PSX - Corporate Spinoffs Are Surging: How Not To Get Taken For A Spin

2023-10-09 18:23:44 ET

Summary

• Investors in corporate spinoffs have historically outperformed the market by unlocking hidden value and taking advantage of investor constraints and biases.
• However, recent spinoffs have underperformed due to an increased prevalence of companies isolating debt and dumping unattractive assets into new entities.
• Investors should be cautious and conduct due diligence to separate successful spinoffs from those loaded with bad assets or debt.
• A brief look at several recent spinoffs.

You're not just imagining it– corporate spinoffs have markedly increased over the past couple of years. High-profile spinoffs over the past couple of years include WK Kellogg ( KLG ) from the company formerly known as Kellogg ( K ), Warner Brothers Media ( WBD ) from AT&T ( T ), and Mobileye ( MBLY ) from Intel ( INTC ). But are they good investments? Historically, academic research shows that spinoffs tended to outperform the broader market due to unlocking hidden value and from the inherent constraints and biases of investors who dislike spinoffs. For these reasons, you could blindly buy spinoffs and expect to beat the market. Now, some different dynamics have come into play, and I think they're worth highlighting– because I see a lot of unwitting investors getting issued low-quality spinoffs. Wall Street and private equity seem to have become keen on isolating debt and dumping unattractive assets into spinoffs, flipping the logic and turning a historically attractive asset class upside down. As such, ETFs that track corporate spinoffs such as the Invesco Spin-Off ETF ( CSD ) have posted poor returns over the past five years.

Why Spinoffs Historically Outperform

Prior to the past five years, spinoffs actually had quite a strong track record of beating the market and creating value for shareholders. Spinoff activity first surged during the 1990s . During the early years, activist investors and early private equity operators were able to unlock big-time value this way. Old-school investors such as Peter Lynch and Joel Greenblatt were frequent investors and proponents of spinoffs.

A couple of key reasons for spinoffs outperforming historically:

1. Removing the " conglomerate discount. " This is thought to average about 10-15% of a typical conglomerate's market value. If you break the company up, the sum of the different parts tends to be worth more than the combined company. This is historically the reason most spinoffs were done, and this was a legitimate financial innovation that made a few smart bankers rich and some shareholders richer.
2. Another brand of spinoff that I like is when companies separate their real estate into REITs. This works great for casinos, car dealerships, and other cyclical businesses by creating a safer asset beneath a risky business. Owning the commercial real estate under your business in a separate company is a classic small business tactic that works well for many big businesses as well. These deals also offer tax benefits for investors under the current U.S. tax code.
3. Investor bias and constraints. Investors receive shares in spinoff companies without asking for them, they therefore will tend to sell when they get their shares. Certain institutional investors also have mandates that sometimes force them to sell their spinoffs. Company insiders don't have much of an incentive to market spinoffs the way they do with IPOs, so their incentive is often to spin off a division with little fanfare and buy up shares cheaply. Analysts also tended to sparsely cover new spinoffs, leading to inefficient markets and opportunities for savvy investors to buy low.

Overall, spinoffs have historically outperformed the market by as much as 7-10% annually over the first few years of their existence. I've made surprising amounts of money on spinoffs, most notably from Phillips 66 ( PSX ), which I got from ConocoPhillips ( COP ). However, recent studies show that this strategy may no longer be working. And when you dig deeper, I think there are some very specific reasons why many spinoffs are not working.

Why Spinoffs Are Now Underperforming

Spinoffs used to beat the market by 7% or more annually, and now over the past five years, they're losing to the market by roughly an equal margin. You could just chalk this up to variance, but if so I think you'd be making a serious mistake. Instead, take a look at what's really going on with some of these spinoffs and you'll see that it's not bad luck hampering spinoffs, it's that the companies and their investment bankers are often loading them with underperforming entities.

It starts with their names. The new breed of spinoffs often have consultant-selected names that belong in a Charles Dickens novel. Additionally, they can hold the assets and personnel that the parent didn't want, and a disproportionate share of the previous company's debt load. Adding insult to injury, spinoffs have also been used in several high-profile cases to effect sneaky dividend cuts to investors.

