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CNBC EXPLAINS

Five Short-Sighted Stock Spin-offs

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

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By: Antoine Gara
Analyst

2. Morgan Stanley's 2007 Discover Financial Drama

With a boardroom drama for his ouster escalating, Morgan Stanley [MS Loading... () ] Chief Executive Philip Purcell began to pull for a 2005 spin of the investment bank's credit card unit Discover Financial Services [DFS Loading... () ], which he built at Dean Witter prior to the two firms' 1997 merger.

Purcell called for the spin instead of a previously rumored sale to help reestablish Morgan Stanley's investment banking pedigree after top-tier rivals Goldman Sachs [GS Loading... () ] and Merrill Lynch, along with scrappier rivals Bear Stearns and Lehman Brothers gained market share.

While Purcell said a spin would maximize Discover's value, it would also help Morgan Stanley "[further] intensify our focus on the high return growth opportunities within our integrated securities businesses."

Heading the vaunted investment bank was an unusual coup for Purcell. After working as a consultant at McKinsey & Co., Purcell entered banking by way of Sears Roebuck when the retailer bought brokerage Dean Witter Reynolds in 1981.

Hired to head Dean Witter, Purcell then founded the Discover Card in 1986, which grew to be one of the largest U.S. credit card issuers. At the same time, Purcell freed Dean Witter and its Discover business through a 1993 IPO. Four years later, the firm merged with Morgan Stanley.

After the merger, Purcell took Morgan Stanley's reins and forced out President John Mack, who went on to head Credit Suisse First Boston. With growing dissatisfaction of the post-merger culture, a faction of Morgan's board pulled for Purcell's ouster, leading to his 2005 resignation.

Mack returned triumphantly to Morgan Stanley to complete the Discover spinoff, which was first floated by Purcell as he faced pressure to resign. In June 2007, over two years after the spin proposal was made by Purcell, Morgan Stanley's board agreed to complete the spinoff.

Echoing Purcell's words, CEO Mack said the move would maximize Discover's growth, while allowing Morgan Stanley to focus on its institutional securities unit that had earned $21.1 billion in revenue, driving a record $7.5 billion 2006 profit.

After the spin, the shares values and growth prospects of the two businesses diverged tremendously. Only months later, blips of an oncoming credit crunch emerged and a little over a year later, Morgan Stanley faced demise.

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Since its June 2007 IPO, Discover's shares have shed nearly 4 percent, while Morgan Stanley's shares have plummeted nearly 75 percent.

With the onset of the financial crisis and a souring of mortgage securities, Morgan Stanley, like its Wall Street peers, took billions in writedowns, losing a record $3.5 billion in the fourth quarter of 2007.

As quarterly losses continued in 2008, the firm managed to survive the crisis that felled three of its peers by selling a 20 percent stake to Mitsubishi UFJ [MTU Loading... () ]for $9 billion in October 2008.

A year later, John Mack stepped down as CEO, leading to the nomination of James Gorman, an executive with a brokerage background, who pulled the bank back from risky trading businesses.

In retrospect, the spin may have been a strategic misstep ahead of the crisis. Discover Financials' earnings and balance sheet proved to be a source of stability.

Just over a year after the spin, Morgan Stanley had to convert to a bank holding company to access the Federal Reserve's discount window as interbank lending dried in the days after the bankruptcy of Lehman Brothers.

At that time, Discover Bank — an arm of Discover Financial — had over $28 billion in deposits, giving the unit a stable funding source and $10.2 billion in cash to weather the crsis. During the crisis, Discover Financial also saw minimal losses.

Meanwhile, Discover Financial has grown revenue and profit at a faster rate, stabilizing shares. Revenue has grown 42 percent and profits have doubled to $2.2 billion at Discover Financial since 2006, as of the year ended in December.

In contrast, Morgan Stanley's revenue has grown just over 8 percent and profits, fueled by accounting gains on the value of the firms debt, are still well below pre-crisis levels.

To move away from trading businesses that are now confined by new regulations, Morgan Stanley cut a brokerage venture with Citigroup [C Loading... () ] in 2009, buying a 51 percent stake into a joint venture called Morgan Stanley Smith Barney.

In 2012, the firm will be able to begin accumulating shares, putting it on a path for full ownership by 2014.

1. Circuit City's 2002 CarMax Spin of Doom

Initially a top secret development called "Project X" in 1991, big-box electronics retailer Circuit City opened its first CarMax [KMX Loading... () ] store in 1993 and increased the used car dealership business over nearly a decade, until it decided to spin the unit to realize its value and focus on the increasingly competitive electronics retail market.

Speaking in the mantra of divestitures, Circuit City's chief executive at the time, Alan McCollough, said that a spin would benefit growth and share prices.

"CarMax has produced solid sales and earnings growth during the past two years and is now able to support its growth with no assistance from Circuit City," said McCollough in a move that would "enable the investment community to analyze each business on its own merits." The move was also part of a restructuring plan as Circuit City's earnings estimates for the quarter would fall far short of expectations.

After announcing the spin and an earnings cut, Circuit City's shares dropped by over 30 percent. In October 2002, Circuit City spun CarMax in a dividend to shareholders At the time, CarMax operated 33 used car superstores and 18 new car franchises, in 12 states.

Since then, CarMax has tripled its stores and generated record sales and profits in 2011. In that time span Circuit City saw its store count go from 603 to zero when the company filed for bankruptcy in October 2008 after a credit crunch led to tighter credit terms from vendors and an economic crisis shelved consumer spending.

The 59-year-old electronics retailer initially filed Chapter 11 reorganization but a little over a year later the company converted the bankruptcy into a Chapter 7 liquidation after being unable to find a buyer, spurring the sale of its inventory and the closure of its stores.

While the credit crunch drained Circuit City's liquidity and a recession made its electronics sales slow, the company's brick and mortar business model was imperiled by the growing shift of consumer spending online with retailers like Amazon.

At CarMax the recession and a growing adoption of Web-based shopping had a far different impact. As auto spenders retrenched, they flocked to CarMax's used cars, keeping the company profitable through the recession.

Meanwhile, auto buying didn't face the same threat from the Web as big box retailers, with consumers generally still making purchases in showrooms. In 2011, CarMax earned a record $380 million in profit on its highest ever sales of $8.9 billion. Meanwhile, its shares have more than doubled since the spin.

While it's unclear whether Circuit City had the financial strength to hold onto CarMax, the unit was an earnings hedge to both the economic cycle and the threat of online retailers.

Ultimately, the spin was part of a corporate strategy that led to Circuit City's dissolution, while CarMax has since thrived.

Additional News: Facebook May File for IPO By Wednesday: Report

Additional Views: Biggest Year Ever for Spin-Offs

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TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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