Will Xerox’s Spinoff Unlock Value for Investors?

Xerox

When Xerox Corporation CEO Ursula Burns announced the takeover of Affiliated Computer Services (ACS) in 2009, she described it as a “game changer” for the iconic, century-old copier company. Although it was not particularly a unique move for a technology hardware enterprise to diversify by buying a service-oriented business, Burns and Wall Street talked about the potential for synergistic growth from the $6.4 billion deal, as the merging companies — one with considerable global reach and the other primarily domestic — shared efficiencies, customers and technological innovation.

That didn’t turn out to be the case. Despite the combination that took effect in 2010, the merged company’s revenue has declined every year since, and its market capitalization has plummeted — dropping from $15 billion at the end of that year to just $9.4 billion around the time the split was made public on January 29 of this year. Today, as Xerox prepares to begin the process of dividing the business into two publicly traded entities — the biggest part in terms of revenue consists essentially of the pre-merger Xerox and the other is constructed around ACS’s business process outsourcing operations or BPO — the company seems, in many respects, to be back to square one.

“The document company is essentially returning to where it was before,” says Ken Weilerstein, an analyst at the research and advisory firm Gartner. “The ACS deal was a big leap, and now Xerox will have to revisit the question [of how to grow] in a more nuanced way.” Weilerstein specializes in document-related technologies and closely tracks the printer, managed print services and digital document industries. “There was some cross-selling, but at the end of the day the two divisions didn’t become highly interdependent and offered no strong reasons to stay together,” he adds. The document side of the business is expected to have $11 billion in 2015 revenue, and the BPO side, $7 billion.

Shares of Xerox have fallen by a third in the last 12 months as it pursues a turnaround strategy of focusing on IT services amid declines in its printer and copier sales. The company said it is splitting into two because the document and BPO sides serve different client needs that call for customized operating models and capital structures, and each company would be more valuable as a separate entity. The spinoff is expected to yield $2.4 billion in savings over the next three years.

Do Spinoffs Work?

Will the split prove any more successful than the decision to merge in the first place? While most experts, including Weilerstein, believe it will, several warn of challenges facing the two new companies even before the dust settles.

“On average, spinoffs do create value for shareholders, but the devil is in the details,” says Emilie Feldman, Wharton management professor and a divestiture expert. “There are all sorts of issues and decisions that have to get made that affect both the distribution of value between the two new companies and the magnitude of the gains associated with those deals. And some of the decisions may not always end up being positive for both.”

“By doing these spinoffs, companies are trying to allow shareholders to choose … which kind of investment best fits their portfolios.” –Emilie Feldman

Xerox is hardly the only company that finds itself undoing acquisitions in search of greater shareholder value through spinoffs. Hewlett Packard, eBay, ConAgra, Alcoa, Abbott, Tyco, Kraft, and ConocoPhillips, to name a few, have all gone down the same road in recent years with the same end in mind — to unlock value by creating less complex, easier-to-understand companies for shareholders to invest in.

“In recent years, we’ve seen tons of companies pursuing this strategy, separating a high-growth, high-margin business from a low-growth, low-margin business,” Feldman says. “By doing these spinoffs, companies are trying to allow shareholders to choose based on their risk tolerance which kind of investment best fits their portfolios. They get to clarify themselves.

“Investors get to know exactly what Xerox the hardware company does and exactly what Xerox the services company does,” she adds. “From an investor’s perspective, nothing is muddled. We don’t have elusive terms like ‘synergy’ floating around, which may or may not be happening in the first place. That clarity and the ability to allocate money as investors into each of those businesses is a key source of value and the reason why shareholder activists are pushing so hard [for spinoffs] to generate returns.”

In the case of Xerox, Carl Icahn, the legendary shareholder activist who turns 80 this year, is leading the charge for a Xerox split, although Burns has said in multiple news interviews that she and the board had already decided on a split around the same time as Icahn approached them.

While clarity for the entire investment community has become a major rationale for pursuing a spinoff strategy, it is far from the only one. Most companies can produce a list of forces driving them to split — about as long as the ones they produced when Wall Street was telling them they needed to acquire and merge. Between the original acquisition of ACS and the subsequent effort to undo the marriage, The Wall Street Journal has estimated that somewhere close to $130 million has been paid out in fees to investment bankers and legal counsel for the two deals.

Incentives to Split

Another frequently cited incentive behind spinoffs is the need for management to focus and become organizationally more effective, says Wharton emeritus management professor Lawrence Hrebiniak. Take HP, which has divided into its traditional printer and ink operations and an enterprise business revolving around new software services and other fast-growth lines.

“Before its split, HP strategic managers were handling all sorts of products — tablets, phones, ink, PCs, printers, software requirements for customers, a lot of different things that required different strategies,” Hrebiniak explains. “By separating older products from newer products and then putting CEOs in charge of different divisions, they hope this guarantees more focus. Managers no longer have to worry about selling a grab-bag of products; they can concentrate on selling their designated products.”

This decentralization that separates companies into smaller, more manageable groups helps with talent development, as smaller, exciting divisions are created that managers would be excited to run, Hrebiniak says, suggesting yet another rationale for the split.

