Spinning in circles?
Spin-offs and carve-outs: The latest thinking on these forms of financial engineering
Norm Alster, illustration by Art Valero -- EDN, July 1, 2002
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Worried about the mounting debt that's got a choke-hold on your balance sheet? Impatient that your corporate growth rate is being dragged down by one steady, but unspectacular, division? Or is there an executive VP across the hall who's really beginning to get on your nerves?
If you are a corporate chieftain that answered yes to any of these questions, you may already be considering an asset spin-off. Perhaps it even looks like a no-brainer. Spin-offs are tax-advantaged maneuvers that generally involve two steps. First, in what's called an IPO carve-out, a parent firm raises cash and establishes a market valuation for one of its businesses by selling a minority stake in that unit to the public. Some months later, the parent distributes the shares of the new company that it still holds to its own shareholders—a deal that creates more shareholder value than an asset sale since it's generally tax exempt. Highly successful deals of recent years include AT&T Corp.'s spin off of Lucent Technologies Inc., Hewlett-Packard Co.'s spin off of Agilent Technologies Inc. and Microsoft Corp.'s IPO carve-out of Expedia Inc., which actually quadrupled in share price the day of its debut, but that was back in the salad days of 1999.
Indeed, if you are contemplating a spin-off you probably know that several studies have shown that the stocks of spin-offs and their parents tend to do well. One 1998 Pennsylvania State University study, for example, found that spin-off stocks outperformed industry peers and market indices by 10% a year in their first three years. Spin-off parents outperformed by about 6% a year. Another study, co-authored by Hemang Desai, an assistant professor at the Cox School of Business at Southern Methodist University in Dallas, found that spin-offs and their parents actually enjoyed improved operational performance, as well as higher stock prices. Spin-offs that separate unrelated businesses, resulting in two more sharply focused firms, perform especially well, he found.
That's why Professor Desai was so surprised back in January when he picked up his Wall Street Journal. Tyco International Ltd., the Bermuda-based conglomerate, whose crazy quilt of businesses includes circuit board connectors, undersea fiber optic cables and burglar alarm systems, had announced on January 22 that it would spin off not just one but four of its major business units. Tyco's stock tanked on the news, plunging 18 points in a week to lose over one-third of its value. Among investor concerns was the suspicion that Tyco was spinning off assets to head off a looming cash crunch. But Desai, expecting the usual spin-off bump in share price, was jolted by the market's brutal reaction to Tyco's plan. "This is exactly the opposite of what I would have expected," he says. It also was not what Tyco CEO L. Dennis Kozlowski expected. In April, Kozlowski announced Tyco, having already shed more than half its market value since the January announcement, was abandoning its spin-off plans, which he now described as a "mistake." (Kozlowski, facing sales tax evasion charges along with shaken investor confidence, resigned in early June.)
Tyco is but one of several recent high-profile spin-off mistakes that have left investors burned and wary. Much ballyhooed deals like Lucent's spin-off of optical components maker Agere Systems and Williams Companies' spin-off of Williams Communications, its optical fiber network, have tanked, leaving embittered shareholders. Now, as bear market investors in technology shun all but the best deals, some planned spin-offs have been put on hold. And firms such as The Walt Disney Co., Burbank, CA, and Fairfield, CT-based General Electric Co., seeing spun-off units trade at an embarrassing fraction of their offering price, actually have applied reverse spin, buying these units back in what are termed spin-ins. Meanwhile, the overall pace of spin-off activity has slowed. Whereas 63 spin-offs and carve-outs were done in 2000, last year there were just 37, according to Spin-Off Advisors LLC, a Chicago-based research and consulting firm.
Could it be that investors are closing the book on spin-offs, a well-thumbed favorite in the manual of financial engineering? Not quite.
Properly done, spin-offs remain a viable option for enhancing shareholder value, and in such industries as energy and defense spin-off activity remains strong. But as with most successful financial engineering ploys, spin-offs began to push the envelope as more and more firms and their investment bankers rushed to cash in. Once the tech bubble burst, the most aggressively structured spin-offs, which often repaired the parent's balance sheet at the expense of the progeny's, began to unravel. Now, with investors more selective, corporate managers who may once have looked at spinning as easy-money financial engineering, must think twice or risk an embarrassing spin-off flameout. Poorly conceived deals can lead to massive shareholder lawsuits, bitter conflict between bondholders and equity holders and a tumbling IPO carve-out stock that can also bring down the parent, which, after all, remains majority shareholder.
