Commentary: This Spin Off Is Asking For Too Much TrustDavid Greising
Weigh this offer, investors. Would you buy stock in a new company that:
-- is controlled by the board of another company;
-- can never be taken over;
-- must sell its products to one of the industry's low-cost buyers;
-- relies on the other company's board for capital;
-- is subjected to serious conflicts of interest?
That is the deal being offered by the chairman of the other company, Georgia-Pacific Corp. A.D. "Pete" Correll in December pushed through a quasi spin-off of GP's timber assets because, like many CEO's, he wants the stock market to recognize the value of assets that otherwise might be overlooked. What is now called GP Group is a cyclical, capital-intensive paper and building products maker that cannot generate profitable returns on investment. But the new company, Timber Co., which has 5.4 million acres of land, is a predictable, high-margin business with a promising outlook.
HALF A LOAF? Instead of a pure spin-off, though, Correll has created a little used entity called a "letter" company--the term derives from the practice of naming such companies with letters, though GP doesn't use one. Timber is tightly controlled by GP. Decisions on capital allocation, corporate strategy, even product pricing are dictated by the parent company's board. Correll is aware that in managing the somewhat divergent interests of two separate but related companies, the new structure is fraught with potential conflicts. And he acknowledges that trust will be a key issue for stockholders in the new company. "It's a trust-me security. By definition, it's a trust-me security," Correll says.
For investors, though, the securities may offer only half a loaf of opportunity. "Out of many alternatives, letter stocks get the least bang for your buck for shareholders," says Joseph Cornell, an expert on corporate divestitures for High Yield Analytics in Chicago.
General Motors Corp. introduced the letter-stock concept in 1983 with its Electronic Data Systems Corp. unit. USX's Marathon Oil and GM's Hughes unit are two leading examples. Those deals were done to facilitate acquisitions or ward off takeover threats. Only recently have corporate managers introduced letter stocks to wake up Wall Street without giving up control of one of their operating units. Last year, Circuit City Stores Inc. created letter stock when it launched CarMax, the nationwide chain of used-car superstores.
GP is the first to create a letter company that is directly related to its core business. The arrangement is a study in conflicts, in both capital structure and management systems. Because Timber is controlled by GP Group's board, there's nothing to stop the board from starving Timber for capital when it repurchases shares. Holders of the parent company's bonds have a call on Timber's assets.
The GP compensation system will tempt Correll and about 15 top executives to favor the GP Group, because 75% of their bonus compensation will derive from that unit, with only 25% coming from Timber's results. And bonuses, Correll readily admits, "are where you make your real money."
GP, further, has contractually obligated Timber to sell 80% of its products to GP Group at a price that matches the average price the parent company pays to other suppliers. But because of its huge volume purchasing, GP is one of the industry's low-cost buyers. The arrangement may prevent Timber from finding the market's top price. Sherman Chao, analyst with Merrill Lynch Global Securities, does not like what he sees. "There's a whole question of corporate governance involved" with GP's letter stock, he says. "The pricing mechanism is foolproof," says Correll.
Correll says he considered alternatives to letter stock. But, he explains, the tax bill for an outright spin-off would have been too high, in part because he is loading Timber with $1 billion in debt, which exceeds the book value of the company.
PAINED CEO. So far, investors seem to be fairly comfortable with the conflicts. Correll figures that Timber has added about $12 a share to the combined stock market value of the two companies. And he says it's that premium that will make him keep a sharp eye on the economic vitality of both of his companies. "If you violate the trust of shareholders and do what you say you won't do, it's going to cost you $12 a share," he says.
It pains Correll when people complain about how he built Timber Co. "What they're saying is, `Pete, I don't trust you,"' Correll says. "I don't think you want to say that to someone." But if he hadn't structured his deal this way, trust would not be such an issue.