An Investor Looks at Spinoffs

Investing
History
By
Patrick A. Labbe, CFA

In some ways, the role of the average Fortune 500 CEO is very similar to that of an investor.  The CEO must determine how to best allocate the company’s limited resources.  Which units are likely to achieve outsized returns, and which are likely to be a drag on results?  In assessing these prospects, a CEO may reach the conclusion that a business unit may be better off operating as a separate entity. The result may be a “spinoff”—a type of divestiture wherein the company distributes its ownership interest in a current subsidiary to existing shareholders.

This solution to the challenge of managing a large public firm has become more popular lately.  A study prepared by Edge Consulting and Deloitte estimated that the total market value of parent companies announcing spinoffs was $664 billion globally last year, far greater than 2013’s $131 billion.  The consulting team projected spinoff parent values would top $775 billion this year, with further growth expected in the coming years.

Part of the reason why spinoffs have become popular is because they allow a corporation to reorganize itself by dislodging a component business in a tax-friendly manner.  Typically, shareholders receive new shares of the stand-alone company in what is essentially a tax-free distribution.  Activist investors may also have played a role in the increase in spinoffs.  Activists buy relatively large amounts of shares in companies they consider to be mismanaged, and then they petition company management for changes, including spinoffs of subsidiaries the activists believe to be undervalued.  For example, well-known investor Carl Icahn recently persuaded eBay’s management to spin off the company’s faster-growing payment subsidiary, PayPal, as a separate business.

Historically, spinoffs have outperformed the broader market, making them a potentially interesting area for analysis.  The amount of outperformance varies widely based on the time period analyzed.  Studies capturing the largest amounts of data suggest that, on average, outperformance has been around 10-12% per year, with most of the outperformance limited to the first two years.  However, the Edge-Deloitte study makes it clear that picking winners can be challenging.  Using data from 2000 to 2013, they found that four out of 10 spinoffs failed to add value as separate businesses, and the perfor­mance of these shares was disappointing.  The study offered a few clues as to why some spinoffs performed well and others disappointed.  Companies that were spun out of very large, complex businesses usually did well.  This appears to make sense, as investors generally value simplicity while often discounting highly complex, hard to understand corporations.  The spinoffs most likely to underperform were those that were used to essen­tially unwind an earlier acquisition. It’s not clear why this particular category resulted in underperformance, but it may suggest the acquired business was difficult to manage or had some problems the acquirer simply couldn’t fix.

Since spinoffs offer a possible source of outperformance, you can be sure that we analyze corporate announce­ments on a regular basis.  Should the expected growth in these corporate actions materialize, it may prove an increasing source of investment opportunity.