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: