spinoffs (3)–“bad” spinoffs

In the typical case where multi-line company ABC spins off C, the biggest rewards go to holders of C, although there’s no reason to believe, simply from the fact of a spinoff, that the residual AB won’t do well, too.

value, but for whom?

There are some instances, however, in which the apparent intention of ABC is to stuff C full of detritus before spinning it off.  The whole idea is to make the residual AB more attractive, without regard for the fate of C and its owners.  In some cases, C is so weighted down with liabilities that it almost seems designed to fail.   Some do end up in bankruptcy a short time after they become independent.

In this case, the spinoff may create value   …but it is value for AB, not for C.

the Deal Doctor’s litany of bad spinoffs

I wrote a post about spinoffs that deals with the toxic variety about two years ago.  In it I reference a New York Times article which recites a litany of spinoff failures.  By Steven Davidoff Solomon, the “Deal Professor,” who teaches law at Cal Berkeley, the article is well worth reading.

what a bad spinoff looks like

The characteristics of a “bad” spinoff include:

–having weak operating performance and unattractive prospects

–being burdened with potential legal liabilities from, say, the cleanup of toxic chemicals improperly disposed of

–being loaded with excessive debt, sometimes caused by AB allocating too much of the corporate total to the spinoff.  Sometimes it’s worse, though.  As you can read in the NY Times article linked to above, sometimes AB forces C to borrow large amounts of money pre-spinoff and fork over the proceeds to AB.  This is pretty awful.  To my mind, it’s a clear sign not only to steer clear of the spinoff, but the parent as well.

bad, but not a secret–read the deal documents!

The one point I would make about defending ourselves from “bad” spinoffs is that none of the bad pre-separation stuff that is done to a C (and its shareholders) happens in secret.  Everything must be disclosed in the offering documents filed with the SEC.  The facts may not be in bold print, or underlined or in ALL CAPS.  But it’s there for anyone to read.

Don’t expect the warts to be headline material for the deal roadshow, either.  Don’t think the head of C, who (finally) gets to be an independent CEO, will be 100% objective about his (poor) prospects.  He probably figures he can manage himself out of anything–and it may be his only chance at commend, to boot.  So he’s likely to have serious stars in his eyes.

preliminary prospectus and final:  an arcane note

The preliminary prospectus, sometimes called a red herring, is circulated in advance to potential investors.  Technically speaking, it’s not the official information, however.  That’s only in the final prospectus, given to investors right after the offering.  In my experience, although professionals pore over the preliminary, no one reads the final.

I’ve only seen one instance where the final differed from the preliminary in any meaningful way.  It was Occidental Petroleum’s “bad” spinoff of its meatpacking subsidiary, IBP.  IBP was loaded up with $1 billion of debt at the last minute.  The information only appears in the final.  More info at the bottom of my 2011 post on preliminary and final prospectuses.

 

 

 

 

spinoffs (2)–the ugly duckling

Yesterday, I wrote about the stock market value that can be created by separating multi-line companies into their components.

Today, the real world counterpart in value creation–the ugly duckling.

the ugly duckling…

Many times the top managers of company ABC come mostly or entirely from A and B.  As a result, they typically don’t understand C.  In many cases, they don’t care to put in the effort to figure out how C works, especially if C is significantly smaller than A or B.

Because of the perception that C “doesn’t fit” in ABC, it may be starved of the capital it needs to expand.  Because it’s small it may be perceived as not worth the trouble or to be incapable of moving the profit needle significantly no matter what it does.  No matter what its standalone prospects, it may be run simply to generate cash for the rest of the company.

Management of C will likely be poorly paid by industry standards, because of this perception.  A significant portion of that compensation will through stock options.  Since C isn’t publicly traded, those options are doubtless on ABC stock. There’s very little the management of C can do to influence their value.  More than that, if ABC is a mature firm these options may only accrue value slowly.

…can become a swan

If C is spun off, however, the hands of the management of C become untied as it gains control of an independent enterprise.  Freed of the shackles of an unimaginative ABC corporate mindset, it can raise and use new capital to expand.  It can change its corporate structure and focus.  It can experiment.

Management will participate directly in the success of C both through higher salaries and by holding options on C’s stock.  So it will probably be a lot more highly motivated to grow.

the Coach spinoff from Sara Lee

The spinoff of Coach(COH) by Sara Lee in 2000 in an offering that valued all of COH, now a $10 billion  company, at $140 million is a prime example.  At the time, Sara Lee said it wanted to spend its time managing larger brands like Sara Lee baked goods, Ball Park franks, Hanes underwear and Kiwi shoe polish.

