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Five Short-Sighted Stock Spin-offs

Published: Friday, 27 Jan 2012 | 7:47 PM ET

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By: Antoine Gara
Analyst

Divestitures became a major 2011 strategy as some of America's biggest blue-chip stocks —Kraft Foods [KFT Loading... () ], ConocoPhillips, Abbott Laboratories [ABT Loading... () ], Northrop Grumman [NOC Loading... () ], Tyco and Marathon Oil — spun assets to unlock value in their shares.

Shareholders big and small may cheer the flurry of recent spin-offs, but in some cases divestitures can be a sugar high that comes at the expense of long-term earnings.

Shareholder spins are a quick way to get the full value of businesses that may be weighing on operations, while opening up new avenues for growth. Existing shareholders benefit from owning stakes in divested businesses that oftentimes become far more valuable with brighter prospects as an independent concern.

Meanwhile, management accountability to shareholders is easier to track and investors have a much easier time valuing simpler businesses.

The mother of all spin-offs was the Sherman Act breakup of John Rockefeller's Standard Oil in 1911, which made shareholders' stock multiply many times over when the broken-up "baby standards" — among them the precursors to ExxonMobil [XOM Loading... () ]and Chevron [CVX Loading... () ] — turned into some of the most valuable U.S. companies.

One hundred years later, vestiges of the Standard Oil empire and others in the energy sector slimmed down after a generation of consolidation in 2011.

Along with ConocoPhillips [COP Loading... () ] and Marathon Oil [MRO Loading... () ], Sunoco [SUN Loading... () ], Forest Oil [FST Loading... () ], Williams Companies [WMB Loading... () ]and Chesapeake Energy [CHK Loading... () ] all announced 2011 spins.

Meanwhile, what was once the $100 billion-plus market cap Tyco [TYC Loading... () ] empire underwent an epic dismantling in two separate spin deals. Thursday, Murphy Oil [MUR Loading... () ] CEO David Wood said he's considering a spin of the company's downstream businesses, a positive sign for 2012 industry divestitures.

Across all sectors, corporate divestitures were a bright spot for deal makers, rising 165 percent from 2011 and representing 5 percent of all deals activity, according to Dealogic.

In the U.S., divestitures also didn't slow in the second half of the year, as companies spun assets to bolster shares, streamline their strategy and raise capital.

The moves may have launched many stocks higher, but it's to be seen whether they will they will generate long-term outperformance.

For instance, the Claymore Beacon Spin-Off [CSD Loading... () ] exchange-traded fund recently of spun off entities showed mixed results, underperforming Dow Jones Industrial Average and gaining on Standard & Poor's 500 Index.

Ascent Capital [ASCMA Loading... () ], Altisource Portfolio Solutions [ASPS Loading... () ], Phillip Morris [PM Loading... () ], Brookfield Infrastructure [BIP Loading... () ], Lorillard [LO Loading... () ] and HSN [HSNI Loading... () ] were the largest holdings in the portfolio as of Jan. 25, according to its Web site.

Meanwhile, at the parent company spin moves represent a snapshot in time. Those who own shares prior to a spin gain a stake in any new company, while new investors only get a claim on the earnings prospects of what remains at the parent.

For some, it means that spin-offs actually can rid companies of a growth asset, or one that provides balance sheet or cyclical stability.

Here's a look at five asset spins that raised capital while jettisoning a needed asset. With the spin dance is expected to continue in 2012, a look at past deals shows that some companies may view spin-off decisions with regret.

5. McDonald's 2006 Chipotle Spin

In 1998, as the U.S. fast food pioneer McDonald's [MCD Loading... () ] was rolling out the Chicken McGrill and Crispy Chicken sandwiches to complement its burger supremacy, the company made a bold diversification into new foods by taking a minority stake in a popular Denver-based taco and burrito chain called Chipotle Mexican Grill [CMG Loading... () ].

By 2001, McDonald's had a controlling interest in Chipotle Mexican Grill and was investing heavily in its U.S. growth.

In September 2005, after a more than thirty-fold store expansion, newly minted McDonald's Chief Executive Jim Skinner decided to spin Chipotle Mexican Grill, preferring to focus on customer and profit growth at McDonald's, which celebrated its 50th anniversary earlier that year.

In the IPO of over 20 percent of its stake in Chipotle on Jan. 25, McDonald's raised $173.4 million, pricing shares at $22 a share, according to Thomson Financial.

