Introduction
Over the past decade there have been numerous examples of companies that have experienced dramatic growth and built huge revenues using aggressive acquisition programs (Sherman 2011). This is supported by the fact that experienced executives have always searched for efficient and profitable means to increase and gain market share.
A merger typically involves a combination of two or more companies in which the buying firm absorbs the assets and liabilities of the selling firm. It is common in mergers for the selling firm to maintain identity (Sherman 2011). An acquisition on the other hand involves the purchase of an asset such as a plant, a division or in some cases an entire company (Sherman 2011).
However, in some cases a firm may need to improve its position in the market and as such may need to consider undertaking a divestiture. Divestiture and asset sales are a valid method of corporate restructuring that is aimed at creation of value (Hunt 2009). This approach aims at the elimination of underperforming assets, capitalizing on the value of better performing assets or simply divesting to pay off debts owed (Hunt 2009). This report seeks to analyze the available divestiture options for DuPont with regard to Conoco.
History of DuPont and Conoco
DuPont was established in 1802 as a gun powder manufacturer (Gilson 2010). At the time its main activity was supplying the US army with gun powder under the current US president Thomas Jefferson (Gilson 2010). Over time the company developed a long tradition of technological innovation in businesses as diverse as food and nutrition, agriculture, fashion and apparel, health care, home and construction, transportation and energy (Gilson 2010).
One of the most memorable days in the company’s corporate history took place in 1939 when hordes of housewives mobbed stores in Delaware. The reason for this massive turnout was the company’s latest breakthrough at the time namely, nylon stockings (Gilson 2010). In the years that followed DuPont would continue with its legacy of innovation and create Teflon for pans, Kevlar for bullet proof vests, Stainmaster for carpets, popular synthetic fabric known as Lycra, Dacron for clothing and Mylar for packaging and wires (Gilson 2010).
In 1998, DuPont appointed Holiday as the CEO which led to a series changes within the organization. The first change was the reorganization of DuPont’s 16 diverse businesses into three groups namely, the foundation, the differentiated and the life sciences operations.
The foundation focused on basic low growth businesses such as polyester fibers, nylon and some polymers. The differentiated group focused on Corain countertop surfaces, Kevlar, Lycra, Stainmaster, and business units supplying paints to the automotive industry. The third group focused on pharmaceuticals and Biotechnology (Gilson 2010). The new CEO dubbed DuPont as the miracles of science company (Gilson 2010).
Investors were initially positive about the appointment of Holiday but this would soon change due to some unforeseen events. By May the same year the DuPont share price had risen by 26 percent (Gilson 2010). However, by August the share price stalled at $60 due to the Asian economic crisis and the pressure on profits due to expensive acquisitions. These events in combination drove down profits by 68 percent when compared to the previous year.
DuPont purchased Conoco in 1981 to allay fears of an increase in oil prices and the subsequent effect it would have on its chemical businesses (Gilson 2010). DuPont beat all challengers to take over the company in what was the largest merger of its time. The company staged a “white knight” acquisition and paid $7.8 billion for the firm.
As of now Conoco is a wholly owned subsidiary of DuPont. It was major integrated global energy company that operated in 40 countries (Gilson 2010). Conoco was involved in both upstream and downstream activities. Upstream activity included exploration, development, sale of crude oil, natural gas and liquids (Gilson 2010). Downstream activity included refining crude oil and other products, transportation, distribution and marketing of petroleum products (Gilson 2010).
Conoco is involved in the development and operation of power facilities and also maintains a marketing network of almost 7900 retail outlets located in the US, Europe and Asia (Gilson 2010). By 1998, Conoco was ranked at position 8 globally in production of petroleum liquids. It was also ranked at position 11 in natural gas production as well as ranking at position 8 in refining throughput (Gilson 2010).
Following the poor financial performance of DuPont in 1998 the need arose to take urgent remedial action to ensure that the company continued making profits. However, one crucial question that needed to be answered was the source of the money to achieve this. This is what led to the need for restructuring within DuPont (Gilson 2010).
Available Options for Divestiture
In line with the need to restructure DuPont there were several options available that could be used to effectively achieve a solution. The first option available was an Equity Spinoff.
