Try a Carveout When the Whole is Less Than the Sum of the Parts

Thursday, May 15, 2008

Vincent Ryan, CFO - February 2008, Pgs. 35-37, http://

In tough capital markets, carving out has special allure. When credit markets are tight and the stock market languishes, companies look for inexpensive ways to raise money. An IPO of part of a subsidiary may be less expensive than borrowing money or selling parent stock.

Subsidiaries that capture investors' imagination can produce much higher returns for a parent than selling its own stock, Vincent Ryan explains. For example, EMC (with a price-to-cashflow ratio around 14) carved out 10% of VMware, its virtualization software section. EMC has 33,000 employees to VMware's 4,500. EMC's revenue is over $11 billion, compared to a bit over $700 million for VMware. In shares outstanding, EMC has 2.1 billion to VMware's 382.9 million. Yet because of the IPO fanfare and investors' interest, the high valuation multiple gives VMware a market cap almost equal to the parent (EMC's market cap was $33.7 billion in January 2008; VMware’s was $28.6 billion). EMC still owns most of the business, which it can sell bit by bit at its pleasure. Carving out a tenth of VMware clearly topped EMC's alternatives for raising capital.

Carve out part of a unit.
Carving out and listing just part of a subsidiary can provide the parent with significant business benefits. Unlike a spinoff, which fully divests the business unit, the carveout or partial spinoff is a precursor to a potential future separation. Thus, the carveout not only gives investors access to a hot unit but also lets the parent predict the market's response to the unit's future divestment. Not every subsidiary is a good choice for carving out, the author cautions. Separation can prove far too complex and expensive for many business units. Financials, compliance, personnel, and systems need to be divided before listing a portion of the company. Often the best candidates are former acquisitions that retain largely separate operations from the parent. A high-performing unit that is currently hot can often zip ahead of the stodgier parent in valuation multiples. For example, when EMC carved out VMware, it had a price-to-cashflow ratio around 14. VMware's own price-to-cashflow ratio skyrocketed to 116, over 100 points higher than its parent, which still owned most of the unit.

Carveouts generally perform well.
Clearly most parents do not have such an astonishingly successful carveout, but most carveouts still do better than most IPOs after listing for a year. Looking at 2007's crop of companies one year after their IPOs, 45% were trading below their initial offering price. Among the carveouts of the same period, only a third were trading below their initial offering price. Several have been spectacularly successful, the author points out. McDonald’s spun off 31% of Chipotle Mexican Grill, which has risen 162% since going public. Halliburton spun off something under 20% of KBR, which is up 79%. VMware’s market cap of $28.6 billion is a 30% gain over the initial offering price.

Abstracted from CFO,
published by CFO Publishing Corp.
253 Summer Street, Boston, MA 02210

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