Break-up boom: How investors can win betting on the growing stock spinoff trend on Wall Street

Published Sat, Mar 26 20228:03 AM EDTUpdated Wed, Apr 13 20228:49 AM EDT

Christina Cheddar Berk @in/christina-cheddar-berk-b864404/

The scene is set on Wall Street for an increase in companies looking to break up their companies: Growth is expected to slow. Borrowing costs are on the rise. And activists are making their opinions heard. By Goldman Sachs' count, U.S. companies announced 34 new spinoffs last year, with 17 deals making it to completion. Right now, more than 20 deals are in the pipeline — with several set to close in the coming weeks — and even more rumored to be on horizon. All in, last year's spinoffs tallied $112 billion in value, nearly double the average of the previous five years, Goldman said in a research report published in early February. Examples include Dell's spin off of cloud-software firm VMware and DTE Energy's decision to become a pure-play utility company by separating from the natural gas pipeline and storage operations that formed DT Midstream . While spinning off businesses is a well-worn page from the corporate playbook, the results can be hit-and-miss for investors. Many cite the 2020 spinoff of Carrier from United Technologies as a winning example. But last year's crop didn't fare nearly as well. VMware's record, for example, has been pretty poor. As of Thursday's market close, the stock has lost 13% since its Nov. 2, 2021 debut. DT Midstream, meanwhile, has gained 29% since it began trading on July 1, 2021. There are strategies that can help investors make bets that are more likely to succeed. A review by Goldman analysts in early February of 361 transactions completed since 1999 suggests that the typical spinoff will outperform its parent company by 4 percentage points during the one-year period after it's completed. But the average doesn't show how big the performance gap can be. Fifty-five percent of the spun out companies outperformed their parents, according to Goldman's analysis. Properly placed bets can yield big returns. Almost 10% of the spun-out companies topped a parent company's performance by more than 70 percentage points, the report said. On the flip side, 7% lagged by more than 70 percentage points, it said. Wolfe Research analyst Chris Senyek said his review of spinoff performance also shows uneven results, with big winners and losers. He also warns returns have fallen for more recent spinoffs, which he said have been "lower quality" than older counterparts. "It's been a little bit about ... this market environment," Senyek said, in an interview. "Just in general, because smaller mid-cap companies ... have underperformed, and then some are more highly levered ... [and] some are just in more cyclical businesses." Senyek said the most significant factors investors should consider are size, valuation, leverage, sector and margin performance. Specifically, he's found that companies with pricier valuations have performed better, a trend he said may be a reflection of the quality of the company. "Buying cheap spinoffs is not necessarily the ticket to success," Senyek said. Instead, it's looking for lower leverage and reasonable valuations. For the purposes of his research, Senyek drew a line at stocks that were trading at 10 times enterprise value to EBITDA to signify a lofty or lower price. Outside of the company's sector Another observation he made was that spinoffs that operate in a different sector from the parent company tend to outperform those that do not. "So if an industrial company is spinning off a consumer company that would tend to do better than if an industrial company were spinning off another industrial company, because, I think, that goes back to it being a proxy for the rationale," he said. Senyek explained that it can make more sense for a company to spin off a business in a different sector, while if the companies both operate in the same sector, it may be a case where the parent is looking to shed underperforming assets. An promising example Senyek cited is Colfax . On April 4, it is planning to separate an industrial business that makes equipment for welding and gas control instruments, mainly for the oil and gas industry, from its medical technology unit, which is a leader in orthopedic devices. Colfax, itself a spinoff from Danaher , had built up the medtech business to diversify away from the cyclical oil and gas industry. Colfax CEO Matt Trerotola will take the helm of the medtech company, which is nearing $2 billion in annual revenue, and rename it Enovis. The industrial business will then be known as ESAB, and it will be led by Colfax EVP Shyam Kambeyanda. XPO says investors crave simplicity Contract logistics business GXO Logistics was another spinoff stock that did well last year. Shares have gained 19% since beginning to trade on Aug. 2, 2021, giving it a market value of more than $8 billion. Shedding GXO made XPO Logistics a pure-play transportation company, but it's not done shaking up its operations. In early March, XPO said it would split its less-than-truckload business, which moves cargoes smaller than a full truckload, often for industrial customers, from its asset-light brokerage division. That unit supplies last-mile delivery and other services. Finally, it said it planned to sell or publicly list its European operations and its intermodal operations. The latter was sold on Friday for $710 million . It took more than a decade for CEO Brad Jacobs to cobble the company together, acquisition by acquisition. But Jacobs has said he anticipates that there is one set of investors who would want to invest an asset-based LTL business and a separate group who prefers its tech-focused truck brokerage. By operating together, the company's stock is being short-changed. "Investors value simplicity in evaluating a business," said Matt Fassler, chief strategy officer at XPO, in an interview. He said GXO was not being "adequately recognized" by the market, but becoming independent can correct that. XPO's breakup was contemplated as part of strategic review that began prior to the Covid pandemic, but was terminated amid the uncertainty created by the initial wave of the health crisis. Eventually, the company restarted the process, beginning