5 Short Sighted Stock Spinoffs

NEW YORK ( TheStreet) - Divestitures became a major 2011 strategy as some of America's biggest blue chip stocks like Kraft Foods ( KFT), ConocoPhillps ( COP), Abbott Laboratories ( ABT), Northrop Grumman ( NOC), Tyco ( TYC) and Marathon Oil ( MRO) spun assets to unlock value in their shares.

Shareholders big and small may cheer the flurry of recent spin offs, but in some cases divestitures can be a sugar high that comes at the expense of long term earnings.

Shareholder spins are a quick way to get the full value of businesses that may be weighing on operations, while opening up new avenues for growth. Existing shareholders benefit from owning stakes in divested businesses that oftentimes become far more valuable with brighter prospects as an independent concern. Meanwhile, management accountability to shareholders is easier to track and investors have a much easier time valuing simpler businesses.

The mother of all spinoffs was the Sherman Act breakup of John Rockefeller's Standard Oil in 1911, which made shareholders' stock multiply many times over when the broken up "baby standards" - among them ExxonMobil ( XOM) and Chevron ( CVX) - turned into some of the most valuable U.S. companies.

One hundred years later, vestiges of the Standard Oil empire and others in the energy sector slimmed down after a generation of consolidation in 2011. Along with ConocoPhillips and Marathon Oil, Sunoco ( SUN), Forest Oil ( FST), Sunoco ( SUN), Williams Companies ( WMB) and Chesapeake Energy ( CHK) all announced 2011 spins.

Meanwhile, what was once the $100 billion-plus market cap Tyco International ( TYC) empire underwent an epic dismantling in two separate spin deals . Thursday, Murphy Oil ( MUR) CEO David Wood said he's considering a spin of the company's downstream businesses, a positive sign for 2012 industry divestitures.

Across all sectors, corporate divestitures were a bright spot for deal makers, rising 165% from 2011 and representing 5% of all deals activity, according to Dealogic. In the U.S., divestitures also didn't slow in the second half of the year, as companies spun assets to bolster shares, streamline their strategy and raise capital.

The moves may have launched many stocks higher, but it's to be seen whether they will they will generate long-term outperformance. For instance, the Claymore Beacon Spin-Off ( CSD) exchange traded fund recently of spun off entities showed mixed results, underperforming Dow Jones Industrial Average and gaining on Standard & Poor's 500 Index. Ascent Capital ( ASCMA), Altisource Portfolio Solutions ( ASPS), Phillip Morris ( PM), Brookfield Infrastructure ( BIP), Lorillard ( LO) and HSN ( HSNI) were the largest holdings in the portfolio as of Jan. 25, according to its Web site.

Meanwhile at the parent company, spin moves represent a snapshot in time. Those who own shares prior to a spin gain a stake in any new company, while new investors only get a claim on the earnings prospects of what remains at the parent. For some, it means that spinoffs actually can rid companies of a growth asset, or one that provides balance sheet or cyclical stability.

Here's a look at five asset spins that raised capital while jettisoning a needed asset. With the spin dance expected to continue in 2012, a look at past deals shows that some companies may view spinoff decisions with regret.

For more on 2012 deal predictions, see Morningstar's 10 top M&A stock investments and 5 big deals that may flop in 2012.

5. McDonalds 2006 Chipotle Spin

In 1998, as the U.S. fast food pioneer McDonald's ( MCD) was rolling out Chicken McGrill and Crispy Chicken sandwiches to complement its burger supremacy, the company made a bold diversification into new foods by taking a minority stake in a popular Denver-based taco's and burrito's chain called Chipotle Mexican Grill ( CMG).

By 2001, McDonald's had a controlling interest in Chipotle Mexican Grill and was investing heavily in its U.S. growth. In Sept. 2005, after a more than thirty-fold store expansion, newly minted McDonald's Chief Executive Jim Skinner decided to spin Chipotle Mexican Grill, preferring to focus on customer and profit growth at McDonald's, which celebrated its 50th anniversary earlier that year. In the IPO of over 20% of its stake in Chipotle on Jan. 25, McDonald's raised $173.4 million, pricing the stock at $22 a share, according to Thomson Financial.

