Spinoffs

They’re gimmicky.  Most of the time they lower the intrinsic value of the business due to legal and accounting fees (which I’m not a fan of).  I wouldn’t bother learning about special situations investing in spinoffs.  But… in rare cases they are worth looking at.

The costs of spinoffs

The SEC filings for a spinoff will state the legal and accounting expenses related to a spinoff.  They often cost several millions dollars.  In some cases, there are some tricky legal issues in conjunction with the spinoff.  There may be concerns that the parent will be liable for the spinoff’s liabilities (e.g. asbestos liabilities).  Or, the spinoff may create conflicts of interest between the parent and the subsidiary.

From a tax standpoint, it is best to avoid spinoffs so that operating losses at one subsidiary can be used to offset profits at another subsidiary.  Tracking stocks avoid this problem although they introduce conflicts of interest between the trackers.  Tracking stocks lead to a lot of legal and accounting fees.

From a financing standpoint, spinoffs weaken the ability of the company to finance major investments.

Reasons why companies pursue spinoffs

They want the share price to go up in the short term

Sometimes management teams will pander to how investors value stocks.  A spinoff can make the parts more attractive due to any of the following reasons:

  1. Investors like steady earnings.  By spinning off a subsidiary with volatile earnings, the part with steady earnings may receive a higher valuation.
  2. Part of the business may have an ‘ick factor’ associated with it- asbestos liabilities, lawsuits, etc.  Some investors may overestimate these liabilities because they don’t understand them well.  By dumping the ugly parts of the company into a spinoff, the parts may attract a higher valuation.
  3. ‘Pure play’ stocks that are only involved in a single industry tend to receive a premium.  Sector-specific funds are allowed to hold them.  More analysts and institutional investors understand the stock because it is only in one industry rather than more than one industry.  Spinoffs can split up a company so that one or both of them are pure play.
  4. Some investors want to bet on a very specific macro view.  Some shipping companies will separate their dry bulk, oil tankers, and deepwater drilling assets.
  5. Spinoffs can highlight a quickly-growing company whose growth is obscured by the parent company.  McDonald’s for example spun off Chipotle Mexican Grill.

Sometimes activists investors will try to pressure management into performing spinoffs because the activists want to achieve a quick short-term profit at a very high internal rate of return.  In my opinion, these activist shareholders are harmful to shareholders in the long-run.

In my opinion, the quest for quick short-term profits often hurts the business slightly in the long run.  I prefer management teams that try to increase the intrinsic value of their businesses.  If a stock is undervalued, it might make more sense to buy back shares rather than a spinoff.

Story stocks

Junior miners don’t do a lot of spinoffs.  But when they do, it’s usually because the separation will split the company into story stocks that are simpler to understand.  The NovaGold/NovaCopper spinoff clearly turns the stock promotions into simpler stories.  However, I find that these spinoffs are damaging to shareholders.  Often these juniors are underfinanced and will need to waste a lot of money on raising capital.  Spinoffs make the underfinancing problem worse.  The separate companies cannot access each other’s cash.  Spinoffs also increase corporate overhead, which is quite significant for nanocap companies (*NovaGold is not a nanocap).

The question is: does management want to mine investors or to mine ore?  Spinoffs help management mine investors.

IPO spinoffs

Management may IPO off a portion of a subsidiary that investors are willing to overpay for.  Or they may spin off a company and have the spin-off sell shares in secondary offerings (e.g. RESI / Altisource Residential).

Management wants to simplify their empire

Perhaps they want their investors to more easily understand what they own.  From the CEO’s perspective, the company may be easier to run without having to divide attention between completely different businesses.

Complying with regulations

Ownership restrictions may push a company to get rid of assets.

Avoiding conflicts of interests with your customers

In the case of the Ocwen/Altisource spinoffs, the spinoff allowed Altisource to sell its mortgage servicing platform to Ocwen’s competitors.

Screwing the bondholders

Spinoff off assets reduces the amount of collateral backing bonds.  The spinoff that is unencumbered with debt will have a lower cost of capital.

Good stock bad stock

This is where the best special situations opportunities arise.

One variation is putting the good assets into one stock and the bad assets into another stock.  Michael Smith has done this a few times in the past, where he would use various tricks to hide value in the spinoff.  One of the tricks was giving the spinoff payment-in-kind debt from the parent at a very low interest rate.  Such debt is very low risk for the borrower and very risky for the lender.  The book value of the debt did not reflect the attractiveness of the debt to the spinoff.  (FYI: I do not think highly of Michael Smith’s integrity or his skills as an operator.)

In the case of Furiex Pharmaceuticals (FURX), it seems that the best assets were spun off into FURX.  Shortly after FURX began trading, the CEO Fredric Eshelman started buying up significant amounts of shares in the open market.  Because I did not understand the company or industry well, I did not buy any FURX and missed out on a stock that went up several times.  It seems I’m not the only person who missed it- see stockspinoffs.com.

The other variation is putting the wonderful businesses into one stock and the mediocre businesses into another stock.  John Malone constantly puts the high-growth businesses into one stock and the mature low-growth businesses into another stock.  His LINTA/LVNTA spinoff allowed him to buy the wonderful business (Ventures, which had a big position in the high-growth TripAdvisor) without having to also buy Liberty Interactive’s other low-growth businesses.

