Time Warner and the Spinoff Surge
The financial press observes correctly that Time Warner’s recently announced cable spinoff reflects a more general surge in corporate spinoffs in 2008. Why would this be happening now? Like everything else these days, it results from the credit crunch.
The first reason is the collapse of private equity. Before August 2007, if a public company even hinted about splitting off an attractive division, the division was immediately swallowed up by Blackstone, Cerberus or their peers. This is now impossible, because private equity firms cannot obtain cheap debt financing for acquisitions.
The second reason is slightly more complicated. Most stocks are priced as a multiple of their earnings per share. Many such stocks have been going down in recent months, for three reasons:
- Corporate earnings have stalled as consumers and businesses feel the pinch of reduced borrowing power.
- Pessimistic investors will no longer pay so large a multiple of earnings as before.
- Stocks compete with bonds. The credit crunch has increased the amount you can earn from a bond investment, making stock yields less attractive by comparison.
How does this result in spinoffs? Because corporate management and investors constantly seek ways to increase share value. If the normal solution — increased profits — doesn’t work, they look for other ways.
Spinoffs fill the bill nicely, because they address two of the three issues above:
- Corporate earnings have been shown to grow faster post-spinoff. This is believed to result from better management incentives: if you increase profits as a division head within a company, you get a pat on the back, but if you do it as CEO of an independent firm, you get millions of dollars in incentive pay.
- Investors have been shown to pay higher earnings multiples for more easily understandable businesses. Spinoffs increase understandability. For example, Time Warner is a complicated conglomerate, but Time Warner Cable is simply a cable company.
Activist investors are increasingly aware of the spinoff effect, and have been pushing for breakups at well-known companies. For example, Nelson Peltz appears to have been instrumental in spinoffs Cadbury Schweppes in 2008 and Wendy’s in 2006; Carl Icahn pushed for the spinoffs at Time Warner and Motorola in 2008.
There are two barriers that prevent a real flood of spinoffs.
- Some conglomerates tend to receive higher debt ratings than would their component businesses. As a result, and again because of the credit crunch, some spinoffs may be prevented by the inability to issue bonds as an independent company. For example, there was some question whether the Dr. Pepper Snapple spinoff from Cadbury several weeks ago would be delayed by debt issuance problems.
- The compliance costs of the Sarbanes-Oxley Act of 2002 make it prohibitively expensive for companies under about $100m market capitalization to go public. This would not affect larger companies like Time Warner Cable.
Both these barriers may be removed, as corporate debt issuance settles down and the SEC provides an exemption (proposed) for smaller firms from the most onerous parts of Sarbox compliance.