Medical Device Link.

FINANCE

Unlocking Hidden Value

Using the right business strategies, medical technology executives can ensure that their companies and subsidiaries get the full valuation they deserve.

Among the frustrations faced by executives at publicly traded companies is seeing the market fail to fully value all the pieces of a firm's business. A surge in the value of some types of business relative to others often leads to a perception of mispricing. Witness the tendency of Internet and biotechnology stocks to fall in and out of favor with investors. At other times, a shift in market sentiment occurs when analysts change the metrics used to evaluate a company's prospects.

One example of this imbalance is the relative values of companies engaged in Internet-based device distribution and their asset-based competitors. Investors have chosen to use a different set of tools to value the Internet-based device marketers than they apply to asset-based companies that produce many times the revenues of on-line firms.

Executives must always focus on building their core businesses, but they can also benefit by being aware of some keys available to unlock hidden shareholder value. Long-term discrepancies between a company's public value and the true value of its underlying components are often a source of shareholder disputes and hostile transactions. A prominent example is the Johnson & Johnson (New Brunswick, NJ) acquisition in late 1995 of Cordis Corp. (Miami), whose stock, prior to J&J's hostile bid, did not fully represent the potential value of its emerging stent business.

When the pieces of their firm's business are undervalued relative to peers, managers have a number of tools at their disposal to highlight hidden value. These include spin-offs, divestitures, tracking stocks, and acquisitions. How can each of them affect stock performance?

Spin-Offs

A spin-off transaction may be the most effective means of highlighting the performance of an undervalued business. By disaggregating a highly valued division from a relatively lower-value base business, a company can deliver previously unrecognized value to its shareholders. Or, if a lesser-valued business is spun off, shareholders may benefit from a higher valuation for the main business.

Spin-off transactions take a variety of forms and can be structured to deliver different outcomes for the parent company. Most spin-off structures fit one of three types:

• Spin-offs, in which shares of a subsidiary are distributed to shareholders of the parent company.
• Split-offs, in which shares of a parent company are exchanged for shares in a subsidiary.
• Split-ups, in which shares of the parent company are tendered for new shares in both the parent company and the subsidiary.

Spin-off transactions can be executed with or without an offering transaction, often called a "carve-out," in which shares of the subsidiary are sold to the public prior to the spin-off. The proceeds from an offering can be allocated to the parent or to the newly created subsidiary. Offerings also provide a market price for the postoffering distribution or exchange, alleviating the difficulty of accurately valuing the subsidiary as a stand-alone entity.

The key things that differentiate a spin-off from other methods of liberating hidden value are control, timing, and market factors. When a company decides to spin off a subsidiary, the spin-off must assume its own corporate governance. In practice, this involves independent management, a separate board of directors, and internal administrative functions. The increased expense this entails can often outweigh the benefit a spin-off can provide.

To implement a spin-off takes time. Before proceeding with the transaction, the company must obtain a variety of approvals and opinions, including an IRS opinion that the transaction will be tax free. Once the approval process is complete, shares in the subsidiary must be registered with the Securities Exchange Commission. Studies have illuminated a tendency for parent company shares to post slight gains after a spin-off has been announced. However, these gains are usually minor in terms of overall shareholder value. Spin-offs, therefore, are useful in the context of long-term planning but rarely effective in quickly altering the market's perception of share value.

In evaluating the merit of a spin-off, consideration must also be given to market factors. Management should analyze the attractiveness of the business as a stand-alone unit compared with its publicly traded peers. A subsidiary's lack of critical mass will in many cases make it unattractive to institutional shareholders, who often require companies to have substantial market value to qualify for investment.

Divestitures

Divestiture can be a means to disaggregate an under- or overperforming business in much the same manner as a spin-off, but with two critical differences: the parent company realizes greater potential benefits, but loses tax advantages.

In a spin-off, most, if not all, of the proceeds from the transaction are received by shareholders. But with a divestiture, the company gets to allocate the proceeds. Either it can pay out funds to shareholders through a special dividend or stock buyback or it can retain the proceeds for debt reduction or investment in other businesses. Another consideration is that strategic buyers are often willing to pay a premium for a business, compared to what shareholders might receive in a spin-off, because of the advantageous synergies that result from creating a new combination.

Tax implications must also be weighed when considering a divestiture. A spin-off transaction, properly structured, allows both the parent company and its shareholders to receive value without taxation on their gain. Divestitures are subject to taxes, however, and thus may be an inefficient means for transferring value.

Tracking Stocks

The issuance of tracking stock is another way to highlight the performance of an undervalued business unit. It enables a company to enjoy many of the benefits of a spin-off without the accompanying loss of control and associated expense.