"Since we made our initial investment in 1998, Chipotle has grown from 16 restaurants in the Denver area to a strong and popular restaurant concept with more than 500 locations throughout the U.S.," said Skinner of the rationale to spin Chipotle.

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As CEO, Skinner decided that wrenching out comparable store sales growth would be key to growing the then-struggling McDonald's business, which was suffering an image problems from Morgan Spurlock's Super Size Me documentary on fast food.

"Just 1 percent growth in McDonald's global comparable sales translates to approximately $100 million in additional operating profit for the company and a substantial cash flow increase for all of our McDonald's owner/operators," said Skinner.

When Chipotle shares hit stock markets the next day, investors bought relentlessly into the company's growth prospects, more than doubling shares to over $44 and leading to one of the biggest IPO rallies since just after the burst of the dotcom bubble in 2001.

At the time, Chipotle had opened roughly 500 stores and had $627 million in annual sales and $37.7 million in profit.

In a follow-on offering that May, McDonald's sold an additional $250 million worth of shares priced at over $60 and arranged a tax-free share exchange to fully divest its stake later that October.

McDonald's and Chipotle shares have both soared since the spin as the companies followed different growth trajectories and were able to successfully navigate the financial crisis.

After opening its first store in China in 1990 and bringing drive through to the region in 2005, McDonald's opened its 1000th store in the fast growing region in 2008.

Its sales have grown nearly 30% to $27 billion since 2006, while profits have grown nearly 60% on a near doubling of revenue in the Asia Pacific, Middle East and African regions, proving many doubters wrong.

Meanwhile, Chipotle more than doubled its stores in the U.S. and Canada, growing sales by over 175 percent and profits by over 400 percent to a forecasted $2.3 billion in sales and $216 million in 2011 profits, respectively, according to consensus estimates compiled by Bloomberg.

For stock investors there's been a clear winner among the two, however. While McDonald's shares have risen 175 percent since spinning Chipotle, it has paled in comparison to Chipotle's share gains of 767 percent.

While both companies have fared well since the spin, making it an exemplar of the belief that freed assets can create growth all around, Chipotle would rival emerging markets as McDonald's fastest-growing business for sales and profit, potentially lifting shares significantly above their already near record-high levels.

4. Merck's 2003 Medco Spin

In 1993, Merck [MRK Loading... () ], then the world's largest pharmaceuticals company, cut a rare vertical merger buying a controlling stake in Medco Containment Services for $6 billion, allowing it to make and distribute prescription drugs directly to consumers.

As a result of the deal, Merck was then able to market its drugs to consumers via Medco's then-33 million-strong customer base, managing over 95 million annual prescriptions for government employees, corporations and unions.

"This is an aggressive but carefully considered strategic move to keep Merck close to patients and customers in a rapidly changing and highly competitive health-care market," said Merck Chief Executive P. Roy Vagelos of the deal.

The deal faced intense immediate resistance because of the possibility that the tie-up would increase prescription prices.

When the merger was cut the Philadelphia Inquirer quoted an aide for Sen. David Pryor (D.-Ark.), a key advocate for low drug-prices as saying that "this is a step backward for health-care reform. The whole foundation of health-care reform is competition; this takes a competitor out of the market."

Nevertheless, the merger closed. Less than decade later, Merck relented to conflict over the deal, spinning a now rebranded Medco Health Solutions [MHS Loading... () ] for little gain in a 2003 tax-free dividend to shareholders.

"Medco's ownership by Merck has been a lightning rod for criticism, although there's been nothing inappropriate," said Medco's Chairman David Snow to USA Today at the time of the spin.

During the tie-up Medco's sales grew astronomically, while Merck saw comparatively minor gains and had its drugs lead surpassed by Pfizer [PFE Loading... () ] and GlaxoSmithKline [GSK Loading... () ].

Merck's revenue more than doubled to $22.4 billion by the end of the merger, while Medco grew revenue to $34.2 billion, a more than tenfold increase. It meant that by the time of the spin, 63 percent of overall revenue came from Medco. However, low Medco profit margins dragged on Merck's overall share pricess, leading to a radical shift in strategy.

After the spin, which gave shareholders one Medco share for every eight Merck shares, both companies stock prices and earnings abilities diverged.

Medco's shares have gained over 500 percent since its August 2003 initial public offering, while Merck's shares have fallen by nearly a quarter. As a result, even with Medco's subsequent stock gain, Merck shareholders have seen losses since the spin, when excluding dividend payments.

Since the spin, Medco's sales are expected to have nearly doubled to $68.5 billion, while profits are expected to triple to $1.5 billion according to 2011 earnings estimates compiled by Bloomberg.