"Since we made our initial investment in 1998, Chipotle has grown from 16 restaurants in the Denver area to a strong and popular restaurant concept with more than 500 locations throughout the U.S.," said Skinner of the rationale to spin Chipotle.

As CEO, Skinner decided that wrenching out comparable store sales growth would be key to growing the then struggling McDonald's business, which was suffering an image problem from Morgan Spurlock's Super Size Me documentary on fast food. "Just 1 percent growth in McDonald's global comparable sales translates to approximately $100 million in additional operating profit for the company and a substantial cash flow increase for all of our McDonald's owner/operators," said Skinner.

When Chipotle stock hit markets the next day, investors bought relentlessly into the company's growth prospects, more than doubling shares to over $44 and leading to one of the biggest IPO rallies since just after the burst of the dotcom bubble in 2001.

At the time, Chipotle had opened roughly 500 stores and had $627 million in annual sales and $37.7 million in profit. In a follow-on offering that May, McDonald's sold an additional $250 million worth of shares priced at over $60 and arranged a tax-free share exchange to fully divest its stake later that October.

McDonald's and Chipotle shares have both soared since the spin as the companies followed different growth trajectories and were able to successfully navigate the financial crisis.

After opening its first store in China in 1990 and bringing drive through to the region in 2005, McDonald's opened its 1000th store in the fast growing region in 2008. Its overall sales have grown nearly 30% to $27 billion since 2006, while profits have grown nearly 60% on a near doubling of revenue in the Asia Pacific, Middle East and African regions, proving many doubters wrong. Meanwhile, Chipotle more than doubled its stores in the U.S. and Canada, growing sales by over 175% and profits by over 400% to a forecasted $2.3 billion in sales and $216 million in 2011 profits, respectively, according to consensus estimates compiled by Bloomberg.

For stock investors there's been a clear winner among the two, however. While McDonald's shares have risen 175% since spinning Chipotle, it's paled in comparison to Chipotle's share gains of 767%.

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While both companies have fared well since the spin, making it an exemplar of the belief that freed assets can create growth all around, Chipotle would rival emerging markets as McDonald's fastest growing business, potentially lifting shares significantly above their already near record-high levels.

For more on McDonalds and Chipotle shares see TheStreet ratings portfolio of top rated restaurant stocks.

4. Merck's 2003 Medco Spin

In 1993, Merck ( MRK), then the world's largest pharmaceuticals company, cut a rare vertical merger buying a controlling stake Medco Containment Services for $6 billion, allowing it to make and distribute prescription drugs directly to consumers.

As a result of the deal, Merck was able to market its drugs to Medco's then 33 million strong customer base, managing over 95 million annual prescriptions for government employees, corporations and unions. "This is an aggressive but carefully considered strategic move to keep Merck close to patients and customers in a rapidly changing and highly competitive health-care market," said Merck Chief Executive P. Roy Vagelos of the deal.

The deal faced intense immediate resistance because of the possibility that the tie-up would increase prescription prices. When the merger was cut the Philadelphia Inquirer quoted an aide for Sen. David Pryor (D., Ark.), a key advocate for low drug-prices as saying "this is a step backward for health-care reform. The whole foundation of health-care reform is competition; this takes a competitor out of the market." Nevertheless, the merger closed.

Less than decade later, Merck relented to conflict over the deal, spinning a now rebranded Medco Health Solutions ( MHS) for little gain in a 2003 tax-free dividend to shareholders. "Medco's ownership by Merck has been a lightning rod for criticism, although there's been nothing inappropriate," said Medco's Chairman David Snow to USA Today at the time of the spin.

