What Is A Stock Spin Off And How Does It Work?

Stock spin-offs are popular events for shareholders. You owned a share of one stock, and at some point you get two stocks! That sounds like a pretty good deal - because it is!

But what really happens in a stock spin off? Why are companies splitting up? Are there taxes involved? As a shareholder, is this a sign of a good thing, or is it a warning sign that the future might not be as profitable.

With anything in finance, it depends. But let's dive in and see what happens with a stock spin off and whether you should be happy or sad as a shareholder. 

What Happens in a Spin Off?

A spin off is what happens when a piece of a company is disconnected from a parent company and made public as its own little piece. In the past, Kraft (KFT), which makes everything from Mac & Cheese to Capri Sun drinks, has spun off many different pieces of the business.

Most famously, it spun off Post Cereals (POST) to Ralcorp (RAH), which later continued the “hot potato” transaction to spin off Post Cereals once again into its own individual company.

Abbott Laboratories (ABT), which has previously spun off its hospital supply division Hospira (HSP), is now going to spin off its branded drug company, and will call it AbbVie.

And recently, ATT(ATT) spun off Warner Brothers Entertainment (WBD). 

When a Spin Off Happens, Shareholders Usually Receive:

1. Shares in the New Individual Company: When a company is spun off, it can be listed and set up for an IPO on the public market as a standalone enterprise. Investors would then own shares in the parent company as well as a proportional amount of shares in the new standalone company. Shareholders then own stock in the original company minus the spin off as well as stock in the spin off.
2. Shares in a Merger Deal: In the Kraft-Ralcorp deal, shareholders of Kraft received Ralcorp (RAH) shares, which merged with Post Cereals. Of course, investors also retained ownership of their Kraft (KFT) shares.

In short, shareholders own just as much of a company as they did before, but with changes in how the companies are structured (two individual companies vs. one bigger company).

Sometimes, shareholders may receive a little bit of cash as well, if they had a partial share that wasn't able to be converted.

The Benefits Of Stock Spin Offs

Spin offs can create substantial shareholder value for investors. Here's how:

1. Spin offs are almost always tax-free to the parent company, which explains their popularity. The best way to sell a company is to do so is to do it in a way that gets you the highest after-tax price. Spin offs are one such way to accomplish this goal.
2. Wall Street realizes unappreciated value. Some of the cheapest stocks on Wall Street are those that are too complicated to fit the portfolios of most investors. Value investors might like utility stocks, and growth investors might like Angie's List, but who would want to own a combined electric company and a dot com in one stock? Dividing the two helps Wall Street realize the full value of each company as a standalone enterprise.
3. Spin offs are tax free to the investor, too. Spin offs are one of the few dividends that investors do not have to pay taxes on. Taxes are only paid when an investor sells his or her new position in the spun off firm.

Finally, in the 24 months post-spinoff, most companies who complete a spinoff outperform the market.

The Downsides Of Stock Spinoffs

As an investor, there is very rarely anything to lose from a spin off and much to gain. Spin offs are a favorite of activist investors seeking to create a catalyst to push stock prices higher, and companies that want to streamline operations and focus on a single good or service.

However, there are potential downsides. The biggest - you might not want to invest (or believe in) the two individual companies going forward. While most spinoffs do well, some don't.

Second, there is a new trend of spinoffs to avoid lawsuits. Sometimes a company will spinoff a single division that has the potential to lose the bigger company a lot of money due to class-action lawsuits or other issues. This basically makes one healthy company and one toxic company.

Final Thoughts

Stay tuned in to the business news over the next 12 months. As companies reorganize as REITs, divest non-core businesses, and rethink their operations, spin offs will once again be a major part of the day-to-day discourse on Wall Street.

What are your thoughts on company spin-offs?