What’s a Key Ingredient in the Formula for a Successful Spin-off?
Answer: A little “cash chemistry.” Companies that focus on optimizing their use of working capital stand a better chance of surviving and thriving.
Spin-offs, in which companies cleave off a part of themselves to create new, separate, publicly traded entities, represent exciting times for the parent company, its shareholders, and the managers and employees of the new spin-off, and they’ve become very popular. There were 79 completed spin-offs across industries in the United States in 2015, with a total value of almost $245 billion.
These transactions are popular because investors, boards and managers believe companies can command a higher valuation if owned and managed separately rather than as part of the same enterprise. And spin-offs tend to perform well. From the conclusion of the global financial crisis of 2009 through 2014, the S&P 500 generated a total return of 201 percent; a representative index of spin-off companies generated returns of 379 percent over that same period.
However, it’s rarely smooth sailing for spin-offs right off the bat. Many of these new companies start out highly leveraged. Furthermore, when a large company carves out and spins off a smaller unit, showing the Street that it is pursuing a lean strategy with a greater focus on its core competencies (be it a service or product line), it sometimes transfers old challenges to the new entity, potentially weighing it down with less attractive and slower-growth assets; suboptimal, hard-to-adjust contracts with vendors and suppliers; risky products prone to litigation; and longstanding operational dysfunctions.
Even so, spin-offs are still enormously compelling for shareholders of both the parent company and the spin-off, as well as its managers, who typically are enthusiastic about their prospects for running their own show without the distraction of operating within a larger, more diverse corporate entity. Now they can show their stuff. Now they can be innovative, creative and laser-focused on creating new value.
And in all the excitement of new branding, new market strategies, new and more responsible roles for new managers, and new challenges for the new business and its workforce, spin-off leaders may overlook the lifeblood of any enterprise: the company’s investment in and management of working capital.
FTI Consulting believes that actively managing working capital — and beginning to do so as soon in the life of the spin-off as possible — is critical to short and long term success.
Analyzing the new firm’s working capital requirements reveals risks and challenges that must be assumed, mitigated and overcome. It encourages the discipline needed to assess the new company’s operations up and down the value chain. It can be a hammer to break down silos, allowing day-to-day managers to partner more closely with other managers in different functions to understand more comprehensively the cash implications of their decisions. It is, in sum, not just a way to repurpose cash to service debt; it illuminates opportunities for value creation in every part of the business, while serving to change its culture and mindset.
Here’s how it works.
The SpinCo Story: A New Company with Cash Challenges
A global diversified chemical manufacturer (let’s call it SpinCo) was spun-off from its large, investment-grade parent company. Like many spin-offs, it was highly leveraged. But despite the distractions and challenges this debt might pose, SpinCo’s C-suite was confident it could improve the business’ free cash flow substantially within two years.
Shortly after the spin-off, SpinCo’s financial results began to decline due to weakening demand in its end markets, and investors became worried that perhaps its debt burden was too large. Cash concerns had the potential to derail the company’s broader, long-term transformation plan.
As part of a larger entity before it was spun off, the units that were to become SpinCo had not prioritized optimizing their use of working capital. Specifically, how much excess cash was being committed to what – and for how long – across the company’s inventories, customers and production processes. Knowing this history, SpinCo’s management hypothesized that dollars were being left on the table, so they prioritized releasing and repurposing excessive working capital investment as a source of liquidity.
The hypothesized opportunity became a priority as cash pressure mounted, and FTI Consulting was brought in to assess the potential amount of working capital that could be released, then help SpinCo accelerate the process of releasing it.
The first step in managing working capital is to identify those operational and financial choices that contribute to inefficiencies and measure their effect on liquidity. To do that, it is essential to first understand the state of the company’s processes and performance. Once that data is collected and thoroughly understood, the next step is to evaluate what the company’s industry peers have achieved in the same macroeconomic environment (recognizing that many industrial and chemical companies have no perfectly analogous peer).
At SpinCo, one thing became clear: management’s hunch was correct. There was a sizable opportunity to reduce SpinCo’s working capital investment. And the company was keen on seizing this opportunity as quickly as possible.
Too Much Stagnant Inventory and a Complex Supply Chain
Benchmarking and analysis revealed a significant amount of slow-moving finished product in one of SpinCo’s business units. [See Figure 1.] Why? A large and diverse SKU portfolio made accurate forecasting difficult. One consequence of the company’s forecasting deficiency was it had too much cash tied up in inventory that its customers simply didn’t want.
At the same time, elevated sales targets incentivized managers to focus their efforts on the easiest-to-move SKUs, leaving more difficult-to-move products languishing. The pile of slow-moving, unsold inventory grew, negatively affecting SpinCo’s working capital efficiency. Not only was there too much finished product held in its own warehouses, but SpinCo also had too much inventory held on consignment at its customers’ locations.