Motive matters
But tech carve-outs and spin-offs can still work, say experts, if they are done for the right motives. These include the desire by a parent to realize a higher stock multiple for a hidden high-growth business. Or the need to let that business operate more independently. Or the desire to focus the parent on a core business, and allow the unrelated subsidiary to do the same.
"I think the best use of a carve-out has to do with the parent believing it's not getting credit for hidden jewels," says John Hand, professor and chairman of the accounting facility at the University of North Carolina's Kenan Flagler Business School. And Michael Boublik, managing director with Morgan Stanley in New York, argues that spin-offs make sense because they can produce improved management: "A spin-off can achieve simplification for the parent company, allowing management to focus on the core business," says Boublik.
But a whiff of less pure motives can scare off investors, producing wounded-duck trajectories for both parent and spin-off stocks. Among the suspect motives: The parent's desperate need for capital; or its desire to unload debt or slough off a unit whose fundamentals may have peaked. Sometimes, as in the case of Tyco, a jittery post-Enron market simply is suspicious of a company that outlines a business plan so transparently based on financial engineering. "You have to look at the strategic reasons for a spin-off. Sometimes spin-offs are done to provide short-term solutions to long-term problems," notes Mark Minichiello, a principal with Spin-Off Advisors.
Such appears to have been the case with debt-plagued Lucent, when it announced that it would offer its optical components and semiconductor units to the public. From the start, the IPO carve-out of Agere Systems Inc. ran into trouble, with underwriters Morgan Stanley forced to lower the offering price several times, before finally doing the IPO at $6 a share. But apparently, even that was not low enough. Agere shares have recently fetched less than $2.50 (as of mid-June).
What went wrong? The unarguable half of this answer is that Lucent was spinning off a seemingly solid business in markets whose predicted high growth would not materialize. As it turned out, the prospective customers for Agere's optical components and semiconductor business were on the same slippery slope as Agere's divesting parent. "It [the spin-off] was based on optimistic assumptions. They [Lucent and Agere] had provided us with very aggressive projections. They didn't come anywhere near meeting their views," recalls Bruce Hyman, an analyst with Standard & Poor's, a New York-based division of McGraw-Hill Companies.
"The adverse market environment clearly had a negative impact on the optical and IC (integrated circuit) sectors," notes Morgan Stanley's Boublik, who worked on the Lucent-Agere spin-off. "No one expected to see the declines in spending on either the optical systems side or the semiconductor side."
But Agere, some say, was undermined by more than disappointing market conditions. In establishing the new company, a struggling Lucent helped itself in two ways: It raised more than $2 billion in cash by selling Agere shares to the public and also transferred more than $2 billion of its debt to Agere's balance sheet.
"I think the best use of a carve-out has to do with the parent believing it's not getting credit for hidden jewels."
—John Hand, professor and chairman of the accounting facility, University of North Carolina's Kenan Flagler Business School
"Lucent needed the cash," says Minichiello. "They managed to move $2.3 billion off their books and bring in cash. For Lucent, it was great. Agere had the deck stacked against them from the beginning." S&P's Hyman notes that Agere's debt might not have been an issue if it had met its own revenue targets. Still, he allows that while the absolute level of debt might have been bearable, the fact that it was short-term debt, due within a year, weighed on Agere.
But Lucent and other spinners are in uncharted and unregulated territory when they allocate debt to spin-offs. "There are no guidelines. Companies have a lot of discretion," notes SMU's Desai. And in some cases, that discretion is tempting. For one thing, to achieve tax-free status for a spin-off a parent must prove a valid business purpose, apart from simply raising capital. These might include sharpened business focus for the parent and offshoot or enhanced access to credit. So the parent may in fact base a spin-off on its anticipation of a better credit rating after the deal. Hence, the incentive to offload as much debt as possible. Another creative foray into the unregulated frontier of spin-off accounting was at the heart of software maker PeopleSoft Inc.'s 1998 spin off of Momentum Business Applications Inc., a move that allowed Pleasanton, CA-based PeopleSoft to offload some of it's R&D costs to Momentum.