with GXO, which is now the biggest standalone player in the highly fragmented contract logistics industry. "It had enormous tailwinds at its back with e-commerce and outsourcing ... a blue-chip client list, and long-term contracts," Fassler said. "And we didn't think this cocktail was adequately appreciated by Wall Street because it represented less than 40% of our total business." "We had the expectation that when you have a larger company with different business lines and you have the opportunity to create one or more smaller companies that are more focused, and more fit for purpose, with a management team that's focused on only doing one thing, you can drive outsized growth," he said. And that is what XPO plans to do by the end of this year. As of Thursday's market close, XPO has a market value of $8.74 billion, and its stock is down 1.6% year to date. Profits at its less-than-truckload business rose to $618 million last year on revenue of $4.1 billion. In 2020, it earned $487 million on revenue of $8.9 billion. Meanwhile, the freight brokerage division earned $282 million on revenue of $8.9 billion, up from $21 million in profits on revenue of $6.6 billion in 2020. The case for a breakup XPO executives have cited many common reasons for splitting up its business: the ability for management to have a sharper focus, the benefits of dedicated capital allocation and the ability to have one stock that tracks the business that can be used to incentivize employees. The deal also will help XPO reduce debt, which also could help bring in new investors. XPO has carried more debt than its publicly traded peers, and Fassler said this has been an obstacle to some investors owning its stock. After the transactions are completed, it expects to have have an investment grade credit rating. According Jonathan Boyar, president of Boyar Research, investors need to be very focused on the reasons why a company is seeking to split up. He likes companies that are forced to break-up due to clear regulatory hurdles. "That's a great opportunity," he said. "Because it's not like they're spinning out a problem." Boyar's research has shown that spinoffs that outperform in the their first year tend to continue to outperform, while those that did badly in their first year, continue to do so. "It's important for someone who's doing a screen for spinouts and they see one that's down 50% in the first year and that might look like a bargain. Historically, that's not necessarily a great place to fish," he said. Follow the management Boyar said he pays close attention to where a company's management is going or whether the parent company is retaining a stake in the spun-off business. It can be a bullish indicator if the CEO is going to lead the new business or become its chairman, Boyar said. He cited IAC/Interactivecorp as an example of a company that is known for producing well-preforming spinoffs such as Match and Expedia . Boyar anticipates it will spin off its digital publishing business, acquired Meredith, in a year or two. Dotdash acquired Meredith's National Media group last year in a bid to boost its commerce operations. Since then, it has been cutting some of Meredith's print editions. "They are really good at spinning off companies and giving them the room to do well," Boyar said. "...They are trying to get the companies strong enough to be able to leave the nest, and they won't spin it off until that's the case." The model IAC has established is that spinoffs are another way to create value for shareholders because the company typically maintains a stake in the spun out entity. Part of that stems from IAC Chairman Barry Diller and CEO Joey Levin's large stake in the company. But even IAC stumbles. Last year, Vimeo became the 11th public company spun out of IAC. But on its own, the video software service has not performed well. As of Thursday's close, it is down 72% since it was spun off on May 25, 2021. Timing the investment Boyar said the biggest gains can be made on the parent company when an investor already owns the stock on the day of the announcement. The potential for a spin-fueled pop is one reason he likes Scotts Miracle-Gro . He anticipates that the company will eventually look to spin off its Hawthorne business, which sells lighting, nutrients and grow media to cannabis producers. Boyar said there are really good reasons for Scotts to spin off Hawthorne. For one, even though Scotts isn't directly handling cannabis plants, the association with the industry could be enough for some investors to avoid Scotts shares. But investors who like cannabis stocks might not be interested in owning a more mature consumer products business. Then, there is the matter of Hawthorne's growth as the cannabis industry takes off. "The cannabis company is going to need a dedicated currency in order to do acquisitions," Boyar said. Senyek's analysis suggests that the best entry point is own the parent company one month prior to the break-up. The group he looked at had non-annualized relative returns of 3.3%. However, post-break-up the parent company underperformed on a relative basis during the six months post-spin. Spinoffs can see a lot of selling pressure in the months that follow the deal as the investor base adjusts. Many times a parent company's shareholders don't want to own the stock, or can't because it's not in the index the investor needs to own. Analysts also say that many times these deals can lead to additional acquisitions. Senyek said his research shows that 19% of spinoffs and 14% of parent companies are acquired within five years of separation. "The median time to acquisition is 3.6 and 2.2 years for Spin and Parent companies respectively," he wrote. So the conditions are set for a break-up boom on Wall Street. Investors will need to do their homework to find the spinoffs that pay off over the long run. "It's an interesting place to be because you can find these great, great bargains, but you can also get into a lot of trouble," Boyar said.

Josephine Flood | CNBC

By Goldman Sachs' count, U.S. companies announced 34 new spinoffs last year, with 17 deals making it to completion. Right now, more than 20 deals are in the pipeline — with several set to close in the coming weeks — and even more rumored to be on horizon.