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Is it Time to Prune the Portfolio?
Gregory V. Milano  |  June 04, 2013  | CFO.com
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Are we back at a point where company executives should think about pruning their business portfolio by selling their unwanted business units?
The second important piece of criteria is whether or not the parent company  management believes after an objective strategic analysis that they can add value to the business.
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Management shouldn’t be too jumpy to sell and buy businesses. They need to carefully
evaluate their strengths and competitive advantages.

Back in 2009 with the stock market sitting at about half the peak it reached two years earlier, a client
CFO shared a disheartening story about a divestiture he planned but never made. It seemed he and his
CEO decided during the previous downturn that they should sell one of their business units. But they
failed to sell it when the time was right.

The business unit didn't strategically fit well with their other businesses and its financial performance
was spotty and cyclical. When they decided to divest it, the business was suffering very low
profitability and the public peers were trading at dismal valuations.

So they decided to wait until the financial performance and valuations rebounded.

Fast-forward a few years and just as they had hoped the financial performance of the business
bounced back stronger than ever and stock market valuations among comparable companies jumped
back up as well.

Just when their strategy signaled it was time to sell, they didn’t sell. The CFO recalled with a sting that
he and the CEO decided “…it's producing decent cash flow so we should keep it.”
Are we back at a point where company executives should think about pruning their business portfolio by
selling their unwanted business units?

The National Bureau of Economic Research (NBER) publishes data on the time between economic
cycles. The duration of cycles does vary but over the 11 cycles since World War II, the average time
between economic peaks has been 66 months.

The last peak was in December of 2007 so on average the next peak should be right about now - June
2013. But the last 3 peak to peak cycles have been longer, averaging 106 months. This implies the next
peak is over three years away. The point is that sometime over the next few years we are likely to hit
an economic peak so it seems worthwhile to evaluate strategic alternatives now.

Another way to consider the business cycle is to examine net income trends. Based on consensus
equity research analyst estimates, the expected 2013 net income for the companies in the S&P 500 is
about 38% higher than the same companies delivered in 2007. So whether we are at the peak yet or
not, financial performance is strong in many industries.

On top of this the stock market is now hitting peaks regularly with earnings multiple valuations still a
little bit lower than they were at the last peak but quite high by many standards and certainly in many
industries.

For those who think this may be the time to dispose of unwanted business units, there are two key
considerations.

The first and most important piece of criteria is whether the business fits from a strategic perspective.
The answers to a few key strategic questions can answer this:

. Do the key value drivers of the business coincide with the core competencies of the parent company?

. Do any of the parent company's other businesses possess competitive advantages that help the
subject business unit to be an above-average player among competitors?

. Are there any cross-fertilization opportunities between this and other parts of the portfolio?

The second important piece of criteria is whether or not the parent company management believes
after an objective strategic analysis that they can add value to the business. It is not enough to
decide if a business is a good business with strong growth and high returns or a bad business with weak
growth and/or low returns. Can value be added?

Managing a portfolio of businesses is very similar to managing a portfolio of stocks. You want to hold
the ones you think will grow in value and not the ones that you don’t think will rise in value.

Consider an example. A company may have a business unit that produces a 20 or 30% return on capital
with 6 or 8% growth and rightly believe this to be a good business. But if there isn’t any room for the
company to improve upon the returns or the growth rate of this business, why are they holding it?

Why not sell it for what it’s worth given the return and growth profile, and redeploy the capital into
business areas where management can invest to increase growth or improve returns by doing something
to make the business worth more than has to be invested to buy it?

In fairness, management’s shouldn’t be too jumpy to sell and buy businesses. They need to carefully
evaluate their strengths and competitive advantages. They must assess each business in the portfolio
in absolute terms and against peers. They must decide how best to try to grow the value of each
business, and then with this information in hand they must identify opportunities where portfolio
changes can create value.

And then, of course, they must execute the plan effectively. The best portfolio realignment plans in the
world are worthless without effective execution. Management must sell and buy the right businesses at
the right price and at the right time. Just as now may be a great time to sell business units, it may be
best to wait and build investment capacity for the next downturn so acquisitions can be made at lower
prices.

Those that execute portfolio changes well can add a significant dimension to their ability to drive higher
total shareholder returns for their owners.
Gregory V. Milano, a regular CFO columnist, is the co-founder and chief executive officer of Fortuna Advisors LLC, a value-based strategic advisory firm.
Everyone knows what happened next. A few years rolled by and both the
business unit performance and comparable company valuations dropped. In fact
they couldn’t get 50% of what they once would have easily sold it for. They
regretted the decision they made at the top of the cycle.