Spin-Offs vs. Sale of Subsidiaries

Which One is Better for Your Portfolio?

A reader recently wrote me asking about the difference between a tax-free spin off and a sale of division or subsidiary. “What’s the difference and which is better for me as a stockholder?” they wanted to know. The answer is important for your portfolio and can help you evaluate the shareholder-friendliness of management.

Why Spin-Offs Occur

Let's say you owned 5,000 shares of stock in a Power & Light company. For some reason, this particular utility also owns a tiny chain of jewelry stores (this sort of thing happens - insurance company AIG owns a ski resort!). The Power & Light CEO talks to the Board of Directors and says, "This has nothing to do with our business - we can't focus on generating electricity if we have to monitor inventory levels at the jewelry store. We can either sell it or spin it off the stockholders but I’m tired of dealing with the subsidiary."

If the utility company decided to sell the subsidiary, it could go to someone like Warren Buffett, who would typically buy the business for cash. The problem is, the IRS will charge the utility company a capital gains tax on the sale of the business if it has appreciated in value; if it has been part of the corporation for very long, it has certainly increased in value over the holding period. With most companies in the 35% tax bracket, it means that the management will only receive about 65% of what the subsidiary is “worth” on an after-tax basis.

If, however, the utility company decided to issue a tax free spin off to the stockholders (this is what Sprint Nextel is doing with the local phone business), it would instead incorporate the jewelry store as its own, stand-alone business, give it a new CEO, its own Board of Directors, corporate offices, etc. It would print up stock certificates and distribute them to the existing stockholders of the Power & Light company on a pro-rata basis; in other words, if you owned 5% of the utility company stock, you would receive 5% of the total stock in the new jewelry store.

Benefits of Spin-Offs vs. Sale of Subsidiaries

Why should you, as a stockholder, prefer the tax free spin-off? Here are three reasons:

1. There are generally no tax consequences because you haven’t received anything new – you always owned 5% of the jewelry store chain, now it is just a separate company.
2. The jewelry store chain will be able to focus on what is best for it. Before, it probably couldn't convince the CEO of the utility company to let it borrow money and expand across the United States. Now, it only has to focus on what maximizing its own capital structure. It can sell stock, issue bonds, borrow money from the bank, etc.
3. The utility company is free from distraction and doesn't have to worry about a business that doesn't fit within its strategic long-term goals.

Most of the time, spin-offs really are win-win situations for everyone involved.