Spin-Offs: New companies for the New Year

It seems one form of special investing that doesn’t go out of style is investing in spin-offs. I first ran into this special investing style while reading Buffet’s original letters in his partnership. It seems this tactic is not new, but seems to be continuously explored by many value investors. Also notable investors such as Joel Greenblatt and John Keeley consistently buy recent spin-offs, and have had stellar returns. According to academic and Wall Street research spun-off companies for the first three years have an average return of 10% greater than the S&P 500 average. There are a number of reasons for this.

1. Unrelated businesses may be separated via a spin-off transaction so that the market can better appreciate the separated businesses. The market tends to value individual companies higher than conglomerates.

For example, a conglomerate in the steel and insurance business can spin off one of the businesses and create an in­vestment attractive to people who want to invest in either in­surance or steel but not both. A recent example would be the Altria spin-off of Kraft. This value “arbitrage” is the main deciding principal that most boards and companies think about spinning apart companies or splitting up into different companies.

2. Sometimes, the motivation for a spin-off comes from a desire to separate out a “bad” business so that an unfet­tered “good” business can show through to investors.

The “bad” business may be an undue drain on management time and focus. As separate companies, a focused manage­ment group for each entity has a better chance of being effective.

3. Sometimes a spin-off is a way to get value to shareholders for a business that can’t be easily sold.

Occasionally, a business is such a dog that its parent com­pany can’t find a buyer at a reasonable price. If the spin-off is merely in an unpopular business that still earns some money, the parent may load the new spin-off with debt. In this way, debt is shifted from the parent to the new spin-off company. With the recent credit markets, more companies might be forced to spin-off companies instead of selling them to different private equity groups.

4. Tax considerations can also influence a decision to pur­sue a spin-off instead of an outright sale.

If a business with a low tax basis is to be divested, a spin-off may be the most lucrative way to achieve value for share­ holders. If certain IRS criteria are met, a spin-off can qualify as a tax-free transaction – neither the corporation nor the in­dividual stockholders incur a tax liability upon distribution of the spin-off shares. A cash sale of the same division or subsidiary with the proceeds dividends out to shareholders would, in most cases, result in both a taxable gain to the corporation and a taxable dividend to shareholders.

5. A spin-off may solve a strategic, antitrust, or regulatory is­sue, paving the way for other transactions or objectives.

In a takeover, sometimes the acquirer doesn’t want to, or can’t for regulatory reasons, buy one of the target company’s businesses. A spin-off of that business to the target company’s shareholders prior to the merger is often a solution. In some cases, a bank or insurance subsidiary may subject the parent company or the subsidiary to unwanted regula­tions. A spin-off of the regulated entity can solve this problem.

6. The spin-off process itself is a fundamentally inefficient method of distributing stock to the wrong people.

Generally, the new spin-off stock isn’t sold; it’s given to shareholders who, for the most part, were investing in the parent company’s business. Therefore, once the spin-off’s shares are distributed to the parent com­pany’s shareholders, they are typically sold immediately without regard to price or fundamental value.

7.The initial excess supply has a predictable effect on the spin-off stock’s price.

Most of the time spin-off companies are much smaller than the parent company. A spin-off may be only 10 or 20 percent the size of the parent. Even if a pension or mutual fund took the time to analyze the spin-off’s business, often the size of these compa­nies is too small for an institutional portfolio, which only con­tains companies with much larger market capitalizations. Think about many of the mutual funds that you own; if its prospectus claims it is a US large cap focused fund then if one of its holdings spins off a small-cap stock, then the fund will be forced to sell the shares once they are delivered.

8.Many funds can only own shares of companies that are included in the Standard & Poor’s 500 index.

If an S&P 500 company spins off a division, you can be pretty sure that right out of the box that division will be the subject of a huge amount of indiscriminate selling.

9.Entrepenerurial Forces

When a business and its management are freed from a large corporate parent, pent­-up entrepreneurial forces are unleashed. The combination of accountability, responsibility, and more direct incentives take their natural course. After a spin-off, stock options, whether issued by the spin-off company or the parent, can more directly compensate the managements of each business. Both the spin-off and the parent company benefit from this reward system. In addition, the smaller company is no longer “fighting” for funds or capital to make the proper long-term investments.

 

In the Penn State study, the largest stock gains for spin-off companies took place not in the first year after the spin-off but in the second. It may be that it takes a full year for the initial selling pressure to wear off before a spin-off’s stock can perform at its best. More likely, though, it’s not until the year after a spin-off that many of the entrepreneurial changes and initiatives can kick in and begin to be recognized by the marketplace. So lets examine some past spin-offs and some recently announced spin-offs.

 

First some past spin-offs that might be interesting. Note, that there are many other spin-offs, these are just some that have caught my attention:

 

Altria-Kraft (KFT) Warren Buffet has taken a stake;

Tyco Splitting into three companies: Tyco (TYC), Covidien (COV), and Tyco Electronics (TEL) ;

Morgan Stanley spun-off Discover (DFS);

Walter Industries spun-off Mueller Water (MWS);

American Standard spun-off Wabco (WBC);

NCR spun-off Teradata (TDC);

Alberto-Culver spun-off Sally Beauty (SBH);

First Data spun Western Union (WU);

Verizon spun Idearc (IAR);

Duke Energy spun-off Spectra Energy (SE).

 

Recently Announced Upcoming spin-offs are:

Altria will spin-off its international diversion;

IAC is splitting off into five companies;

E W Scripps is splitting into two companies;

Cadbury Schweppes is spinning off its American Bottling Unit;

Belo is also splitting into two companies.

 

As always any comments or ideas are welcome. Please do your own due diligence before purchasing any equity position.

 

Full Disclosure: Long Western Union

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