Firms Need Patience to Reap Stock Gains From Break-Ups

If the stock market doesn’t immediately applaud your company’s plan to spin off a major business, don’t panic. There’s a good chance, according to recently disclosed research, that the parent’s share price will show gains over the year following the restructuring announcement – and they could be strong. A study by the London office of Deloitte & Touche is the latest to sound off on the question of whether a multi-business company is worth more broken up than staying intact. Initial effects, the survey concluded on the basis of large split-ups executed during the 1990s, are not encouraging. The parent’s stock tended to drop 2% to 10% on announcement, yet recovered on average as the divorce was being completed. Commenting on the mixed results, the researchers suggested that restructuring companies were not telling a good story about the advantages of a simplified parent and a pure-play subsidiary. Indeed another study by the corporate identity firm of Lippincott & Margulies found a close correlation between the post-split stock performances of spun-off companies and their conscious efforts to position themselves as new entities and reinforce their independence from former parents. Deloitte & Touche started with 1,653 “demergers” – straight spin-offs or equity carve out IPOs that became complete spin-offs – between 1990 and 1999 and then boiled the sample down to the 118 largest divorces, all valued at $2 billion or more. The researchers did not provide average numbers for the 118 survivors nor report how many parents rose in price and how many fell but broke them into clusters or “quartiles” based on long-range performance. The best performers (upper quartile”) averaged price gains of 52% a year from the break-up announcement while the “median” performers climbed 12%. Companies posting declines after one year (“lower quartile”) were off 19% on average (see Exhibit 1). The researchers concluded that the initial hostility could be traced to fears that a valuable asset was being shed too cheaply and that the parent would suffer a loss of scale. Subsequent stock gains, they said, usually could be tied to whether the parent delivered on promised growth. As for the spun-off companies, the best performers scored stock price gains of 46% from IPO or equivalent prices a year after they went public, slightly less than the gains for parents in the same quartile. Median performers were up 13% as pure-play companies and the worst performers suffered declines averaging 13% (see Exhibit 2). Lippincott & Margulies focused on companies spun off in the five years through September 2001 and their stock performances during that time period. A total of 79 newly independent companies that achieved market values of at least $500 million at any point during that span were chosen for the sample. About half the stocks rose and half declined from their original “going public” prices, according to Ken Roberts, CEO of L&M. The gainers, Roberts pointed out, were big-time exponents of specific efforts to establish themselves in the marketplace and new and vigorous competitors that had achieved full independence, which often included adoption of new names. For example, nine out of 10 firms sporting higher share prices communicated a “good terms” relationship with the former parent. That type of image-making exercise, Roberts said, was specifically targeted at delivering a message that the business was not spun off because it was a weak operation or a drag on the parent. In addition, 88% of the companies with higher prices clearly described their business and markets to investors while 83% both articulated an independent vision and declared full independence from the former parent. Of the spun-off companies suffering price declines, 71% communicated that the “parent’s best interest” was the primary driver of the spin. That was a reverse of the image-bolstering steps taken by the firms whose share prices rose and, Roberts suggested, gave the impression that the newly independent firm had something wrong with it. In addition, 61% did not adopt new names and some of them retained names that resembled the former parent’s. A recent study by McKinsey & Co. carried in the June 2002 issue of Mergers & Acquisitions found that equity carve-outs generally did not create value for parent companies unless the subsidiary was completely spun off sometime after the IPO. NYSE Splits Rules For Controlled Subs The New York Stock Exchange’s newly adopted corporate governance rules split the difference on mandating the allocation of independent directors at publicly traded subsidiaries listed on the Big Board. Under the final rules, “controlled companies” are not required to have a majority of independent directors, as are other firms traded on the NYSE. That means that the parent can continue to control the board as well as the voting power at the sub. However, the new NYSE rules tempered the absolute power of parents by requiring that the controlled subs have audit committees of at least three members, all of them independent directors. The rules define a “controlled company” as one in which more than 50% of the voting power is held by an individual, group, or another company. They would cover firms taken public through equity-carve outs, partially spun-off, or formed by the merger of a corporate subsidiary with a freestanding public company. Requirements for an independent audit committee are potentially important because accounting rules allow parents to consolidate results of subs at least 80% owned for both tax and accounting purposes and subs at least 50% owned for financial reports. Many subs are taken public by parents that intend to spin off remaining interests to shareholders in a second step. In complete divorces, the former subs would be required to have independent majorities on their boards. However, some parents retain controlling interests in subs, such as Philip Morris Cos. Inc.’s dominant stake in Kraft Foods Inc.