IPO’s Are Dead. New Companies Via Spinoff Offer Extreme Value in Bear Markets. Here Are 3 Worth Watching.

The term “Initial Public Offering” (IPO) is the process of a private company coming to the public market for the first time and offering shares in the business. It’s the ultimate accolade of a small company that can work its way up from nothing to offer ownership to a wider market whilst raising money in the process. Traditionally, these are exciting new companies to look for and analyze. Depending on the size of the offering, the fanfare around it can be deafening and can make investors excited. This occasionally forces those same investors into purchasing shares in a company that they know very little about and haven’t really carried out full due diligence on. Sometimes this turns out to be a huge mistake.

According to Statista, the equity returns of IPOs were twice as large as those from NASDAQ investments or even SPAC mergers in 2020, but returns were negative in 2021. However, the share of companies that are profitable post-IPO has fallen in recent years.

The share of companies in the United States which were profitable after their IPO has been decreasing year-on-year over the past decade from a peak of 81 percent in 2009. In 2021, only 28 percent of companies were profitable after their IPO. The emergence of SPAC’s (Special Purpose Acquisition Company) was an attempt to fill that void, but in hindsight, the ease in which companies seemingly came to the market through a faster-track and less-regulated process ended up with investors taking greater losses. SPACs launched in 2019 and 2020 have mean returns of -12.3 percent and -34.9 percent over six and 12 months, respectively, following merger announcements.

Why the Decline?

So far this year, tra­di­tional IPO’s have raised only $5.1 billion according to Dealogic. By this point last year, these of­fer­ings raised more than $100 bil­lion.

I am a fan of Efficient Market Hypothesis (EMH). The theory states that share prices reflect all information currently available. The EMH hypothesizes that stocks trade at their fair market value on exchanges and all information available in the share price is factored in. Not really a difficult theory to buy into, considering technology these days. IPO’s are designed to offer you an early entry into a new company (usually with huge supposed growth prospects). What started as a good idea has turned into a money-making machine not for the investor, but for the founders and the investment banks that orchestrate the offering.

Today, an IPO has sadly been reduced to a sale of a company at the highest possible price to raise the highest amount of money possible for the owner.

Does that sound like a great investment to you? So from that standpoint, they are manufactured investments with all the current news flow priced in that start with an uphill battle for the buyer to make a return.

• The marketing is geared to sell you the investment;
• Valuations are aimed towards the higher end;
• They only have one price to buy and no averaging, restricting value;
• Expiring lockout periods can cause the stock to fall;
• The investment is designed to benefit the seller;

So through the years, they have become less profitable for a couple reasons. Firstly, the market achieves efficiency more quickly on a newly listed IPO than investors can be. Secondly, the IPO’s promoters tend to be more than liberal with the truth behind the offering in order to sell questionable valuations with slick marketing to an unsuspecting public. It’s time to move on from the IPO space if you are looking for newly listed growth companies without the fluffy packaging.

Spinoffs - X Marks the Spot

What if you were offered a newly listed company that wasn’t the result of a manufactured process, no one was becoming rich with you buying it (except maybe you), there was no marketing or roadshow, and you could take your time and choose a price and valuation with very few (if any) analysts covering it? Would you be interested? I suspect you would at least consider it. Spinoffs, also known as company break-ups or demergers, are exactly the area to find these companies.

Spinoffs are a corporate action in which a company releases value to shareholders by separating two or more divisions currently existing within the larger entity and listing them separately. You might think this sounds like an IPO, but shares of the newly listed company(ies) are given to shareholders of the parent company whether they want them or not. This last point throws up a whole heap of dynamics in terms of value, which we will go into shortly.

A big proponent of Spinoffs is the legendary investor Joel Greenblatt, who appeared at The Edge’s Special Situations Conference last year and commented, “It’s no fun to run around the neighborhood randomly digging for buried treasure… but if there was a big X somewhere, that’s more interesting – Spinoffs are the big X.” In 1985, Joel started his own hedge fund, Gotham Capital, and in the decade that followed, he produced a huge annualized return of over 50 percent — after fees. He concentrated heavily on Spinoff situations and remains a huge fan of the space.

We live in a world where big is perceived to be better. Up until recently, everything we did, watched, and purchased came from a few companies. The global dominance of the FAANG stocks (namely Meta Platforms META FB (Facebook), Amazon AMZN , Apple AAPL , Netflix NFLX and Google GOOG ) needs no explanation. But recent developments have cast a question over whether big is indeed better or, more importantly, better for us - the consumers. The evidence is stacking up as to whether these companies can even hold it together, never mind deliver value for the consumer. For example, Facebook parent Meta reported its first ever decline in revenue in July, Amazon revenue is slowing and costs are rising, Netflix is seeing subscribers fall off a cliff, and data collection companies like Google are under attack for what they store and use. Apple (for the meantime) seems to be holding up, but how long before another device encroaches the share of the market on their jewel of a smartphone? It’s a matter of time.

