The Spin-Off Effect

The financial crisis of the past several years has highlighted an old phenomenon, “the Spin-Off Effect”. A company breaking up with part of itself can allow each individually to outperform the market. There is evidence of diseconomies of scale if we ever needed it. In fact, evidence reveals that companies that have spun off from their parent companies in the past five years have increased their share price over 300%, on average, compared with an 85% increase in the S&P 500. This could be called the “Spin-Off Effect”.

Looking on the Up after Split

One recent example has been Rupert Murdoch’s News Corp’s split in two in June between itself and the film and television business of 21^st Century Fox. Both’s shares have since risen by 25%, easily beating the S&P 500 in the same period. Another example is Siemens’ spin-off of German lighting company Osram, which has allowed both of their shares to rise by roughly 35% since July. Last December, the UK’s Cookson also split itself into a technology specialist Alent and ceramics supplier Vesuvius – both are doing far better apart.

Familiar Names?

Yet, companies have been spinning-off for over 100 years. The most famous were court-mandated destructions of monopolies such as the breakup of Standard Oil into 34 companies in 1911 and the splitting of AT&T into 8 companies in 1984. Other famous spin-offs have been due to changes in strategic direction, such as American Express’ spin off of Lehman Brothers in 1994 as they stopped trying to become a financial conglomerate and the UK chemical company Imperial Chemical Industries’ spin-off of its pharmaceuticals business Zeneca in 1993 as the link between chemical and pharmaceutical businesses grew more tenuous.

Part of the reason for the “spin-off effect” is that companies are able to focus their capital on their core operating areas. Additionally, investors often overlook weaker businesses within a company until they are spun-off. A case in point is Thailand’s Major Cineplex plc where investors could be charged with overlooking its bowling alley and ticket booking businesses. Therefore it seems that just as mergers and acquisitions are oft said to destroy value, their undoing can also create value. Another case in point is AOL and Timewarner, the promulgated “deal of the century”, who split from each other in 2010 after ten years together. At the time of splitting up, the combined entity was worth a mere 10% of its value at the firm’s zenith, US$2.5 billion. Both companies have since managed to find their feet in their respective business areas and excel.    

However, spin-offs can also initiate new M&A opportunities for the newly separated companies. Dutch telecoms giant KPN agreed to divest its German business to Spanish giant Telefonica, engendering a bid for the whole of KPN from Mexican Carlos Slim, who as KPN’s biggest shareholder was against the German sale. Even here the “spin-off effect” was palpable with KPN’s shares escalating by 16% shortly afterwards.

Divestitures are admittance that jigsaw doesn't fit?

Yet, most CEOs won’t happily shrink their business – there is an element of self-interest and moral hazard inherent in their bias. CEOs fear that suggesting divestitures to shareholders may be viewed as admitting their strategy and vision of the company has failed, that employees’ morale may be damaged, or that the company may lose some of their economies of scale. Moreover, spin-offs do not generate the cash for reinvestment that sales do. It is about finding the courage to shrink as spinning off businesses can genuinely create value. There are many examples of companies that should be considering this. For example, the UK’s Whitbread has been a perennial candidate for breaking up its Costa Coffee chain from its hotels and restaurants business. Meanwhile Microsoft has mooted spinning off its Xbox business as they see few synergies going forward.

The annual Shareholder letter

The “Spin-Off Effect” comes down to a simple principle of corporate finance. Business creates the most value for shareholders and the economy as a whole when it is owned by the best owner. Adhering to this principle would suggest that companies should continually reallocate their resources as circumstances change. Too bad there are a few too many self-interested CEOs without the courage to admit a change of strategy is sometimes necessary.

Key Benefit of Spin-Offs: Long-term Strategic Vision

Ultimately though the “Spin-Off Effect” is more than just providing a favourable boost to both companies’ share prices. In fact, it provides the most benefit from a realignment of the companies’ strategic visions, the corporate restructuring opportunity, and the tax advantages relating to the transaction. The misperception is that the “Spin-Off Effect” is about a quick fix to low market capitalizations. It’s much more than that – the real factor in the value of spin-offs is that they are tied to expected performance. In other words, increased valuations of the split off businesses reflect the market’s expectation that performance will improve at both companies once each company has the freedom of self-determination with regards to strategy, people and organization. This is why spin-off businesses, on average, increase their profit margins by 2% and double their growth rates.

There are also the tax advantages – sometimes spinning-off a business is better than selling it. UK and US tax laws treat spin-offs as tax-free transactions. Furthermore, many continental European countries also treat spin-offs favourably for tax purposes in order to facilitate them. For example in the USA, a company has to pay 35% income tax on any gain arising from the sale of a business. A company decides to divest one of its business units which, if spun off would have a market capitalization of US$500 million. There is an offer of US$650 million for the business unit from another company, which is at a premium to the market capitalization. Yet, the company’s book value for the business unit is US$150 million, so a sale would carry a tax liability of US$175 million on a US$500 million gain on the sale, which reduces after-tax proceeds from the sale to US$475 million. This would be less than the business unit’s expected market capitalization from spin-off. Therefore, from the perspective of creating shareholder value, taxes alone should make the company consider a spin-off rather than a sale. The tax dynamics will lead to companies being more likely to spin off highly profitable businesses and sell less profitable businesses.

And how does the “Spin-Off Effect” help the wider economy? Changes in strategy within spun-off businesses suggests an improved allocation of capital with higher-profit businesses more likely to increase their investment spending while lower-profit businesses are more likely to cut their investment. Therefore, watch out for the benefits of the “Spin-Off Effect” when making investment decisions; there may be a temporary boost but it may also herald a longer period of long-term growth.