Solutions & Networks operation would be called Motorola Solutions.
Motorola’s board is seeking to ensure the financial viability of Motorola Mobility by eliminating its outstanding debt and
through a cash infusion. To do so, Motorola intends to buy back nearly all of its outstanding $3.9 billion debt and to transfer as
much as $4 billion in cash to Motorola Mobility. Furthermore, Motorola Solutions would assume responsibility for the pension
obligations of Motorola Mobility. If Motorola Mobility were to be forced into bankruptcy shortly after the breakup, Motorola
21, 2010, would receive one share of Motorola Mobility common for every eight shares of Motorola Inc. common stock they
held. Table 15.3 shows the timeline of Motorola’s restructuring effort.
Discussion Questions
1. In your judgment, did the breakup of Motorola make sense? Explain your answer.
4 De La Merced, 2011
31
2. What other restructuring alternatives could Motorola have pursued to increase shareholder value? Why do you believe it
pursued this breakup strategy rather than some other option?
Table 15.3
Motorola Restructure Timeline
Motorola (Beginning 2010)
Motorola (Mid-2010)
Motorola (Beginning 2011)
Mobility Devices
Mobility Devices
Motorola Mobility spin-off
*Wireless Networks sold to Nokia-Siemens.
In August 2008, Kraft Foods announced an exchange offer related to the split-off of its Post Cereals unit and the closing of the
merger of its Post Cereals business into a wholly-owned subsidiary of Ralcorp Holdings. Kraft is a major manufacturer and
distributor of foods and beverages; Post is a leading manufacturer of breakfast cereals; and Ralcorp manufactures and
distributes brand-name products in grocery and mass merchandise food outlets. The objective of the transaction was to allow
Kraft shareholders participating in the exchange offer for Kraft Sub stock to become shareholders in Ralcorp and Kraft to
Kraft’s $300 million liability, 100% of Kraft Sub’s stock, and Kraft Sub debt securities with a principal amount of $660
million. The consideration that Kraft received, consisting of the debt assumption by Kraft Sub, the debt securities from Kraft
Sub, and the Kraft Sub stock, is considered tax free to Kraft, since it is viewed simply as an internal reorganization rather than
a sale.5 Kraft later converted to cash the securities received from Kraft Sub by selling them to a consortium of banks.
In the related split-off transaction, Kraft shareholders had the option to exchange their shares of Kraft common stock for
their Kraft shares in the exchange offer owned 0.6606 of a share of Ralcorp stock for each Kraft share exchanged as part of the
split-off.
Concurrent with the exchange offer, Kraft closed the merger of Post with Ralcorp. Kraft shareholders received Ralcorp
stock valued at $1.6 billion, resulting in their owning 54% of the merged firm. By satisfying the Morris Trust tax code
regulations,6 the transaction was tax free to Kraft shareholders. Ralcorp Sub was later merged into Ralcorp. As such, Ralcorp
Discussion Questions and Answers:
1. What does the decision to split up the firm say about Kraft’s decision to buy Cadbury in 2010?
5 The intracompany transfer of certain assets and associated liabilities is considered a tax-free event if it complies with the requirements of a D reorganization under Section 355 of the U.S.
Internal Revenue Code.
6 Split-offs and spin-offs undertaken as part of a merger must be structured to satisfy Morris Trust tax code rules if they are to be tax free. Such rules require that the shareholders of the parent
undertaking the split-off or spin-off end up as majority shareholders in the merged firm.
7 The $660 million represents the book value of the debt on the merger closing date. The more correct representation in calculating the purchase price would be to estimate its market value.
2. Why did Kraft chose not to divest its grocery business, using the proceeds to either reinvest in its faster growing snack
business, to buy back its stock, or a combination of the two?
