Divorces, as anyone who has been through one (and I haven’t) will tell you, are expensive. Ask Jeff Bezos. In 2019, Jeff and MacKenzie finalized their separation, which, at roughly $160 billion, set a financial world record that will be difficult to beat. Were they better staying together or are they freed up to realize their real true potential apart? Time will tell, I guess.
The structure of human relationships and breakups is something I’m not really an expert on. However, what I have done for over 17 years is to examine corporate divorces – when companies go through a separation of businesses and, more specifically, figure out whether the entities are better off together or not. If not, where is the real value and how can an investor capitalize on the opportunity? Call me the best company divorce lawyer in town if you like, but analyzing these regular key events is something you should consider as an investor as these “Special Situations” can create enormous wealth for you if analyzed correctly.
Corporate breakups, more commonly known as Spinoffs, demergers, or divestitures, are the equivalent of a divorce as we know it, but on the company side. A stock Spinoff is a corporate action whereby a company separates a portion of its business into a new independent company and distributes shares of the new company to its existing shareholders. This is usually done to unlock the value of the business unit, allow it to operate more independently, or to focus on the core business.
When a company Spins off a business unit, it creates a new publicly traded business that operates independently of the parent company. Shareholders of the parent company receive shares in the new company in proportion to their existing holdings in the parent. This is a key dynamic and as opposed to IPO’s, where you subscribe to buy shares, you gain the new company’s shares in a Spinoff whether you like them or not.
Why Do Spinoffs Happen?
The big-firm conglomerate model has never really been in favor throughout history, for the company or the consumer. A conglomerate is defined as several different parts that are grouped together to form a whole but remain distinct entities. The larger and more diverse an organization becomes means it sometimes can become hard to manage, less efficient, and particularly when a company becomes bigger by integration and takeovers, the culture and core purpose of the entity can become lost and value is eroded. This can take many forms, but ultimately finds its way to the share price.
There have been several failed large conglomerates in history, and the others frequently have problems. The underlying reasons for their failures can vary, but common issues include overextension, poor management, and unsuccessful mergers and acquisitions. Here are three interesting ones that adhere to those reasons.
General Electric – GE is a legendary company. It was once the biggest and most dominant corporation on the entire planet. Thomas Edison and J.P. Morgan, two innovators, played key roles in its development. A whole generation of executives looked up to the company’s illustrious CEO Jack Welch, who authored five #1 best-selling books on leadership. The company reached its peak in 2000 and has been heading south ever since. Welch left in 2001 and the market capitalization was around $130 billion. One of the biggest issues for GE was its financial performance, which drastically declined during the 2008–2009 global financial crisis. The company’s financial services division, GE Capital, had a lot of exposure to hazardous assets, which caused big losses and necessitated a government rescue. Together with its financial problems, GE also faced challenges from underperforming companies and a convoluted organizational structure. Sales and divestures were made throughout the term of then-CEO Jeffrey Immelt, who took over from Welch, but the share price continued to decline. Since Larry Culp entered in 2018, GE has been steadily reducing its debts and selling off parts of its business. In November 2021, the company said it would Spinoff its last remaining three business divisions – aviation, healthcare, and power – into separate publicly traded companies.
Large conglomerates don’t seem that good for the consumer either. Market dominance by large companies frequently lowers competition and reduces consumer options. As a result, there may be less incentive for the conglomerate to innovate or improve its offers, which could lead to higher costs and lower-quality goods. Also, due to the possibility that they already own a sizable portion of the market, large corporations may be less motivated to spend on R&D or launch new items. This may hinder innovation and constrict the variety of goods that buyers can choose from. Lastly, concentration of power is a problem for many. Big corporations have a lot of influence over government regulators, which can result in a lack of supervision and accountability. This might lead to monopolies or unethical business practices, which would be bad for smaller companies as well as customers.
So, the case is clear in the arguments against big companies. The traditional idea of “bigger is better” sounds great but can fail and as we’ve seen, it’s like a house of cards when it does. What all the companies above have pursued is the idea that small and focused might be the way to go after they got into trouble, and that pure-plays make sense and are the hallmarks of Spinoff value creation throughout the years.
Spinoffs Have Been Around Forever
As far back 1911, the US Supreme Court mandated the breakup of Standard Oil, a huge oil corporation, into 34 distinct firms. After years of antitrust litigation, a decision was made with the intention of fostering competition and preventing monopolistic behavior in the oil sector.
Fast forward to the ‘80s, and the United States government compelled AT&T
To free up the enterprise business from the sluggish PC business, Hewlett-Packard
Regulatory action, as in the cases of Standard Oil and AT&T, or a business decision, as in the cases of Hewlett-Packard and General Electric, can lead to corporate breakups. In all scenarios, the objective is typically to increase productivity, foster competition, or refocus the company’s activities on its core competencies.
The Rise Of The Activist Investor
Regulatory and/or a business decision by the company can be the driving force for a breakup. However (and more so in recent times), selective breakups have been led by shareholders who perceive companies not achieving their full potential and want to step in. These are usually not long-term standing investors, but more so organizations that accumulate enough voting shares quickly to gain a seat on the board and push for change. In the ‘80s, they were called “corporate raiders.” Now they are known as Activists.
