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 spin-off, or both?
The question comes up a lot. In just the two years between 2018 and 2020, at least 21 major public companies were planning or implementing spin-offs, from L Brands Inc.'s creation of a separate Bath & Body Works to Smith & Wesson Brands Inc.'s separation of its American Outdoor gear business. Between 1990 and 2006, there were more than 800 spin-offs added to U.S. exchanges, totaling more than $800 billion in market value, according to Peter Hunt's "Structuring Mergers & Acquisitions."
The Spin on Spin-offs
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.
- Most studies suggest that spin-offs outperform over time.
- In the short run, however, they tend to be volatile.
- Look at the new stock's fundamentals and management before deciding.
Many studies have found that spin-offs and parents both out-perform the market, with the edge going to spin-offs. A commonly cited study by Patrick Cusatis, James Miles, and J. Randall Woolridge was published in a 1993 issue of The Journal of Financial Economics. It determined that spin-offs and their parents surpassed the S&P 500 Index by an average of 30% and 18%, respectively, during the first three years of trading in spin-off shares.
A Lehman Brothers study by Chip Dickson discovered that between 2000 and 2005, spin-offs 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 examined spin-offs from 1985-1995 and estimated excess returns of 20% for spin-offs and 5% for parents over the first 18 months.
Those impressive figures aren't a certainty, though. A 2019 study by The Boyar Value Group found that spin-offs underperformed the S&P 500 by an average 2.7% a year during the decade-long bull market.
What Keeps Spin-Offs Turning
Spin-offs often outperform for a few reasons. Management teams at the spin-offs have greater incentive to produce, due to their generous stock options awards and stock holdings. They also have greater freedom to start new ventures, rationalize operations, and trim overhead. Meanwhile, management teams at parent companies can focus more on core businesses. Stock valuations for both may rise because of investors' preference for focused and pure-play companies.
Thus, shares in spin-offs 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 out-performance, on average, the parent should get the ax.
A 2004 study by John McConnell and Alexei V. Ovtchinnikov in the Journal of Investment Management concluded that parent companies performed no better than the market after correcting for one very large positive outlier.
Why Spin-Offs Are More Volatile
Still, spin-off stocks come with a couple of caveats. First, they are more volatile. With their smaller capitalization and financial capacities, they tend to be higher beta stocks that under-perform in weak markets and outperform in strong markets. As such, spin-off stocks can be better to own during a bull market than during a bear. (Although that 2019 study of the latest bull market is an exception.)
Second, spin-off stocks often sell off in the months immediately following the restructuring. Giving shares in a spin-off 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 spin-off does not fit with its mandates. It may be too small, or have no dividend, or lack the history that the fund uses to make its choices.
A number of studies reveal that the immediate dip in spin-off stock prices is typically replaced by strength over the next two to three years. So, an investor planning to keep the spin-off may have to wait it out.
Evaluating Individual Spin-offs
Even though spin-offs and parent companies tend to fare well relative to the market, this success is only in the aggregate. It's important to assess individual spin-off situations to ensure that the law of averages is on your side.
A 2019 study found that spin-offs underperformed throughout the most recent bull market. That bucks the trend of other analyses.
Joel Greenblatt, a former hedge fund manager with a successful track record based in large part on spin-offs, is a guru on the topic. In his book, "You Can Be a Stock Market Genius," 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.
William Mitchell, head of Spin-off & 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 spin-off 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 spin-off could end up over-leveraged because the parent may be doing a leveraged recapitalization. In other words, the spin-off is loaded up with debt and the proceeds are being pocketed by the parent.
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 spin-off (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: Spin-off Valuation
Valuation levels are another criterion. Greenblatt has commented in the media about some of his past investments in spin-offs, and his statements provide two case studies that illustrate the application of valuation and other yardsticks.
The first was the spin-off of Lehman Brothers from American Express 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. That decision was more than confirmed by the collapse of Lehman Brothers in 2008.
The NCR Spin-Off
The second was the spin-off of NCR from AT&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.
In many cases, spin-offs 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 spin-off carefully before making a decision on whether to keep, sell, or buy companies that are planning to make or have made this move.