Deals

Brooke Sutherland is a Bloomberg Gadfly columnist covering deals. She previously wrote an M&A column for Bloomberg News.

Wall Street has industrial breakup fever and CEOs know it. At some point, something 's got to give.

Top executives from some of the biggest U.S. manufacturers descended on Florida this week for their annual spring confab, and the clear theme that's emerged after two days of presentations and Q&A is this: If you run a conglomerate, you better have a good reason for keeping it that way.

Activist interest in U.S. industrial companies has soared, with a Bloomberg News analysis of S&P data finding that the number of campaigns in the sector had more than doubled from 2015. It's easy to see why: many of these companies are sitting on a kaleidoscope of businesses and are getting punished for that in their valuations.

Target Practice
Ingersoll-Rand has outperformed over the past five years, but so has Honeywell and it has an activist. United Technologies and Eaton have lagged, giving them even less of a buffer.
Source: Bloomberg

Honeywell International Inc. is among the biggest activist targets so far, with Third Point LLC calling for a spinoff of its business that makes airplane engines and cockpit systems. CEO Darius Adamczyk is still mulling the idea, which he called an "intriguing concept" that he'll consider as part of a comprehensive review of how the company fits together. I'm skeptical that this is going to play out exactly as Third Point envisioned it, but Adamczyk is on board with the idea that simpler and smaller can be better. As for his peers… eh, not so much.

Among those that got asked about a breakup (and there were many) were Johnson Controls International Plc, Eaton Corp., United Technologies Corp., Dover Corp. and Ingersoll-Rand Plc. And we still have another day of presentations to go, with final speaker General Electric Co. (under pressure from activist Nelson Peltz to improve its operating performance) almost guaranteed to face questions about whether its massive remodeling effort over the past few years has gone far enough or whether other businesses should be shed -- like health care, light bulbs or the pending merger of its energy business with Baker Hughes Inc.

In Need of a Tune-Up
Johnson Controls significantly transformed its business with the Tyco merger and auto spinoff, but its valuation hasn't caught up and that may be partly to do with the battery business
Source: Bloomberg

The general response of CEOs to the breakup talk can perhaps best be summed up by Johnson Controls' Alex Molinaroli: "We're not deaf, that's for sure." But, for one reason or another, they're also not  jumping on board just yet. At Johnson Controls, Molinaroli dropped hints of structural limits on the company's ability to spin out its more volatile battery business following the split from its automotive business and inversion-style merger with Tyco International last year. You'd think it might have learned a lesson from Eaton and crafted those deals differently.

Speaking of Eaton, I don't really know what its excuse is at this point. CEO Craig Arnold tried to stress that he's taking a harder look at businesses than predecessor Sandy Cutler by not just evaluating whether Eaton as a whole can be consistently profitable through market fluctuations, but whether each of its divisions can meet that standard. He failed to mention that while Eaton's electrical products, aerospace and electrical systems units have already hit or are set to hit their 2020 targets this year, its vehicle components and hydraulics units lag behind and yet still remain in the company.

Under Construction
Eaton's vehicle unit is trailing its margin targets. Eaton increased its margin forecast for the hydraulics unit after a better than expected first quarter performance.
Source: Eaton

United Technologies CEO Greg Hayes and Ingersoll-Rand's Mike Lamach both noted the hundreds of millions of dollars it would cost to replicate centralized functions for an additional public company and to renegotiate supplier agreements on a smaller scale. United Technologies has also argued that it needs the cash generated by its climate controls and elevator operations to help fund the high development costs in its jet engine business.

Fair enough, but I don't think those arguments are necessarily going to save them from an activist investor showing up to complain about their valuation gap relative to more-focused peers. The success of other industrial spinoffs and a rise in exchange-traded funds that's pushed active money managers to seek out smaller-sized companies with growth stories has put a greater burden of proof on conglomerates, as Barclays Plc analyst Scott Davis has noted. The typical synergy and sum-of-the-parts spiel might not be enough anymore. 

Dover is probably the only one on Gadfly's breakup watch list with valid reason to wait and see. Analysts have wondered whether it might decide to sell the energy business that's given it so many headaches during the commodity rout of the past few years. CEO Robert Livingston's response was that he'd be remiss to deprive investors of the earnings growth that unit is finally starting to see, but to not "lose sight" of the breakup question. He might get a bit more for the business in a sale by holding out for a while as well.

As for the rest of them, the conference is ending today, but the questions about breakups aren’t going to stop and just listening to them isn't going to cut it.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Brooke Sutherland in New York at bsutherland7@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net