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Monday, February 16, 2009
Tuesday, February 3, 2009
Tax free Spin Offs
When a company is restructuring its operations, it often announces that it wants to exit certain businesses. Sometimes these lines aren’t complimentary to the core mission of the enterprise. Other times, there may be risks inherent in the subsidiary that don’t fit within the risk profile of the parent company. In any event, there are typically two ways to unload a business:
1. Sell it outright and use the cash to pay down debt, buy back stock, or make acquisitions. This includes selling out to other enterprises of sponsoring an initial public offering.
2. Declare a tax free spin off to existing shareholders.The first option may sound the simplest as the transaction is fairly straightforward.
General Electric, for example, recently divested its reinsurance operations through this method by selling them to another corporation in exchange for cash. Typically, however, managements do not like selling a business because it may be forced to pay capital gains taxes. For businesses that have been owned for decades, this tax bite can be huge.That often leads the Board of Directors to consider a tax free spin off. A new company will be created with its own CEO, management team, ticker symbol, financial statements, and facilities. Typically, this can be completed in one of two ways:
1. A Pro-Rate Distribution: Under this scheme, shares of the new company are sent to shareholders proportional to their existing ownership of the parent company (i.e., if an insurance company owned 10% of the parent, it would receive 10% of the spin off).
2. An Exchange Offer: Shareholders are given the choice to give up their existing shares of the parent company in exchange for shares of the new spin off.Value Added Through a Tax Free
Spin Off In many cases, a company that has been spun off and is now independent is more valuable than the same enterprise as part of a conglomerate. This is due to the different economics of the business – things such as return on equity, return on assets, and debt levels. This will also reflect the level of potential future growth; a tiny enterprise with much promise is going to be valued more on its own because investors can directly profit from the action.Consider Coach, a maker of luxury handbags. Originally a division of Sara Lee, Coach was spun off several years ago through an exchange offer made to existing SLE shareholders. Since that time, the stock has appreciated more than 1,000% and now has a market capitalization nearly the same size as its former parent company! Why? Management was able to focus on what was best for Coach – not a parent company that may need excess earnings for debt payments rather than expansion, for example.
How a Tax Free Spin Off Can Make Return Calculations Deceptive Imagine if you had invested $10,000 in Goodrich in January, 2002. Your investment would have purchased approximately 360 shares at an average cost of $27.82. Looking at today’s stock price of $39.50, a stock chart would show that your position was now worth a little over $14,000. A nice gain, to be sure, but it certainly doesn’t show the whole picture because during your holding period, you would have received roughly $1,621 in cash dividends plus 72 shares of EnPro as part of a tax free spin off (today worth $2,022).
In other words, you would have roughly $17,863 from your position – not $14,000 as it would appear at first glance. On an original cost basis of $10,000, that is nearly 40 percent that simply wasn’t on the radar screen.Identifying Tax Free Spin Off OpportunitiesThere is some empirical evidence that suggests that pure spin offs – those that are distributed pro rata to existing stockholders with little fanfare – offer the best opportunity for long term profit.
1. Sell it outright and use the cash to pay down debt, buy back stock, or make acquisitions. This includes selling out to other enterprises of sponsoring an initial public offering.
2. Declare a tax free spin off to existing shareholders.The first option may sound the simplest as the transaction is fairly straightforward.
General Electric, for example, recently divested its reinsurance operations through this method by selling them to another corporation in exchange for cash. Typically, however, managements do not like selling a business because it may be forced to pay capital gains taxes. For businesses that have been owned for decades, this tax bite can be huge.That often leads the Board of Directors to consider a tax free spin off. A new company will be created with its own CEO, management team, ticker symbol, financial statements, and facilities. Typically, this can be completed in one of two ways:
1. A Pro-Rate Distribution: Under this scheme, shares of the new company are sent to shareholders proportional to their existing ownership of the parent company (i.e., if an insurance company owned 10% of the parent, it would receive 10% of the spin off).
2. An Exchange Offer: Shareholders are given the choice to give up their existing shares of the parent company in exchange for shares of the new spin off.Value Added Through a Tax Free
Spin Off In many cases, a company that has been spun off and is now independent is more valuable than the same enterprise as part of a conglomerate. This is due to the different economics of the business – things such as return on equity, return on assets, and debt levels. This will also reflect the level of potential future growth; a tiny enterprise with much promise is going to be valued more on its own because investors can directly profit from the action.Consider Coach, a maker of luxury handbags. Originally a division of Sara Lee, Coach was spun off several years ago through an exchange offer made to existing SLE shareholders. Since that time, the stock has appreciated more than 1,000% and now has a market capitalization nearly the same size as its former parent company! Why? Management was able to focus on what was best for Coach – not a parent company that may need excess earnings for debt payments rather than expansion, for example.
How a Tax Free Spin Off Can Make Return Calculations Deceptive Imagine if you had invested $10,000 in Goodrich in January, 2002. Your investment would have purchased approximately 360 shares at an average cost of $27.82. Looking at today’s stock price of $39.50, a stock chart would show that your position was now worth a little over $14,000. A nice gain, to be sure, but it certainly doesn’t show the whole picture because during your holding period, you would have received roughly $1,621 in cash dividends plus 72 shares of EnPro as part of a tax free spin off (today worth $2,022).