Tracking stocks have a relatively short history. Although General Motors created the first tracking stock to track its EDS division in 1985, companies did not widely adopt the tracking structure until the mid-1990s. The enormous returns realized by investors in a notable handful of tracking stocks—Sprint PCS (PCS), Celera Genomics (CRA), and Liberty Media (LMG.A)—have underscored the potential of the tracking structure and overshadowed the relative underperformance of tracking stocks as a group. A variety of studies, including a recent report by McKinsey & Co., have shown that tracking stocks consistently produce returns below both market averages and those of their parent company's stock.¹

While not all tracking stocks produce a boost in value for shareholders, a well-designed tracking issue can result in a gain both for the parent company and for shareholders. A tracking stock follows the performance of a specific segment of a company's assets, but does not represent an equity claim on those assets; that is, owning a majority of a tracking stock would not give an entity control over the business represented by that stock. Thus, the key to creating a tracking issue is to identify the most attractive area of the company's business without inadvertently damaging the parent company's valuation. To achieve this goal, most tracking units are designed to mirror comparable firms. If, for instance, a medical device manufacturer seeks to highlight a unit engaged in biotechnology research, it is less important to design an issue that will have immediate earnings or pay dividends than to showcase the underlying intellectual property that will produce future returns.

Also important in evaluating the benefits of a tracking issue is to be alert to the potential for conflicts between management and the board. For a tracking stock to be successful, managers must carefully project the future needs of the business unit and plan accordingly. The device manufacturer just mentioned, for instance, would have to provide the biotech-research tracking unit with sufficient funding to reach profitability. Funding can be provided several ways. Tracking stocks can be issued through a carve-out initial public offering (IPO), in which proceeds are earmarked for operating the tracking business unit. Alternatively, the parent company can issue debt secured by future cash flows from the subsidiary business. In either case, the parent company must keep in mind that any alteration in capital structure will be reflected in its equity valuation because the subsidiary remains a component of the parent entity's operations.

One more consideration in evaluating a tracking stock issue is its tax status. To date, tracking stock transactions have been tax exempt, being defined as tax-free distributions. Proposals recently drafted by the Clinton administration would revoke this status, resulting in tax liabilities for shareholders.

Acquisitions

An effective—if somewhat counterintuitive—way to highlight an undervalued segment of a business is to acquire another company. For example, let's say a unit in a highly valued business area generates one-quarter of a company's revenues, while the remaining three-quarters come from what the market considers a slow-growth business. The company may be able to boost the multiple on its entire enterprise through an acquisition that increases the percentage of business generated by the more highly valued segment. While an acquisition of this sort would likely be dilutive at the company's existing multiple, the new business mix could command a higher multiple. Thus, the transaction would ultimately generate shareholder value.

Unlocking Shareholder Value in Practice

Public companies in every industry use these four methods of unlocking shareholder value every day. Medical device companies have employed them, successfully and unsuccessfully, to generate returns for shareholders. Here are some examples.

Isolyser. Isolyser Company, Inc. (Norcross, GA), was founded in 1987 to profit from several innovative infection control technologies. In 1990, the company developed its proprietary OREX thermoplastic, a material that dissolves in hot water and can be used in wovens, nonwovens, films, and molded plastics. Isolyser purchased MedSurg Industries Inc. (Herndon, VA), a company focused on the assembly of custom procedure trays, in 1993. After its 1994 IPO, Isolyser extended its strategy of buyhealthcare-product manufacturers that could integrate OREX technology into their products. It acquired White Knight Healthcare Inc. (Childersburg, AL) and SafeWaste Corp. (Charlotte, NC) in 1995 and merged with Microtek Medical Inc. (Columbus, MS), a manufacturer of specialty surgical drapes and other infection control products, in 1996.

While Isolyser's strategy made sense on paper, the healthcare industry was slow to adopt OREX-based drapes, towels, and other disposables. Declining sales and net losses were accompanied by a collapse in the company share value from a peak of more than 19 in August 1995 to below 1 1/8 in early 1999. In August 1998 Isolyser began an aggressive program of divestitures, including the sale of manufacturing facilities in August and October 1998, the sale of White Knight Healthcare in June 1999, and the divestiture of MedSurg to Allegiance Healthcare Corp. (McGaw Park, IL) in July 1999.

The management decision to divest these businesses was bold. The White Knight and MedSurg divisions produced 65% of Isolyser's revenue in 1998. The divestitures produced proceeds of about $48 million to be used for both debt reduction and continuing development of the OREX technology. By shifting the company's focus from healthcare manufacturing to developing environmentally beneficial technology for a variety of industries, management has been able to produce substantial value for its shareholders. Since January 1999, Isolyser's shares more than tripled in value to a recent price of $4.

