A single company – one you’re probably familiar with – sold all three seemingly unrelated products. A few years ago, Sara Lee Corp (SLE ) – maker of frozen (yet tasty) pies and cakes – owned hundreds of brands, many of which made no sense.
For instance, the frozen cheesecake manufacturer was the sole owner of Coach handbags and Hanes underwear. These two subsidiaries obviously didn’t make much sense to the company. That’s why – during two separate transactions – Sara Lee’s management and board of directors divested them through a process known as a spinoff.
Spinoffs are common in the business world. They can present smart investors with huge opportunities and sometimes, less fortunate investors with even larger losses. Spinoffs are usually as simple as they sound – a parent company decides it can do without one of its business. So, the subsidiary is spun off onto its own.
There are four basic reasons for a parent to spinoff one of its “children”:
Unrelated Businesses – many times, companies like Sara Lee own certain subsidiaries – like Coach and Hanes – they have no business owning. This happens often in conglomerates when a certain product takes off and is held back by the organization of the parent company.
Tax Benefits – taxes can be burdensome and confusing. But every once in a while, the mathematicians and financial wizards find a loophole to save on taxes and preserve shareholder value. Occasionally, it takes a spinoff to do it.
Refocusing – oftentimes, a large company will take a look at its operations and find one of its businesses lagging behind, which inevitably puts a strain on management to fix the problem. The best solution is to spinoff this business so management of the parent company can get back to growing profitable businesses. This often benefits both the parent and “child” company.
Pinching Off Debt – some spinoffs are created to unload debt and other burdensome liabilities. This is where many unfortunate investors take enormous losses. As you can imagine, a company created out of a need to unload debt is doomed from the start.
It’s important to decipher between the four reasons because if you find the right one, you stand to make colossal gains. Let’s look back at our top example…
As we noted, Sara Lee’s situation fits the first mold – unrelated businesses. Spinning off a perfectly capable business creates earning potential neither the parent nor the “child” even realized.
Sara Lee first spun off Coach in 2000. Almost immediately, the newly formed Coach Inc (COH) began its own marketing program. This turned into an enormous success and unrealized profit potential came to light, which shot shares straight up over the next six years. As you can see in the chart below, Coach outperformed its former parent by more than 2,000% to negative 15%.
The same thing happen in round two, when Sara Lee spun off Hanesbrand Inc (NYSE:HBI) in 2006. Although the gains were not as fantastic, Hanes shareholders watch their shares double as Sara Lee shares stayed flat:
Of course, not all spinoffs work this way. It takes serious studying and an ear to the ground to find out exactly what’s going on.
Many times, when parents spinoff businesses, they keep it quiet. If the media gets a hold of it, shares can crash artificially, or spike prematurely. And, as we mentioned, many spinoffs negatively affect shareholders.
One recent example is InterActiveCorp’s (IACI ) spinoff of Ticketmaster Entertainment Inc (TKTM ) . When Ticketmaster was sent on its way, InterActiveCorp left it with a parting gift of about $750 million in debt, just as the credit crisis began to peak this summer. Shares of Ticketmaster, inevitably collapsed under this weight, falling more than 80 %:
Of course, you have to use your best judgment when you discover a spinoff. You’ll have to make the decision on why you think the parent company spun it off.
More than not, however, buying spinoffs when they’re fresh is a pretty good idea. According to Chris Mayer of Mayer’s Special Situations – a newsletter focused on spinoffs and other unique investments – “spinoffs beat their industry peers and outperformed the S&P 500 Index by about 10% per year in their first three years of existence.”
Those numbers account for both spin offs that lead to gains and those that lead to losses. Obviously, this is something to look into.
If you are lucky enough, and have the right inside knowledge, you can easily take advantage of the next Coach spinoff and leave the next Ticketmaster alone.
December 18, 2008