Also, SpinCo had a great deal of cash tied up in raw materials. Indeed, an analysis of historical trends indicated that SpinCo was taking an overly cautious view of required feedstock supply availability — a position that was sustainable (if not ideal) in a low leverage environment, but less so considering the spin-off’s more constrained resources. That, combined with an overly rosy view of future sales growth, and an equally optimistic belief that the quality of its products would protect it from competitive pressures and macroeconomic headwinds, drove company projections, thereby skewing its investment in raw materials. Indeed, that investment was large enough to supply several months of sales at a time when low-cost competition from China was emerging and the market was flooded with product.
Obviously, the cash SpinCo had tied up in raw materials could not be used to pay down its debt. Additionally, uncertainty surrounding supplier-financing agreements created even more potential risks.
SpinCo management knew it had room for improvement when it came to managing working capital; it just didn’t know how to go about capturing it without, it feared, creating unforeseen and negative consequences for its customers.
How Functional Finance Created a Hierarchy of Transformational Action at SpinCo
The biggest opportunity for freeing up SpinCo’s working capital and helping it fulfill its free cash flow promises lay in addressing its inventory challenges. The investigation into why some SpinCo inventory wasn’t moving or was moving too slowly broadened into a discussion of how much risk the company wished to assume in chasing sales.
Ultimately, analyzing customer performance in this manner led to an initiative to simplify SpinCo’s SKU offerings in the spirit of reducing supply chain complexity, while enabling it to more effectively appeal to and address the needs of its most profitable customers. In turn, this allowed SpinCo to take a long, hard look at the working capital it had tied up in finished product inventory and subsequently enabled the company to turn over roughly half of its slow-moving inventory in a few months.
SpinCo also focused on its raw material inventory levels. After in-depth analysis, it realized it did not need enough inventory to support several months of production; it could reduce its safety stock levels substantially and draw down its investment by more than $100 million over a short time. [See Figure 2.] And despite its fears that reducing inventory might prevent it from meeting customer expectations, especially if the market for its products rebounded, SpinCo did so without affecting either the service levels or lead times to which its customers were accustomed.
By analyzing finished goods inventory, SpinCo sliced and diced its inventory in terms of historic consumption levels — segmenting its product into “good” (which would turn over expeditiously) and “challenged” (which would hang around) — and wrote new business rules to deal more effectively with each category.
SpinCo also began examining its annual supply contracts to search for and enhance flexibility clauses and strategies, e.g., leveraging contract staggering that would allow it to effectively address the supply-demand imbalance, and thereby strategically mitigate the impact of forecasting inaccuracy.
SpinCo’s supply chain managers, by zeroing in on lean, best practices in working capital management, realized an additional reduction of tens of millions of dollars in working capital investment — just from improvements in inventory management.
Such is the power of working capital management.
At the same time SpinCo was addressing its inventory inefficiencies, management was also exploring parallel opportunities to drive working capital savings in both payables and receivables. It stood up an enhanced cash collection team that, supported by analytics, could prioritize (and follow up on) key customers and invoices. Analytics also supported sales in the effective use of discounts and helped it rationalize sometimes over-generous payment terms.
Vendor segmentation also allowed SpinCo to move away from daily payment runs — with many contracts calling for payment on the same day of each month — thereby tremendously reducing the complexity of treasury’s cash forecast.
Combined, these initiatives — reducing inventory (both raw material and finished product), prioritizing and focusing on profitable customers, reducing SKUs, optimizing consignment inventory, and addressing payables and receivables — enabled SpinCo to reduce its net working capital investment by more than $200 million.
A company born, like so many spin-offs, in debt, was now on track to fulfill both the initial promise of the spin-off and the promises the new company had made to its stakeholders.
If You Take Care of Working Capital, Working Capital Will Take Care of You
Paying attention to — indeed, focusing on — working capital can be transformational in a spin-off situation, especially (as is usually the case) when the spin-off is highly leveraged or when the macroeconomic climate is volatile.
Unfortunately, in many cases working capital management is too often an afterthought for management teams. This is a mistake. Done right, it can unleash potential value-creating energy trapped inside a new enterprise — the raison d’etre for the spin-off.
As it did at SpinCo.
Given that working capital management touches on almost every transactional activity within a business, and the functional departments in charge of these activities are often stuck in their ways (even in the new spin-off environment), it generally is beneficial for spin-offs to welcome outside experts who can look at their business, their processes and their operations with fresh eyes.
A serious focus on working capital begins with a thorough assessment of current business operations and continues with an equally thorough analysis of the risks and benefits of adjusting or changing those operations. This is how spin-offs can identify and prioritize opportunities while isolating those activities that are tying up cash inefficiently and needlessly. Management teams often are surprised by how quickly working capital can be released, if done right, from even the most entrenched inefficiencies. This freeing up of working capital can produce greater levels of operational excellence than the most optimistic spin-off leaders have promised their investors — or even may have themselves dared hope.
We'd like to thank FTI Consulting Senior Managing Director Stuart Gleichenhaus and FTI Consulting Managing Director Rasmus Gerdeman, who contributed to this article.
© Copyright 2016. The views expressed herein are those of the author(s) and not necessarily the views of FTI Consulting, Inc., its management, its subsidiaries, its affiliates, or its other professionals.
Senior Managing Director