Sometimes in these situations, insiders may take steps to make the good stock appear unattractive (e.g. Malone, Smith).

Exploiting the gimmick

IPO spinoffs are generally bad for the same reasons secondary offerings are bad.

If a company is doing a spinoff for short-term share price gains, I would be suspicious of management.  I would rather management create long-term shareholder value rather than waste money on lawyers and accountants.  Perhaps the stock will go up slightly in the short run but I don’t see the wisdom in chasing a very small edge (if it even exists).

“Good stock bad stock” scenarios are the most promising special situations.  Unfortunately, the analysis can be very difficult.  It really helps to understand the industry and the company.

The Warren Buffett way

The value proposition that Warren Buffett offers to people who want to sell their businesses to him (at a bad price) is that Buffett will leave them alone.  The seller of the business does not have to worry about institutional investors pressuring them into generating short-term returns at the expense of long-term returns.  They won’t have to deal with so-called “activist” investors who put forth proposals to waste money on lawyers and accountants.

Historically, Berkshire Hathaway stock has done quite well without a single spinoff.  What I’m trying to say is that many spinoffs are silly and unnecessary.  Shareholders are better off with fewer spinoffs.

Spinoffs as an investment style

I’m not really a fan of it.  Most of the time focusing on spinoff dynamics can cause investors to lose sight of what’s important.  I made a ~20% profit by investing in IDT.C before the CTMMA/B spinoff.  Unfortunately for me, I sold IDT.C far too soon as the stock went up several times afterwards.  Had I understood what I owned, I would have made a lot more money.  Unfortunately, spinoff investing largely forces the special situations investor into industries that he/she does not understand.

*Disclosure:  While I admire Warren Buffett’s integrity and skill, I don’t own any Berkshire Hathaway.  I do own LMCA, which is a John Malone spinoff that will perform another spinoff.

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12 thoughts on “Spinoffs

  1. Two other reasons for spinoffs

    1) Everyone’s doing it. (Aka institutional imperative.) This would seem to apply right now as the last few months have been going at a near record clip in the US.

    2) Diseconomies of scale. You don’t hear about this one as much in introductory or intermediate micro, but it is definitely a real phenomenon. If a business is too large / too complex and operating with diseconomies of scale, then shrinking via selling or spinning off businesses can add a lot of value. Amongst other things, a couple of key drivers of scale diseconomies are bureaucracy and internal politics.

  2. There is only one Buffett. Good honest management with lots of skin in the game are rare. Kindler seems to be one, but most management teams are there trying to enrich themselves at the expense of shareholders. Any thoughts on why spinoffs and their parents have outperformed the market by a wide margin over 2-3 year time period?

  3. Munger told Pabrai to focus on 3 areas:
    1. spin-offs 2. copying great value investors 3. cannibals (large share repurchasers).
    Einhorn, Klarman, Greenblatt etc. have all extolled spin-offs as terrific.

    Why, after 50 years of investing, would Munger continue to recommend spin-offs?

    Also, how many of Malone`s spin-offs have lost money over a 2 year time frame?

    • I don’t know if Munger is a fan of spinoffs.

      Liberty Digital (LDIG) may have lost money; I’m not sure about that one. Some of the things that Malone was involved in have lost money (e.g. @home).

  4. I think the whole point of spin offs are sellers who sell for non fundamental reasons. That is why they could be so profitable. But it seems after this got out, that there are a lot of buyers now who will be there to take it from them now. Everyone and their mother watches spin offs now. Probably more low hanging fruit 10 years ago.

  5. Glenn – it’s just a pond to fish in. While it is important to be mindful of the depth of the pond (like you stated here), we choose to fish there because allegedly there are (1) less fishermen there and (2) buying/selling dynamics are not entirely rationale due to scale, misunderstanding, mandate, laziness, and, like you stated, inexperience with the industry. I personally think it offers many of us a more even starting point and this area is a great place to hone stone-turning skills. That said, I also think this area is fairly well under the limelight and there isn’t much alpha to be had in the large cap space.

    • If you look at the Liberty complex, there are constantly mispricing in the large cap Liberty stocks. When LMDIA owned DTV, LMDIA was selling at a discount to the sum of the parts. LMCK traded higher than LMCA shares, creating a share class arbitrage opportunity. Who cares about spinoffs… there are opportunities in studying Buffett, Malone, etc.

      • The Liberty complex is the best special sits out there that keeps on giving. I own LMCA myself and am involved in the LVNTA-LTRPA trade. I do think LMCK could deserve a premium though given the 2x liquidity, especially when outsider votes in Malone enterprises never really matter. To your point, why so few study liberty still baffles me to this date.

        I’m not fighting w/ you. There are great merits in developing deep understanding on well-vested names already screened for you, but if one has time (this is important) it’s also just plain fun flipping over stones – especially when sometimes the counter-party is too lazy, trust me I’ve seen it 1st hand. Additionally, I think incentive is a powerful thing that you overlooked. With the right and clear yardstick and no upper management to answer to, independent SpinCos can do great. It’s like moving out of your parent’s house w/ a new job. Less operating leverage and scale yes, but it’s far more liberating and nurturing than otherwise.

  6. Pingback: CWC merger / John Malone liked LiLaC more than Global – Glenn Chan's Random Notes on Investing

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