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Shareholders’ Equity Analysis
- Are the stockholders really
owners?
- Do you know where your
equity dollars are?
- How comprehensive income
can affect stock values
- Watch out for your Dividends
- Stock splits, dividends
and reverse splits
- Spin-offs, tracking stocks
and determining new cost
basis
- Stock rights give board of
directors more power then
they are entitled to
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Spin-offs, tracking stocks and determining new cost basis
Historically, public companies have found it
beneficial to distribute, to their shareholders, businesses that deviate
from core activities. The two main methods used to restructure an
organization are discussed below:
Spin-offs – This involves distributing
a subsidiary or division to the shareholders, which usually does not have
synergies with the core parent company. Usually, these are non-core and/or
under-performing business units. It’s an easy way for a company to reduce
cost and rid itself of low profit margin segments, thus improving the
consolidated margins on the remaining businesses. Additionally, by shedding
the weaker divisions, it refocuses management’s attention on its main
business. The resulting higher margin business may make favorable
impressions on the stock analysts and investment bankers, resulting in
higher valuations for the parent company.
The newly created spin-off may also benefit by not
being constrained by the bureaucracy of a larger parent company, and might
become more entrepreneurial and profitable. When the shares are initially
distributed as a new public company, however, these issues may not meet the
portfolio criteria of many investors, and may be sold, sometimes regardless
of price. One may also wind up with only a small number of shares, and the
securities might becomes more of a nuisance to hold rather than valuable
assets. Additionally, stock analysts can only cover a dozen or so stocks at
one time, many times leaving these companies with no coverage. This
culmination of events leads to initial selling pressure on the stock. The
investment strategy should be to wait until the selling subsides, and the
price stabilizes at its fair value, before making a decision.
Additionally, be aware of those instances where
management loads up the spin-off with debt, making it difficult for the new
company to make a fair return for its new investors.
There are also a few situations where a company’s mix
of businesses is confusing to the investment community, resulting in a total
market value that is lower than the sum of the individual businesses. This
is the same issue as the drawbacks of the conglomerates in the 1960’s.
Normally, in these situations, the parent company can either have a full or
partial distribution of certain divisions or subsidiaries.
Partial spin-offs - A partial distribution
behaves as a short-term tracking stock or “carve-out.” The company will have
an initial 15% to 20% IPO of the valuable subsidiary. Usually, the proceeds
will go to the parent company, and at some subsequent date the remaining
portion of the subsidiary will be distributed to the shareholders. Here the
market results are mixed. In some situations, the market values these
businesses at a premium; the future short-term upside may be limited for
investors.
The investment landscape includes many companies like
Kraft Foods or KBR, which are great franchises, but may take a decade before
their shareholders substantially profit. In other cases, such as when Eli
Lilly spun-off Guidant in 1994, the market for pacemakers, leads and
implanted defibrillators was uncertain. Thus, the initial shares were
reasonably valued, rewarding both the initial investors, and the IPO
investors, many times over. Guidant became a darling of Wall Street and
eventually was purchased by Boston Scientific.
The investment strategy for partial spin-offs is more
difficult. Often, the hype of the IPO inflates demand, pushing the stock
price up, and leaving investors in a quandary.
Tracking stocks – These are stock investments
where a parent company is raising equity by selling a minority interest in
one of its highly visible divisions to the public. The valuation ratios of
the tracking stocks are usually higher then those of the parent company, in
effect advertising to the investment community that the parent has a prized
asset. Additionally, because of the higher valuation of the tracking stock,
it can be used as currency to make acquisitions, further enhancing the
prospects of both companies. The tracking stock can also be offered to
management as a form of sweat equity, as an incentive to conserve cash while
motivating their employees. The new investors only have an interest in the
public tracking stock.
The board of directors of the parent company usually
governs both companies. In many cases, the shareholders of the tracking
stock have fewer rights than the parent company’s shares, as well as fewer
votes per share. The parent will still control the subsidiary. Additionally,
such administrative functions as SEC reporting, taxes, etc. are usually
handled by the parent company. The parent company may cross-collateralize
the debt of the tracking stock, keeping interest expense low, as well as
establish tax-sharing agreements to fully utilize tax benefits.
Many tracking stocks have high growth potential and
investor appeal, and are issued at high valuations. Parent companies can
take advantage of this appeal by pushing the negative aspects of growth to
the tracking stock. Often, growth requires up-front cash outflows, initial
losses, as well as higher debt levels and capital needs. These negative
attributes can be transferred to the tracking stock, thereby improving the
fundamentals of the core parent company, sometimes at the expense of the
tracking stock, while also controlling the future profits of the tracking
stock.
In most situations, the strategy is to invest in the
company that ultimately controls the profits of the tracking stock. Most
business professionals tend to hold onto their most valuable assets and sell
their least attractive or most overvalued businesses first. These securities
are relatively new to the investment community, and extreme caution should
be exercised when purchasing them.
Determining new cost basis – Spin-offs are the
result of a parent company breaking off a division into a separate public
company, resulting in two separate stocks. This distribution is normally
tax-free until either of the companies is sold. When sold, the investor is
required to file a capital gain or loss schedule D with the annual 1040 tax
return to the IRS. The complicated part for schedule D, is how to allocate
the original cost basis between the two securities.
Generally, one’s cost basis is allocated based on the
fair market value of the combined securities when first traded. Normally,
the company will supply this information to its shareholders. Additionally,
the investor’s original purchase date is used for both securities. Below is
an illustration:
A person purchased 50 shares of an oil company 50
years ago, at $20 per share. Six 2 for 1 stock splits later, the stock is
now trading at $20 per share. At that time, the company spins off its
industrial machine tool division and the investor now receives an additional
320 shares of the new industrial machine tool company, initially trading at
$10 per share. Here is the cost basis distribution:
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#
Of Shares |
FMV
at Split Date |
Allocation
of
Cost |
New Cost
Per Share |
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Oil Co. |
3,200
|
$64,000 |
$
952.38 |
.30 |
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Spin -off
|
320
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$
3,200 |
$
47.62 |
.15 |
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$67,200 |
$1,000.00 |
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This is a typical example of a buy and hold strategy.
The rate of return, in the above example, excluding the dividends, is only
approximately 8.78% per year.
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