Spin-Off Characteristics: The Making of Compelling Investment Opportunities

Summary

By focusing on spin-offs, investors can tilt the odds in their favor by self-selecting for a group of companies that have unique characteristics. While these transactions are executed by companies in a wide range of industries and come in a variety of different forms, each one shares numerous underlying features. These various characteristics can be organized into three broader categories:

  • Market Factors
  • Opportunities for Fundamental Analysis by Active Investors
  • Opportunities for Improved Fundamental Performance at the SpinCo

Spin-Off Market Factors

Potentially forced selling of the SpinCo by parent company shareholders.

This can happen for a few different reasons:

1) It could be small relative to the parent.

For example, if a company decides to spin-off a small segment and the parent company is a 3% position in an investor’s portfolio, then the position size of the SpinCo post-transaction could be as little as 0.3%, or maybe even less. As a result, it might not be worth it for the investor to do the work to understand a company that is such a small position. Also, investors with certain mandates could be forced to sell the SpinCo purely due to the small market capitalization (Index Funds, Large Cap focused Mutual Funds, etc.).

2) The SpinCo could have very different key business drivers than the Parent company. Thus, the reason for the investment in the Parent by an investor is much different than the investment rationale for the SpinCo. As a result, investors might just sell the SpinCo post-spin-off.

3) This is somewhat related to #2, but the SpinCo could be in a completely different industry that the Parent. Therefore, sector-focused funds or funds with sector/industry constraints will have to sell the investment.

Limited or new analyst coverage

If the parent spins off a business in an unrelated industry, then the sell-side analysts covering the parent may transfer coverage to a new analyst or the firms might just drop coverage altogether.

Let’s use a quick example to illustrate this point. IndustrialCo is comprised of two main businesses and a smaller third business which they decide to spin-off. The main businesses produce equipment for the agriculture market and hydraulic equipment for general industrial markets. The smaller third business produces paints and sealants for the housing market. They comprise 50%, 40%, and 10% of overall company profits, respectively.

Since the vast majority of the business is comprised of equipment, all the analysts who cover the company are Machinery analysts within the Industrial Sector. However, the SpinCo will be reclassified to the Specialty Chemicals Industry within the Materials sector. Therefore, the analysts who covered the IndustrialCo will not initiate coverage on the SpinCo. Furthermore, other specialty chemical analysts might not initiate coverage depending on the SpinCo’s market cap, capital structure, and business strategy (may or may not generate enough trading commissions and/or banking revenue for firms to merit coverage). Importantly, none of the reasons for covering or not covering the company is due to the fundamentals of the spin-off, but rather the economics of sell-side research.

Valuation Re-Rating

The spin-off allows investors to value the business based on its own growth opportunities and financial profile rather than as part of a larger company that has multiple businesses of varying quality. Simply put, a “crown jewel” business might not be appropriately valued because it is part of a larger entity that also comprises cyclical segments. By separating the businesses, investors can more appropriately value the individual businesses.

This is one of the main reseasons spin-offs have historically posted market-beating returns.

Spin-Off Present Opportunities for Fundamental Analysis 

Can’t Find these Opportunities through Analytical Screens

Since there isn’t any historical trading data yet, investors can’t run analytical screens to find these opportunities. Furthermore, spin-offs routinely have “one-time” costs running through the income statement, including legal, consulting, and banking fees which could adversely impact profitability and make the company seem less profitable than actuality.

Limited Financial History as a Standalone Company

 The filing documents typically only provide the financial statements for the prior couple years.

Cumbersome to Piece Together Historical SpinCo Financials

In the filing documents, investors only have the details on the last few years of financial performance – which can be helpful. However, to get additional details on how the business performed during economic cycles and when the business’ key drivers were strong or weak, they need to go through the Parent company’s footnotes. Here they can find the segment reporting which will hopefully provide more details on the historical financial performance. Furthermore, they can analyze the SpinCo’s direct competitors to get a sense for industry trends. All this research to better understand the SpinCo represents an opportunity for investors willing to do the work.

Filing Documents are not Written for Investors to Easily Understand

These documents are written by lawyers and include paragraph upon paragraph to explain the company’s business, material arrangements and agreements, capital structure, management compensation, adjustments to the financials, key risks, spin-off rationale and mechanics, as well as a whole host of other details. Investors who are willing to read through and understand these documents separate themselves from many who are unwilling to do the work.

“Orphan” or Other Types of Unique Assets Can Lead to Limited or New Peer Group for Market Valuation and Benchmarking Purposes

A SpinCo’s peer group is likely much different than the parent’s peer group or even non-existent (“orphan company”). Therefore, investors could have trouble valuing the company because there aren’t any other obvious companies to point to for comparison purposes. This gives investors who do the work to appropriately value the business an advantage over those who simply would rather look at peer multiples.

Potential Management Incentivizes for a Low Initial Valuation

Managements’ stock-based compensation could be based on initial trading prices. Therefore, if the CEO receives a $1 million-dollar stock comp package, s/he will receive more shares if the stock is trading at a lower price. This could cause management to undersell the opportunity.

Spin-offs are Effectively New Public Offerings, but Without Fanfare

Unlike an IPO, spin-offs don’t need to attract an investor base to raise capital.

Opportunity for Improved Performance at the SpinCo

New Management Incentives

The board has the opportunity to implement an incentives package that makes sense when considering the unique dynamics of the SpinCo.

Better Alignment of Incentives

In the past, a significant portion of the SpinCo managements’ performance-based pay might have been dependent on the results of the overall company. However, post-spin-off management’s performance-based-pay metrics, whether it be revenue, EBITDA, and/or EPS growth, as well as other metrics such as margins, working capital levels, ROIC, free cash flow, etc are now more directly within their control.

Furthermore, the stock they receive through option or restricted stock unit grants is now in a currency (the SpinCo stock) which they have a much more direct impact on versus the past when they received stock in the larger parent company.

Reduces Business Complexity and Improves Focus

Takes out layers of management above the SpinCo’s executives and pushes ultimate decision-making authority down to individuals closer to the business.

Optimizes Capital Structure and Capital Allocation

The SpinCo could very well have a much different business model, key revenue driver, and unit economics than the former parent company. Therefore, the optimal capital structure could be very different. Similarly, the SpinCo no longer needs to get approval for capital allocation priorities from a higher up executive team. As a result, personnel closer to the business are now deciding which areas are needs for internal investment and M&A as well as setting prudent dividend/buyback policies.

Improves Corporate Functions, Decision Making, and Accountability

The SpinCo is able to now set suitable expense levels and policies for HR, Finance, Tax, Legal, etc without a larger corporate parent pushing down a broad set of policies which may or may not be appropriate for the business. Also, the ultimate accountability now sits directly above the business rather than at a larger corporate parent. This is motivating and enticing for talented executives who want to create per share value.

Investors Can See if Management Prefers One Business Over Another

People vote with their feet and corporate managers are no different. It says a lot if the CEO of a much larger organization decides to leave to become the CEO of a smaller spin-off company. If this happens, investors should take note.

The Fact Management Pursues a Spin-off, In and of Itself, Says Something

Setting aside all the other characteristics, the fact that management is pursuing a spin-off, in and of itself, means they have a sense of shareholder value creation (in a tax efficient manner) rather than empire building. Therefore, by focusing on spin-off opportunities, investors can self-select for a universe of companies where management teams are trying to do the right thing for long-term value creation.

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2019-03-20T11:36:30-05:00