“Some examples of recent spin-offs”
What is a Spin-off?
- A spin-off is where a company separates a portion of its business (a division or a subsidiary) from the parent company and organises it as an independent company. Typically, a spin-off is accomplished by distributing the shares of the new business/unit as a share dividend to existing shareholders in a tax-free transaction. Often, this subsidiary is involved in operations that are viewed as non-core to the parent company and a spin-off is preferred to an outright sale of the division because simply selling the division can result in a large tax bill for the parent company. In some ways, you can think of a spin-off as the opposite of a merger.
Why Would We Want To Keep (or Purchase) a Spin-off?
- Research into spin-offs highlights that they are attractive for two key reasons: 1) smaller, more focused spin-off companies operate better as a result of being unshackled and able to focus solely on core competencies as opposed to wide ranging activities; and 2) spin-offs are often misunderstood and mispriced leading to attractive valuations at which they can be potentially purchased.
Key Drivers of Spin-offs in Our Opinion:
- In our opinion, a spin-off delivers to shareholders the real effect of capitalistic market forces. Employees of smaller, more focused companies are more accountable, responsible and benefit more directly from the fruits of their own labour. For example, in a large company, a certain division can have exemplary results, but overall bonus compensation for employees of that division could be dragged down by lackluster results in another division. By spinning these companies out from each other, the employees of each division can be more directly compensated based on the performance of their own division. This often improves employee performance and morale as employees feel that they have control over their own fate. Management of companies that are spinning off a division may also be better aligned with promoting shareholder interests.
- The share prices of spun-off companies are often depressed at the time of spin-off due to indiscriminate selling (refer CDK Global chart below). Shares of the spun-off companies are often distributed to uninterested parties (large institutional investors) that were primarily invested in the core business of the parent company so they sell the spun-off shares.
- Large institutional investors also have other reasons for selling the shares which present opportunity for unconstrained investors:
- Spin-offs tend to be smaller companies that do not initially warrant the attention of institutional investors. Often times, the investment mandates of certain institutional investors would not even allow them to own companies with market capitalisations below a certain size. Many funds have restrictions on ownership that may prevent them from owning companies with a market cap < $X bln or companies that are not a member of the S&P 500 (or other benchmark indices);
- Additionally, sell-side (share broking) equity research analysts often do not have the capacity to cover these smaller spun-off companies leading to less general awareness among, and support for, institutional buyers.
Two examples of recent spin-offs within client portfolios:
ADP spin-off of CDK Global (spun-off on 30/9/2014)
- ADP is primarily in the business of business outsourcing solutions and more specifically, providing payroll and HR solutions to large companies.
- CDK Global (formerly ADP Dealer Services) is the largest global provider of integrated IT and digital marketing solutions to automotive dealerships in 100+ countries around the world (US$2B Revenue in FY2014). Notably, 7 of the top 10 and 57 of the top 100 largest American auto dealerships by vehicle sales are clients. Its “Software as a Service” (SaaS) business model is highly attractive with investors at present.
- The main reasons for the spin-off were firstly to allow CDK Global to focus solely on its business and growth, and secondly to create value for ADP investors. ADP received at least US$700M tax-free from the spin-off and plans to return the capital to ADP shareholders via a share repurchase program.
- Additional potential catalysts for value creation at CDK Global:
i. Increased investor awareness with additional “street” coverage (currently only two analysts researching the Company)
ii. Possible announcement of a sizeable share buyback program
iii. Low leverage and strong cash flow generation could attract the attention of private equity
iv. Increasing vehicle sales will lead to higher transaction-based revenue
Kimberly-Clark spin-off of Halyard Health (spun-off on 1/11/2014)
- Kimberly-Clark is a consumer products company that produces paper-based products (toilet paper, tissues, diapers, etc., that include brands like Cottonelle, Kleenex and Huggies).
- Halyard Health manufactures medical devices and surgical and infection-prevention products. Halyard Health's surgical & infection-prevention segment manufactures products such as surgical gowns, sterlisation wraps and medical exam gloves. The medical devices segment produces products for surgical pain management, interventional pain management and respiratory and digestive health.
- The main reason for the spin-off was that the strategies and priorities for the parent company and Halyard have diverged over time.
Are these two examples just anomalies or does history support the view of holding onto (and /or increasing an investment) in spin-offs?
In an article entitled “The art of the spin-off” The Economist magazine explores spin-offs (refer Appendix #1 for the full article). To quote from the article “Forbes Magazine calculates, American companies completed 80 spin-offs worth at least US$ 500mln between 2002 and 2012. The parent companies (or “spinners”) have delivered a return of 35%, compared with 22% for the S&P 500. The “spun” have delivered a return of 70% “
One of the best ways to learn more about spin-offs (which also provides further support to the thesis of holding and investing into spin-offs) is to read Chapter 3 from Joel Greenblatt’s “You Can Be a Stock Market Genius”. We have included Chapter 3 – Chips Off the Old Stock – “Spin-offs, Partial Spin-offs, and Rights Offerings”.
Elevation Capital Management Limited