In Agere's case, the combination of high debt and overly optimistic projections proved crippling. With flagging revenues, Agere's debt obligations became ever more onerous. Its debt rating actually was lowered to "junk" status by S&P. Meanwhile, Lucent's announced plans to spin-off the rest of Agere to existing shareholders were held up by Lucent's debtors, who insisted that Lucent achieve positive EBITDA (earnings before interest depreciation taxes and amortization) before it divests its remaining Agere shares. Essentially, the two companies, though split, were hostage to each others sinking fortunes.
Lucent's debt holders relented in April and the Agere spin-off was completed in early June. But such conflicts between equity and debt holders are a lurking risk in spin-offs, especially since there is now some evidence that spin-off shareholders may gain at the expense of bondholders. A new study by Ramesh Rao, a professor of finance at Oklahoma State University in Stillwater, found that while the stocks of spin-off parents tend to rise, their bonds actually fall slightly in value.
Fiber follies
Even more disastrous than the Agere IPO-carveout was Tulsa-based Williams Companies' (WMB) carve-out of Williams Communications Group Inc. (WCG) and its 33,000-mile optical fiber network. Owning globe-girdling fiber capacity seemed like a good idea when broadband was still the rage. That's why this October 1999 deal raised more than $2 billion for parent WMB when WCG, priced at $23, debuted as an IPO. Parent WMB then spun off most of its remaining holdings to shareholders in April 2001. However, fiber capacity was seriously overbuilt and WCG's telco customers found broadband a surprisingly tough sell. Bleeding cash and reeling under a heavy debt load, its stock now trading for pennies, WCG filed for bankruptcy on April 22, 2002. Meanwhile, along with WMB, it is the defendant in more than a dozen class-action lawsuits that claim the two firms misled investors.
One suit filed by three different law firms in U.S. District Court in Oklahoma, charges that "the spin-off of WCG was engineered for the sole purpose of removing WCG's mounting losses and rising expenses from WMB's balance sheet, before it was revealed that these costs and expenses had escalated beyond announced expectations, and before investors came to realize the true impaired condition of WCG." Another suit, filed by Goodkind, Labaton, Rudoff & Sucharow LLP of New York City, charges both firms with failure "to inform investors that WCG's financial future was extremely bleak because WCG was excessively over-leveraged and struggling to pay its debt." In other complaints, WMB is charged with inadequate disclosure of its guarantee of a significant chunk of WCG's debt. A Williams Companies spokesperson declined to comment on the allegations.
Was the Williams spin-off just another example of entrepreneurial accounting in the oil patch? Or was WCG blindsided by an unforeseeable capacity glut in the fiber market, whose amplitude, after all, surprised most everyone? Likely, it was a toxic cocktail of the two. At the very least, it's obvious that WMB did manage to sell a property to the public at its peak value, raising capital and lightening its own debt in the process. But WMB did guarantee some of that debt and will have to cover more than $2 billion in WCG obligations, according to Mark Easterbrook, an analyst in the Dallas office of RBC Capital Markets. Williams also has had to take a $200-million write-down on its WCG investment in the first quarter. One way or another, bad spin-offs come back to bite their parents.
"It [the spin-off] was based on optimistic assumptions. They [Lucent and Agere] had provided us with very aggressive projections. They didn't come anywhere near meeting their views."
—Bruce Hyman, analyst, Standard & Poor's
The Williams and Agere spin-outs were among the biggest of the last year, but smaller-scale carve-outs and spin-offs also have run into problems. In many cases, the new firms have been victims of bad timing. Riverstone Networks, for example, was spun off from Rochester, NH-based Cabletron Systems (now Enterasys Networks) but has shrunk to less than half its offering price as Qwest and other telco customers for its broadband Ethernet gear have slashed capital spending. But even apart from deflating tech markets, now may be a bad time for smaller firms to splinter.
