Beating Activist Investors at Their Own Game

4/16/15 | By Peter S. Cohan

Estimated reading time: 9 minutes

Key Takeaways

 

How CEOs can outthink the “barbarians” and boost company performance

Could you become the next Clarence Otis?

Not long ago, Otis was CEO of Darden Restaurants—the owner of Olive Garden and Longhorn Steakhouse. No more. In October 2014, Jeff Smith, head of the $3 billion activist investor firm Starboard Value, outmaneuvered Otis and Darden’s board in a proxy battle. Result: Starboard replaced Darden’s 12-member board and Otis—all while owning less than 10 percent of Darden’s shares.

That needn’t have happened, but it serves as a lesson.

Thinking like an activist investor—being forewarned and forearmed—can not only ensure greater longevity in corner offices, it can make underperformance, the whole premise of activist investors’ attacks, a nonissue. In other words, by understanding their playbook and taking preemptive actions to increase shareholder value, your company won’t become a target of today’s barbarians at the gate. And it will get financially stronger.

The defensive principles I’ll lay out are well worth formally incorporating, because activist investors can make major changes in your company while taking stakes no bigger than 5 percent.

Indeed, activists excel at enlisting pension funds and other institutions to follow their lead in pestering management to do what they want. If that fails, the activists go public in nasty letters and on CNBC.

And activists are not going away any time soon. Their economic impact and growing numbers only add urgency to developing proactive strategies: Hedge Fund Research reports that between 2010 and 2014, their assets under management jumped at a 33 percent annual rate to $112 billion.

The corollary—that ever more public-company CEOs will be targets of such activism—has been borne out, as well. Research group Activist Insight calculated that in 2014, 344 companies fell under the crosshairs of activists—18 percent more than in 2013. And these firms punch way above their weight. About 75 percent of the time in 2014, the activists pressured companies into doing what they wanted, according to the same study.

But do activists really know how to run companies? That track record is poor at best. By the ultimate measure in our shareholder-value-obsessed world, activists were dismal failures last year. Activist Insight, which runs an annual performance review, found that the average activist fund rose a paltry 4 percent in 2014, versus 13 percent for the S&P 500.

The clear lesson: Know your enemy’s weaknesses as well as his or her tactics. Put another way, CEOs should filter activists’ few good ideas from their more numerous bad ones.

The following frequent activist methods should inform how CEOs think about them.

  • Balance sheet changes. This is a favorite maneuver of people like Carl Icahn, who urged Apple to give $100 billion of its cash to shareholders.
  • Operational improvements. This tactic, epitomized by Jeff Smith’s 300-page Starboard presentation that, among other things, excoriated Darden for taking salt out of its Olive Garden pasta, is of more recent vintage.
  • Spinning off business units. Examples include Nelson Peltz’s pyrrhic victory at getting Kraft to spin off its international snack operations into the poorly named and uncompetitive Mondelez.
  • Merging with a rival. This perennial tactic is currently being pushed by Starboard, which is trying to bulldoze Yahoo and AOL—two online media also-rans—into a merger.

You can decide what might make sense of these standard demands in your own situation. But the advice I give CEOs is to hire an outside, unbiased expert firm to think about their companies as activists would. Task these advisers with articulating those invading strategies and determining whether the CEO should implement any of them before an activist starts mounting a public campaign to advocate the move.

Hiring experts might be analogous to posting lookouts and sentinels, but you also need high walls and a strong organization to withstand attacks. So, in addition to doing rigorous strategic analysis, CEOs must get things right tactically, as well. That means setting and meeting quarterly earnings and growth expectations, building good working relationships with board members, and lining up the best advisers for sudden proxy battles. More details on these tactics appear later.

Here are the five steps CEOs should take to win—or avert entirely—the battle with activist investors. A bonus will be improving performance in the ongoing war with competitors.

1. Evaluate the Portfolio

Start by considering whether you have the right mix of businesses in your company.

For example, in 2007, I met with General Electric’s then chief financial officer, Keith Sherin. Sherin—now CEO of GE Capital—asked me what I thought it would take to boost the company’s stock price. I told him that GE should exit businesses like appliances, media, and consumer finance, units with weak profit potential and a poor competitive position. Rather, it should invest in jet engines and energy, businesses with more profit potential and a strong competitive position.

To evaluate Sherin’s question for yourself, you should conduct a rigorous, fact-based analysis to:

  • Identify each business unit
  • Analyze each business unit:
    • The profit potential of the industry in which it competes
    • Its competitive position
    • How much a buyer would be willing to pay for it
  • Put each business unit into one of three categories:
    • Must keep
    • Might sell
    • Should sell

This exercise reveals the vulnerable chinks in your organization, as well as investment opportunities among strong units. You’re thinking like an activist.