Bindley Western/Priority Healthcare. Bindley Western Industries Inc. (Indianapolis) is the fifth-largest wholesale distributor of pharmaceuticals in the United States. Bindley revenues have grown at a compound annual rate of 20% since the company's inception in 1968. Its compound earnings-per-share growth since 1996 is better than 14%. But despite this history of strong results, Bindley's stock in early 1997 was trading at less than $10, which represented a price-to-earnings multiple of 12 and a discount to book value of more than 30%.

In an effort to boost shareholder value, Bindley Western filed for an IPO for 18.4% of its interest in its Priority Healthcare (Lake Mary, FL) division in August 1997. Priority, a specialty distributor to the alternate site market focused on infectious disease, renal, and oncology products, had been created by Bindley through the acquisition of five firms between 1993 and 1997. While the total cost basis of these acquisitions was some $13 million, Priority had grown to have 1996 revenues of more than $150 million. Priority was an ideal spin-off candidate because it was more profitable than Bindley and growing both revenues and earnings at a substantially higher rate than its parent.

Priority's IPO, completed in October 1997 at a share price of $14.50, raised $30 million for the spin-off, of which $17 million was used to repay Bindley for investments in the company. Priority's stock subsequently rose, reaching a price above $34 in December 1998. On December 31, 1998, Bindley spun out its remaining 81.6% interest in Priority to shareholders in the form of a dividend. Prior to the dividend, Bindley's stock, which had been as low as 15½ in early 1997, traded at more than 37.

Priority Healthcare has continued to grow. Its 1999 revenues of $428 million were 55% higher than those in 1998. Whether this growth would have been possible as the subsidiary of a larger company is difficult to determine, but the ability of management to make stand-alone decisions and to receive compensation based upon performance has certainly played a part in Priority's success. And, Bindley shareholders who have held both their Bindley and their Priority shares since the Priority IPO have benefited from a 66% compounded annual return.

Genzyme. Genzyme Corp. (Cambridge, MA) has used tracking stocks more aggressively than any other company in the healthcare industry. Genzyme's first tracking stock, designed to follow the performance of its Tissue Repair division, was issued in December 1994 in connection with the company's acquisition of BioSurface Technology Inc. Genzyme structured the transaction as a dividend, which allowed existing shareholders to choose whether or not they wanted to continue to hold equity in Genzyme's primary business, renamed Genzyme General, in Genzyme Tissue Repair, or in both. The transaction structure also gave Genzyme the ability to compensate managers who joined the business from BioSurface Technology commensurate with the showing of their business segment.

Genzyme created its third tracking stock in November 1998 with the issuance of Genzyme Molecular Oncology shares, and adopted the strategy a fourth time in June 1999 with the Genzyme Surgical Products issue. These transactions further segmented Genzyme's enterprise into smaller business units that could be more easily measured against firms in their market sectors. Genzyme announced in March 2000 its intention to once again employ a tracking stock for acquisition purposes. The company plans to combine the Surgical Products issue and the Tissue Repair business with Biomatrix Inc. (Ridgefield, NJ). The resulting entity, Genzyme Biosurgery, will remain a division of Genzyme Corp. with a separate tracking stock.

In addition to its tracking issues, Genzyme employed an IPO structure to maximize the value of its Transgenics unit. It first sold shares of Genzyme Transgenics to the public in 1993. Genzyme continues to hold a 30% interest in the company, which specializes in producing transgenic proteins from the milk of animals.

While it is difficult to evaluate the performance of Genzyme Corp. relative to its competitors because of the disparate nature of its component businesses, Genzyme shares have done well on an absolute basis. Five-year compound returns for Genzyme's shareholders exceed 20%. Genzyme's performance derives at least in part from the strength of the tracking stock structure it employs. Among other benefits, Genzyme credits its tracking stocks with allowing each business segment to focus on a distinct market, creating entrepreneurial environments, and broadening the company's investor base.

Conclusion

As these three stories demonstrate, there are keys for unlocking shareholder value whose judicious deployment can stand managers of public companies in good stead. None of the four structures outlined is appropriate for every situation, but each allows a company to more effectively segment the performance of an under- or overperforming business unit. Managers who are aware of their utility are armed with tools for constantly reevaluating their business structure.

Reference

1. Patricia Anslinger, Sheila Bonini, and Michael Patsalos-Fox, The McKinsey Quarterly, no. 1 (2000): 98–105.

Christopher Sweeney is with Cleary & Oxford Associates Inc. (Alexandria, VA), a firm that specializes in healthcare investment banking.

Photo by Canstock Images Inc.

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