Leave it to the peddlers of enhanced shareholder value to magically create gold where there is none. With the IPO market still lukewarm vs. years past and few investors hungry for leveraged buyouts and M&A -- presto -- they resuscitate that old corporate finance maneuver, the spinoff.
Wall Street's investment bankers have already spun off Abbott Laboratories'
John Malone's Liberty Media
Don't confuse the spinoff with its cousin, the equity carve-out. Equity carve-outs are partial IPOs, while spinoffs are a distribution of new stock in a company's division to existing shareholders. No money changes hands, so no new taxes are due.
For companies, the rationale for spinoffs is pretty straightforward: Focus on core operations and streamline both the spinner and the spinnee. They choose the spinoff route over the partial IPO to avoid taxes and dilution of the new company's shares.
Sure, all of that makes sense for investment bankers and some of the companies. Spinoffs are a nice way for companies to sweep away problems and pocket some extra cash. But don't forget the important question: Is this exercise any good for shareholders, or is it simply an easy way for a company to get rid of an unwanted business?
A spin job
Enter the finance theorists, fast-money flippers, and short-term traders. According to these folks, spinoffs are pure gold.
Lots of academic studies show that spinoffs, statistically speaking, have a better chance of outperforming the market than the average stock. The big reason, spinoffs frequently receive less publicity or hype than IPOs, which can lead to undervaluation. Also, index funds tend to sell them quickly because the spinoff is usually not in the index being tracked. This explains why spinoffs often look cheap when they first come to market. Traders exploit that price pattern.
But be careful. Blindly placing bets on spinoff statistics is no formula for market-beating returns. Granted, a lot of spinoffs look cheap when they first come to market. But that has nothing to do with their fundamentals. The challenge for investors is to distinguish keepers from corporate cast-offs. Plenty of spinoffs are dogs, so do your homework.
For starters, spinoffs are typically structured in a way that benefits the parent at the expense of the new spinoff. Let's face it, a parent will spin off a subsidiary on the stock market if it can't sell it someplace else for a better price.
Companies typically spin off struggling divisions or those that aren't as profitable or growing as fast their core businesses. Motorola plans to jettison its Freescale semiconductor business this year. Although the subsidiary added more than $1.4 billion to Motorola 2003 revenues and finally managed to achieve profitability in the first quarter of this year, it's subject to the chip industry's whip-neck business cycles. A lot of analysts wonder whether the subsidiary will survive on its own, especially through a severe down cycle.
Parent companies also overload offspring with debt, or dump other kinds of liabilities on them. The energy and auto conglomerate Allete
Another thing, parent companies like to extract big cash takings from spinoffs. Take Allete, again. The company will receive from ADESA not only a payment to cover its debt, but also a $100 million dividend right after the deal for its own use. Taking too much, of course, can doom a young company, hamstring an executive team, and upset shareholders.
When spinoffs work
Don't get me wrong -- some spinoffs work out well. Creating a spinoff can eliminate diffusion of management goals, a problem that goes hand in hand with big, diversified companies. When the aim is to focus on being the best at one or two things, spinoffs make sense.
There is no alchemy with spinoffs. Importantly, investors shouldn't fall for the trick of companies off-loading problems. Instead, they should look for a history of profitability or strong performance fundamentals before buying in. Apply the same kind of analysis you would to any other stock.