Money Magazine ran a great article about spin-offs in March 1999. Despite being over 10 years old, the fundamental principle that spinoffs generally outperform the market in the first 18 months of trading still holds true. Unloved and under-followed, spinoffs are often undervalued by the parent, leading to some excellent arbitrage situations. There are so many at any given time that it's led to the creation of the Claymore/Beacon Spin-Off ETF, a basket of 40 stocks tracking the Beacon Spin-Off Index. The fund's had a spotty record since its inception in 2006. Nonetheless, I'll look at three large-cap companies where owning the spinoff rather than the parent would have been the better move.

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Pepsi's Profitable Spinoff
In September 1997, Pepsico (NYSE:PEP) spun-off its Pizza Hut, KFC and Taco Bell restaurants into a separate company. Existing shareholders received one share in the new company, Tricon Global Restaurants (changed to YUM Brands (NYSE:YUM) in 2002), for every 10 shares of Pepsi. Pepsi's CEO at the time, Roger Enrico, believed this separation would allow it to focus on its packaged goods business, which is a very common reason for making the move. However, it didn't help Pepsi shareholders much. Many Pepsi shareholders likely sold the new stock as soon as it hit their accounts. This would turn out to be a huge mistake. Since September 17, 1997, YUM Brands stock is up 520.8% compared to 132% for Pepsi and 14.4% for the S&P 500. Pepsi shareholders who kept the new stock, sold their Pepsi stock and bought more Yum stock with the proceeds would be very happy today.

Chipotle's Hot Performance
McDonald's (NYSE:MCD) first invested in Chipotle Mexican Grill (NYSE:CMG) in 1998 when there were just 16 stores, all in Denver. Today, it has over 1,000 fast-casual restaurants. In 2006, as part of a turnaround strategy, McDonald's decided to return capital to its investors through an exchange of stock. McDonald's investors could exchange one share of its stock for 0.8879 shares in Chipotle Class B stock, which was converted into common stock on a one-for-one basis in December 2009. At the time of the share exchange offer, the 10% discount to Chipotle's book value probably looked like a sweet deal. In hindsight, it was a great deal. Over the past four years, the spinoff outperformed the parent by 56.7%. Once again, rolling your McDonald's stock into Chipotle stock would have made you wealthier. (For more on playing spinoffs, read Cashing In On Corporate Restructuring.)

Mead's Healthy Gains
This last example demonstrates why the 18-month statistic mentioned in the opening paragraph isn't an aberration. In February 2009, Bristol-Myers Squibb (NYSE:BMY) sold off 15% of its Mead Johnson Nutrition (NYSE:MJN) baby formula business at $24 a share. On Mead Johnson's first day of trading, it gained 10.1%. Eighteen months later, the company's tacked on an additional 99%. Meanwhile, Mead's parent's stock has returned 26.1% over this same period. It's a respectable return, but less than the S&P 500 and clearly much less than Mead Johnson.

Bottom Line
I'm not suggesting for a moment that every spinoff performs this well. However, if you own a stock that's contemplating a spinoff, do yourself a favor and at least consider the possibility that owning stock in the new entity rather than the parent is a potentially lucrative proposition. (For related reading, take a look at Parents And Spinoffs: When To Buy And When To Sell.)

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