Non-Core Businesses has Been All the Rage This Year. The
1st quarter of 2000 produced over 40 announced spin-offs.
The pace at which companies have announced spin-offs is
unprecedented. In 1999,
there were 71 announced spin-offs, and an equally impressive 66 companies
have actually liberated their offspring. Many of these entities begin
their independence as a repository for technology related, under
performing or neglected businesses. Often
spin-offs are viewed as damaged goods initially by investors and discarded
of these discarded stocks have been outstanding investments. We have
chosen to review some of the ground rules for spin-off investing in an
effort to establish a general framework for evaluating and trading
Spin-offs can take many forms but the end result is
the same: A corporation takes a subsidiary, division, or part of its
business and separates it from the parent company by creating a new,
independent, free-standing company. In
most cases, shares of the new entity are distributed to the parent
company's existing shareholders or sold.
There are numerous reasons why a company might choose to separate
itself from the business to be spun off. Unrelated
businesses may be separated so that the market can better appreciate the
example, a diversified company may have a fast growing software or
Internet business that is largely ignored or not valued by the market
because it is a small part of a large company. The fast growing division
would likely garner a richer valuation (P/E multiple) as a stand-alone
business. Highly diversified companies (conglomerates) often trade at a
discount (reflecting the "forced" purchase of unwanted
businesses. Thus, the spin-off of such a business could enhance the total
value of the parent shareholder's holdings, since it might be valued at
little or nothing as part of the current corporate whole.
In spinning off a more desirable unit, management may see a stock
market opportunity where pure plays in specific sectors are highly prized
the motivation for a spin-off comes from the desire to separate a
"poor" or underperforming business so that an untarnished
"good" business can shine through to investors. The benefits of separating problem operations from the
parent's relatively untroubled businesses are self-evident. For the parent company, perhaps the principal benefit of
spinning off a troubled operation is that the market value of the
presumably profitable remaining businesses may be enhanced by the
elimination of the under performing assets. Parent company management may
have lost its patience or ability to deal with the unit's problems.
Some of these problems include lawsuits, environmental issues,
mature or declining markets, over-large fixed cost structures, and a
general history of poor management. In
general, 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. Ironically,
some of these "bad" spin-offs turn out to be rewarding
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 does not want or can not 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 can provide a solution.
In some instances, 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.
Spinning off subsidiary corporations has become an increasingly popular way to create shareholder value while taking advantage of tax laws. A spin-off distribution can be made tax-free to the parent corporation and the receiving shareholder. This can represent significant savings to the parent company, relative to selling the division outright, if the subsidiary is carried on the books at a large discount to current market value. A sale would generate a big capital gain tax. If at least 80% of a subsidiary’s equity is distributed to existing shareholders, a spin-off lets a company avoid the potentially large capital gains tax liability that a straight sale would incur. Spin-offs are the most tax efficient mechanism to separate a division. The parent firm restructures the subsidiary as an independent company with its own stock: then gives those shares to current investors of the parent company. Under Internal Revenue Service rules, to qualify for a spin-off, the company being spun (among other things) must have been in business for at least five years to obtain tax-free status. The Securities and Exchange Commission also requires three years of audited financials.
Spin-offs are one of three basic ways to divest a
subsidiary. The other two
methods are Sell-offs (usually for cash, where the subsidiary is sold to
another corporation, or to the divisions management in an LBO) and Equity
Carve-Outs (also known as partial public offerings.
In a Carve-Out some or all of the subsidiary’s stock is offered
directly to the public) in the form of an IPO.
From a shareholder standpoint, the spin-off, based on distribution
of stock in a subsidiary to create a new public company is the most
attractive restructuring alternative.
Why? Spin-offs differ
from the other two methods in several ways.
First, spin-offs that qualify under IRS Section 355 Code are the
only way to divest assets on a tax-free basis.
The tax efficiency of a pure spin-off is a major reason
corporations have increasingly opted to divest divisions in this manner.
For A Tax Free Spin-Off
In an age when enhancing shareholder value is the
overriding purpose of management’s existence, spin-offs are gaining
popularity. In order to
effectively execute a spin-off, complex rules must be followed to ensure
that the unit will be able to operate independently, that the transaction
is tax-free, and the financial reporting requirements are satisfied. Particular care must be paid to capital structure, IRS rules
and financial reporting requirements. If a spin-off fails to meet all of
the IRS Section 355 Code requirements, the company can be liable for the
full taxes on the divestiture without receiving the cash that could be
used to pay the tax bill. In
addition, shareholders will be taxed on the receipt of an ordinary income
In order to be tax-free, among other things, the
spin-off must be undertaken for a bonafide, non-tax “corporate business
purpose” i.e. to save costs other than federal taxes, to enhance the
profitability of the new company or to enhance management focus on each
business. The parent must
“control” the subsidiary to be spun off immediately prior to the
spin-off, and the parent must distribute “control” of the subsidiary
to the parent’s shareholders. The
shareholders of the parent corporation must maintain a “continuity of
interest” in both the parent corporation and the spun off subsidiary. Finally, the parent corporation and the spun-off subsidiary
must actively conduct a trade or business immediately after the spin-off,
and the business must have been actively conducted throughout the
five-year period ending on the date of the spin-off.