In other words, you would have roughly $17,863 from your position – not $14,000 as it would appear at first glance. On an original cost basis of $10,000, that is nearly 40 percent that simply wasn’t on the radar screen.Identifying Tax Free Spin Off OpportunitiesThere is some empirical evidence that suggests that pure spin offs – those that are distributed pro rata to existing stockholders with little fanfare – offer the best opportunity for long term profit.
Wednesday, January 28, 2009
Think of Your Stocks Like Real Estate
This past week, I was considering buying a home near my parents so that when I was back in area, I would have a place from which to work and live. With the real estate market falling to 2004 prices, on average, it seemed a good time to buy (value investing is not limited to stocks – it’s a business philosophy). Anyway, I made an opening offer roughly 10.6% below the list price, which was more than reasonable given the current economic environment, the fact that I don’t need a property per se, and my outlook for real estate values over the next five to ten years.
The owners of the property came back with their counteroffer, but refused to budge much. They had in mind a price that they thought appropriate for the property based upon their own analysis of the comparable sales in the neighborhood. They determined that based upon their own financial needs that they couldn’t afford to sell their asset for the price the market was currently indicating it was worth; indeed, they demanded the same appreciation that had been the rule for the past twenty years, not recognizing the new reality. That’s fine. That’s what I’ve been trying to teach you with the thousands of articles that have been published. Although I trust my own analysis (this is what I do for a living – valuing assets, buying them at attractive levels, and generating profit on those capital commitments), they had arrived at their own estimate of replacement value for the property. They will now either have to continue holding the real estate, wait for an offer that they think is more inline with their estimate of value, or be forced into a sale if they can’t hold out until the market recovers.
Now, here’s where most people make huge errors that cost them years, even decades, of wealth building effort. If they had owned a basket of stocks – say, shares of Wal-Mart, General Electric, Johnson & Johnson, and U.S. Bancorp – and they had experienced a drop of 10% or 20%, let alone the 50% drubbing many equities have taken over the past year, it’s unlikely that these same people would apply a rational disposition to their portfolio like they did their house. They wouldn’t research the valuation of comparable businesses to each of those they owned, estimate what they think their share of those businesses was, and then refuse to sell (or better yet, buy more while it was cheap) until it reflected a conservative estimate of intrinsic value.
Instead, it’s likely that they would be more likely to sell the further prices fell because they trusted their neighbor’s estimate of what their property is worth instead of their own, cold, dispassionate calculation. I wrote you a few weeks ago and told you that if you were selling your 401(k) assets, people like me were out there buying them in the midst of all the fear. In a few years, you would wonder why we had gotten substantially richer.
The bottom line: You must assess all of the assets in your life based on their estimated intrinsic value. There’s nothing more irrational than saying, “My accounts are down $10,000 or $100,000 or $500,000! What do I do?” If you are invested in a broad-based, low-cost index fund, falling prices are good for you in the long run. That’s because the dividend yield on your portfolio will increase, allowing you to purchase more shares with your reinvested earnings. Your regular contributions will also purchase more shares. This is the secret to building equity, which is the surefire way to building wealth.
The owners of the property came back with their counteroffer, but refused to budge much. They had in mind a price that they thought appropriate for the property based upon their own analysis of the comparable sales in the neighborhood. They determined that based upon their own financial needs that they couldn’t afford to sell their asset for the price the market was currently indicating it was worth; indeed, they demanded the same appreciation that had been the rule for the past twenty years, not recognizing the new reality. That’s fine. That’s what I’ve been trying to teach you with the thousands of articles that have been published. Although I trust my own analysis (this is what I do for a living – valuing assets, buying them at attractive levels, and generating profit on those capital commitments), they had arrived at their own estimate of replacement value for the property. They will now either have to continue holding the real estate, wait for an offer that they think is more inline with their estimate of value, or be forced into a sale if they can’t hold out until the market recovers.
Now, here’s where most people make huge errors that cost them years, even decades, of wealth building effort. If they had owned a basket of stocks – say, shares of Wal-Mart, General Electric, Johnson & Johnson, and U.S. Bancorp – and they had experienced a drop of 10% or 20%, let alone the 50% drubbing many equities have taken over the past year, it’s unlikely that these same people would apply a rational disposition to their portfolio like they did their house. They wouldn’t research the valuation of comparable businesses to each of those they owned, estimate what they think their share of those businesses was, and then refuse to sell (or better yet, buy more while it was cheap) until it reflected a conservative estimate of intrinsic value.
Instead, it’s likely that they would be more likely to sell the further prices fell because they trusted their neighbor’s estimate of what their property is worth instead of their own, cold, dispassionate calculation. I wrote you a few weeks ago and told you that if you were selling your 401(k) assets, people like me were out there buying them in the midst of all the fear. In a few years, you would wonder why we had gotten substantially richer.
The bottom line: You must assess all of the assets in your life based on their estimated intrinsic value. There’s nothing more irrational than saying, “My accounts are down $10,000 or $100,000 or $500,000! What do I do?” If you are invested in a broad-based, low-cost index fund, falling prices are good for you in the long run. That’s because the dividend yield on your portfolio will increase, allowing you to purchase more shares with your reinvested earnings. Your regular contributions will also purchase more shares. This is the secret to building equity, which is the surefire way to building wealth.
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