During the tie-up Medco's sales grew astronomically, but Merck saw comparatively minor gains and had its drugs lead surpassed by Pfizer ( PFE) and GlaxoSmithKline ( GSK). Merck's revenue more than doubled to $22.4 billion by the end of the merger, while Medco grew revenue to $34.2 billion, a more than tenfold increase. It meant that by the time of the spin, 63% of overall revenue came from Medco. However, low Medco profit margins dragged on Merck's overall share pricess, leading to a radical shift in strategy.

After the spin, which gave shareholders one Medco share for every eight Merck shares, both companies stock prices and earnings abilities diverged. Medco's shares have gained over 500% since its Aug. 2003 initial public offering, while Merck's shares have fallen by nearly a quarter. As a result, even with Medco's subsequent stock gain, Merck shareholders have seen losses since the spin, when excluding dividend payments.

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Since the spin, Medco's sales are expected to have nearly doubled to $68.5 billion, while profits are expected to triple to $1.5 billion according to 2011 earnings estimates compiled by Bloomberg. Meanwhile, Merck sales have grown at the same rate and profits have doubled, on the heels of big merger activity.

With the looming threat of its drugs like Vasotec and Prinivil for hypertension, Mevacor for high cholesterol and Prilosec for ulcers going generic, the company relied on osteoporosis treatment drug Fosamax and asthma treatment Singulair. As that drug headed the way of going generic in 2009, Merck pulled the trigger on one of the 10 biggest mergers in Monday history buying Schering-Plough for $41.3 billion in May 2009.

The merger gave it Schering products with longer patent lives like allergy spray Nasonex as well as a popular suntan lotion brand in Coppertone, an insole-maker in Dr. Scholl's and a stronger international presence. However, with it came legal battles. In 2009, Merck and Schering-Plough settled a suit for cholesterol treatment Vytorin after allegations of withholding key clinical trial results. Merck also pleaded guilty to a criminal charge with the U.S. Department of Justice for its marketing of painkiller Vioxx before it was pulled in 2004.

In July 2011, Express Scripts ( ESRX) announced a deal to buy Medco Health Solutions ( MHS) for $29 billion in a deal to combine two of the largest pharmacy benefits managers in the U.S. However, the deal is facing antitrust scrutiny, which jeopardizes its outcome.

Currently, Medco's stock is more than 10% below the $71.36 a share purchase price, signaling investor uncertainty over the deal, or an easy stock return if it's completed.

For more on pharmaceutical mergers, see 8 big acquirers of 2011. See TheStreet's 3 healthcare buys for 2012 for more on the sector.

3. Barnes & Noble's 2001 Babbage's Blunder

In October 1999, Barnes & Noble ( BKS)bought Babbage's Etc. a video games retailer partly owned by chairman Leonard Riggio for $215 million in cash, paving the way for a lucrative and fast growing venture into video game sales. The deal to buy Babbage's Ect. and a later decision to spin the re-branded business, was one of the four deals that rewrote Barnes & Noble history as it struggles to compete against Amazon ( AMZN) in print and tablet based book sales.

The move was a push into growing video-game market as console makers Sony ( SNE), Microsoft ( MSFT) and Nintendo ( NTDOY) and software makers like Electronic Arts ( ERTS) drove gaming innovation. It was also expected to help barnesandnoble.com keep pace with rival Amazon by offering an expanded suite of PC and console games.

At the time of the deal, Babbage's Etc. operated 495 brick and mortar stores and an online games selling business and was valued at 5.1 times estimated 1999 EBITDA. To make the opportunistic purchase, Barnes & Noble drew on a $850 million line of credit.

Babbage's Etc. was then rebranded to the recognizable GameStop ( GME) trademark, which saw stores and sales surge after the acquisition. By August 2001, GameStop nearly doubled its video-game selling stores and was preparing for an IPO spinoff after quarterly sales surged 63% to $206 million. With the IPO, Barnes & Noble expected to reduce its debt and recapitalize the gaming retailer.

After shelving the IPO until February 2002, GameStop shares made an impressive debut on the New York Stock Exchange, rising 12% to close at $20.10 - raising $325 million for Barnes & Noble. Since the IPO, the two companies have seen their fates differ.

