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An essential tool for unlocking corporate value, spin-offs have rebounded in popularity.
Roy Harris, CFO.com | US
September 1, 2001
Two years ago, when Eastman Chemical Co. first considered a restructuring to resuscitate its sagging stock price, a spin-off wasn't even on the radar screen. "Company loyalty was very much in vogue, and there was a sense that we could make a reorganization work in the form we were in," says senior vice president and CFO James Rogers.
But a spin-off quickly emerged as the sensible way to go. For one thing, separating its two main businesses, specialty chemicals and polyethylene terephthalate (PET) plastics, made organizational sense. A rush of competitors into the production of PET resins had turned it into a commodity-style operation, with its own marketing and capital- raising needs, and with a different investor appeal. Also, the company was intimately familiar with the spin-off form: Eastman Chemical itself was born in a spin seven years ago, when Eastman Kodak Co. divested itself of a range of nonphotographic businesses by issuing stock in a new company to Kodak shareholders.
Indeed, Eastman Chemical not only understood the appeal of avoiding taxes through a qualifying spin-off, but it also appreciated the fact that unlike the taxable outright sale of a unit, "there's no other [buying] party you have to work with," as Rogers points out. "The spin is in your control, as long as you handle things well with the Internal Revenue Service." All these factors led Eastman to announce last February that it would split into two new companies via a spin-off (more on this deal below).
During the long bull market, spin-offs became common. They were prized as a tax-free way to squeeze cash out of hot dot-coms, or to package unattractive assets for investors seemingly poised to buy anything. Today, though, the spin-off once again is viewed as a basic tool for allowing noncore businesses to grow by giving them a separate identity and attracting investors.
As a type of divestiture, in fact, the spin-off has been quite resilient over the past 18 months, spiking last year at a near-record volume of $92.3 billion. Through June 30, companies had spun off eight companies of more than $500 million in size, worth a total of $43.6 billion.
"To the extent that spin-offs are consummated to unleash value, they become even more popular in down markets," says Gregory Falk, a mergers- and-acquisitions tax partner at Pricewaterhouse-Coopers LLP. Companies hope, of course, that the purer plays resulting from a spin-off will fare better with investors than one stock representing the combined businesses. Also, the tax benefits of a spin-off "ring true in a strong or a weak stock market," adds Falk. Those benefits are avoidance of the 35 percent federal tax on the unit being divested, as well as of the income tax liability for stockholders that receive the qualified spun- off shares.
Meanwhile, the popularity of one species of spin-off, the carve-out, has suffered somewhat. That's because carve-outs make shares available through an initial public offering as opposed to a shareholder dividend, and therefore depend on a healthy IPO market.
THE TWO "S" WORDS
Experts see little reason for a letup in spin-offs, in part because companies will be looking for ways to unravel the tangles brought on by the merger binge of the 1990s. J. Randall Woolridge, a finance professor at Pennsylvania State University, says that many companies like to predict the synergy that will be achieved through an acquisition, but "the other 'S' word that they don't talk about is spin- off. And when one 'S' word doesn't work out, the other one does."
Correcting a merger miscalculation was at the root of a recently completed spin by Equifax Inc. The Atlanta-based information services concern, with annual revenues of about $1.2 billion, announced last October that it would shed its $780 million payment services business, now called Certegy Inc. When Equifax acquired the business in 1988, "the thought had been that each company could incorporate the other's businesses, but they were two very distinct businesses, with few operating synergies," says Equifax executive vice president and CFO Phil Mazzilli. Now, Equifax has learned that "smaller companies can move more quickly, and each of the companies will grow faster separately than they would together."
The biggest boost from a spin-off may well stem from the psychological lift it gives employees of the newly divided companies, says Woolridge: "There's this tremendous entrepreneurial spirit, especially in the higher-growth units." Executives are energized by the prospect of stock options and other compensation geared to operations of the reorganized units. And operationally, spun-off companies can be a lot easier to manage. "There's much less having to play politics for capital," notes Woolridge.
Investors also like it when companies announce spin-offs, according to a recent report by J.P. Morgan Securities Inc. The report says parent firms making such divestiture plans outperform the market by around 5 percent, on average, with big spin-offs producing larger share- price increases. The spun-off outfits themselves, in the first 18 months of independent operation, outperform the market by an average of more than 10 percent, says the report.
Eastman Chemical, in Kingsport, Tennessee, was in the doldrums early in 1999 when it decided to review its options for increasing shareholder value. The stock price languished in the mid-40s, where it was when Kodak spun it off, and "there was a sense that we'd gone through six or seven years and hadn't created the lasting value we needed," says Rogers. Yet the company was enthusiastic about the future of its specialty and commodity businesses, and believed Wall Street wasn't giving it credit for this potential dual upswing.
As executives considered alternatives, it soon became apparent that the company's structure was working against it. Managers often had to choose between capital spending on the $4 billion chemicals business-- making coatings, adhesives, inks, and specialty polymers and plastics-- and spending on the $2.5 billion PET side, which also produced container plastics and acetate fibers. Dollars for one were seen as dollars stolen from the other.
The company studied several scenarios, including a taxable outright sale of various businesses, but found the spin-off to be easily the most value creating, because of the tax advantages. Gradually, executives realized that the promising prospects being identified for both lines of business were pluses. "When you launched these companies, you wanted to do it when there was plenty of upside left when you did your road show," explains Rogers.
Management also looked to see how complicated it might be to break specialty chemicals from PET. It discovered there could be "a clean asset split" between the two, says Rogers, because for the most part, specialty plants and employees were physically separated from the PET operation. "You could take a map and with a highlighter draw lines around the plants that would stay or go," he says.
In the spin-off as planned, current Eastman Chemical stockholders will receive shares in a second company through a tax-free stock dividend around year-end. Technically, the smaller PET operation will be the surviving entity, although it will receive a new name that hasn't yet been selected. The specialty-chemicals company will become Eastman Co., and the Eastman Chemical name will disappear. "Investors don't care who spins who, and neither do the employees," comments Eastman Chemical treasurer Al Wargo, who will become vice president, CFO, and treasurer of the PET company.
The trick, of course, is to design the new companies so they will succeed on their own. That means avoiding the temptation to transfer huge amounts of debt to the spun-off unit, for example. "Our intent is for both these companies to win as strong an investment-grade rating as we can get for them," says Wargo, noting that Eastman Chemical now maintains a triple-B-plus rating on its $1.5 billion of public debt. The spin-off was first announced on February 5, and details such as a new debt structure and the size of an expected write-off will be announced closer to the deal's completion, now envisioned for the fourth quarter of this year.
His new company will miss the positive associations with the old Eastman name, says Wargo, "but I think the pride will come from our actions, not names. What's important is how we treat our employees going forward."
Roy Harris (email@example.com) is a senior editor ofCFO.