A spin-off, as is well known, is the separation of a subsidiary from the parent company by distribution of shares as dividends to shareholders of the parent company, or, alternatively, by selling shares to the public in an IPO. In both cases, it means the spin-off company changing from a private company into a public one, whose shares are traded on the stock exchange, similar to the common IPO process.
In his excellent book, “You can be a stock market genius”, Joel Greenblatt explains the main points that must be examined when looking at spin-off shares in a simple manner, and also presents a number of case studies in which he has invested. This is an excellent book that could open the door for investors who wish to enter the field. But still, since any spinoff need to be analyzed and evaluate in depth, it is necessary to carefully study the entire picture as it appears in the prospectus that is published by the parent company prior to the separation. In the case of US companies, the prospectus published to the US Securities and Exchange Commission (SEC) is called a 10-12B form.
Similar to the financial reports of public companies, the separation document opens with a description of its activity – what products or services it provides, who are its customers, and who are the major competitors. The company’s financial statements from several years back are than presented, with the addition of pro forma statements, which are supposed to reflect what the current financial report of the company will be, once it is independent. This is the major financial data with which it is possible to assess the potential of the company, the financial risk inherent in its activities, and of course, the fair price of its shares.
Another point worth giving a focus to is who the managers of the spin-off are, and what is their compensation plan. In many cases, senior officials from the parent company move on to manage the spin-off company, whose activity is often significantly smaller compared to that of the parent company. Why would the CEO of a major company give up a central role and a high salary and move on to manage a small, anonymous company? There is only one reason for this: He believes he could turn the small company into a large one, and receive a notable financial reward for it. A specification regarding the compensation policy can be found in the separation document.
It is important to note that the separation document, as is the case with the IPO prospectus, is not a simple document – usually is deals with an unfamiliar, small company, with limited financial data, so the analysis of a spin-off requires not only knowledge of reading financial statements, but expertise dedicated to the field. This is the reason only few investors look at spin-off companies that are just starting out, causing them to be traded too low. Investors who do choose to examine the spin-offs, can detect that pricing distortion and earn big when the shares return to their fair price.