Why Do a Corporate Spinoff?

SMITH BRAIN TRUST – Why would a company with a portfolio of brands seek to do a corporate spinoff?

The idea has been gaining steam lately. Gap Inc. is planning one, prying its more-profitable Old Navy chain from the rest of the company. Barington Capital is urging L Brands to do one, calling for separate equities for Victoria’s Secret and the company’s Bath and Body Works chain.

The spinoff is popular because of the boost it often gives to a company’s stock, says Maryland Smith’s David Kass. He explains.

Research has shown that over time spinoffs tend to outperform the market and that they tend to outperform companies in the same industry that have not done spinoffs.

That’s in part because the people who are tapped to run the spun off companies are often the managers who were running it before, when it was part of the parent corporation. “But, now,” Kass says, “they have become essentially the owners, they are running this business and they don’t have to go through corporate headquarters to get approvals for budgets and spending and raising funds.”

Under the new arrangement, they have greater incentives, shorter paths in the decision-making process. They are “leaner,” Kass says, “and meaner, and able to get things done more efficiently.”

They might also face less potential liability. When Altria spun off Kraft Inc., proponents said the move would protect the food company from incurring potential health and wrongful death liabilities linked to Altria’s cigarette business.

A typical justification that management offers as a reason for spinning off a business is that the move will allow the business to fully realize its value.

Companies who take this step typically move to spin off a minority part of the larger firm, one that accounts for “less than a majority of sales,” says Kass, a clinical professor of finance at the University of Maryland’s Robert H. Smith School of Business. Shares of the “spun off” entity are usually doled out to shareholders, in proportion to the stakes they owned in the parent company.

For example, Kass says, let’s say a shareholder owns 100 shares of the parent company. After a spinoff, he or she will still own 100 shares of the parent company, but also will own 100 shares of the spun-off company.

Now let’s say the parent company was worth $60 per share before the spinoff, and let’s say the spinoff company after the spinoff is worth $20 per share. If that’s true, we can assume that at the time of the spinoff, the value of the parent company’s share price in the market will sink to $40, from $60, since it has lost about $20 of its value, by spinning the new company.

“The shareholder will own 100 shares of the parent at $40 a share and 100 at $20, so at ‘time zero,’ or the moment of that the new stock begins trading, the shareholders will have the same investment, now broken up into two companies.

At time zero, the shareholder essentially has two pieces of paper – “though it’s now all electronic,” Kass adds – and those papers says the shareholder owns two stocks instead of one.

“A truly successful example of a spinoff that many people will not remember happened roughly 12 years ago, when the McDonalds restaurant chain spun off Chipotle,” Kass says. The new Chipotle shares traded in the low $40 range at the time. Now they’re above $630.