This is a divestiture option that involves giving stock of a subsidiary to the parent company shareholders (Brigham & Houston 2009). Under this option DuPont would distribute the Conoco shares to its shareholders on a pro rata basis (Gilson 2010). Each outstanding DuPont share would receive a fixed number of Conoco shares. The shareholders are free to keep or sell these shares.
Another available option for DuPont was to undertake the Tracking stock option. Tracking stocks are a separate classification of common stock issued by a single parent company and represent claims on profits and cash flow generated by certain distinct businesses (Gilson 2010).
The goal is for the market price of each stock to ‘track’ individual performance of each business. The revenues and earnings reported by the businesses are reported separately and dividends are determined based on performance of the businesses (Gilson 2010). Tracking stocks can be created either by distribution of company stock to current shareholders or sale of new stocks for cash to the public (Gilson 2010).
Another option available to DuPont to manage it restructuring was through Asset sale. This may be due to the fact that in 1998 there is the sentiment that the IPO market is weak (Gilson 2010). Based on this sentiment therefore it would appear that the sale of Conoco at a suitable price would be better than the lengthy IPO or a spinoff. This option appears to be able to speed up the process resuming its life sciences businesses (Gilson 2010).
Yet another option was through a spinoff using a modified Dutch auction. This was based on the actions of The Limited with regard to Abercrombie and Fitch. This option saw The Limited sell of 16 percent of its stake in Abercrombie & Fitch through a spin off structured as a modified Dutch auction (Gilson 2010).
In the approach the shareholders were given the choice to swap each of their Abercrombie shares tax free at a predetermined rate of between 0.73 and 0.86 (Gilson 2010). The company would first accept shares at a lower rate and move to the higher rate until it managed to dispose of all its Abercrombie shares.
The final option was to undertake an Initial Public Offering or IPO. This option involved the sale of a percentage of the DuPont stake to the public (Gilson 2010).
Selected Option
Having considered the available options the task of selecting a suitable approach lay in the hands on the management. Upon deliberation it was decided that the best approach to undertake an IPO followed by a split off. This initial IPO would require that the DuPont subsidiary (Conoco) sell a percentage of its shares to the public (Gilson 2010). It was decided that 30 percent of DuPont stock in Conoco be made available to the public through an IPO that is geared to net $4.4 billion.
For this transaction to be considered tax free it is essential that corporate capital gains taxes be avoided. The DuPont management team managed to achieve this by structuring the transaction as a primary offering by its subsidiary, Conoco (Gilson 2010). This approach would allow Conoco to sell new shares to the public and use the proceeds to pay an equivalent amount of its debt.
Following this it is suggested that DuPont make an exchange offer to off load its remaining shares in Conoco. This technique also known as a split off would allow DuPont shareholders exchange their share of DuPont stock for 2.95 shares of Conoco stock on a tax free basis (Gilson 2010). For the transaction to be tax free it would require DuPont sell a proportion of its Conoco shares for cash and satisfy some conditions of the Internal Revenue Code.
The first condition would that DuPont was in control of Conoco before the split off signified by at least 80 percent voting control of Conoco’s stock (Gilson 2010). In addition to that the split off had to be motivated by a valid reason and DuPont would be required to divest itself of all Conoco stock such that it does not exercise any control over Conoco after the transaction.
To attain favorable tax treatment for the spit off, it is suggested Conoco be recapitalized with two classes of common stock. Class A shares (approx 190 million) with one vote each to be issued to the public through an IPO (Gilson 2010). Class B shares (approx 400 million) with five votes each to be retained by DuPont for disbursement to DuPont shareholders in the exchange offer (Gilson 2010).
In addition to this it is suggested that prior to the IPO Conoco issue a $7.5 billion promissory note to DuPont as dividend (Gilson 2010). This payment is tax free to both parties because at the time DuPont owned all of Conoco. In turn, Conoco would use the proceeds from the IPO to repay part of the note and other intercompany notes with DuPont. The balance was to be paid by Conoco through a subsequent $4 billion debt offering (Gilson 2010).
Advantages & Risks
Among the reasons behind the choice of the IPO route with regard to this divestiture undertaking can be traced to the advantages inherent in the use of the IPO strategy. It has been noted that through the use of an IPO a company can increase both liquidity and the share price (Geddes 2003).
This is due to the fact that companies listed on the stock exchange are typically worth more than similar companies that are privately held (Geddes 2003). This is in part due to the fact that the information contained in an IPO prospectus and subsequent annual reports reduces the uncertainty around performance and hence increases the value of business.