The Sara Lee statement is telling.  The businesses whose prospects it understood, and valued most highly, were low-priced, slow-growth, commodity-like consumer goods sold predominantly in retail outlets, like supermarkets, that Sara Lee did not control or run.  Even before its amazing post-spinoff transformation, COH owned its own retail outlets and sold predominantly to women in families with income of $100,000.  Not Sara Lee-like at all!  COD’s biggest issue was that, because it had a very narrow range of leather products, customers only bought something new when the old one wore out, that is, every seven or eight years.

Sara Lee (SLE) no longer exists.  It split itself in two, changed names and had both parts bought out within the past few years.  That total buyout price was about $17 billion.

The earliest market capitalization figure for SLE that I can find is $14 billion at yearend 2002.  By that time, COH, which went public in late 2000 had quadrupled in price and had a market cap of just over $500 million.

 

spinoffs …do they create value?

My daughter asked me this the other day.

My answer is:  most times, yes.

I’m going to elaborate in today’s post, and in the next two days’ as well.

Let’s get started–

what it is

spinoff  is when a company with multiple lines of business, say ABC, separates one line, say, C, and divests it.

lots of variations

There are two main separation techniques:

a)  sale to another company, or

b)  distribution to existing shareholders, who then own shares of now-AB + shares of C.

In the normal way Wall Street works, there are lots of varieties of both sale and distribution–a portion of the shares of C, all the shares of C, or a portion now followed by the rest later.  In perhaps the most complicated case, a partial distribution cum IPO can be followed by a sale of the remainder into the open market.  This means the proceeds of the follow-on sale go to the corporate coffers of AB.

adding value

This can happen in a number of ways.  The one I’ll write about today is for publicly traded companies only.  It’s the portfolio effect.

It’s the idea that any publicly traded multi-line company is like a portfolio of mono-line firms in the eyes of a professional equity portfolio manager who might be thinking of buying shares for his clients.

A PM may be looking to establish a position in industry A.  Maybe he thinks that low oil prices will be with us for longer than most people think and that he should add to his holdings in petrochemical companies because of this.  He’s interested in pure petrochemicals plays.  At the same time, he does not want exposure to oil and gas exploration and production.  So a hydrocarbon conglomerate like any of the large integrated oil companies–which have both exploration and chemicals–raises conflicting emotions.

He is willing to pay a full price for the chemicals   …but you have to compensate him for being forced to take the exploration business he doesn’t want..

At the same time, there may be PMs with the opposite view.  They’re willing to pay up for the exploration but don’t want the chemicals at all.

Both PMs are stuck with stuff they actively don’t want if they buy the conglomerate.  So, in theory–and most often in practice–the stock market value of the business AB is less than if both A and B traded separately.

One might argue that there’s some hedging value to having both a part that benefits from higher hydrocarbon prices and one that benefits from lower.  Maybe, although it’s not my cup of tea.

Even so, there are plenty of companies with completely unconnected lines.  Take Swire Pacific in Hong Kong.  The modern iteration of one of the old British opium companies, it consists basically of property and an airline, Cathay Pacific.  When it announced years ago it was spinning off a portion of the airline– creating a pure play transportation stock + a purer property play, the stock went up by 40% in anticipation of the portfolio effect.  Airline buyers would no longer be stuck with office buildings; property buyers would no longer be stuck with an airline.

 

More tomorrow.

 

 

breaking companies apart: the cons

Many times, separating a conglomerate into its component parts creates value.  Sometimes, it can produce enormous gains.  Spinoffs of corporate stepchildren are often particularly lucrative.  Take Coach (COH) for instance.  Its stock rose by 40x in the first five   years after it was spun off, unloved and starved for expansion capital, from Sara Lee.

There are other instances, however, where breakup can be disastrous.  This may not be evident at first in the stock price action of the separate components, but the ultimate bad news can happen in a number of ways:

1.  Onerous corporate liabilities–debt, lawsuit liabilities, incompetent executives…may all be shunted into one of the new parts, which is more or less designed to fail.  No one will say this, of course.