taxable consequences, the transaction must be structured carefully to
abide to the rules of Section 355, which are summarized as follows:
The parent company must have “control” of the
subsidiary immediately prior to the spin-off and must disburse to the
shareholders a controlling amount of subsidiary stock.
Normally, the parent is required to distribute all of its stock in
the subsidiary. Control is
defined as stock possessing at least 80% of the voting power and at least
80% of each class of nonvoting stock.
Section 355 also requires that both the parent and
subsidiary be engaged immediately after the spin-off in an active trade or
business in which each has actively operated for at least five years prior
to the divestiture.
MAY NOT BE
USED AS A DEVICE TO AVOID TAXATION
Under the code, the transaction must not be used as a
device to distribute earnings of a company.
Basically, this means that the transaction may not be used simply
as a means of escaping dividend taxation rules by converting ordinary
income into capital gains.
This rule requires that the shareholders of the
parent maintain a significant continuing interest in both the parent and
the subsidiary following the transaction.
This requirement for a tax-free spin-off is that the
transaction has a substantial business purpose. This is typically the most rigorous and uncertain
prerequisite. Through the
years a business test has evolved through Internal Revenue Service rulings
and court cases. This test
requires the spun-off company have a real and substantial business purpose
separate from avoiding federal income taxes.
Commonly, a spin-off must bring about material and quantifiable
cost savings or other benefits to one or more of the businesses involved.
Purposes For Rationalizing a
The company indicates that a spin-off will allow the
parent or a subsidiary to trade at a higher valuation than the current
stock price. Again, the IRS
is unlikely to accept that simply increasing the stock price enhances the
business per se, unless a stock offering to raise capital to be used in
the business will follow. Consequently,
the IRS will request a letter from an investment banker stating the case
for the spin-off as a technique of effecting a more successful stock
offering. The IRS will demand
a representation that an offering will take place within a year after the
An example of a business purpose based on regulatory
rules is a divestiture required by a governmental agency. The spin-off may
follow an acquisition whose approval by the Federal Trade Commission or
Department of Justice may be contingent on divestiture of a certain
businesses. Regulatory relief
can be among the more difficult situations to document to the satisfaction
of the IRS. Many times, a
government agency has not mandated a spin-off take place. Usually, private
counsel has advised the acquiring company that a spin-off could help avoid
certain regulatory restraints. If
the divestiture has not been mandated by regulators, a legal opinion may
be required to convince the IRS that the spin-off will lead to that
This business purpose establishes that the
company’s ability to borrow will be enhanced as a result of the
separation of the parent and the subsidiary.
The focus would likely be on circumstances affecting the
company’s credit rating.
Fit and Focus
This purpose often involves a business identified by
management as non-core. Many
spin-offs have received IRS approval based on the parent’s ability to
show that the needs of one business for management direction and access to
capital markets would be greatly improved through separation from one or
more other businesses.
Can Be Misvalued?
Regardless of the initial motivation behind a
spin-off transaction, two studies showed newly spun-off companies tend to
handily outperform the general market.
One study, completed at Penn State, covering a twenty-five year
period ending in 1988, found that stocks of spin-off companies
outperformed their industry peers and the Standard & Poor's 500 by
about 10 percent per year in their first three years of independence
(Patrick J. Cusatis, James A. Miles, and J. Randall Woolridge,
"Restructuring Through Spin-Offs," Journal of Financial
Economics, June 1993). In
their study, the parent companies also managed to do fairly
well--outperforming the companies in their industry by more that 6 percent
annually during the same three-year period. The second study completed by
McKinsey found more than 300 spin-off’s occurred between 1988 and 1998.
McKinsey’s results indicated that spin-offs substantially outperformed
the market, showing a two-year total shareholder return of 27%, compared
to the S&P 500 17% and Russell 2000 14%. McKinsey’s study also
showed that Tracking Stocks returned 19% vs. 21% for the S&P 500.
However, in fairness to Tracking Stocks, McKinsey’s study showed they
kept pace with industry peers. (Patricia L. Anslinger, Steven J. Klepper
and Somu Subramaniam, “Breaking up is good to do,” The McKinsey
Quarterly, 1999, Number 1). These
market-beating results were enjoyed by just owning them across the board.
Why should this be? Why should it continue?
