What is Stock Spinoffs: The Basics You Need to Know

You can make a pile of money investing in spin-offs. The facts are overwhelming. Stocks of spinoff companies significantly and consistently outperform the market average.”

• Joel Greenblatt, Founder of Gotham Capital

Big-time investors like Joel Greenblatt, Seth Klarman, and Charlie Munger have carefully studied the spinoff patterns over the years and believe that it is a great investment tool that always outperforms the market. In 2013, a study analyzing spinoffs performance between 1995 and 2012 was done by Credit Suisse. Their result revealed that in the first 12 months after the spinoff date, the spinoff outperformed the S&P 500 by 13.4%. A more recent study was conducted by the Stock Spinoff Investing team in May 2018, the study revealed that from December 2005 to May 2018 Bloomberg U.S. Spinoff Index generated a return of 511%, outdoing the S&P 500 by 314%. Asides incredibly outperforming the market, a spinoff could be a great way to avoid personal and corporate taxation.

If you are new to the stock market/investing and wondering what really is a spinoff and how does it work? We’d guide you through.

What is a Spinoff?

A Spinoff is the formation of a renamed independent company of an already existing business or company through the sale or distribution of shares of the parent company. This usually happens when a division of a company gets disconnected from the main or parent company to function independently and made public. It is expected that these companies worth more independently compared to when they were part of a larger company.

How does it work?

A spinoff happens when a large company with multiple divisions decide to break out some of those divisions that have a proper management structure and can function independently. The main business becomes the parent company of the spin-off. A spun-off company can retain its employees, intellectual property, and assets gotten from the parent company.

A spinoff is created when the parent company sells or distributes its 100% ownership interest in the intended business division as stock dividend to current shareholders or proposes that the current shareholders exchange their shares in the parent company for shares in the spin-off at a discount. For example, if a share in the parent company is $200, shareholders can exchange it for $220 in the spinoff at a discounted rate. Not all shareholders may agree to exchange their shares in the parent company for shares in the spinoff as it may not fit their investment standards. Spinoffs can be one of the most confusing transactions yet very profitable if properly understood.

Why Spinoffs?

A company can decide to break out some of its units as spin-offs for different reasons, but the major reason remains to generate more revenue and value for its shareholders. The spin-off may either be underperforming or outperforming the main business. Usually, businesses often sell their underperforming units or business subsidiaries as spin-offs.  It could also be a unit of production not in line with the main business focus which may likely affect the growth or risk of the parent company. For example, a company which majorly deals with the production of cereals has a division that deals with the manufacturing of edible oil. The company can decide to spin-off its edible oil division into an independent company to let it focus on its production and operations. Or a company may decide to spin-off one of its units experiencing little or no growth so it can focus on other thriving units. Another reason why companies may decide to spin off some units is due to its vastness. Some companies grow so large over time that controlling all units may be quite tasking.

Read also: Ready For DuPont To Spinoff Chemours?

Necessities for Creating a Spinoff

Usually, when businesses are established, the founder has a particular mind of business he seeks to pursue. Thereby, serving a particular purpose in the selected industry. If a new business idea, totally unrelated to the current business comes up, rather than incorporate the totally unrelated business into the new one it would be better for the business owner or founder to create a new company for the business idea, and let it grow as an independent entity with the current business as its parent company. Other reasons why companies opt for a spin-off are as follows:

• Managerial issues: It becomes daunting for large or diversified businesses to maintain a managerial focus as a single entity due to variations in its objectives and strategies

• Capital Market factors: As a single business, the full potential of a particular unit may remain unknown or unexplored because no special focus is given to it when it remains part of a single business. But, as an individual entity, its economic value can easily be explored, thereby, creating more income for its shareholders.

• Tax Impact: As an independent company the spin-off would incur its own taxes, that way, the parent company would have more tax benefits compared to when both companies are a single entity. 

• Profitability: A spin-off stands as a good opportunity for shareholders to make more money as it has the potential of outperforming the market and generating more revenue. 

• Regulatory/Legal issue: By spinning off units of a company, the parent company would be able to separate regulated units from unregulated ones which may tend to impose legal regulations on the overall company.

• Risk factors: In the case of a particular business unit underperforming, a spin-off would be necessary to ensure that the risk of one unit does not affect the overall performance of the company. 

• Strategic problems: As a single business, the company may suffer losses due to the underperformance of a unit which may attract losses to the company.

A spinoff can be created in two ways, as a unit of a single business like eBay spinning off PayPal, its money transfer unit, or as a subsidiary company, that is, companies that were legally acquired or purchased by other companies to become part of them.

Advantages of Spin-offs for the Parent Company and Shareholders

A spin-off also helps in diversifying the business risk. A spin-off may hold better opportunities for the parent company compared to the spin-off employees, however, it still holds quite a number of advantages. 

One major advantage of a spinoff is that it allows both companies—the parent company and spun-off, to operate as two different businesses each with its own goals and concepts. That way, the new company can focus properly on one line of operation. The parent company ensures that the spin-off gets good leadership of great expertise to manage it and its operations. The value of both companies can be easily noted when they function separately rather than as a single entity. 

For the Parent Company:

• A parent company can politically benefit from a spin-off by avoiding regulatory issues in a particular region.

• Spinning off an underperforming unit would relieve the business off extra responsibilities and incurred losses

• It would allow the parent company to focus on its main business objectives or return to its initial business focus.

• It can also be a way for businesses to expand their operations to other regions with favorable market conditions.

For the Shareholder:

• When a spinoff happens, then shareholders would be offered the opportunity of owning shares in both the spin-off and the parent company proportional to each other. 

• In the case of a merger, shareholders are still opportune to retain shares in the parent company, and becoming part of the merger deal. 