The first place to look for this kind of imbalance is in the part where the CEO and other top executives aren’t going.  Often, executives in the disfavored part of the split will be so excited to finally be the top dog that they’re delusional about their ability to deal with the negatives they’re being loaded down with.  After all, Davy Crockett might have survived the Alamo if he’d been a step quicker;  the Donner party might have gotten through those mountains…

2.  Sometimes a proposed split will end up forcing apart two businesses which need each other to be successful.  In the current hedge fund era, when individuals with little operating experience can wield large amounts of financial capital, this is a particular danger.  Activists. for example, have wanted Target (TGT) to sell/divest its credit card operations a couple of years ago.  Yes, TGT would receive a large one-time payment, and its stock would probably go up.  But its credit-related operating costs would rise.  And the company would have lost the considerable “Big Data” advantage that it gets from being able to see all the credit transactions of its cardholders–not merely transactions done at Target stores.

I think the current talk of splitting up Microsoft (MSFT) is well worth monitoring in this regard.  Sure, spin off  the consumer device business.  To my mind, though, splitting Windows, Office and the cloud from one another is just asking for trouble.

3.  Another issue that has emerged in recent years–the activists may be bunglers.  Look at J C Penney (JCP).  Activists correctly saw that JCP was crediting profits it got from its control of valuable real estate to its retailing operations.  That covered up the true weakness of the company’s retail offering.  But their attempt to “fix” retailing before breaking up the company went horribly awry.  Worse, they persisted in their mistaken direction so long that they created a downward spiral the company has yet to pull out of.  The stock, which some speculated could be worth $50 a share, has dropped from around $30 to $5 or so as a result of their “stewardship.”

spinoffs: sometimes toxic, sometimes hidden gold

The March 12th edition of the New York Times’ excellent Dealbook section has an article written by Buckeye professor Steven Davidoff, titled “In Spinoffs, a Chance to Jettison Liabilities.”  It’s well worth reading.

spinoffs

In it, Mr. Davidoff documents how in a spinoff ( which is when publicly listed companies separate out a chunk of themselves into a separate legal entity, whose shares they then distribute to existing shareholders) the parent companies sometimes have ulterior motives.  (…shocking!)

being left behind on an ice floe

Many times, such “spinoffs” are businesses the parent wants to sell but can’t find buyers for.  They often are loaded up with a disproportionately large amount of the company’s debt.  Sometimes the spinoff is even forced to take out new loans and turn the proceeds over to the parent before it’s launched.  Davidoff gives lots of examples.

One of my favorites is the case of Monsanto, which spun off its industrial chemicals and fiber operations as Solutia, to get rid of liabilities relating to its production of PCBs.  It later spun off its agricultural businesses as the “new” Monsanto, retaining its pharmaceutical businesses in the parent, which was renamed Pharmacia.  Spinoff Monsanto was forced to agree to compensate Pharmacia for any losses it might suffer from Solutia-related litigation.  Sort of like a belt and suspenders.

three points

–None of this spinoff-unfriendly activity takes place completely in secret.  Somewhere in the SEC filings all of the potential bad stuff is disclosed.  Don’t expect it to be to be highlighted in LARGE print and a bold typeface.

There is a quick and dirty way to help focus your attention, though.  See where the current CEO is going end up.  There’ll never be potentially toxic liabilities there.  Look at the other parts of the deal.

–Not all spinoffs are disasters waiting to happen.  There’s a legitimate case to be made against conglomerates.  If a company has, say, two unrelated businesses, one which generates tons of cash flow but has few growth prospects, and a second that has huge growth opportunities, it may make sense to separate the two.  Income investors will bid up the price of the first, growth investors the second.  The sum of the two parts can be worth much more than the original conglomerate.

Sometimes, too, a small growth business can be lost in a much larger entity and starved of capital.  Spinoff will allow it to flower.

Two things to look for:  in my experience, it’s a good sign if the spinoff is relatively small and doesn’t “fit” with the rest of  the firm (think:  Sara Lee and Coach).  Also, it’s a plus if the parent retains an interest in the spinoff.

–There’s a perverse, human nature aspect to the spinoff game.

A captain, dying to get his own ship–even if it is rapidly taking on water–may be unduly optimistic in talking about his new command.

On the other hand, if you’re a shrewd businessman, once you learn your division is going to be spun off–usually at least a year, maybe two, in advance–you know there’s no sense in shining up the business any more until it’s its own public entity.  Improving your business pre-spinoff only makes your post-spinoff job harder!!  Best just to go on vacation for a while.  The result:  a “good” spinoff can be shockingly good in the first few years.