Answer: Many of Kraft’s grocery brands were quite old and the firm’s tax basis was probably quite low. A divestiture
would have resulted in a huge tax liability to the firm and have significantly reduced the after-tax proceeds available
3. How might a spin-off create shareholder value for Kraft Foods shareholders?
Answer: Spin-offs create value for shareholders in a variety of ways. First, if properly structured, they are tax-free to
4. Kraft CEO Irene Rosenfeld argued that an important justification for the Cadbury acquisition in 2010 was to create
two portfolios of businesses: some very strong cash generating businesses and some very strong growth businesses in
order to increase shareholder value. How might this strategy have boosted the firm’s value?
5. While Kraft’s share value did increase following the Cadbury deal, it lagged the performance of key competitors. Why
do you believe this was the case? Explain your answer.
6. There is often a natural tension between so-called activist investors interested in short–term profits and a firm’s
management interested in pursuing a longer-term vision. When is this tension helpful to shareholders and when does it
destroy shareholder value?
Exhibit 15-1. Structuring the Transaction
Step 1: Kraft creates a shell subsidiary (Kraft Sub) and transfers Post assets and liabilities and
$300 million in Kraft debt into the shell in exchange for Kraft Sub stock plus $660 million in
Kraft Sub debt securities. Kraft also implements an exchange offer of Kraft Sub for Kraft
common stock.
Step 2: Kraft Sub, as an independent company, is merged in a forward triangular tax–free merger with a sub of Ralcorp
(Ralcorp Sub) in which Kraft Sub shares are exchanged for Ralcorp shares, with Ralcorp Sub surviving.8
8 The merger is tax free to Kraft Sub shareholders in that it results in Kraft Sub shareholders owning a significant ongoing
Liabilities +
Assumed $300
Million in Kraft
Common Shares +
$660 Million in
Kraft Shares
Ralcorp
Ralcorp Sub
Kraft Sub (Post)
(i.e., former Kraft
Shareholders)
Ralcorp
Ralcorp
Kraft Sub Assets & Liabilities
Ralcorp
Stock
After spurning a series of takeover offers, Sara Lee, a global consumer goods company, announced in early 2011 its intention
to split the firm into two separate publicly traded companies. The two companies would consist of the firm’s North American
retail and food service division and its international beverage business. The announcement comes after a long string of
restructuring efforts designed to increase shareholder value. It remains to be seen if the latest effort will be any more successful
than earlier efforts.
share price continued to flounder.
In September 1997, Sara Lee embarked on a major restructuring effort designed to boost both profits, which had been
growing by about 6% during the previous five years, and the company’s lagging share price. The restructuring program was
intended to reduce the firm’s degree of vertical integration, shifting from a manufacturing and sales orientation to one focused
on marketing the firm’s top brands. The firm increasingly viewed itself as more of a marketing than a manufacturing
Hills Bros, and Chase & Sanborn.
Despite these restructuring efforts, the firm’s stock price continued to drift lower. In an attempt to reverse the firm’s
misfortunes, the firm announced an even more ambitious restructuring plan in 2000. Sara Lee would focus on three main areas:
food and beverages, underwear, and household products. The restructuring efforts resulted in the shutdown of a number of
meat packing plants and a number of small divestitures, resulting in a 10% reduction (about 13,000 people) in the firm’s
food, beverage, and household and body care businesses. To this end, the firm announced plans to dispose of 40% of its
revenues, totaling more than $8 billion, including its apparel, European packaged meats, U.S. retail coffee, and direct sales
businesses.
In 2006, the firm announced that it had completed the sale of its branded apparel business in Europe, Global Body Care and
European Detergents units, and its European meat processing operations. Furthermore, the firm spun off its U.S. Branded
In 2009, the firm sold its Household and Body Care business to Unilever for $1.6 billion and its hair care business to Procter &
Gamble for $0.4 billion.
In 2010, the proceeds of the divestitures made the prior year were used to repurchase $1.3 billion of Sara Lee’s outstanding
shares. The firm also announced its intention to repurchase another $3 billion of its shares during the next three years. If
completed, this would amount to about one-third of its approximate $10 billion market capitalization at the end of 2010.