Many companies expand by purchasing complementary businesses, removing cost duplication and creating cross-selling synergies with customers. But it’s not the only way to create value through transactions. Some companies do so by shrinking in size.
Companies may look to spin off operations that have a distinct growth trajectory, product category or customer base. A spinoff can be more attractive than an outright sale, since it shouldn’t trigger a tax gain and can remedy situations where management can’t find a buyer.
The usual rationale behind a spinoff is that the market is not recognizing the value that exists in a company’s disparate assets. Spun-out assets are more easily comparable to other pure-play companies and can attract an investor base with a distinct strategy, such as a focus on higher-growth businesses or, conversely, steady income-producing assets. Greater comparability and predictability can lead to higher valuations.
Aggregated firms, on the other hand, may offer diversification but few synergies, and they also tend to suffer from what’s known as a “conglomerate discount” in the market.
Investor preferences hinge somewhat on the investment cycle. Sometimes a corporate acquisition strategy is in vogue one decade but then falls out of favour, resulting in companies spinning off businesses they purchased just a few years prior.
For example, H&R REIT spun out its retail shopping properties into a separately traded entity, Primaris REIT, at the beginning of this year, and distributed the units to H&R investors. H&R originally took Primaris private in 2013, touting the creation of “a fully diversified commercial portfolio emulating the real estate investment model adopted by large Canadian pension plans.” Last fall, H&R management unveiled plans to divest its retail and office assets to concentrate on industrial and multi-residential properties. The company described its latest strategy as simplified, streamlined and better aligned with investor preferences.
Similarly, Bausch Health is attempting to spin off two previously acquired businesses: its Bausch+Lomb eyecare business (acquired in 2013) and its Solta medical-aesthetics segment (acquired in 2014). It’s a complicated, multi-stage process, and its success depends on the value the market is willing to attach to the separate entities. [Update: Bausch Health’s stock slid significantly after it missed earnings expectations on the final day of Bausch+Lomb’s IPO, and it was down 60% for the year as of May 16.]
Which brings up the most important question for advisors: Do spinoffs create value for shareholders?
Spinoffs are more about financial engineering than actual change, with companies trying to convince the market to pay more for the same assets. An argument can be made that separating a unit from the whole might allow dedicated management to focus on improving the underlying fundamentals. On the other hand, there are additional expenses to consider that drag on profits.
Research on spinoff outcomes is varied. Companies are constantly spurred by investment bankers, advisors and even research analysts to undertake deals — including spinoffs — because of the fees they produce. This makes the studies produced by management consulting firms somewhat untrustworthy when they proclaim clear support for the investment benefits of corporate spinoffs.
Academic research may be more balanced. A paper published last year in the journal Humanities and Social Sciences Communications confirmed that “spinoff restructuring remains overwhelmingly a value-creating strategy,” with an average positive abnormal return of approximately 3% immediately following a spinoff announcement. However, this represented more than half the excess return for the period from announcement to finalization, with a disproportionate bump around the completion date. In fact, the return data overwhelmingly indicates information asymmetry as the major contributor to abnormal returns, as opposed to factors such as increased management focus. This dovetails with past studies that have disproven the idea of long-run outperformance from spinoff events.
The takeaway for advisors is that there is little to be gained by chasing a company that has announced a spinoff. And if you already own the shares and need to sell prior to finalization, you needn’t worry about leaving money on the table by exiting early.
Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE. They run Accountability Research Corp., providing independent equity research to investment advisors across Canada.