It is a little counterintuitive why a company would want to spin-off a business in the first place. Spinning off a business goes against a corporate executive’s self-interest of running a larger company and getting paid more. However, companies continue to announce spin-offs each and every year.
This article explores the top reasons why companies execute spin-offs, which could be driven by the management team, an activist investor, or regulatory conditions.
Many public companies are large, sprawling enterprises with different divisions that sell a variety of products and services to many different end markets across the globe. These companies are very complicated and difficult for a single chief executive officer to oversee. Consequently, the senior management, who make the large capital allocation decisions, could lose focus on the opportunities that create the most per share value for the overall company.
Thus, separating off businesses that consume a disproportionate amount of time relative to the value of the enterprise allows executives to refocus their attention and efforts on the more important decisions.
Alternatively, the smaller spin-off could have been neglected as part of the larger entity. This means that it may not have received the necessary level of investment or the required operational attention. Companies spun-off for this reason demonstrate many of the characteristics of the best performing spin-offs.
Zoetis develops and manufactures medicines and vaccines for the animal health market. They were carved out of Pfizer in February 2013. Since the separation, they have eliminated lower margin SKUs, improved their sales model, reduced corporate G&A, optimized R&D, and improved their supply chain. These efforts led to margins increasing from the ~20% level to the mid-30% range (subscribers can learn more about Zoetis competitor and Eli Lilly carve-out Elanco Animal Health by reading the Elanco Research Report).
Allegion is a provider of access control security products and solutions (locks, latches, deadbolts, monitoring controls, etc) for residential and commercial buildings. They spun off from Ingersoll-Rand in 2013 after Trian Partners obtained a seat on the board.
The business has received much more attention since the spin-off. In the international segment, margins were historically very low and even negative. However, over the last few years management has improved their operations through exiting businesses, restructuring, and making internal investments as well as acquisitions. They have also benefitted from favorable end markets. This has resulted in a massive improvement in the EMEIA segment margins as well as the overall margins.
When an enterprise is comprised of many different segments and subsegments, it is difficult to align these employees’ incentives (revenue growth, earnings growth, ROIC, cash flow, working capital, etc) and rewards (cash bonuses, option grants, etc). This is because many of the factors that impact the incentive metrics are completely outside of an employee’s control.
For instance, if the business an employee manages only contributes ~20% of the overall company’s profits, then the other businesses will have a much larger impact on the overall company’s financial metrics and bonus payouts. Thus, the employee might not be properly rewarded for driving growth and efficiencies.
Similarly, the stock they receive (and could be required to own) will be driven more by the performance of the other business segments rather than the business they can directly impact. If the subsidiary is spun-off, then it will be much easier to align incentives.
Howard Hughes (HHC)
Howard Hughes was spun-off from General Growth Properties in 2010. Around the time of the spin-off their new CEO, David Weinreb, spent $15 million of his own money to purchase warrants to acquire over 2.3 million shares. In many ways, this was a negative sign-on bonus to join the company but highly incentivized him to increase the per share value of the company.
More recently in 2017, Weinreb again spent his own money (a whopping $50 million this time) to purchase warrants to acquire nearly 2 million shares of Howard Hughes in the future. Remember, if the share price is below the strike price, then the warrants will expire worthless.
KLX Energy Services (KLXE)
KLX Energy Services is an oilfield services company serving the major shale basins in the U.S. They spun-off from KLX Inc. in 2018. The Chairman & CEO of the company, Amin Khoury, and the CFO, Thomas McCaffrey, are forgoing cash compensation and instead will receive restricted stock awards representing 5% and 3%, respectively, of the company that will vest in four equal annual installments. (for more information subscribers can read the full KLX Energy Services Research Report). This is an example of an executive team actively aligning themselves with shareholders as principals rather than agents.
Over time businesses evolve through introducing new products and services as well as entering new markets. Consequently, situations can arise where two segments of the same corporation have conflicting interests. This could be a result of one segment’s customers being competitors of another business segment.
In order to neutralize these conflicts, the parent company could spin-off one of the segments.
PayPal Holdings (PYPL)
PayPal is a large payments company that enables digital and mobile payments for customers and merchants across the world. eBay owned PayPal from 2002 through the spin-off in 2015. Over the years PayPal’s business evolved to the point where more and more of their new relationships were with retailers rather than smaller individuals accepting payments. Therefore, eBay was a direct competitor to many of PayPal’s new customers. As a result, some retailers were hesitant to accept PayPal as a payment gateway on their website for fear of giving eBay important information on their business. This conflict of interest largely went away when eBay spun-off PayPal.
In large enterprises with sprawling operations across different business lines and geographic locations, the major capital allocation decisions are made at corporate headquarters. However, headquarters can be multiple layers removed from running the actual businesses. Thus, the people making the decisions on where and how much to invest are not necessarily the people who are in the best position to make those decisions.
When a company spins-off a segment, the executives now have full control over where to invest capital and/or how to return it to shareholders.
GCP Applied Materials (GCP)
GCP supplies admixtures and additives for concrete and cement as well as manufactures construction products that protect structures from water, vapor, air, and fire damage. They spun-off from W.R. Grace & Co in early 2016.
When the company was spun-off, they had a third business segment, Darex Packaging Technologies. Darex manufactures sealants and coatings mainly for food and beverage containers. It accounted for ~23% of revenue and ~28% of segment operating income when they spun-off. In March 2017, they announced the sale of the business to Henkel for over $1 billion. This sale allows GCP to be a focused construction products company with significant capacity to reinvest in the business and not have a third, non-core segment. GCP is a good example of a management team reevaluating the portfolio post-spin-off and choosing to allocate capital away from one business and into another.