"My sense is smaller companies are having a hard sell," says Mark Burnett, an attorney with Testa, Hurwitz & Thibeault LLP, Boston, who has served as legal counsel on some small spin-offs. Buyers of technology products currently are concerned about the long-term viability of their suppliers, explains Burnett. "Then you split the company and you've got two smaller companies," he notes.
Faced with uncertain business fundamentals and picky equity investors, some firms have chosen to suspend or delay spin-off plans. Santa Clara, CA's Palm Inc., for example, has established PalmSource Inc. as a wholly-owned subsidiary with its own CEO and board in hopes of establishing an operating history that will attract investors once markets improve. Palm has indicated it could attempt an IPO carve-out or outright sale of PalmSource by the end of the year. In all, there are about 40 backlogged deals, including 18 potential carve-outs and 22 potential spin-offs, according Spin-off Advisors' Minichiello.
Innies and outies
Meanwhile, many failed spin-offs, trading at a fraction of their IPO prices, have become an embarrassment to their corporate parents and been spun back in. The Walt Disney Co. (Burbank, CA) bought back its Internet properties for well under a third of their IPO value. General Electric also bought back its NBC Internet spin-off at a discount. Reuters reportedly is considering buying back Instinet, its electronic trading systems carve-out that has lost well over half its value since a May 2001 IPO. Parent firms are not so much bargain-hunting when they buy back shares as they are burying embarrassing financial details a public subsidiary would disclose. And in some cases, explains Jim Rossman, head of equity restructuring at Lehman Brothers in New York, "it's not worth the hassle to have two public companies anymore." Spin-ins and their parents no longer need to maintain separate boards of directors and do multiple SEC filings. Combined, the two also may benefit from unified credit, purchasing and other functions. Of course, all this represents a reversal of the logic that rationalized the independent spin-off in the first place. But, as Rossman says, "Most spin-ins are a signal failure. For the most part, the spin-ins represent the failure of the business model."
But where the spin-off has had some success, any effort to reel it back in can run into problems. Fort Worth, TX-based Sabre Holdings Corp.'s effort to reabsorb the online travel service Travelocity.com Inc. (Fort Worth) sparked suits by Travelocity shareholders contending that Sabre's offered price was inadequate. Sabre then sweetened the offer—actually giving shareholders almost the price they paid for their original IPO shares—and in April reabsorbed Travelocity. McAfee.com Corp. of Sunnyvale, CA, the Net security spin-off from Santa Clara, CA-based Network Associates Inc., is a bit of a rarity—an Internet spin-off that actually has produced earnings. McAfee rejected Network Associates first effort to buy back shares, finally agreeing in April to a sweetened deal. But Network Associates, facing inquiry into its accounting practices, then had to withdraw its bid, which was based on exchanging Network Associates share for McAfee shares. With Network Associates likely to restate earnings for 1999 and/or 2000, it will be difficult to provide McAfee shareholders with needed financial details.
One way parents can sidestep the potential problems of spin-ins: Write language into the original spin-off deal that gives the parent the right to buy back shares at a pre-ordained premium—say 20%—to market price on a given date. But such terms limit the upside for spin-off investors and would likely cap what investors will pay for the original spinout.
For all the failures of the current spin cycle, such deals remain a legitimate strategy for raising capital, creating more focused business operations and improving shareholder returns. Unlike, say, Enronesque debt-erasing partnerships, debt-loaded leveraged buyouts or dot-com IPOs, spin-offs are unlikely to wind up in the towering scrap heap of financial engineering. Indeed, with so many deals now held up but eventually due to get done, Spin-off Advisors' Minichiello expects deal volume to pick up by 20 to 25% this year, following last year's decline of more than 40%. Indeed, he believes the current business slowdown has set the stage for a pick-up in spin-off activities.
"Companies in the last year may have reviewed their corporate structures and made plans to set themselves up for the next cycle of growth," reasons Minichiello. But with tech investors now a wiser and warier lot, deal-makers will have to clean up their act just a bit.
Norm Alster, now freelancing, has worked for Forbes, BusinessWeek and Investor's Business Daily. Send him e-mail atwhicrow@aol.com
