Spin-Offs: IPOs With No Pop

Recently, there has been lots of activity in spin-offs.
Unfortunately, there is also lots of confusion. Here’s a primer on what it
all means to investors.

How to Spin Spin-Offs

In the past year, there has been much activity in spin-offs and tracking
stocks. Despite this, there has been little explanation as to what these
transactions mean — especially for investors.

Think of a spin-off as an IPO, however there is no big “pop” on the first
day. In fact, playing spin-offs can be an indirect way to play the IPO
game.

In a spin-off, a big company (known as the parent) wants to divest itself
of a division. The new division becomes an independently traded company.

There are a myriad of reasons for spin-offs:

1. Unlocking Shareholder Value: This is perhaps the most common reason.
That is, the division is not being properly valued, because it is
overshadowed by the parent company.

2. Incentives: It might be easier to attract employees by using stock
options that are tied to the performance of the spin-off, not the
parent.

3. Currency: The spin-off can use its stock as currency to purchase other
companies and thus grow the business.

4. Less Confusion: It is easier for Wall Street to place a value on a
pure-play company versus a conglomerate.

Now, there are different types of spin-offs:

Traditional Spin-Off: Here, shares of the division are distributed to
existing shareholders of the parent on a pro rata basis. The new entity
becomes a completely separate company (new board of directors, management,
assets, etc).

Spin-Off with an Equity Carve-Out: In this transaction, part of the shares
of the division are distributed to existing shareholders of the parent and
the remaining shares are sold to the public. But to avoid adverse tax
consequences, no more than 20% of the equity can be sold to the public.

Tracking Stock: This is a separate class of stock that is issued by the
parent. The stock, while it represents the value of the division, is still
part of the parent. The tracking stock shares the same board of directors,
as well as assets and liabilities of the parent.

Perhaps the most famous spin-off is when AT&T let go of

Lucent (LU).
At one point, Lucent had a higher market cap than AT&T.

In fact, this is no fluke. Empirical research shows that spin-offs can be
good investments. According to a study done by researchers at Penn State,
spin-offs between 1965 and 1994 returned 76% in their first three years, on
average.

Of course, there is no easy explanation for this phenomenon. But, I will
hazard some guesses. First, a spin-off is not shackled by the bureaucracy
and politics of the parent. Thus, the new entity can exploit markets more
quickly. Second, there is less channel conflict. For example, years ago GM
owned EDS, which provides high-end computer consulting. Because of its
relationship with GM, EDS had difficulties getting Ford, Chrysler and other
auto makers as clients. But with the spin-off, this problem was solved.
Finally, and perhaps most importantly, there is great incentive for
management to produce results. Typically, management owns a major part of
the company. So, if the stock price surges, management becomes extremely
wealthy.

True, there are examples when spin-offs are not successful. But, so long as
the management is heavily incentivized and the new division has strong
growth prospects, a spin-off can be a great investment play.


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