When a company in which you own stock is spinning off one of its units to shareholders, what's the best move to make? Do you keep stocks in the parent company, in the spinoff, or both? That question has been asked often by investors over the years.
Between 1990-2006, there were more than 800 spinoffs in U.S. exchanges, totaling more than $800 billion in market value, according to Peter Hunt's "Structuring Mergers & Acquisitions."
The Spin on Spinoffs
In a pure spin-off, a company distributes 100% of its ownership interest in a unit as a stock dividend to existing shareholders. It's a tax-free method of divestiture that usually helps both the parent and unit achieve better results as separate and more highly-valued entities.
Many studies have found that spinoffs and parents do outperform the market, with the edge going to spinoffs. One of the more commonly cited studies by Patrick Cusatis, James Miles and J. Randall Woolridge was published in a 1993 issue of The Journal of Financial Economics. It determined that spinoffs and parents surpassed the S&P 500 Index by an average of 30% and 18% respectively during the first three years of trading in spinoff shares.
A Lehman Brothers investigation by Chip Dickson discovered that between 2000 and 2005, spinoffs beat the market an average 45% during their first two years, while parent companies beat it by an average 40% in the same two years. JPMorgan (NYSE: JPM) examined spinoffs from 1985-1995 and estimated excess returns of 20% for spinoffs and 5% for parents over the first 18 months.
What Keeps Them Turning
Spinoffs outperform for a few reasons. Management teams at the spinoffs have greater incentive to produce, due to stock options and stock holdings, and greater freedom to start new ventures, rationalize operations and trim overhead. Management teams at parent companies can focus more on the core businesses. Stock valuations for both may rise because of investors' preference for focused and pure play companies.
Thus, shares in spinoffs and parents both appear to be worth holding. However, if one has to be sold, study findings suggest that, because of its smaller margin of outperformance, on average, the parent should get the ax. A 2004 study by John McConnell and Alexei V. Ovtchinnikov appearing in the Journal of Investment Management concluded that parent companies performed no better than the market after "correcting for one very large positive outlier."
Still, spinoff stocks come with a couple of caveats. First, they are more volatile. With their smaller capitalizations and financial capacities, they tend to be higher beta stocks that underperform in weak markets and outperform in strong markets. As such, spinoff stocks are better to own during a bull market rather than they are during a bear.
Second, spinoff stocks often sell off in the months immediately following the restructuring. Giving shares in a spinoff to existing shareholders is not a particularly efficient way to distribute stock since the shareholders are primarily interested in the parent company. Index funds will also sell the company since the new company is not in the index. Other institutions will sell because the spinoff does not fit in with mandates (either it's too small, has no dividend or there is no research available).
As academic and sell-side studies reveal, the immediate dip in spinoff stock prices is typically replaced by strength over the next two to three years. So, an investor planning to keep the spinoff may have to wait out short-term price weaknesses. Similarly, an investor wishing to dump spinoff shares may want to wait and sell into relative strength later on.
Evaluating Individual Spinoffs
Even though spinoffs and parent companies tend to fare well relative to the market, this success is only in the aggregate. It's still important to assess individual spinoff situations to ensure that the law of averages is on your side.
Joel Greenblatt, a former hedge fund manager with a highly-successfully track record based in large part on spinoffs, is a guru on the topic. In his book, "You Can Be a Stock Market Genius" (1999), he says it's important to see where the interests of the managers lie. Managers earning big salaries without owning much stock may not enhance shareholder value as much as managers with large equity stakes or stock option grants might.
William Mitchell, head of Spinoff & Reorg Profiles, says it's essential to "deduce the reason for separation," which can be done by comparing the pro forma balance sheet and income statements of the spinoff and parent. The first thing to check is debt levels and the allocation of other liabilities and troubled assets (such as real estate in 2008).
For example, a spinoff could end up overleveraged because the parent may be doing a leveraged recapitalization, whereby the spinoff is loaded up with debt and the proceeds are pocketed by the parent. An example of this, according to Mitchell, can be seen in some of the units spun-off from internet conglomerate InterActiveCorp (IAC) in 2008.
Another important factor for Mitchell to study is the return on capital employed, which involves taking the ratio of operating income to net working capital less cash. A spinoff (or parent) with a low reading on this measure may not have much of a strategic advantage in its line of business.
The Real World: Spinoff Valuation
Both Greenblatt and Mitchell would agree that valuation levels are another criterion. Greenblatt has commented in the media about some of his past investments in spinoffs, and his statements provide two case studies that illustrate the application of valuation and other yardsticks.
The first was the spinoff of Lehman Brothers from American Express (NYSE: AXP) in 1994. Greenblatt decided against investing in Lehman Brothers because the insiders didn't own much stock. He did, however, like American Express because its remaining businesses of charge cards and investment management were Warren Buffett-type franchises and they were going for just nine times earnings, after subtracting the value of Lehman's stock.
The second was the spinoff of NCR (NYSE: NCR) from AT&T (NYSE: T) in 1997. Greenblatt liked NCR because its shares were valued at $30 yet the company had $11 per share in cash, no debt, and a fast-growing data-warehousing division. If the latter was valued at a very conservative one-times sales, it brought the net asset value up to the $30 share price. The rest of NCR's business, delivering $6 billion in sales annually at the time, was therefore basically going for free.
The Bottom Line
Company spinoffs have happened at an average rate of about 50 per year since 1990. As such, it's important for investors to know what this action can mean for the value of their shares. In many cases, spinoffs have proved valuable for both the parent company and the spun-off unit. However, it is important to examine the particulars of a company's spinoff carefully before making a decision on whether to keep, sell or buy companies that are planning to make or have made this move.