“If you wish to sell off an operation, it’s easier if you’re dealing with a separate company, with separate divisions, with separate numbers, with a separate listing on the stock exchange.” –Lawrence Hrebiniak

The ability to zero in on certain product lines also allows CEOs to avoid an age-old problem: milking the corporate cash cow, which usually comes from the older, more established product lines of a company, in order to satisfy the voracious appetite of its often more appealing fast-growing enterprise, Hrebiniak says. While the conflict can go both ways — sometimes the older part of a business can be too risk-averse and hold the newer operations back — one side often grows at the expense of the other.

Spinoffs also prepare companies for a future sale of parts of their business. “Xerox is breaking into two companies that will be publicly traded,” Hrebiniak says. “If you wish to sell off an operation, it’s easier if you’re dealing with a separate company, with separate divisions, with separate numbers, with a separate listing on the stock exchange. It’s much easier to rid yourself of unwanted operations, especially if you have publicly traded splits.”

At the same time, it makes it easier for companies to invest. Wharton’s Feldman expects the legacy Xerox to consider making acquisitions of other document-type enterprises, maybe even picking off a competitor to increase its market share and create the growth it has not been able to attain organically as the market gradually shrinks.

One of the final reasons often cited by managers for pursuing splits relates to making the company leaner and meaner — ironically, a similar argument that was made when Xerox acquired ACS in the first place. With the merger, the hope was that many duplicate functions could be eliminated and more efficiencies achieved. While the promise was for a reduction of the workforce, it instead increased even as revenue declined — moving up from around 128,000 at the time of the merger to more than 140,000 last year.

So, can investors expect decentralization to decrease the number of employees that once worked for the larger Xerox? There are certain centralized functions that service all product lines across the combined enterprise, and the question is whether they will have to be duplicated after the split.

“If they are publicly traded and independent, you might have to put all of those functions that were centralized into each of the publicly traded companies, which can actually increase costs,” Hrebiniak notes. “For example, if you have a bunch of engineers doing work centrally, you might now need to have a critical mass of engineers in each of those divisions to do the necessary work. You still can get rid of some less important, probably less expensive people to become leaner, but the whole change from centralization to decentralization isn’t always that easy and isn’t always that straightforwardly efficient.”

Tricky Leadership Decisions

One of the biggest challenges company splits face involves management — the choice of the top executives and board members for each division. Sometimes managers end up looking out more for their own interests than for the interests of the new companies.

“It’s very hard to generalize splits,” says Wharton management professor John R. Kimberly. “I think I’d go back to that old saying: If you’ve seen one split, you’ve seen one split. A lot depends on how the spinoff is managed.”

To Kimberly, cleaner and clearer splits are more likely to succeed because they avoid any ambiguity about who is in control at the new companies. He brings up the Agilent spinoff from HP in 1999. “What you saw was a number of senior HP managers going over and becoming part of the management team at Agilent. This raised questions about whether Agilent was really a separate company and about how much of a split there had really been.”

“In the case of splits, I would argue you probably need someone from the outside [to lead] precisely because that person is not a prisoner of the old way of thinking.” –John R. Kimberly

A similar situation has developed with the recent HP split where Meg Whitman, the former HP CEO, has chosen to head up the faster-growing service side of the business as chief executive of Hewlett Packard Enterprise, but remain as chairman of the legacy printer and PC company, HP Inc. According to Kimberly, decisions like that “make it more challenging” for spinoffs to succeed.

“It’s an age-old management question about leadership in a company,” Kimberly says. “Does it make more sense to promote from within, or do you bring in someone from the outside because the company needs to break from the past and find its own way forward? This is a huge generality, but in the case of splits, I would argue you probably need someone from the outside precisely because that person is not a prisoner of the old way of thinking about strategy or positioning [and] comes in with a fresh eye to take the spun-out company in a direction that the new leader thinks is appropriate.”

There is also the issue of dual directors — when board members of the parent take on the same role at the spinoff. Wharton’s Feldman argues that such a set-up is prevalent and troubling because priorities are muddled. “You never see a situation where one of these dual directors is explicitly prioritizing one company’s interests over the other, but boards like to be collegial. It’s more of a soft power situation where the mere presence of the dual director forces the board to give more credit [to the needs of the other company].

Feldman’s research on companies with dual directors shows that three years after a spinoff, 35% still share directors. “If activist investors aren’t aware of this problem, they really should be taking steps to prevent it,” she adds. “Intuitively, the potential for conflict is clear even for someone not involved with business.”

One reason activists may not take action is because the value derived from the split only lasts about 15 months, and after it fades, activists have usually moved on, Feldman says.

At Xerox, Icahn struck a deal with management that ensures a say in the search for a CEO for the new BPO company. He will also hold three board seats in the 9-person board. Only two of the directors of the six that Xerox will appoint can come from the current board of the merged company. Burns also has said she will refrain from dealing with the question of her own role in either of the new businesses in order to prioritize the needs of the two new companies rather than her own.

Such a declaration is unusual for CEOs, Feldman notes. “Her decision is really impressive in my mind and certainly not the norm for executives who rarely take their own ego out of the equation.”

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