NOT AN ANALYST

What is a spin-off? The parent company (ParentCo) distributes to its existing shareholders new shares in a subsidiary, thereby creating a separate legal entity with its own management team and board of directors. The distribution is conducted pro-rata, such that each existing shareholder receives stock of the subsidiary in proportion to the amount of parent company stock already held. No cash changes hands, and the shareholders of the original parent company become the shareholders of the newly spun company (SpinCo).

Reasons for a spin-off Divesting a subsidiary can achieve a variety of strategic objectives, such as:

• Separate an unrelated business For example, a diversified company may have a fast growing software or Internet business that is largely ignored or not valued by the market because it is a small part of a large company. The fast growing division would likely garner a richer valuation as a stand-alone entity.
• Eliminating dissynergies Divest non-core businesses, reduce bureaucracy and give SpinCo management complete autonomy
• Unlocking hidden value Establish a public market valuation for undervalued assets and create a pure-play entity that is transparent and easier to value.
• Public currency Create a public currency for acquisitions and stock-based compensation programs
• Motivating management Improve performance by better aligning management incentives with SpinCo’s performance (using SpinCo, rather than ParentCo, stock-based awards), creating direct accountability to public shareholders, and increasing transparency into management performance
• Anti-trust Break up a business in response to anti-trust concerns
• Corporate defense Divest “crown jewel” assets to make a hostile takeover of ParentCo less attractive

Accounting for spin-offs The parent accounts for the disposition of its subsidiary in a single line item on its balance sheet called “Net Assets of Discontinued Operations”, or similar. The parent also segregates the net income attributable to the subsidiary on its income statement in an account called “Income from Discontinued Operations”, or similar.

Structure of a spin-off The parent company will often extract value from the subsidiary before spinning it off by levering up SpinCo and siphoning the cash proceeds as a special tax-free or pushing down debt to SpinCo. The special dividend and amount of debt pushdown are both limited in size to ParentCo’s inside basis in the subsidiary’s assets. If either exceeds the inside basis, the spin-off is taxable to the extent of the excess. The amount of debt ParentCo can push down to SpinCo is also limited by SpinCo’s ability to service the debt.

Let’s look at an example where a Company sought protection under the Bankruptcy code after a spin off: Verizon’s spin-off of Idearc, which I have talked about not long ago. The following is excerpted from Idearc 8-K filing detailing its spin-off from Verizon, and outlines how the spin off deal was structured

“On November 17, 2006, Verizon Communications Inc. (“Verizon”) spun off the companies that comprised its domestic print and Internet yellow pages directories publishing operations. In connection with the spin-off, Verizon transferred to Idearc Inc. (“Idearc”) all of its ownership interest in Idearc Information Services LLC and other assets, liabilities, businesses and employees primarily related to Verizon’s domestic print and Internet yellow pages directories publishing operations (the “Contribution”). The spin-off was completed by making a pro rata distribution to Verizon’s shareholders of all of the outstanding shares of common stock of Idearc.

In connection with the spin-off, on November 17, 2006, and in consideration for the Contribution, Idearc (1) issued to Verizon additional shares of Idearc common stock, (2) issued to Verizon $2.85 billion aggregate principal amount of Idearc’s 8% senior notes due 2016 and $4.3 billion aggregate principal amount of loans under Idearc’s tranche B term loan facility (collectively, the “Idearc Debt Obligations”) and (3) transferred to Verizon approximately $2.4 billion in cash from cash on hand, from the proceeds of loans under Idearc’s tranche A term loan facility and from the proceeds of the remaining portion of the loans under Idearc’s tranche B term loan facility.”

Often spinoffs are required to incur heavy debt loads, and FCFE can easily be eroded by high interest payment if growth prospects aren’t met, which makes the SpinCo a candidate for a short position.

Fraudulent Conveyance When SpinCo incurs a loan and distributes the proceeds to the ParentCo, as described above, creditor claims of fraudulent conveyance may arise if SpinCo later declares bankruptcy because it is unable to service its debt. Similar creditor claims may also arise if the spin-off leaves ParentCo insolvent. Therefore, it is necessary to ensure that both SpinCo and ParentCo are adequately capitalized following the spin-off.

Capital Markets implications The separate business entities created in a spin-off sometimes differ in many ways from the consolidated company, and may no longer be suitable investments for some original shareholders. Institutional investors committed to specific investment styles (e.g. value, growth, large-cap, etc.) or subject to certain fiduciary restrictions may need to realign their holdings with their investment objectives following a spin-off by one of their portfolio companies. For example, index funds would be forced to indiscriminately sell SpinCo stock if SpinCo is not included in the particular index. Also, the lack of a dividend may push income-oriented investors out of the spun off stock.

So why invest in spin-offs? Companies that have been spun off usually trade at a significant premium or discount compared to their peers. The spin off world is littered with many dogs and horses. Also there is often an absence of adequate financial information when the SpinCo commence trading as a standalone entity and the stock it’s mispriced. This a good reason for coverage on the Blog because a well written valuation can take you a long way.