spin-off.com
Companies eager to maximize shareholder value are offering up their sexier, high-tech divisions to seemingly insatiable investors.
By Brian E. Taptich
The Red Herring magazine
From the April 1999 issue

Beneath the tumult of multibillion-dollar mergers and the concerns about industry consolidation, a well-worn financial strategy is resurfacing: companies are carving out the fast-growth technology portions of their businesses for initial public offerings.

This time around, however, there's a new twist. Although auctioning off individual divisions as independent companies on the public markets is a common fiscal strategy, the tenor of these divestitures has changed dramatically -- instead of shedding properties that are underperforming or are incompatible with core businesses, companies are now freeing the divisions that offer the greatest potential for growth and, oftentimes, are essential components of their businesses. "Over the last two years, we've seen a new class of spin-offs where it's clear that a business is hidden under an organizational umbrella and not being valued properly by Wall Street," explains Dwight Decker, CEO of Conexant Systems, the communications semiconductor company recently spun off from Rockwell International. "So companies are eager to get these businesses into the sunlight."

This strategy has been common since 1996, beginning with the carve-out of Sterling Commerce from Sterling Software and the divestiture of Lucent and NCR from AT&T, and may continue through the widely expected separation of Palm Computing from 3Com. The highest-profile spin-offs have been the handful of Internet properties -- uBid, Ticketmaster Online-CitySearch, and MarketWatch.com -- rewarded by the recent explosion of Internet stock prices.

There's more to the ZDNet tracking stock than meets the eye.
Did Barnes and Noble begin a spin-off revolution with barnesand noble.com?


TECHSPLOITATION

Dazzled by the astronomical valuations that Wall Street is granting technology properties, however, some parent companies seem interested mainly in exploiting market conditions. The tireless 11-year ascent of the stock market has raised shareholders' expectations, and because "maximizing shareholder value" is the mantra that is supposed to guide every decision made by the CEOs of publicly traded companies, there is a great deal of pressure to realize every last ounce of growth potential. "The simple truth is that if today's CEO is truly a steward to the shareholders and not an empire builder," says Bill Burnham, an e-commerce analyst with Credit Suisse First Boston, "spinning out an asset that is competitively disadvantaged because it is not being given fair market value could be the right thing to do." Could be.

The three methods for freeing an asset -- classic spin-off, carve-out, and creation of a tracking stock -- differ only marginally, except to accountants. In the classic version, the parent company gives away all its ownership interests in the asset as a dividend to its existing shareholders. For example, Rockwell (NYSE: ROK) spun off Conexant (Nasdaq: CNXT) by giving one share of the newly formed company for every two shares of Rockwell stock. In a carve-out, the parent company sells a stake of less than 20 percent in an initial public offering and gives the remaining interests to existing shareholders at a later date. In 1996 AT&T (NYSE: T) sold a 17.6 percent stake in Lucent to the public (NYSE: LU) for more than $3 billion before giving the balance of its ownership interest to its existing shareholders. A tracking stock is created when a parent company wants a separate issuance to reflect the value of a particular division without relinquishing any control over it -- for example, Hughes Electronics (NYSE: GMH), the communications and automotive electronics division of General Motors (GM), trades separately but is still entirely owned by its parent.

FLYING THE NEST EGGS
In return for granting a division its freedom, parent companies like Rockwell, AT&T, and General Motors get valuable equity in the form of stock or cash. In fact, the five most lucrative IPOs of all time were spin-offs: in addition to the $3 billion pocketed by AT&T for Lucent, News Corporation took home more than $2.8 billion for its 1998 carve-out of Fox Entertainment Group, CBS netted $2.8 billion last year for its Infinity Broadcasting position, Sears earned $2.1 billion in 1993 for Allstate, and in the largest IPO ever, DuPont sold off Conoco for more than $4.4 billion in October (NYSE: (NWS), (FOX), (CBS), (INF), (S), (ALL), (DD), (COC)).

In addition to gaining equity, the parent company benefits from its books' suddenly being divested of the newly formed company's financials, which often improves its income, price/earnings ratio, and stock price. Moreover, says Mitchell Bartlett, an analyst for Dain Rauscher Wessels, the parent company frequently enjoys reflected glory from a successful IPO. "The success of the spin-off in the stock market reflects positively on the parent company's stock," he says, "and inevitably there's a surge in both stock prices."

ON THEIR OWNERSHIP
The newly formed company can also gain several advantages. Armed with fresh capital, the spin-off suddenly has the freedom to operate as an entrepreneurial venture and pursue its own business model -- it can capitalize the company in whatever way it sees fit, use its equity to make acquisitions for growth, and grant stock options to employees, which is crucial for recruiting and retaining talent. Spun off from the storage software developer Stac, for example, Hi/Fn has been able to focus entirely on developing semiconductors for communications applications; Midway Games is no longer distracted by the casino, hotel, and pinball-machine business of its former parent, WMS Industries. "Whether we're deciding to start a new project or to make a new hire, we can move more quickly now because there is less noise to contend with," says Mr. Decker of Conexant. "When we need to get things done, instead of working to achieve consensus among layers of management, all I have to do is walk down the hall."

