Snapple, the once-trendy iced tea drink, has turned out to be a bit of a downer for Quaker Oats. Since Quaker acquired it for $1.7 bn in 1994, the brand has lost both money and market share. So, as might be expected in the mid-90s, Quaker is considering disposing of it by spinning Snapple off into a separate entity.
If Snapple is in trouble with giant Quaker Oats behind it, and if no potential acquirer wants it at what Quaker would consider a reasonable price, how much chance does the bottled-tea maker have for survival as a stand-alone company?
A lot, if the experts are right. If it follows the typical pattern of spin-offs, Snapple’s stock price would perform far better than that of the average Nasdaq or S&P 500 company. Yet few challenges are as daunting for an investor relations professional as heading the IR department of a newly spun-off company, the experts say.
Problem One: The IRO – like most of top management – is relatively unschooled in the job. He or she may have little, if any, direct IR experience. The IR officer’s background most likely was in finance or communications, rarely both.
Problem Two: Unless the spin-off is as celebrated as that of a Lucent Technology, the market will be unfamiliar with its name.
Problem Three: The company is likely to be highly leveraged and its credit rating below investment grade or only a notch or two above it.
Problem Four: Most of the company’s initial investors are likely to dump the stock. The profile of the spin-off is usually very different from its parent’s, and institutional investors that hold the parent company are unlikely to want to hold the stock. This is especially true of index investors, who will sell out of a spin-off straight away unless it is big enough to meet their criteria. But there can be other reasons. US investors are not expected to hold their new Imperial Tobacco shares, for example, when these are spun off by Hanson, because of the environment for tobacco stocks in the US.
Sounds like a nightmare? Not according to Barbara Goodstein who follows spin-offs for New York investment bank Rothschild Inc. She has produced a study showing that things may not be so bad; they might even be wonderful. According to Goodstein’s study the stock of the average company spun off between January 1992 and the end of June 1995 rose 40.5 per cent during the first year of operations; that compares to 19.2 per cent for the average Nasdaq company and 12.4 per cent for the S&P 500.
Goodstein and others, such as J Randall Woolridge, professor of finance at Pennsylvania State’s Smeal College of Business Administration, partially attribute the success of spin-offs to management’s enthusiasm and ability to put its ideas into practice. ‘How many times have you thought to yourself, Boy, if only I were running this place?’ asks Goodstein.
Another reason for these companies’ stocks doing so well is that they are undervalued when first issued. The spin-offs’ initial challenges seem so great that no-one is particularly eager to buy their stock.
There are several types of spin-off. In the most typical, a parent company carves out businesses from its own operations and puts them into a new subsidiary. The subsidiary may be sold to a buyer or turned into a corporation and the stock given to the parent’s existing shareholders – whether they want it or not. A current shareholder of the parent may get, say, one share of the new company for every ten held in the old one. Immediately after the shares are distributed, the market determines their price.
Other spin-offs take the form of IPOs, in which the parent may retain a stake, as Tenneco did when it spun off Case. Here the initial price is set by the underwriters and the market then reacts to that pricing.
Even among the same types of spin-off – a give-away or an IPO – experts stress that there are many different motivations for the move. Peter B Doyle, analyst for The Spin-Off Report1, cites several reasons why divisions are let loose to stand on their own.
Some are spun off because they are problematic and are dragging down the parents’ earnings; some because they are fast-growing and the parents want to capitalise on their value; some to meet regulatory requirements; and some to resolve market conflicts in which potentially big customers don’t want to buy goods from an entity whose parent is a competitor.
The stock price of many spin-offs is helped by the possibility that the company will be taken over again once its management gets its act together.’Spin-offs are five times more likely to be acquired than an S&P industrial stock,’ says Doyle. But he notes that ‘generally it takes time – you have to hang onto it three years for that to happen, to get that extra return.’
But what is life like for the person in charge of IR for a spin-off? David Gould, head of IR for 360 Communications Co gives us some idea. 360, a cellular phone company, was spun off by Sprint Cellular last May, mainly to avoid regulatory conflicts. But 360 had to pay a hefty $1.5 bn ‘dividend’ to its former parent, and had to borrow to do it. As a result, like many other spin-offs, 360 started off deeply in debt. Unlike others, it had a clearly viable business and was already generating substantial amounts of cash. And it started out with a giant market capital of more than $2.5 bn.
Although 360’s stock price has not soared from the $22.25 where it began, it withstood the market declines of mid-July and was selling at $24.25 on July 19 – up 9 per cent – and around $24 in late August.
Softly-spoken Gould fits the profile of the top IR person in a spin-off. He’s had little experience in IR, coming from the financial side of Sprint. He is familiar with the operations and engineering aspects of the company, however, because he has been in the cellular industry since 1988. His intimate knowledge of finance ‘helps with the sell-side analysts and investors in building discounted cashflow analysis,’ he says.
Gould is shy on the communications side, but ‘over the past couple of months I’ve been speaking with so many investors on a one-on-one basis, or in small meetings, my confidence level has risen greatly,’ he says.