1. Debt dumping. A game that companies can play sometimes is to move assets or liabilities into subsidiaries in a way that benefits them at the expense of their creditors. If you're able to offload a bunch of unwanted debt onto a spinoff without losing your best assets, that's great for you. This isn't illegal per se but is generally restricted by debt covenants . During the ZIRP era, debt covenants got really weak, so I think we're going to see companies take full advantage. My perception is that there's a lot of this going on. You have to watch these spinoffs like a hawk to see where the debt is going, especially since refinancing costs are about to skyrocket. Debt costs today don't necessarily reflect where they'll be in 12-24 months.
2. Corporate deadwood. For an example of a deal I really never liked, take IBM's ( IBM ) Kyndryl ( KD ) spinoff. Kyndryl's income statements show that IBM was able to put businesses that lose roughly $1-$2 billion per year in a separate entity. To my first point on debt dumping, Kyndryl's balance sheet shows that they loaded it up with over $10 billion in debt. They seem to have given the company enough cash so it wouldn't bust out right away, but much of the assets gifted to the new company consisted of property, equipment, and paper goodwill. Meanwhile, they were able to offload billions in long-term debt, leases, and even nearly $900 million in pension obligations. Given the way it was set up, it was going to be nearly impossible for Kyndryl to be successful and the stock is down 62% in two years. This is not an uncommon scenario for private equity-backed spinoff deals in the small and mid-cap space, or even for large companies. Investors should be very careful with spinoffs to make sure they aren't being loaded up with bad assets or debt, and alternately to make sure that all the good assets aren't being spun off and leaving the parent company holding the bag. For another example, look no further than Realty Income's ( O ) spinoff of Orion Office REIT ( ONL ). At first glance, Orion has a reasonable balance sheet, and some people think it's a value play. However, they're in obviously rough shape with the post-pandemic office market. When their current leases expire, what will happen? The answer to that question may be related to why Realty Income decided to spin them off in 2021. If the leases renew then great, and if they don't, then Realty Income likely won't be on the hook for Orion's office debt.
3. Backdoor dividend cuts. AT&T did it, and W.P. Carey recently ( WPC ) did it too. The idea here is that companies are cutting the dividend, but doing it quietly by spinning off part of their business, "maintaining" the dividend in the previous business but dishing out a dividend cut via the spinoff. It's still a dividend cut.

How To Separate The Wheat From The Chaff

Successful corporate spinoffs that unlock value still exist, but many are now being done for fundamental reasons that make them likely to be poor investments .

In my opinion, the number one thing to look for in a spinoff is whether it makes money or not. For example, this WK Kellogg spinoff has been getting demolished since it came public, and a cursory look at the income statement shows that it's been losing money since 2022. My guess is that this will not be a good investment. Kyndryl had a long track record of losses, so its decline was not that hard to see coming. Aramark's ( ARMK ) spinoff of Vestis ( VSTS ) is interesting. My initial look doesn't show the full net income data yet, but one analyst noted the high debt load of the newco (surprise surprise). GE has another big spinoff deal on deck, but whether it's a good investment or not will depend on the specific corporate capital structure. Intel is expected to do some sort of AI-themed spinoff as well. Here, GE Healthcare ( GEHC ) is the spinoff with the best outlook from analysts, while Kyndryl is probably the worst. I agree with this from looking at their respective income statements. Take from that what you will.

As a general rule, you can probably blindly sell both sides of the dozens of spinoff transactions expected over the next 12 months here and save yourself some drama and losses. There will be some opportunity though for event-driven investors, which you can do with a bit of research.

An investment shop called Boyar Research recently published a guide on spinoffs, and here's what they said for choosing which ones to hold (to paraphrase). Their findings are mostly in line with what a Harvard Business Review study found on winning and losing spinoffs.

1. Momentum– choosing businesses that are doing well and stocks that are doing well. Rising stock prices generally indicate underlying business success.

2. Antitrust spinoffs– If the FTC is demanding a spinoff, it's on average a better deal than those done by companies looking to do spinoffs for other reasons.

3. Aligned incentives– if the parent company dumps its stake then it's a red flag regarding the newco. If the parent company keeps a large stake it's a green flag.

These make sense to me. I'll also note that specialized investors tend to do best in situations like these, while generalists like me tend to just graze on opportunities as they come along, using rules of thumb like cutting losses and avoiding money-losing companies to avoid a high percentage of bad situations.

Bottom Line

Spinoffs are historically a great source of returns for savvy investors as the sum of the parts are worth more than the whole. However, many recent spinoffs are now being done to isolate debt and bad businesses into new entities, resulting in some disastrous returns for investors. Separating the former from the latter takes its fair share of due diligence. At a minimum, you should be aware of some of the tricks and traps that are surfacing from corporate spinoffs. The names and faces tend to change, but the underlying incentives don't. What do you think? Share your thoughts in the comments below!

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