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GameStop shares surged over 145% since its initial public offering - even after a post-recession share slump and dimming sales outlook -- while Barnes & Noble has seen its shares cut by more than half. GameStop has been profitable in every quarter as a public company, with sales and profits growing in 2010.

Meanwhile, Barnes & Noble lost money in 2011, and is tied to a strategy of plowing cash into its Nook business to drive sales growth as its brick and mortar stores lag. In January, the nation's largest in-store bookseller saw its shares plummet and fall within reach of all-time lows after it announced a spin of its Nook tablet books selling business and cut its overall 2012 earnings outlook - leading to an earnings per share loss expectation as high as $1.40.

The share drop put into question the wisdom of the spin after the unit saw sales jump over 40% in the nine week 2011 holiday season, compared with the prior year. In recent earnings, Barnes & Noble ascribed a glowing outlook to its Nook-fueled BN.com business, which it expects to grow as much as 50% in 2012, while its brick and mortar and Barnes & Noble College businesses achieve flat sales.

Other Barnes & Noble deals like the rejection of a May 2011 bid by John Malone run Liberty Media ( LMCA) to buy the bookstore for $1.02 billion, or $17 a share - a 20% premium to shares at the time - also panned.

For more on Barnes & Noble here's a look at black-friday-2011-stock-short-squeezes and the reasons why Barnes & Noble can't act like Amazon.

2. Morgan Stanley's 2007 Discover Financial Drama

With a boardroom drama for his ouster escalating, Morgan Stanley ( MS) Chief Executive Philip Purcell began to pull for a 2005 spin of the investment bank's credit card unit Discover Financial Services ( DFS), which he built at Dean Witter prior to the two firms' 1997 merger.

Purcell called for the spin instead of a previously rumored sale to help reestablish Morgan Stanley's investment banking pedigree after top tier rivals Goldman Sachs ( GS) and Merrill Lynch, along with scrappier competitors Bear Stearns and Lehman Brothers gained market share. While Purcell said a spin would maximize Discover's value, it would also help Morgan Stanley, " Further intensify our focus on the high return growth opportunities within our integrated securities businesses."

Heading the vaunted investment bank was an unusual coup for Purcell. After working as a consultant at McKinsey & Co., Purcell entered banking by way of Sears Roebuck when the retailer bought brokerage Dean Witter Reynolds in 1981. Hired to head Dean Witter, Purcell then founded the Discover Card in 1986, which grew to be one of the largest U.S. credit card issuers. At the same time, Purcell freed Dean Witter and its Discover business through a 1993 IPO. Four years later, the firm merged with Morgan Stanley.

After the merger, Purcell took Morgan Stanley's reins and forced out the company's President John Mack, who went on to head Credit Suisse First Boston ( CS). With growing dissatisfaction of the post-merger culture, a faction of Morgan's board pulled for Purcell's ouster, leading to his 2005 resignation. Mack returned triumphantly to Morgan Stanley to complete the Discover spinoff, which was first floated by Purcell as he faced pressure to resign.

In June 2007, over two years after the spin proposal was made by Purcell, Morgan Stanley's board agreed to complete the spinoff. Echoing Purcell's words, CEO Mack said the move would maximize Discover's growth, while allowing Morgan Stanley to focus on its institutional securities unit that had earned $21.1 billion in revenue, driving a record $7.5 billion 2006 profit.

After the spin, the shares values and growth prospects of the two businesses diverged tremendously. Only months later, blips of an oncoming credit crunch emerged and a little over a year later, Morgan Stanley faced demise. Since its June 2007 IPO, Discover's shares have shed nearly 4%, while Morgan Stanley's shares have plummeted nearly 75%.

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With the onset of the financial crisis and a souring of mortgage securities, Morgan Stanley, like its Wall Street peers took billions in writedowns, losing a record $3.5 billion in the fourth quarter of 2007. As quarterly losses continued in 2008, the firm managed to survive the crisis that felled three of its peers by selling a 20% stake to Mitsubishi UFJ for $9 billion in October 2008. A year later, John Mack stepped down as CEO, leading to the nomination James Gorman, an executive with a brokerage background, who pulled the bank back from risky trading businesses.