Given the particular benefits for the parent company, it's little wonder that Internet assets have dominated recent spin-off issuance activity. In order to develop an Internet property, companies must invest enormous capital and incur huge losses just to keep pace -- a strategy that the company's investors would likely penalize it for pursuing. But by spinning off its Barnesandnoble.com division, for example, Barnes & Noble will eliminate the debt accruing on its balance sheet and raise huge amounts of capital. Meanwhile, Wall Street will reward the Internet property with a huge valuation.

Case in point: Creative Computers. Prior to carving out its online auction division, uBid, the company was a little-known direct marketer of computer products whose stock price historically vacillated between $5 and $10 per share (Nasdaq: MALL). But investors embraced uBid's December IPO despite the fact that the company's trailing 12-month revenues were only $25 million--4 percent of Creative's total revenues--uBid's stock, offered at $15 per share, was bid up to $188 in just two weeks (Nasdaq: UBID). In addition to the equity that Creative Computers raised through its majority position in uBid, Creative's stock was driven as high as $59 before settling into the mid-$30s.

Such exuberance, however, inevitably leads to temptation. And for every strategically sound spin-off, there are bound to be companies content just to make a buck. "There are good spin-offs and bad spin-offs," says Joe Cornell, president of Spin-Off Advisors, a research firm. "The former are racehorse divisions that are buried in a company and undervalued, and the latter are used simply to raise funds and prettify the parent company."

BABY-SITTING DUCKS
There's no guarantee that a newly independent company will survive on its own. As Mr. Burnham of Credit Suisse First Boston puts it, some companies are "just spinning a division out into a firing squad." Already, the divestitures of certain properties -- like PeopleSoft's Momentum Business Applications, CBS's MarketWatch.com, and Ziff-Davis's ZDNet Group -- have raised analysts' eyebrows.

At first glance, the decision of the publishing giant Ziff-Davis (which holds a minority stake in Red Herring Communications) to spin off the ZDNet Group, its online property, makes perfect sense. In 1997 Ziff reported net losses of $71.2 million on revenues of more than $1.1 billion; in its December IPO registration statement, the ZDNet Group reported 1997 net losses of $21.2 million (30 percent of Ziff's total losses) on revenues of only $32.2 million (3 percent of Ziff's total revenues). As a spin-off, the ZDNet Group would be granted all the freedom afforded an independent, entrepreneurial Internet company. Moreover, if ZDNet were an entirely independent entity, it would no longer be a drag on Ziff's finances.

What has analysts and investors wary of the deal, however, is Ziff's method for spinning off its Internet division, as well as its intentions for the IPO proceeds. Ziff has chosen to create a tracking stock for the ZDNet Group -- as a result, the subsidiary's negative financial performance will still affect its parent company's bottom line. And according to its registration statement (Ziff-Davis was in the quiet period that precedes any public offering, so its executives were unavailable for comment), Ziff-Davis plans to use most of the proceeds from the offering not to expand its online business, but to pay off a portion of the debt with which the parent company was saddled during its April 1998 spin-off from Softbank. "Companies that are spinning off businesses have to demonstrate a willingness to change their business practices," warns Mr. Burnham. "Whether it's slapping a '.com' on the end of your Internet property or parsing off your technology consulting group, simply spinning off a division in order to raise some quick money is not in the best interest of shareholders."

In the late '70s, a slowing economy forced companies that had spent the prior 50 years becoming enormous, hyperdiversified multinationals to shed assets that were inconsistent with their primary business. Since then, companies have concentrated on building around their core competencies. "For the last 20 years, these companies have cut costs, downsized, increased productivity -- everything they can do to maximize their valuations," argues Mr. Cornell of Spin-Off Advisors. "If their stock is still undervalued, the only remaining way to squeeze out some valuation recognition is to chop their vertically integrated business into smaller, more focused entities."

CAP DANCING
By balancing the compulsion to build the most successful company possible with the obligation to maximize shareholder value, many companies have reaped the rewards of dissecting their businesses. "We had a fast-growing, highly profitable e-commerce business that was being dominated by more classic software businesses," reflects Warner Blow, Sterling Commerce's CEO. "The e-commerce business was a hidden asset that we had to spin off." Prior to the 1996 divestiture, the market capitalization of Sterling Software was $2 billion; roughly three years later, the combined market cap of Sterling Commerce and Sterling Software is more than $6 billion. "I'm happy, and I think our shareholders are happy," says Mr. Blow.

As long as current market conditions persist, companies will continue to comb through their business for assets that they can repackage for a public offering. Some spin-offs will make sense and make company CEOs and investors happy. Others will not. The challenge for all of us is to differentiate between the two.