Review & Outlook

Our take on the investing, financial, & economic themes of the day

An Investment Theme for 2016: Spinoffs

8 January, 2016 by Ben O'Brien in Commentary

2015 was a huge year for Mergers and Acquisitions with over $4 trillion in announced deals. Pfizer announced it was buying Allergan for $183 billion, Annheuser Bush In Bev bought SAB Miller for $120 billion, and Dow Chemical announced it would buy Dupont for $65 billion, just to name a few of the biggest deals. While mergers tend to get all the headlines, whether these giant transactions, which are so lucrative for management and investment bankers, actually create any value for investors is widely disputed.

More promising for investors are mergers’ less glamorous cousins: spinoffs.

In a spinoff, a company separates itself or divests from a subsidiary or unit of the company. These transactions come in various shapes and sizes. The parent company can issue shares of the new entity to existing shareholders, they can have an initial public offering of the new company or they can give parent shareholders the option to exchange their shares for shares of the new company (technically called a split-off).

Not all spinoffs are good investments, but these types of transactions produce more than their share of promising investment opportunities. There are numerous reasons why spinoffs tend to create value for shareholders, while mergers often don’t. Though many companies have been successful by swallowing up lots of smaller companies, mergers are often the result of management’s empire building or an attempt to expand even when organic growth is lacking. They pose lots of challenges in integrating the new company, and their supposed synergies don’t always materialize.

Spinoffs on the other hand are more commonly pursued by shareholder-minded management who want to unlock value or improve the management of both the parent and spinoff. Spinning off a unit often allows management of both the spinoff and the parent to focus on their core operations. When a subsidiary is spun off, it’s easier to track performance and to align the interests of management with shareholders by awarding stock to managers as part of compensation.

Aside from the management benefits of spinoffs that can drive better company performance, there are also market inefficiencies that arise from spinning off a company, which investors can exploit. One major mispricing results when large institutional investors who own the parent’s stock are forced to sell the spinoff regardless of its merits because it does not meet the right size or sector or other requirements. Many institutional investors can only hold large cap stocks and most spinoffs are small caps, so there is usually a wave of indiscriminate selling that pushes down the price immediately after the spinoff. Some spinoffs are in different sectors than the parent or have too much debt or don’t meet various other requirement of the parent’s shareholders.

Not only do spinoffs tend to perform well, but in many cases the parent stock also outperforms as its management can refocus on the core business, reduce regulatory scrutiny or make the company a more attractive acquisition target.

Again, not all spinoffs are good stocks. Sometimes a company tries to get rid of a chronically under-performing business through a spinoff. Sometimes they load the new company up with debt to get it off their books.  So how do you choose which spinoffs to invest in? First of all, you use the same sort of criteria that you would use for any stock, looking for high-quality companies with a good competitive advantage, reasonable valuation, strong financials and so on. But for spinoffs you want to pay special attention to the behavior of the insiders and how they are compensated. If insiders have a large stake in the newly created company or somehow stand to benefit from its success in a material way, that is always a promising sign.

Another possible catalyst is when the market misunderstands the new stock. Key information is sometimes buried in long, tedious documents that most investors don’t bother to read. Often management will not go to great lengths to make a spinoff appear attractive because a low initial price can boost their own stake, leading to big profits for themselves down the road.

Some recent spinoffs involved General Electric, HP, Ebay and Barnes and Noble and there is a large list expected in 2016. Just to name a few, already this year Fiat-Chrysler spun off Ferrari, Johnson Controls will spin off an automotive business, Danaher is splitting up in a complicated three way split, and Emerson Electric is spinning off its Network Power Business. Other major spinoffs expected this year involve Taco Bell/KFC parent Yum! Brands, Alcoa, the newly merged Dow/Dupont and Citrix.

Some companies are serial spinners. ADP for instance is a relatively unexciting payroll processing and HR company. But two of its spinoffs Broadridge in 2007 and CDK Global last year have produced some exciting returns.

Broadridge, an fairly unglamorous business itself, which handles investor relations and proxy voting for public corporations, has almost tripled since its 2007 spinoff while the S&P 500 is up less than 30% over that period. Below is the chart since 2007.

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CDK, a company that provides back office services to car dealers followed the classic spinoff pattern, pulling back sharply before jumping more than 80% in its first nine months. (Full disclosure: We own shares of ADP and held onto our shares of CDK for a while but sold a bit too soon to capture the full gain.) Since then the stock has fallen a bit, but its performance is still impressive.
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One of the nice things about investing in spinoffs is that it is not a complex trade only suitable for hedge funds or insiders. The two examples above were fairly straightforward spinoffs from a large public company that anyone could have identified and participated in.

Spinoffs are not guaranteed to make money and are not a get-rich-quick scheme. But they are a promising hunting ground for an investor willing to do his homework.

Though the market appears to be somewhat expensive and economic growth around the world is sluggish, looking for attractive investments in special situations such as spinoffs tends to provide opportunities in bad markets as well as good ones. Good spinoff opportunities outperform because they are frequently overlooked, misunderstood and mispriced regardless of the overall performance of the market.