To deal with some of the nitty gritty aspects of IR, Gould says 360 uses ‘New York consulting group, the Carson Group.’ Carson, he says, is used primarily for stockwatch functions. Gould also praises Niri, which he describes as ‘very helpful,’ adding that he has been ‘shocked’ by the amount of free advice professionals in the industry have given him.
Because ‘we’re the second largest stand-alone cellular company after Airtouch,’ Gould says he doesn’t have trouble setting up analyst meetings. About eight or nine sell-side firms follow 360. A a result, Gould says he’s focusing on large institutional shareholders for the time being. His greatest challenge is being a small IR department consisting of just himself and one assistant. ‘I’d like to return all phone calls the same day, but I can’t,’ he comments.
Sprint has a very different shareholder base from its offspring’s. 360, like its competitors, Pactel and Airtouch – which also were spin-offs – is experiencing a big turnover in shareholders. ‘Historically, the holders of Sprint have been the traditional value investor, looking for higher dividend yields and lower p/e ratios,’ says Gould. ‘We of course, have a very high p/e – it’s in the 50s right now.’ Gould predicts that the high p/e will drop quickly, as profits rise.
The situation is very different at Crown Vantage, a paper company that was spun off by James River Corp. Unlike 360 Communications, which has a top position in a rapidly growing industry, it was less clear to investors that Crown Vantage would thrive. James River spun off Crown Vantage because the new subsidiary’s operations had been dragging down profitability. When Crown Vantage was spun off in September, 1995, its stock initially sold at about $22 a share. As of late July, it was trading at $10.75 – less than half its initial level.
As soon as it was spun off, Crown Vantage paid a ‘dividend’ of about $500 mn to James River. That was financed through a $250 mn bond offering with a coupon of 11 per cent, and a $292 mn credit facility from a group of banks. Virtually all the company’s assets were put up as collateral for the bank loan. Crown Vantage also owed James River $100 mn in pay-in-kind notes, bearing 11.75 per cent interest. These would be paid off with paper and other goods produced by the spin-off.
Whether Crown Vantage will make it depends heavily on conditions within the paper industry. As the initial prospectus warned: ‘The successful operation of the company (Crown Vantage) after the spin-off is subject to a number of risks, including the cyclical nature of the paper industry; the high degree of competition in the industry; the significant leverage resulting from the financings; the company’s substantial debt service requirements and net losses in 1993 and 1994.’
Good call. The company lost $12 mn in 1993, $10 mn in 1994. Back in 1992, it lost $65 mn. It earned $38 mn in the first half of 1995, largely reflecting soaring prices for the paper it produces. Based on Crown Vantage’s costs, including those from its financings, the company’s ‘earnings would have been insufficient to cover its fixed charges by $83.7 mn in 1994,’ the prospectus says.
James River may actually compete with Crown Vantage in some product areas, as the prospectus points out. It acknowledges that James River is ‘privy’ to Crown Vantage’s ‘pricing and cost structure, technical information and know-how, customer lists, corporate strategy and certain other competitive information.’ Fortunately for Crown Vantage, only about 10 per cent of its revenues come from products that will compete with those of its former parent.
Making the outlook even worse, James River bequeathed its liabilities for judgments against it for environmental problems to Crown Vantage. James River, the prospectus points out, had been identified as a ‘potentially responsible party under federal and state laws regarding waste disposal at about 17 sites in the US.’
So Crown Vantage is spun off and in walks poor Katie Cutler to head the new company’s IR function. Clearly intelligent, Cutler has been thrust into a difficult job in an area in which she has no experience. Seeking basic knowledge of the field, last July she attended Niri’s San Francisco conference for small cap companies. Before joining Crown, she headed external affairs for James River’s paper business. But she hadn’t been involved in IR at Crown Vantage’s parent and wasn’t even part of the corporate staff.
Cutler attributes the downward pressure on the stock to technical factors, such as Crown Vantage’s vastly different profile from that of James River. ‘Institutions and funds have their own guidelines for investing and we may not fall within their guidelines as a new and different kind of company,’ she says. For one thing, James River trades on the New York Stock Exchange, Crown Vantage on Nasdaq.
Crown Vantage may be a special case. But Smeal College’s Woolridge has found that the primary benefit to the stock price of spin-offs and their parents has to do with the likelihood of their being acquired rather than with their actual performance.
Like Rothschild’s Goodstein, Woolridge concludes that the stocks of spin-offs – and their parents – do extremely well for the first two or three years after the restructuring, but that the unusually high levels of stock price increase apply only to those parents and spin-offs that are acquired by other companies. ‘When the firms involved in takeovers are removed from our sample, adjusted returns are positive but not significantly different from zero over most intervals.’
In other words, Woolridge’s findings raise questions about the widespread belief – his included – that spun-off companies are better managed than they were as divisions or subsidiaries. The key seems to be that their greater value stems largely from becoming pure plays in a particular industry.
Rothschild’s Goodstein, while holding to her optimism about spin-offs, acknowledges that some don’t thrive. ‘If all of them did well, why would I have a job?’ asks the spin-off analyst.