Carl Icahn is someone most investors are familiar with as a high-profile Activist and investor who has taken part in numerous board fights. He helped dismantle the airline TWA in the 1980s, and in the 2000s he advocated for the dissolutions of Time Warner and Motorola. In addition, he played a role in the corporate change of numerous other businesses, such as Texaco, RJR Nabisco, and Netflix
Dan Loeb of Third Point LLC is a hedge fund manager and another Activist who has been involved in several high-profile corporate breakups. In 2013, he pushed for the breakup of Sony, and in 2015 he pushed for the breakup of Dow Chemical. He has also been involved in the breakups of Yahoo and Sotheby’s. Lastly, JANA Partners, led by Barry Rosenstein, is an Activist money manager that has been involved in several corporate breakups. The Activist campaigned for the breakup of Qualcomm
Whether or not Activists are good for the company is a debatable issue. Are they short-term investors looking for a quick buck for their investors, or are they long-term value creators there for the good of the shareholder? Whatever the answer, the facts remain that they have been instrumental in forcing corporate breakups through their actions and recommendations. By pushing for changes in corporate strategy and governance, they have been able to create value for shareholders and improve the performance of the companies they invest in. As an investor, it’s a good idea to watch their movements and look at their initial proposals for the target company in a separation, as it can be value creating.
How To Invest In Spinoffs
The best way to analyze Spinoffs is to start by looking at what the company is saying their reason is for a Spinoff. In my experience, this may not be the whole story, but it’s the #1 place where you should start. Over the years, there are some familiar reasons why companies Spinoff, and it’s here where you can start to work out any potential value creation.
- Businesses may split up to concentrate on their core strengths and Spinoff non-essential operations. This enables them to increase resource allocation and operational effectiveness. Usually this involves new management. Watch carefully to see how the managers of the division have historically performed. Watch what incentives are in place and what they are going to be given. The transaction could release the entrepreneurship spirit that has been hiding for many years. Sometimes there is also a better business with the separation, and could offer you an opportunity to decide what to invest in, maybe both.
- Unlocking value is a popular stated reason for a split. Sometimes by enabling each business to trade alone and attain a greater valuation than when united, the division of a business unit can unlock significant value for shareholders. The place to start here is to look at the standalone businesses and find their relative valuations to their peers within the wider market pre-Spin. Chances are the business will experience an uplift when it Spins if the goal is to achieve a higher valuation once separated – hence the term “Unlocking of Value.”
- Companies at the tops or bottoms of cycles are a great hunting place in my opinion. Businesses in trouble may decide to split themselves in order to raise money, pay off debt, or increase profitability. You must watch companies in two ways. The first is when the market is exceptionally bullish. Things are great, stocks just go up, and there isn’t bad news in sight. Everyone is a genius, and we can give up work to invest full time! At this point, many companies and their entities become fully valued, and the company might decide to Spin something off. Watch for these fully valued assets, because they are usually not the best investments and on a downward move in the market, they could fall very fast as investors discard holdings they don’t know much about. This is what happened in 2021. Spinoffs were the first things to go in a market panic. If you can play stocks from the short side, it’s a great potential opportunity. If you own the parent, you may want to consider selling the Spinoff with a view to maybe buying it back cheaper once the market retraces. When feelings are low and markets are depressed, watch for companies Spinning off as it’s a sign of forced exits because they cannot sell and need to shore up the balance sheet. These are my favorite situations. Distressed selling is never a great sign for anyone, and you should be ready to take advantage of it. The Street rarely picks up these companies until further down the road and they could remain cheap for a while with no attention on them and hence could make good investments.
Three Areas To Focus When Analyzing Spinoffs
In my experience, analysts get caught up in the weeds with analysis of Spins. I focus on three areas: 1) the Fundamentals of both companies and the metrics; 2) the Technical considerations of the Spin when it can move in or out of an index on the event; and 3) the Insiders (which people tend to gloss over). Look into their background of value creation, their incentives, and whether they are linked to the share price. Remember, humans are the main drivers of great companies.
The Negatives of Spinoffs
Other than complexity in the transaction, there isn’t a lot of downside for the company in a Spinoff. However, for the investor, there are a few things to consider when you aim to be involved in these types of transactions. In general, investors should exercise caution and perform extensive research before investing in any company, including Spinoffs, even if they can present appealing investment prospects.
Some Spinoffs may struggle because of adverse industry trends, weak market conditions, or subpar execution. Investors should carefully consider Spinoffs on an individual basis, taking into account aspects such the company’s financial stability, competitive position, growth potential, and value. Contrary to popular opinion, they don’t all make money.
What Does The Data Show?
At the end of 2022, we compiled and analyzed just over 1,100 companies from both the US and Europe from January 2000 to March 31, 2022, in which the parent was above a $500 million market cap ahead of the break-up. Around 70% of Spinoffs take place in the US. Spinoffs Overall Outperform Their Parents and the Market Over Time: There are often questions around corporate break-ups as to which part of the transaction performs better, the Parent who Spins off its division or the Spun off entity itself.
According to the data, Spinoffs on a combined basis (listings in the US and in Europe) give a stronger performance than their former Parent companies and outperformed/beat the benchmark indices (the MSCI World Index, the S&P 500 and Euro Stoxx 600). On average, Spinoffs generate a return of 17% one year after the effective date while over the same time frame, Parents generate a 5% return. Likewise, Spinoffs have generated a 25% return two years after the effective date while the Parent generated a 9% return.
What’s Coming Up?
If you are interested in taking advantage of Spinoffs and the next 40 on the calendar that are scheduled to happen, contact us for a chat here.