Meanwhile, Merck sales have grown at the same rate, while profits have doubled, on the heels of big merger activity.

With the looming threat of its drugs like Vasotec and Prinivil for hypertension, Mevacor for high cholesterol and Prilosec for ulcers going generic, the company relied on osteoporosis treatment drug Fosamax and asthma treatment Singulair.

As that drug headed the way of going generic in 2009, Merck pulled the trigger on one of the biggest mergers in Monday history, buying Schering-Plough for $41.3 billion in May 2009. The merger gave it Schering products with longer patent lives like allergy spray Nasonex as well as a popular suntan lotion brand in Coppertone, an insole-maker in Dr. Scholl's and a stronger international presence.

However, with it came legal battles.

In 2009, Merck and Schering-Plough settled a suit for cholesterol treatment Vytorin after allegations of withholding key clinical trial results. Merck also pleaded guilty to a criminal charge with the U.S. Department of Justice for its marketing of painkiller Vioxx before it was pulled in 2004.

In July 2011, Express Scripts [ESRX Loading... () ] announced a deal to buy Medco for $29 billion in a deal to combine two of the largest pharmacy benefits managers in the U.S. However, the deal is facing antitrust scrutiny, which jeopardizes its outcome.

Currently, Medco's stock is more than 10 percent below the $71.36 a share purchase price, signaling investor uncertainty over the deal, or an easy stock return if it's completed.

3. Barnes & Noble's 2001 Babbage's Blunder

In October 1999, Barnes & Noble [BKS Loading... () ] bought Babbage's Etc., a videogame retailer partly owned by chairman Leonard Riggio, for $215 million in cash, paving the way for a lucrative and fast-growing venture into videogame sales.

The deal to buy Babbage's Etc. and a later decision to spin the re-branded business was one of the four deals that rewrote Barnes & Noble's history as it struggles to compete against Amazon.com [AMZN Loading... () ] in print and tablet-based book sales.

The move was a push into growing videogame market as console makers Sony [SNE Loading... () ], Microsoft [MSFT Loading... () ] and Nintendo[NTDOY Loading... () ] and software makers like Electronic Arts [EA Loading... () ] drove gaming innovation. It was also expected to help barnesandnoble.com keep pace with rival Amazon by offering an expanded suite of PC and console games.

At the time of the deal, Babbage's Etc. operated 495 brick and mortar stores and an online games selling business and was valued at 5.1 times estimated 1999 Ebitda .

To make the opportunistic purchase, Barnes & Noble drew on a $850 million line of credit. Babbage's Etc. was then rebranded to the recognizable GameStop [GME Loading... () ] trademark, which saw stores and sales surge after the acquisition.

By August 2001, GameStop nearly doubled its videogame-selling stores and was preparing for an initial public offering spinoff after quarterly sales surged 63 percent to $206 million. With the IPO, Barnes & Noble expected to reduce its debt and recapitalize the gaming retailer.

After shelving the IPO until February 2002, GameStop shares made an impressive debut on the New York Stock Exchange, rising 12 percent to close at $20.10, raising $325 million for Barnes & Noble.

Since the IPO, the two companies have seen their fates diverge.

GameStop shares surged over 145 percent since its initial public offering, even after a post-recession share slump and dimming sales outlook, while Barnes & Noble has seen its shares cut by more than half.

GameStop has been profitable in every quarter as a public company, with sales and profits growing in 2010. Meanwhile, Barnes & Noble lost money in 2011, and is tied to a strategy of plowing cash into its Nook business to drive sales growth as its brick and mortar stores lag.

In January, the nation's largest in-store bookseller saw its shares plummet and fall within reach of all-time lows after it said it was considering a spin of its Nook tablet business and also cutting its overall 2012 outlook for sales and earnings, leading to an earnings per share loss expectation as high as $1.40.

The share drop put into question the wisdom of the spin after the unit saw sales jump over 40 percent in this year's nine-week holiday season compared with 2010.

In recent earnings, Barnes & Noble ascribed a glowing outlook to its Nook-fueled BN.com business, which it expects to grow as much as 50 percent in 2012, while its brick and mortar and Barnes & Noble College businesses achieve flat sales.

Other Barnes & Noble deals such as the rejection of a May 2011 bid by John Malone-run Liberty Media [LMCA Loading... () ] to buy the bookstore for $1.02 billion, or $17 a share — a 20 percent premium to shares at the time — also panned.

CONTINUED: The Top Two Spin-offs

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Companies:TheStreet.com

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