Due to the above point it has been noted that investors are willing to pay a premium for liquidity. This is due to the fact that privately held companies have little or no liquidity (Geddes 2003). Due to that factor, the liquidity premium varies over time and economic conditions though a reasonable estimate would be in the 30 percent range (Geddes 2003).
This can be taken to mean that if two identical companies exist with one being listed and the other privately held the listed company will be approximately worth 30 percent more than the other company (Geddes 2003). This is due to the daily liquidity activity which allows insiders to know the value of their holdings accurately.
In addition to the above point, another advantage of the IPO option is due to the fact that it can be used to motivate and retain staff (Geddes 2003). During the 90’s it was observed in the US and UK that the use of incentives such as stock options and stock bonuses are quite effective when it comes to attracting and retaining employees.
Based on this equity based awards and ownership indicate a tendency to be more broadly spread among management and employees in public companies than within private companies (Geddes 2003). In addition to that is the fact that both management and employees are able to observe the results of their efforts immediately in the share price.
Another advantage with the IPO option that is significant to consider is the fact that it comes with prestige and an enhanced image (Geddes 2003). This is a significant though intangible benefit that arises from the increased visibility of the company through ongoing disclosures to the stock exchange.
In addition it has been observed that many believe there is prestige associated with working in a publicly listed company (Geddes 2003). This is likely to lead to the recruitment and retention of high quality employees. The quotation may also bring market benefits by making the company appear more substantial and stronger. This is supported by the fact that press coverage of public companies is generally greater than that of privately owned companies.
Another advantage in favor of this option comes from the fact that it allows for access to alternative sources of capital (Geddes 2003). It has been observed that quoted companies are often able to raise money for expansion more easily and at better rates than private companies (Geddes 2003).
This is because the public debt markets allow greater access to quoted companies than to those without a listing. This is without considering the fact that going public generally improves the company debt-equity ratio and may enable it to borrow more cheaply.
Finally the IPO option also brings with it ancillary benefits (Geddes 2003). For example, it has been noted that the flotation process often forces management to formulate and articulate a clear business strategy (Geddes 2003). This alone clearly is beneficial to the future success of the business.
In addition to this it has been noted that in anticipation of public ownership many companies improve management and financial structure (Geddes 2003). It has been noted that many fast growing medium sized companies neglect formal structures which help them in growing to become large companies.
However the IPO option also comes with disadvantages such as those associated with increased disclosure. This is due to the fact that when company goes public the number of people with access to financial records increases significantly (Geddes 2003). This can cause major shock especially since it involves disclosure of management salaries and perks. This increased access to information provides a potential ground for disputes to arise when business slows down.
In addition to that is the fact that IPO’s cost a lot of money (Geddes 2003). The process involves large payments to investment bankers, lawyers, accountants resulting in significant payouts. In addition to that there is the huge indirect cost of under pricing. It has been observed that IPOs around the world are under priced compared to their short term performance (Geddes 2003).
On an average an IPO will close at 15 to 20 percent above its issue price though this varies based on the market, industry and time. This suggests that shareholders and the company leave significant sums of money on the table when going public (See Appendix A).
Another disadvantage of the IPO option is the potential restriction on management action (Geddes 2003). In many companies the managers are the owners. As a result there is little restriction on management action other than statutory and legal regulations. However, upon going public the regulations that govern public companies restrict the management in acting freely. This may result in loss of control of the company. In addition to that the IPO option brings about new difficult questions due to the separation of ownership and control.
References
Brigham, E. F., & Houston, J. F. (2009). Fundamentals of Financial Management. Mason, OH: South-Western Cengage Learning.
Geddes, R. (2003). IPOs and equity offerings. Burlington, MA: Butterworth-Heinemann.
Gilson, S. C. (2010). Creating Value through Corporate Restructuring: Case Studies in Bankruptcies, Buyouts, and Breakups. Hoboken, NJ: John Wiley & Sons Inc.
Hunt, P. A. (2009). Structuring Mergers & Acquisitions: a Guide to creating Shareholder Value. Printed in USA: Aspen Publishers.
Sherman, A. J. (2011). Mergers and Acquisitions from A to Z. New York, NY: Amacom.