2. Seek the Best Parent for Each Business Unit

Next, determine the answer to this question: Is your company the best one in each of the business segments in which you operate?

Consider one action GE took after I met with its CFO: the company decided to sell its appliances unit. The collapse of the financial markets interceded until 2014, but that’s when GE sold the unit for $3.3 billion to Electrolux, a global leader in that industry.

Since GE Appliances was a relatively weak performer within GE’s portfolio of businesses, this unit had never received the resources it needed to compete with more focused rivals. Within Electrolux, GE Appliances was expected to add to earnings and yield $300 million in cost savings—a win-win done without prompting from activists.

To figure out whether your company is the best parent for each business unit, make these evaluations:

  • Identify the critical skills needed to sustain leadership in its markets.
  • Analyze how well each business unit performs these skills:
    • Score the leading company on each skill.
    • Audit how well your business unit performs each skill.
    • Reach a conclusion about whether your business unit leads or lags.
  • Decide whether to sell the business unit to a better parent and, if so, find those parents and initiate negotiations.

3. Apply the Four Criteria of a Successful Acquisition to Merger Candidates

Well before an activist shows up on your doorstep, you should know the terrain of potential merger partners. Doing so by applying the four criteria below will prepare you for such suggestions.

For instance, if you were Yahoo’s CEO, and Starboard proposed you merge with AOL, here’s a summary of why the deal would not pass all the hurdles.

  • Is the industry attractive? Not particularly. Display advertising is a large market that is growing slowly and is being overtaken by mobile and social media advertising.
  • Are the combined companies better off? No. Both are mediocre survivors from an era in which they were leaders. Combining two mediocre companies will not make a formidable competitor—though it will lead to job cuts.
  • Will the present net value of the acquisition be positive? Unclear. It depends on the acquisition price and a host of key assumptions, sometimes known as the investment thesis.
  • Will the integration of the two firms be successful? Unclear. The answer depends on the skills of the acquiring management team at managing merger integration. Neither Yahoo nor AOL has demonstrated excellence in this area.

4. Scrutinize the Business from the Customer’s and Employee’s Perspective

Another key step in building an adequate defense against activist investors is honestly answering this very accurate two-part predictor of future growth:

  • Do customers almost always recommend you to people they know?
  • Do employees love to work at your company?

If you don’t know the answers, you need to conduct systematic research to find out. This is what Starboard did with Darden while that company slumbered. Its 300-page presentation on Olive Garden painted a very embarrassing picture of the company’s operations.

As Jeff Smith said, “Shockingly, Olive Garden no longer salts the water it uses to boil the pasta, merely to get a longer warranty on its pots. We believe this results in a mushy, unappealing product that is well below competitors’ quality despite similar cost.”

Smith also wrote that Darden could cut $4 million to $5 million a year from the cost of the 700 million “hot dog bun”-like bread sticks Olive Garden serves each year.

Without getting into the details of how to perform this kind of analysis, it is pretty clear that Starboard’s research gave it deeper insight into what ailed Darden than its board and CEO possessed.

A public-company CEO does not deserve to hold the job if an activist investor knows more about the company’s operations—and what its customers value—than the CEO.

5. Win the Short-Term Game

The final step in your readiness plan involves getting steady and predictable results. In other words, CEOs must make the right short-term decisions while anticipating the strategic ones outlined in the previous steps.

When it comes to activist investors, a CEO will be able to maintain the upper hand by:

  • Setting and meeting quarterly earnings and growth expectations. Missing quarterly earnings or lowering guidance almost always causes a public company’s stock price to plunge—thus making it more vulnerable to activists. It’s your job to make sure you always beat and raise.
  • Building good working relationships with board members. If you have been CEO for a long time, you should have developed good working relationships with all your board members. If you are new, you should run an offsite meeting at which you simulate how you would respond to a proxy battle in order to “exercise those muscles” before they are needed.
  • Lining up the best advisers for sudden proxy battles. Target, for example, came under attack by William Ackman’s Pershing Square in 2007. Target had been working with Goldman Sachs and legal counsel Wachtell Lipton for over a decade and was confident that the company was on solid ground in denying Ackman’s demands.

Like predators, activist investors keep surviving companies agile and strong. They will remain dangerous and opportunistic in attacking public companies for the foreseeable future. But the flip side is that a company’s ongoing and thorough analysis of its competitive strategies, combined with tactical excellence, can preserve deserving CEOs—while also benefiting from activists’ best ideas.​​