• Shareholders have the liberty to decide whether or no they want to be a part of the spin-offs. Usually, the shareholders receive spin-off shares as a form of a dividend, they can either retain the shares of the spinoff or sell them off. For example, say, an institutional investor called XYZ owns $2 million worth of shares in Amazon, and Amazon decides it wants to spin-off its web services division—AWS. Fund company XYZ would then own a stake in both Amazon and its AWS spin-off. If XYZ decides that it has no use for AWS because the spin-off doesn’t meet XYZ’s investment criteria, it can simply sell off its shares in AWS and focus on Amazon alone.

• Shareholders may be one of the greatest benefactors of a spin-off or merger as they can retain their portion in parent companies, yet have a good standing in the newly independent companies as well.

• Spinoff shareholders and investors are not required to pay taxes. Taxes will only be paid when an investor sells off their slot in the newly spunoff company.

General spinoff advantages:

• Profitability: A spin-off has better chances at profitability since it focuses on a single operation line with its own business goals in place. 

• Increased Shareholder’s value: Spin-offs’ outperforming nature tends to not only generate more revenue for the company but increase its shareholders’ value.

• Independent Brand: Through a spin-off, especially in the case of a new idea or innovation, the parent company can create an independent new brand that wouldn’t affect the overall affairs of the parent company. Rather, it would function as an independent brand and build itself around that. For most spin-off’s that do well as an independent brand, sometimes the parent companies are not so known due to its popularity and outperforming like Kering, the parent company of Gucci. Most people are more familiar with Gucci as a popular designer brand, but not with the parent company.

• Investment benefits: Its impeccable growth and potentials can also attract other private and institutional investors to invest in its public stock.

Disadvantages of Spinoffs for the Parent Company and Employees

A spinoff may be great but not all that great enough to keep drawbacks out of its launch and operations. In the creation of an independent unit, a lot of resources go out to ensure its possibility and smooth running. Resources such as finance, assets, employees, etc., and any other resources required to ensure a smooth separation. 

The major disadvantage of spinoffs is the volatility of their share prices. They can outperform strong markets and underperform weak markets which are not good for the spinoff and its shareholders. 

For the Parent Company:

• A spinoff is most likely going to affect its financial structure by increasing the cost of rent, maintenance, insurance, and property tax.

• All contracts and partnership agreements of the parent company such as partnership deed, support agreement, loan agreement, and vendor contract would need to be revisited and revised in order to include the spin-off in these agreements.

• The initial performance of a spin-off may be dependent on the type of support it receives from its parent company. It may have been easier functioning under the covering of the parent company, however, as an independent entity more managerial and operational efforts must be in place. Usually, a bulk of the support must come from the parent company. 

For the Employees:

• The employees are usually at the receiving end of whatever decision a company decides to make. Some employees may not consider the necessity of a spin-off in the light of outperforming the market, since, at the end of the day, its shareholders may be the highest benefactors.

• Some employees may also consider being transferred to the spin-off a.k.a. the smaller company as a form of demotion from the bigger company. Unless such employees belong to the managerial or leadership category.

• There may be cases of job insecurity in the case of spin-offs created due to underperforming the parent company. The doubt and fear of the spin-off not meeting the standards and employees losing their jobs would often get in the way.

Tips for Stock Spin-off New Investors

• Get a useful education on how stock spin-offs work before getting into the market. You may assume it’s just like every other investment, but you would be shocked to find out a few differences, especially in the stock value.

• Carry out in-depth research and analysis before committing your money into stock spin-offs

• Look for reoccurring patterns and use them to gain an advantage in your trade entry and exit points

• Be mindful of stock promoters. These promoters get paid for what they do, therefore, they would, by all means, sell all the “juicy” parts of a stock spin-off to their audience. Not all the promotions are dubious, but you can remain on the safer side by carrying out personal research and knowing all the parameters.

The Best Books to Read on Stock Spin-off Investments

There are different approaches to stock spin-off investing. The end “might” be the same but the means differ. Great minds and stock spin-off investors like Joel Greenblatt have shared their secrets to successful stock spin-off investment. They serve as good guides for both new and old investors. 

• You Can Be a Stock Market Genius. Joel Greenblatt, 1997

• How to Profit from Special Situations in the Stock Market. Maurece Schiller, 1959

• The Acquirer’s Multiple: How the Billionaire Contrarians of Deep Value Beat the Market. Tobias E. Carlisle, 2017

• Spin-off to Pay-off: An analytical Guide to Investing in Corporate Divestitures. Joseph W. Cornell, 1998

• Spin-offs and Equity Carve-outs: Achieving Faster Growth and Better Performance. J. Randall Woolridge and James A. Miles, 1999

• Special Situations in Securities. Maurece Schiller, 2018.

Conclusion

Based on the statistics provided in the introduction above, and other testimonies of spinoffs you are likely to come across, it would be best to note that not all spinoffs yield increase and generate shareholder value in their first year—at least 38% of spin-offs don’t. Though in general, stock spinoffs outperform the market by 10%, yet as individual spinoffs, some of them underperform the market. As a new investor, seeking to invest in a stock spinoff, it would be best to first carry out in-depth research on selected spinoffs’ company financial information. Like all investments, stock spinoffs also have risk tendencies which may likely cause you to lose money if not done properly.

You can go about your spinoff research by paying more attention to news catalysts and the cycle of news that surrounds your selected spin-offs. There are also websites dedicated to stock spin-offs which would provide you with necessary information such as the name of the parent company, the name of the spin-off, and the estimated spin-off date. There is also a fundamental analysis software that can help you better understand the fundamentals of the stock spinoff, and know why a stock is valued the way it is after s spin-off. It would also help you determine the right entry and exit trade points