BWX Technologies (BWXT)
BWX Technologies is the sole manufacturer of naval nuclear reactors for submarines and aircraft carriers as well as provides services and components to the commercial nuclear power industry. They were the parent company when Babcock & Wilcox spun-off their Power Generation business in 2015 (RemainCo was renamed BWX Technologies).
After they spun-off the Power Generation business, they had a clean balance sheet which allowed them to pull a handful of balance sheet levers. This included instituting a dividend and buying back a few hundred million dollars’ worth of stock. Also, they reevaluated their capital spending which resulted in the termination of investments in the unprofitable mPower project.
Each of the different segments of a large, sprawling conglomerate have varying levels of business quality and their own unique drivers. Consequently, it is difficult for investors to value a collection of these businesses. For each of the segments, investors must understand the business model and its durability as well as growth potential. Since it is very difficult to perform this analysis, investors routinely analyze the consolidated financials and use this to value the company.
The current market value for a conglomerate could be much less than what the company is worth on a ‘sum-of-the-parts’ basis. In other words, the value of the whole company is worth less than all the individual pieces. In order to help close this discount, the company can elect to spin-off one or more segments. Investors can then assess and value the individual businesses on their own.
For example, let’s assume that a company is comprised of two separate segments, a Cyclical Co and a High-Quality Co. The Cyclical Co generates $100 in revenue and $7 in earnings and deserves to be valued at 10x earnings ($70 valuation). The High-Quality Co generates $50 in revenue and $10 in earnings and is such a great business that it deserves to be valued at 20x earnings ($200 valuation). However, the market currently values the consolidated company’s $17 in earnings at 12x ($204 valuation). The market valuation gives partial credit to the company for not just being a capital-intensive cyclical business, but not full credit.
If the company spun-off the Cyclical Co (or High-Quality Co), then the market would be able to value each company on its own. In this case, the individual segment values would combine to be worth more than the former consolidated company.
A large reason for the close in the valuation discount is because it better aligns investor bases. For instance, a company that has a large growth opportunity will be aggressively reinvesting in the business which could result in very low levels of current profits. While certain types of investors will avoid these types of opportunities, other types of investors will be attracted to a business that has the ability to reinvest for growth.
Separating the businesses off from one another allows each business to be valued and owned by an aligned investor base.
Cable ONE (CABO)
Cable ONE is a highspeed Internet, cable television, and telephone service company, serving ~800,000 customers. They spun-off from Graham Holdings Company in the summer of 2015.
Graham Holdings was a collection of businesses, including education (Kaplan), media (television broadcasting, cable, and print and local TV news), home health, and manufacturing. Given the broad collection of assets across many different industries, Graham sold at a discount to the sum-of-parts valuation and Cable ONE’s value was not fully recognized as part of the part of the larger enterprise. The spin-off helped to close this valuation gap.
In many instances, companies naturally begin to move in different directions. This could be the result of an acquisition or a once very small segment becoming a much larger business. Spinning off a segment can allow both the parent company and SpinCo to invest in impactful projects. For example, if a subsidiary is only 20% of a company’s profits, then even very attractive, high returning investments will not have a large impact on the overall company. But when the company is a standalone business, those investments will be very, very valuable to it.
Fortive Corporation (FTV)
Fortive is a diversified industrial company that has leading market positions in instrumentation, transportation technology, sensing, automation, and franchise distribution. They spun-off from Danaher in 2016.
Danaher announced the spin-off on the same day they announced the acquisition of Pall Corporation, the largest in company history. The spin-off separated Danaher’s life sciences business from Danaher’s legacy industrial focused assets. The main reason for the spin-off is that Danaher was moving the portfolio in a different direction and the legacy businesses would be better served as a separate company.
“Danaher has always been at its best when all platforms have the ability to invest in the highest impact organic growth opportunities, pursue meaningful acquisitions and use the Danaher Business System to continuously improve performance.”
Thomas Joyce, President and CEO
Murphy USA (MUSA)
Murphy USA is one of the largest owner-operators of gas-station chains in the United States with nearly 1,450 retail stores. They were spun-off from Murphy Oil, an oil and gas exploration and production company, in September 2013.
It is clear that Murphy Oil (oil and gas E&P) and Murphy USA (gas stations) have very different growth opportunities and capital needs. In the press release announcing the spin-off, Murphy Oil said as much when they discussed two of the key reasons for the spin-off:
Each business would focus on its strategic priorities with financial targets that best fit its own market and opportunities;
Each business would be able to allocate resources and deploy capital in a manner consistent with its priorities
Regulatory considerations can be an important driver of spin-offs. There are a handful of different situations where regulatory matters drive transactions.
- A company may need to spin-off a business in order to execute a large merger.
- A quickly growing company with a dominant market share in an industry may need to spin-off a business to comply with regulatory pressures.
- Companies in highly regulated industries might need to spin-off businesses in order to stay within regulatory benchmarks.
- Certain industries become more regulated over time which can hamper returns and make other areas more attractive for investment
Synchrony Financial (SYF)
Synchrony is the largest provider of private label credit cards in the U.S. They were carved out of General Electric in 2014.
Separating off Synchrony was part of former CEO Jeff Immelt’s plan to move GE out of more regulated financial businesses and to focus on their industrial assets.
While there are many different reasons companies execute spin-offs, the underlying theme is that the company is executing a spin-off in an attempt to create shareholder value. This could be through closing a valuation discount in the shares, recognizing that a segment will be much better off as a stand-alone business, or executing a strategy that requires a spin-off in order to navigate regulatory hurdles. By studying spin-offs, investors are self-selecting for a group of companies that have historically performed well above market averages.
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