The spin-off process itself is a fundamentally inefficient method
of distributing stock to people who may not want it.
Generally, the new spin-off is given to shareholders that, in most
cases, were investing in the parent company's business.
Once the spin-off's shares are distributed to the parent company's
shareholders, they are often sold immediately without regard to price or
fundamental value. The
initial excess supply has a predictable effect on the new spin-off's stock
price: it usually goes down. Therein
lies the value. This type of
selling can push spin-offs to price levels not reflective of the
longer-term outlook for the business.
Savvy investors can take advantage of temporary declines in prices
by accumulating shares at attractive levels.
OWNERSHIP CHANGES RAPIDLY
In a pure spin-off, people receive shares that they have not chosen
to buy, and often have no interest in keeping.
In addition, there is often “structural” selling associated
with spin-off situations. For example, if the parent company is in a major
index (S&P 500), and the subsidiary that is spun-off is not, index
managers will be forced to sell the spin-off without regard to the
prospects of the business if it wishes to mirror the index it designed to
mimic. This generally will place selling pressure on newly spun-off
INADEQUATE or PARTIAL
For a variety of reasons, there is often an absence of adequate
financial information. Management
is typically reluctant to provide sufficient information to perform
financial analysis due to uncertainties over spin-off effects on earnings.
Less research is done until more complete information is available.
This leads to spin-offs being underfollowed by Wall Street
UNCERTAIN EARNINGS OUTLOOK Since
many spin-offs are often made up of underperforming assets to begin with,
it is difficult to target appropriate valuation parameters. It is difficult to precisely project new expenses the
spin-off will incur as a freestanding company, which adds to the
difficulty of forecasting earnings and appropriate valuations. In addition, there is a lack of comparable public companies
to provide acceptable valuation comparisons, which compounds these
LITTLE STREET RESEARCH The
lack of street coverage initially for spin-offs can create excellent
opportunities for investors.
There is little economic motivation for large brokerage firms to
initiate coverage of spun-off companies.
Remember that the shares are given to shareholders, therefore Wall
Street can not make any fees on the distribution (versus a big payday with
an illustrious IPO). In
addition, usually the spin-off is small to mid-cap in size; this will
further inhibit Wall Street’s interest.
Further, management (in the new spin-off) is often ill equipped to
deal with investor relations at a sophisticated level. Often, the staff is without adequate, experienced personnel
to convey the company’s message to investors.
STRUCTURAL SELLING EFFECTS For
example, if the parent company is included in a major stock index and the
spin-off is not, index fund selling usually generates selling pressure on
the divested company. A large
spin-off ratio (one for 10 or greater, for example) will intensify selling
pressure as investors who are not interested in keeping small or odd lot
positions in an unfamiliar company. Lack
of a dividend may push income-oriented investors out of the spun-off
stock. A spin-off of a
small capitalization stock from a large capitalization stock may prompt
large cap managers to sell due to liquidity concerns.
Many institutional portfolio managers are forced to realign their
portfolios to meet preset investment criteria.
In other words, if the spin-off does not fall within the manager's
investment parameters (size, yield, industry, etc.), it may be necessary
to sell the shares without regard to the prospects for spin-off.
This typical structural selling often pushes spin-offs to price
levels, which are not reflective of the long-term outlook for the company.
Savvy investors can take advantage of this temporary decline in
prices by accumulating shares on the cheap.
ENLIGHTENED SELF INTEREST Some
companies would rather have their stock price decline after the
distribution. Yes, it
is true. Upper management is
often "incentivized" with stock options whose strike price is
determined by some average number of days trading after the spin-off.
It is to management's benefit to have their options strike at low
prices rather than higher prices.
Therefore, management may not communicate with the investment
community initially (who presume there is nothing good to discuss and
bailout on the spin-off). For
example, in 1998 Midas (NYSE: MDS) was spun from Whitman.
We attended the spin-off roadshow just prior to the distribution.
Most people who attended the meeting were not excited about the
muffler chain's near-term prospects.
They started out with a highly levered balance sheet (thanks to
Whitman), a slew of operating problems and a brand new CEO who made it
sound as if it would take some time to get the ship on course.
In addition, Midas was getting booted from the S&P 500 index.
Naturally, many Whitman shareholders chose to sell their Midas
stock after the distribution. While
we could not prove it in a court of law, we suspect that the CEO
downplayed their near-term prospects so that his options would price at a
favorable level. (His options priced at around $16).
In fact, Midas was the second best performing spin-off of 1998,
appreciating nearly 70%. The
moral of the story is you should not automatically disregard a new
spin-off if management does not appear overly enthusiastic initially.
They could be "sand-bagging" the Street for cheap
Should You Invest in Spin-Offs?
