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Spin-sanity

Can't sell that ill-fitting subsidiary or launch an IPO? The old tax-free spin-off may still be a good bet.
Kris Frieswick, CFO Magazine
September 1, 2002

With the current market so dreadful for both initial public offerings and the outright sale of operations, what do you do these days if you need to cut a subsidiary loose?

As is often the case in market slumps, tax-free spin-offs have grown as a percentage of all divestitures being done.

These distributions to shareholders may have only limited allure in normal times; experts recognize them as among the least-profitable types of divestiture. Still, in this economy they may be about the only port in the storm for a company with that particular need. As a result, many companies have developed tax-free spin-off plans to make the best of the situation.

Take Allergan Inc., of Irvine, California, which in June spun off Advanced Medical Optics (AMO), a division that makes contact lens supplies and ophthalmic surgery products. Late last year, says Allergan CFO Eric Brandt, the parent decided to separate AMO in order to focus on its pharmaceuticals business. "We have been transitioning to a pharmaceutical company," he says. "It was clear that the [AMO] business wasn't a part of the strategy," even though its $540 million in sales was a third of Allergan's annual volume. "The best thing to do was give it its own future." (Examine tax efficiency at Allergan and other companies discussed in this article with the CFO PeerMetrix interactive scorecards.)

Other methods for granting AMO that independent future--an IPO or other initiative based on investor interest--had been severely impaired by the September 11 terrorist attacks and Wall Street's ensuing plunge. "It was our view that it would be best for us to take control of the situation directly," says Brandt. "That way we wouldn't be subject to the vagaries of the market."

A Decline in Altruism?
In the traditional tax-free spin-off, of course, a parent company distributes all the stock of a subsidiary to the parent's existing holders in the form of a dividend. To win tax-free treatment from the Internal Revenue Service, the company must meet several specific criteria: most important, the parent must own at least 80 percent of the voting stock of the subsidiary. Proposed spin-offs follow one of two scenarios.

If a subsidiary already exists as a stand-alone business, with completely separate assets and debt, it typically takes on additional bank debt to pay off the parent with a "midnight dividend" in cash just before the spin-off occurs. The parent, which is entitled to recoup the unit's basis, in this case may use the cash any way it sees fit.

More common, though, are deals like Allergan's spin-off of AMO, involving a parent that shares assets and debt with a division. In such cases the parent first must form a subsidiary through a so-called Type D reorganization. In that process, the parent has a chance to both structure the subsidiary's debt and adjust its own balance sheet.

When the subsidiary makes dividend payments to the parent in this situation, the parent is obligated either to distribute the cash to its own shareholders or to use it to pay off creditors. Any other use makes the payment taxable.

As in most spin-off deals, Allergan used the opportunity to improve its own balance sheet. Before being spun off, says Brandt, AMO raised $300 million in financing, using $275 million to pay Allergan, which in turn used the money to lower its debt-equity ratio from 81 percent to about 70 percent.

"We didn't give them more than their pro-rata percent of our debt," says Brandt, who notes that the ratio of AMO debt to earnings before interest, taxes, depreciation, and amortization was about 4-to-1, compared with about a 2.5-to-1 EBITDA ratio at Allergan after the spin. (Debt-to-EBITDA is a more relevant ratio for AMO, says Brandt.) "In some cases, companies put a lot more debt on their subs, but we didn't give them more debt than they could handle," he says. "We did it this way so they could have a much better future outside of our hands."

While the stated goal of most parents is to strike such a balance, allowing subsidiaries to succeed on their own, few companies are really so considerate, suggests Robert Willens, managing director at Lehman Brothers in New York. "There's no longer any altruism" when a company spins a subsidiary, he says. "The real action is in finding tax-free ways to extract as much value from a sub as possible."

Going too far, of course, can doom a young public company, hamstring an executive team built from the former parent's ranks, and anger the shareholders that the two companies have in common.

Mellow Yellow
While divestitures obviously can make sense for lots of operational and financial reasons, the spin-off's special ability as a means to those ends is that it can lower the parent's debt--even in dismal economic climates, when other types of divestitures won't fly. "It makes the stakeholders feel like management is doing something," says J. Randall Woolridge, a professor of finance at The Pennsylvania State University's Smeal College of Business.


The actual number of tax-free spin-offs hasn't increased, as deal-making in general remains sharply off. There were 26 spins completed last year, a dozen fewer than in 2000, according to the Chicago-based research firm Spin-Off Advisors LLC.

But as a percentage of all announced divestitures of subsidiaries--including through carve-outs and tracking stocks--tax-free spin-offs rose to 67 percent in 2001 from 58 percent the previous year. (In a carve-out, the parent sells a portion of its subsidiary to the public, while a tracking stock reflects the performance of a division, but is generally nonvoting.) Through the first half of this year, the 15 completed spin-offs represented a smaller percentage of total divestitures than in the previous-year period.

Experts expect the proportion to be higher by year-end, however. Carve-outs are expected to slow considerably, with many companies forced to withdraw them because of a lack of interest in the marketplace.

A few companies have slowed their pursuit of a spin-off because of market conditions. Yellow Corp., a broad-based transportation services provider based in Overland Park, Kansas, decided about 18 months ago to spin off its regional SCS Transportation division when market and financial indicators were appropriate.

Why is Yellow divesting? The company "is spinning off the regionals to its shareholders because it believes each entity will be better able to extend its strategies," says CFO Donald G. Barger Jr. After a spin-off, "investors will be able to see a clearer story, because the regional businesses are growing faster than the longer haul, while longer haul has a better return on capital."

Yellow is still talking about the amount of debt to be transferred to the subsidiary, he says, but right now he expects the new company to have about $130 million of debt and a debt-to-EBITDA ratio of less than 2-to-1. Before its recent equity offering, the debt-to-EBITDA ratio of the parent was less than that as well.

The Debt-Swap Twist
Some companies have developed creative ways to extract tax-free cash from a subsidiary without burdening it with additional debt. Merck & Co.'s recent plan to spin off its Medco Health Solutions Inc. unit was originally to have begun with an IPO of nearly 20 percent of Medco in a deal with a debt-swap twist.

Merck planned to transfer the Medco stake to IPO underwriters J.P. Morgan Chase & Co. and Goldman Sachs, which in exchange would swap back to Merck an amount of Merck debt that both banks had purchased in the open market in advance of the deal. Had Merck received cash from the underwriters, it would have been taxed on the proceeds. (Merck recently withdrew the registration for the IPO, but presumably plans to proceed at some point with its spin-off.)

AT&T recently spun off its wireless division and executed a similar equity-for-debt swap, as did Lucent Technologies with its Agere Systems Inc. subsidiary. "We're seeing a lot more action in this area," says Lehman Brothers's Willens.

Kris Frieswick is a staff writer at CFO.




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