Spin-Offs: Gems among the Trash?

They're often loaded with woes. But the exceptions are worth the research

After years of merger mania, some of the largest U.S. companies are doing a 180-degree turn. They're spinning off pieces of their empires for a variety of reasons: to raise badly needed cash, to recast their images as more-focused entities, or simply because the merger didn't work.

If these companies are selling, should you be buying? Unfortunately, spin-offs don't have a great track record. Management consultant Booz Allen Hamilton studied 232 spin-offs by companies in the Standard & Poor's 500-stock index during the 1990s and found that only 26% outperformed the index in the first two years after the split. On average, the parent company's shares outpaced the S&P by 3.8 percentage points, while spin-offs trailed the market by half a point. "For every home run, there are many more spin-offs that bomb," says Chuck Lucier, a senior vice-president at Booz Allen Hamilton. Why? In part, because the parent typically structures the deal to benefit itself at the expense of its offspring. Often, a parent sells a subsidiary via the stock market if it can't get a better price elsewhere. Tyco International (TYC ) is seeking to sell its financial-services arm, either to another company or through a spin-off, whichever route proves more lucrative.

Typically, companies shed divisions that aren't as profitable or growing as fast as their core businesses. Drug giant Merck (MRK ) recently announced plans to jettison Merck-Medco, the mail-order pharmacy unit acquired in 1993. Although the subsidiary generates 55% of Merck's revenues, its profit margins are much slimmer than Merck's core drug business. Merck hasn't yet released sufficient details about the spin-off to tell if it's a good deal for investors. However, analysts believe Merck-Medco could boost sales as an independent entity because it will be more easily able to distribute a broad array of drugs. Originally, Merck purchased it to push Merck products.

Parent companies also tend to overload spin-offs with debt or dump other liabilities on them. On Mar. 21, Citigroup (C ) spun off 21% of its Travelers Property Casualty unit in a $3.9 billion initial public offering. The financial giant plans to distribute the remaining Travelers shares as a dividend to Citigroup shareholders by yearend. One possible reason for the deal is that Citigroup wants to distance itself from the potential costs of Travelers' asbestos claims (BW--Apr. 1). Similarly, Goodrich plans to pass on its asbestos liability to EnPro Industries, its diversified industrial subsidiary slated for a spin-off in June.

Another problem: Parent companies often hoard the money they get when they spin off subsidiaries. Nestlé (NSRGY ) kept most of the proceeds when it sold a 23% stake of its Alcon eye-care unit in a Mar. 20 IPO that raised $2.3 billion. Alcon (ACL ) further paid Nestlé a $1.2 billion dividend right after the deal (BW--Mar. 18).

Still, some spin-offs turn out well. Shares of luxury leather-goods designer Coach (COH ) have tripled since its separation from Sara Lee in October, 2000. That's because the company revamped its product line, opened new stores, and struck a joint-venture deal to tap the Japanese market. Kraft Foods (KFT ), the nation's largest foodmaker, also hit its stride since uncoupling from Philip Morris (MO ) last June. Kraft rolled out new versions of familiar brands such as Oreo cookies. That has boosted revenues, and its shares climbed 26%.

What's the trick to finding a promising spin-off? Booz Allen Hamilton's Lucier advises seeking companies that can articulate a clear plan for growth. Surprisingly, he says, this point is often missed in the prospectus and in pitches to institutional investors. "The focus is on the past performance of the parent and the fact that the new company will be a pure play," Lucier says.

Typically, big companies conduct a spin-off in a two-step process that begins with selling about a 20% stake of a business unit in an IPO. Six to nine months later, the parent company distributes shares to its shareholders. Because these deals tend to be well-publicized, investors usually don't get any bargains, he says.

Investors can often find the best value by sticking with smaller, less well-known spin-offs, usually companies with market capitalizations of less than $3 billion, says Joseph Cornell, a principal at Chicago investment researcher Spin-Off Advisors. Cornell looks for spin-offs in which the parent simply distributes all the subsidiary shares to existing shareholders. Such deals initially get less attention from analysts, and there's often an opportunity to buy shares on the cheap.

If the parent is part of the S&P 500 but the spin-off isn't, for instance, index funds will quickly sell the spin-off and put downward pressure on its stock price. That's one reason Cornell says investors should keep an eye on Combined Specialty, the underwriting unit that insurance giant Aon plans to spin off in May. Both companies should benefit after the spin-off because right now, the parent's rivals don't want to do business with the subsidiary, and vice-versa.

Cornell also favors FMC Technologies (FTI ), which makes such diverse gear as electric juicers and airport cargo loaders. Even though chemical company FMC spun off FMC Technologies in an IPO last June and distributed remaining shares in December, Cornell says Wall Street has paid little attention to the new company. "This is a high-quality spin-off that has fallen through the cracks," he says. FMC Technologies recently traded at $20 a share, around its IPO price.

Another opportunity is drugmaker Allergan's spin-off of eye-care unit Advanced Medical Optics. In June, Allergan plans to distribute all shares in Advanced Medical Optics as a dividend to Allergan shareholders. In this case, Cornell suggests buying the parent before the deal because he expects both Allergan and Advanced Medical Optics to thrive afterward. He says each will be able to better focus on its core business.

Even with an attractively priced spin-off, investors need patience. "It usually takes years to realize the value of a spin-off" because the new company must find its way as a stand-alone entity, says Abbott Keller, co-manager of Undiscovered Managers Special Small Cap Fund. One spin-off Keller finds attractive is Massey Energy, a coal company that was uncoupled from construction giant Fluor 18 months ago. Because of its size, Massey is one of the few Appalachian coal companies that can afford the environmental upgrades required to expand in the region, Keller says. He figures Massey will also benefit from rising coal prices at a time when it is poised to renew long-term contracts with power plants.

Spin-offs are a convenient way for Corporate America to sweep away past sins and pocket extra cash. The challenge for investors is to find the gems among what are usually just cast-offs.

By Susan Scherreik

With Lewis Braham

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