The long and short of it is that these companies are just too big and have too many different businesses to remain efficient or (it seems) stay in the law. My previous article highlights the potential break-up value of the FAANG stocks. In the case of Big Tech, the break-up scenario is inevitable and it will not only help the profitability of these companies, it will hopefully increase choice and ultimately help privacy - not to mention offer an investment opportunity in the same stroke. There is a good argument for saying that big is not necessarily better on a number of fronts. Take into account the phenomenon of Spinoffs. The process of companies splitting up their divisions has been going on quietly in the background and has produced many efficient and profitable businesses over time. Investors will see more to come, this is not a strategy that will go away.

So What Makes Spinoffs Attractive?

Spinoffs are an attempt to create value for the shareholders and not the owners directly. So, from a rare starting point that a transaction is in the benefit of the holder, the next step is to understand why the company is doing it. This could be due to a variety of reasons, including a non-fit to the core operation, better valuations for both companies when separated, or producing clear focused businesses that investors can understand (or even a combination of these). Whatever the reason, the goal is value creation, and investors should be all over analyzing these situations (or at least employing a company that does) so they can benefit.

The Spinoff process is a fundamentally inefficient method of distributing stock to the wrong people. You receive shares whether you want them or not. Investors tend to gain these shares by default and sell them in the open market pretty much immediately, often making them cheap companies that no one is looking at. They are sometimes known as “orphan securities.” It’s at this point where X marks the spot and you should start digging.

Here is why the dynamics of Spinoffs make it an essential area for an investor to analyze:

• Studies have shown that Spinoffs have historically beaten the market by over 10 percent as the pure newly focused business takes off;
• Compensation for executives can be more closely correlated with business performance. The company will become smaller, which will increase the executives' motivation and sense of ownership;
• Separating companies allow each entity to be properly valued and can sometimes unlock a “conglomerate discount”;
• Due to the likelihood that the company would be small and lack a roadshow, it is under-followed. As a result, there are more chances for investors to discover alpha;
• The Edge’s 20 year study shows that Spinoffs are likely to be taken over. Roughly 35 percent are acquired around the two-year mark post-Spin;

Typically, there are hundreds of Spinoff situations a year. Around 40 are over $1 billion market cap. This is a sweet spot where liquidity and “real” companies come together, in my opinion.

Here are three major companies you may not have been aware are breaking up. The complexity of the splits make them worth the analysis.

General Electric (GE) GE – Healthcare in Q1 2023 and Energy in Q1 2024

Industrial mega-conglomerate General Electric Co. (GE) has been on the radar as a divestiture/Spinoff candidate since January 2018 and its potential value creation opportunities. A few years later, GE has announced a 3-way breakup which will take place in two parts: (i) GE Healthcare Spinoff by early 2023 and (ii) GE Renewable Energy & Power Spinoff (to be called GE Vernova) by early 2024. This leaves its Aviation business as the core remaining business. The complex nature of the transaction means there is room for mispricing and, depending on where the cash and debt are distributed (as well as the quality of the management for each entity), this is shaping up to be one of the most interesting situations on the horizon.

Johnson & Johnson (JNJ) JNJ – Consumer Health business in Q2 2023

Johnson & Johnson (JNJ) is following in the footsteps of other major pharma players Pfizer PFE and GlaxoSmithKline GSK in separating its Consumer Health segment to focus on its developmental drug portfolio. In this transaction, JNJ will Spinoff its Consumer Health segment and retain the Innovative Pharma and Medical Devices segments. Compared to the latter two, the Consumer Health segment has seen low single-digit growth and the separation will allow the SpinCo to focus on growth when not overshadowed by the Parent’s operations. JNJ has very little debt (only $2 billion and pension liabilities of $5 billion on a market cap of over $400 billion), meaning that the debt post-Spin will be entirely negligible for the newly listed company. Low debt companies are definitely in favor in this high interest environment and again, should be on your radar.

Kellogg Co. (K) K – North America Cereal and Plant Co three-way split by the end of 2023

The planned three-way break-up at cereals and snacks giant Kellogg Co. (K) will see the North American Cereals and Plant-based foods businesses separately listed from the fast-growing global snacks business. The Spins are compelling acquisition targets and the split puts the RemainCo at an attractive valuation compared to the combined entity. It will split the company into three businesses, temporarily being referred to as Global Snacking Co. (Parent ex-Spins), North America Cereal Co. (Spinoff #1) and Plant Co. (Spinoff #2). The company also expects the Spin of North America Cereal Co. to be executed before the Spin of Plant Co., but both listings should be complete by the end of 2023. In the changing world of consumer tastes, it’s the opportunity to invest in a business that aligns to consumer needs. There could be hidden value unlocked as the different businesses take their respective paths.

Should you wish to know more about these situations or how to track, analyze and profit from them yourself, please send an email to research@edgecgroup.com