Spin-Offs - Why Do Companies Do It, and Should Your Portfolio Care?

Synchrony Financial SYF, also known as GE Capital, spun off on Thursday.  Earlier in the week, Windstream WIN received a private letter ruling from the IRS regarding the tax implications of a spin-off consisting of its fiber and copper network. 

The recent discussion and interest in companies shedding business units raises an important question for investors. What is a spin-off?

A spin-off occurs when a company identifies a business segment and separates it by creating an independent, publically traded company. 

Why Spin-Off A Business Segment?

Companies elect to spin-off a business segment for a variety of reasons.  The major reasons surround focusing the businesses on core competencies.  A spin-off allows each business to put in place operational and strategic plans that utilizes all forms of capital, including physical and human, without sacrificing another business segment.

Each company will also benefit from being able to more effectively manage its identity with investors.  Companies that focus in one area are easier for investors to see opportunities and specify size, style, and growth assumptions.  This transparency can remove some of the undervaluation conglomerates may receive as a function of their extreme size and complex business segmentation.

When a company is looking to realize the value of a particular business segment, it can spin it off or sell it to an interested buyer.  If a sale to a third-party buyer is the chosen route, the sale will produce a large, up front cash infusion to the parent company.  This type of transaction is not necessarily desired because it causes a massive taxable event and the deal may not even go through due to government regulation.

Contrary to a sale, spin-offs usually create a greater value to shareholders because the spin-off often commands a higher public market valuation.  The spin-off causes the parent company and shareholders to receive a stock distribution.  The stock distribution is typically done in accordance with tax laws and is tax-free to the company and investors. 

Not Without Its Own Challenges

Spinoffs aren’t without their own set of challenges.  Typically, a spin-off is done using a compilation of complex financing.  Term debt loans are used to generate the cash needed to pay for the distribution of shares to the parent company.  To meet future liquidity needs and in some cases, fund day-to-day operations, a spin-off company will enter into a credit revolver.

Depending on the situation, the parent company will also require refinancing of debt covenants to avoid default and meet the needs of the new, smaller, entity.

Zoetis, a Past Spin-Off

Last year, in a $2.2 billion IPO, Pfizer PFE, spun off its animal health division, Zoetis ZTS, to create the largest independent company in the world focused solely on animal health.

Zoetis opened for trading on February 1, 2013.  Its IPO priced at $26 per share and opened at $30.50.  In the last year, the stock rose modestly to $32.91. 

The company has performed well, and there are believers at Pfizer.  Thirteen directors and officers subscribed to additional shares in the IPO, and no one has sold their Zoetis shares.  Pfizer shareholders received .9898 shares of Zoetis for every Pfizer share owned, at which point they can hold on to their shares or sell them in the open market while still retaining their original shares in Pfizer.

Financially, the company is sound.  Last year, the company reported sales of $4.56 billion and net income of $504 million.  This year, it expects to grow sales a modest 3 percent to $4.7 billion while growing the bottom line a whopping 50 percent to $764 million.

Windstream Prepares a REIT Spin-Off

Windstream Holdings, announced earlier this week it will be spinning off its copper and fiber networks into a publically traded REIT, which will be leased to Windstream in a long-term, exclusive lease for $650 million per year.

This news comes after the company received a private letter ruling from the IRS.  The transaction will occur tax-free and is estimated to lower Windstream’s debt by approximately $3.2 billion and increase free cash flow. 

Once the transaction closes, Windstream will pay an estimated $0.10 per share annual dividend and the new REIT is expected to pay $0.60 per share annually.

Windstream provides communication systems to consumers including broadband, phone, and television services.  With the IRS giving the nod to Windstream, will companies like T-Mobile TMUS, AT&T T, and Verizon VZ follow suit and begin to spin-off their communication lines in order to lower the level of debt leverage?

What Should You Do?

Until recently, spin-offs have received little fanfare, but with the launch of Synchrony Financial and the favorable IRS decision for Windstream, it’s likely that investors will continue to hear about this type of financial transaction. 

Investors should be aware of the potential impact that spin-offs have on a company when analyzing a potential deal. Important considerations for investing are future goals, and needs, as well as risk tolerance.     

Disclosure: At the time of writing, the author holds no positions in the mentioned securities.