In retrospect, the spin may have been a strategic misstep ahead of the crisis. Discover Financials' earnings and balance sheet proved to be a source of stability. Just over a year after the spin, Morgan Stanley had to convert to a bank holding company to access the Federal Reserve's discount window as interbank lending dried in the days after the bankruptcy of Lehman Brothers. At that time, Discover Bank - an arm of Discover Financial - had over $28 billion in deposits, giving the unit a stable funding source and $10.2 billion in cash to weather the crisis. During the crisis, Discover Financial also saw minimal losses.

Meanwhile, Discover Financial has grown revenue and profit at a faster rate, stabilizing shares. Revenue has grown 42% and profits have doubled to $2.2 billion at Discover Financial since 2006, as of the year ended in December. In contrast, Morgan Stanley's revenue has grown just over 8% and profits, fueled by accounting gains on the value of the firm's debt, are still well below pre-crisis levels.

To move away from trading businesses that are now confined by new regulations, Morgan Stanley cut a brokerage the venture with Citigroup ( C) in 2009 , buying a 51% stake in a JV called Morgan Stanley Smith Barney. In 2012, the firm will be able to begin accumulating shares, putting it on a path for full ownership by 2014.

For more on Morgan Stanley and Citigroup shares, see 19 S&P laggards that could be leaders in 2012 and 10 New York banks with the most upside for investors.

1. Circuit City's 2002 CarMax Spin of Doom

Initially a top secret development called "Project X" in 1991, big box electronics retailer Circuit City opened its first CarMax ( KMX) store in 1993 and grew used car dealership business over nearly a decade, until it decided to spin the unit to realize its full value and focus on the increasingly competitive retail electronics market.

Speaking in the mantra of divestitures, Circuit City's Chief Executive at the time Alan McCollough said that a spin would benefit growth and share prices. "CarMax has produced solid sales and earnings growth during the past two years and is now able to support its growth with no assistance from Circuit City," said McCollough in a move that would "enable the investment community to analyze each business on its own merits."

The move was also part of a restructuring plan as Circuit City's earnings estimates for the quarter would fall far short of expectations. After announcing the spin and an earnings cut, Circuit City's shares dropped by over 30%.

In Oct. 2002, Circuit City spun CarMax in a dividend to shareholders. At the time, CarMax operated 33 used car superstores and 18 new car franchises, in 12 states. Since then, CarMax has tripled its stores and generated record sales and profit in 2011. In that time span, Circuit City saw its store count go from 603 to zero when the company filed for bankruptcy in Oct. 2008 after a credit crunch led to tighter credit terms from vendors and an economic crisis shelved consumer spending.

The-59-year old electronics retailer initially filed Chapter 11 reorganization, however a little over a year later, the company converted the bankruptcy into a Chapter 7 liquidation after being unable to find a buyer, spurring the sale of its inventory and the closure of its stores. While the credit crunch drained Circuit City's liquidity and a recession made its electronics sales slow, the company's brick and mortar business model was imperiled by the growing shift of consumer spending to online retailers like Amazon ( AMZN).

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At CarMax the recession and a growing adoption of Web-based shopping had a far different impact. As auto spenders retrenched, they flocked to CarMax's used cars, keeping the company profitable through the recession. Meanwhile, auto buying didn't face the same threat from the Web as big box retailers, with consumers generally still making purchases in showrooms.

In 2011, CarMax earned a record $380 million in profit on its highest ever sales of $8.9 billion. Meanwhile, its shares have more than doubled since the spin.

While it's unclear whether Circuit City had the financial strength to hold onto CarMax, the unit was an earnings hedge to both the economic cycle and the threat of online retailers. Ultimately, the spin was part of a corporate strategy that led to Circuit City's dissolution, while CarMax has since thrived.

For more on CarMax shares, see 10 diversified stocks to buy ahead of earnings

-- Written by Antoine Gara in New York

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