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Wooing Wall Street: Choosing Between a Spinoff or Targeted Stock for that New Unregulated Subsidiary.Richard H. Pettway and Judith Johnson

Fortnightly Magazine - December 1996

Wall Street Journal ran an article by Liping and Cauley on April 10, 1995, suggesting that the reorganization was no more than financial gimmickry.1 Other analysts clearly saw it as a positive move.2 However, our interest here is with investor reaction.

Recent studies have shown that investors generally react favorably to equity reorganizations such as spinoffs.3 A recent article by Logue, Seward and Walsh identifies the aspects of a spinoff that may improve shareholder value.4 In that article, the authors identified several benefits, including:

s Enhanced access to capital markets. (Investors can better analyze the more tightly focused company where risk issues are isolated, identified, and understood.)

s Improved management incentives. (Rewards now target areas that management can control more directly.)

s Closer monitoring by market forces. (Company results are no longer distorted by allocation methods or decisions.)

In theory, the more focused firm will gain better management. Part of the increased amount investors are willing to pay for these companies may derive from their recognition that they now form better takeover targets.5

As an alternative to a spinoff, the issuance of targeted stock may offer some additional benefits. It provides some of the same advantages as a spinoff: 1) allowing investors to gain a better understanding of the value of each business, 2) providing the total company with greater flexibility in raising capital, and 3) allowing management-incentive awards of stock that reflect the performance of the group in which the employee works.

In particular, U S WEST identified one benefit of a targeted stock restructuring as the preservation of strategic, financial, and operational benefits derived by not losing the synergies of doing business as a single company. Moreover, the restructured company maintains the ability to transact a complete spinoff in the future, if desirable.

One primary disadvantage pertains for targeted stock: No legal or structural division is created between or among the entities represented by the targeted stock. The restructuring is a separation only in the accounting sense, and the market can and will react to that reality.

The financial effects of any business group within the company might still affect the results of operation, the financial position, or the market price of any other group.6 The level of indebtedness of one group can affect the credit rating of the entire company and therefore could increase the borrowing costs of other groups.7

The Results, in Actuality

The results of our analysis are summarized in the Table on page 41: "Equity Abnormal Returns: By Type of Restructuring." The model and computation method are described in the Technical Appendix.

Pacific Telesis. The announcement of the Pacific Telesis spinoff on December 14, 1992, created a very small and insignificant negative return relative to other telephone company shares on the same dates immediately around the announcement. The five-day cumulative abnormal is positive, but also insignificant compared to the return of other telephone companies. Returns are higher when the comparison is drawn against the returns of the S&P portfolio, especially the cumulative five-day return of 2.38 percent. However, all the values for Pacific Telesis using both