Pick Your Moment And Catch A Rising Spin OffToddi Gutner
CompuServe, Lucent Technologies, 360 Degrees Communications, Payless ShoeSource: Not long ago, they were all attached to huge corporations. But today, they are stand-alone companies, the products of a recent spate of spin-offs that shows no sign of slackening. Some $70 billion in spin-off deals are expected to be completed this year, up from $48 billion in 1995 and $27 billion in 1994, according to J. Randall Woolridge, a finance professor at the Smeal College of Business Administration at Pennsylvania State University and co-author of recent studies on spin-off investing.
Spin-offs seem to work to everyone's best interests: The parent gets rid of a troubled or unrelated business and usually receives a quick jolt to a slumping stock price. The unshackled offspring gets a chance to fly on its own. And investors get a shot at a new, potentially lucrative buy. "Spin-off stocks are a very good place to look for value," says Woolridge.
TWO FLAVORS. That's true whether the deal takes the form of a 100% tax-free divestiture or an equity carve-out. In a pure spin-off, the parent company simply gives away the business to existing shareholders--as Sprint did with 360 Degrees Communications in March (BW--May 6) and May Department Stores did with Payless ShoeSource this month. In an equity carve-out, some of the subsidiary's stock is sold through an initial public offering, and the remaining shares are spun off to existing shareholders later on. Examples of equity carve-outs in April include Compuserve from H&R Block , and Lucent Technologies from AT&T.
Regardless of the structure, spin-offs tend to outperform the stock market over time. Woolridge, with Penn State colleague James Miles and Patrick Cusatis, a vice-president at Lehman Brothers, found that shares of tax-free spin-offs over a 25-year period ending in 1990 rose 75% three years after being distributed, while equity carve-outs through the 1980s and early '90s gained 60% after three years. In a separate study of 60 tax-free deals between 1991 and 1994, Barbara Goodstein, an analyst at New York investment bank Rothschild, determined that the spin-off shares appreciated 28.2%, vs. 16.5% for NASDAQ stocks and 10.3% for the Standard & Poor's 500-stock index.
Why do spin-offs do so well? Before separation, the business is often a small, troubled division of a large company, fighting an uphill battle for capital and management resources. But afterwards, the brand new company is forced to take control of its own destiny. "There is a sense of urgency for the newly spun-off company to bring products to market, cut costs, and curtail losses because there is no longer a parent to rely on," says Woolridge.
For example, Host Marriott Services, a leading operator of airport and toll-road concessions, didn't have a chance to grow as a subsidiary of Host Marriott Corp. That's because excess cash flow from HMS was used to fund its parent's needs rather than its own. "This business was a stepchild to the hotel business," says Michael Mueller, restaurant analyst for Montgomery Securities. Not anymore. As an independent company created in January, Host Marriott Services is expanding its international operations and moving into the shopping-mall food-court management arena.
HIGHER PRICES. Earthgrains, the third-largest producer of packaged bakery products in the U.S., didn't get proper attention as a subsidiary of brewing giant Anheuser-Busch. Earthgrains had little incentive to operate efficiently, simply because Anheuser-Busch subsidized it. As a result, it competed aggressively by keeping prices low--while its profit margins suffered, says Peter Doyle, an analyst at The Spin-Off Report, a newsletter based in New York. Since the company was spun off in March, management has made a commitment to improve margins by maintaining more reasonable price levels and even raising prices in some regions. The stock market has reacted favorably, driving up the share price from 28 to 32 3/8 within weeks.
Another reason spin-offs prosper is the increased likelihood that the new company will be acquired. Spin-offs are five times as likely to be taken over in the first three years of trading as are their industry peers, according to the Penn State study. After a unit is spun off, it becomes an attractive target because it offers a buyer a pure play in a specific business. Take for example Galen Hospital, the hospital division that was spun off in February, 1993, from Humana, the health-maintenance organization. Galen was acquired by hospital chain Columbia/HCA Healthcare seven months later--but not before its stock appreciated 140%.
CELLULAR HOOK-UP. With all the merger-and-acquisition activity in the telecommunications industry, Sprint's former cellular-phone company, 360 Degrees Communications, may be an attractive takeover target. This division was no troubled unit. Sprint needed to spin it off to comply with federal regulatory requirements. "360 Degrees is the largest pure play in the cellular industry," says Kevin Roe, telecommunications analyst at ABN AMRO Hoare Govett. But 360 Degrees is not sitting on the sidelines waiting for a suitor. On its own since March, it already has announced plans to buy another operator, closely held Independent Cellular Network. With the cellular industry growing more than 35% annually, 360 Degrees Communications is well-positioned to benefit. Roe expects operating cash flow to increase 44% in 1996, to $374 million, and revenues to grow 32%, to $983 million.
Among the numerous deals lately, analysts think Highlands Insurance Group and the headline-grabbing Lucent Technologies are two stocks likely to beat the market this year. Lucent, a telecom-gear supplier, has plenty of advantages now that it's free from AT&T. Sparked by deregulation, telecommunications providers are rushing to upgrade their networks to improve service. Lucent, a behemoth with $21 billion in 1995 sales, will get a boost from customers who weren't willing to do business with the company before the spin-off, when it was part of AT&T, a competitor. Kathleen Smith, an analyst at Renaissance Capital, an institutional research and money-management firm in Greenwich, Conn., estimates at least 15% earnings growth for Lucent in 1996.
Highlands Insurance Group, a regional property and casualty insurance business spun off in January from Halliburton, a diversified construction company, has a strong incentive to succeed as an independent entity. Management owns 44% of the new company. What's more, Highlands' financial position is strong. Halliburton infused it with $125 million in reserves before letting it go, according to Doyle of The Spin-Off Report.
Of course, not every spin-off will thrive on its own. Investors should be selective and look at individual companies relative to their specific industries. CompuServe, for example, may be the No.2 provider of online services (America Online is No.1), but its growth rate and profit margins are declining despite increases in advertising, notes William Smith, an analyst with Renaissance Capital. And Roadway Services, a spin-off of Caliber Systems, is a unionized long-distance trucking company. Although Roadway Services rumbled away with a debt-free balance sheet, it faces a significant competitive onslaught from independent truckers.
After investors set their sights on a former subsidiary, they should avoid jumping in too soon. With pure spin-offs, the market launch tends to be followed by an immediate sell-off period that lasts until the shares settle down and start to climb again. Similar to initial public offerings, equity carve-out stocks often appreciate in the beginning, then drop back. The experts recommend waiting three months or so before investing in both types of plays. Given the success and popularity of spin-offs, however, investors can expect their heads to be spinning with opportunities in the future.