There are three periods during which an investor can
get involved with a spin-off. Each
period presents different investment opportunities and analytical
problems. Since many spin-offs are made up of underperforming assets to
begin with, it is difficult to target appropriate buying or selling points
based on traditional valuation parameters.
The difficulty in accurately projecting new expenses the new
spin-off can expect to incur as a freestanding company adds to the
difficulty of forecasting earnings and appropriate valuations.
The pre-spin period occurs after a spin-off is
announced. The decision to
buy stock in the corporate parent may be desirable if it enables the
investor to purchase both entities at a lower combined price that the two
separate post-spin companies. But,
this can be difficult without definitive knowledge of the spin-off’s
balance sheet, asset base and normalized earnings power.
Typically, the market reacts positively to announcements of
spin-offs. Often there will
be an initial jolt to the price of the stock, as investors anticipate
increased operating efficiencies that are consistent with these
transactions. Several studies
have examined the market reaction to the announcement of carve-outs (Schipper
and Smith, 1986) and spin-offs (Hite and Owers, 1983, Miles and Rosenfeld,
1983, and Schipper and Smith, 1983).
The studies demonstrated that the announcement of a corporate
spin-off or carve-out is associated with positive stock price movements in
the parent’s stock. This
positive announcement effect is attributable to Wall Street participants
embracing the idea that a divestiture will be a catalyst in unlocking
value inherent in the business. As
the initial euphoria subsides, the stock often settles into a narrow
trading range until the actual spin-off takes place. This can be as long as a year or more, depending on the firm
seeking IRS, SEC, and final board approval.
This can be an attractive time to get involved with the spin-off if
one is patient, and believes both parts are attractive investments.
The initial trading period occurs when the spin-off
begins when-issued or regular-way trading, and continues for a period of
several weeks to several months. Institutional
holders normally are not very active in "when-issued" trading,
preferring to take physical receipt of their shares.
Thus, if you wish to play the percentages (spin-offs often drop
initially), or believe the spin-off’s prospects are poor near term, this
can be a good window for investors to sell shares.
As previously discussed, newly spun-off shares are often subjected
to a downward selling pressure due to “structural” issues. If the
parent is included in a major index and the spin-off is not, index fund
selling generates downward pressure on the spin-off.
A large spin-off distribution ratio (i.e., one for 20) can
intensify selling pressure. Some
investors are not interested in holding small or fractional positions in
an unfamiliar company. A
spin-off of a small capitalization stock from a large capitalization stock
may prompt large cap managers to bail out on the spin-off.
For these, as well as other reasons, spin-offs often face
significant selling pressure when initially freed from its corporate
parent. Therefore, those who are adept traders may wish to consider
selling as soon as possible, then repurchase the shares as the selling
The seasoning period starts from the moment the
spin-off is announced and can last up to several years.
The better the spin-off is understood and perceived the faster the
seasoning period. During this
time more information becomes available, management tells its story to
Wall Street, and more realistic appraisals of the company’s prospects
can be made. Depending on how
much structural selling the spin-off endured, this period can have the
greatest mispricing of a given stock as well as the best opportunity to
profit from that market inefficiency.
One must be patient and selective when sorting out attractive
The Dangers of
Buying Too Soon
Previously, buying most spin-offs in the early weeks
of trading, due to the intensity of artificial selling pressures, was
generally the best strategy. Now,
greater patience and selectivity is more important in ferreting out
attractive spin-offs. Spin-offs
tend to trade at higher initial prices than in the 80’s, due to the
stellar price performance of some earlier spin-offs; more attention is
being paid to this class of security.
Consequently, there is now a greater initial interest in spin-offs
as portfolio managers try to ferret out bargains, and less likelihood of
grossly mispriced issues relative to their inherent value. As a result,
there is now a greater initial interest in spin-offs. Newly spun-off
companies are often subjected to a variety of new and unexpected internal
and external pressures. These
pressures can have a major effect on its ability to meet initial
short-term earnings targets and thus match earnings expectations. If
disappointments occur, investors can prove less patient with a company
that is suddenly viewed as having no long-term operating record and an
uncertain future. The
lack of a long-established “sponsorship” with the understanding and
willingness to take a longer-term point of view can also hurt the stock
Why Invest in
first and foremost reason to invest in spin-offs is, of course, to make
money. Numerous academic
studies suggest that many spin-offs have experienced significant capital
appreciation, both on an absolute and a relative basis.
Spin-off pricing inefficiency, where it can be accurately
identified holds the potential for above-average investment returns over
time. Nevertheless, factors such as the timing of the initial
purchase, length of holding period and selectivity are critical to
successful spin-off investing. Once
removed from the parent, these newly independent spin-offs frequently
undergo significant internal and external changes, which can create major
investment opportunities and problems in spin-off analysis and investment.