Spinoffs are an interesting investment opportunity. These are corporate transactions meant to separate at least two businesses from one another. Many times investors wake to find a new stock added to their portfolios. They don’t know where it came from or even what it does.
Recently I found I was the proud owner of Solventum (NYSE:SOLV). Although I knew 3M (NYSE:MMM) was spinning off its healthcare business, I hadn’t realized the industrial conglomerate completed the transaction. While I’ll be holding onto the stock, many investors in similar situations sell the spinoff. They were investing in the parent company and have no interest in this ancillary business.
Yet spinoffs can be lucrative stocks to buy and own. In his excellent book “You Can Be a Stock Market Genius,” author Joel Greenblatt says:
“There are plenty of reasons why a company might choose to unload or otherwise separate itself from the fortunes of the business to be spun off. There is only one reason to pay any attention when they do: you can make a pile of money investing in spin-offs.”
A Penn State study backs up those assertions, finding that over the 25-year period reviewed, spinoff stocks handily beat their industry peers and the S&P 500 by about 10 percentage points per year over the three years following the spinoff. The biggest gains happened in the second year of independence.
However, more recent data casts a different view. Harvard Business Review says of the 350 spinoffs valued at $1 billion or more it looked at between 2000 and 2020, half failed to create any new combined value within two years of separation. And a quarter of them destroyed “a significant amount” of shareholder value. Its conclusion was spinoffs “delivered as little as a 5% increase in combined market cap two years after spinning off.”
Sometimes, spinoffs harbor deep, hidden problems that can cause deep losses if you’re not careful. Maybe investors need to be more wary. What follows are three disappointing spinoffs that failed to live up to their potential so far.
Warner Bros Discovery (WBD)
Movie and television entertainment company Warner Bros Discovery (NASDAQ:WBD) should have been a hit. AT&T‘s (NYSE:T) WarnerMedia business was spun off in April 2022 and then immediately merged with TV and streaming company Discovery. The resulting Warner Bros Discovery has struggled almost from the day it went public.
AT&T shed the media unit to focus on its telecom business. It also allowed it to pay down the mountain of debt the telecom had amassed over the years. WarnerMedia owned the venerable HBO brand and the HBO Max streaming service. Discovery had numerous TV properties including TLC, HGTV and Food Network, but also the Discovery+ streaming business. Together the two companies would be an entertainment powerhouse because of the Warner Bros Pictures movie studio with its library of films.
Unfortunately, it hasn’t worked out like that. The stock has lost almost 70% of its value since being spun off. Streaming, it turns out, is a harder business to profit from. While Warner Bros Discovery is one of the few profitable streaming services, generating $103 million in adjusted EBITDA from its direct-to-consumer business, it has yet to make up for the $1.6 billion it lost the year before. On the surface, its scale, distribution network, production studios and content ought to ensure it survives the changing media landscape but it’s not likely to be a high-growth stock.
Orion Office REIT (ONL)
Real estate investment trust (REIT) Orion Office REIT (NYSE:ONL) was a case of don’t-want-itis. That is a term used to describe motivated homeowners looking to sell fast. It applies equally to former parent Realty Income (NYSE:O), which wanted to shed its office property assets.
Realty Income is a specialty retail REIT specializing in certain types of properties, typically one-tenant retail locations. The majority of its portfolio consists of retailers including Walmart (NYSE:WMT), Dollar General (NYSE:DG), Kroger (NYSE:KR) and Costco (NASDAQ:COST). Particularly through its acquisition of VEREIT, the character of Realty Income’s portfolio changed. Managing offices is not the same as managing retail space and the office market is in trouble.
Vacancy rates hit a record 19.8% in the first quarter and have been steadily climbing. Orion’s stock has lost 86% of its value since being spun off in November 2021.
While office vacancies have always yo-yo’d over the years, the pandemic set a permanent change in the market. The work-from-home model exploded, and though many people have returned to the office, many others have not. Businesses are also sharply downsizing their workforce, meaning they don’t need as much square footage. Orion seems as if it will have a hard road to travel to make itself an investment-worthy stock.
Vestis (VSTS)
Spun off from Aramark (NASDAQ:ARMK) last October, the uniforms and workplace supplies provider Vestis (NASDAQ:VSTS) services manufacturing, hospitality, retail, food service and numerous other industries. The stock has been largely a disappointment since its separation, essentially treading water while rival Cintas (NASDAQ:CTAS) runs 45% ahead.
However, Vestis badly missed Wall Street estimates last week and the stock’s knees were cut out from under it. Shares plunged on the report and Vestis has lost nearly half its value.
The company’s fiscal second-quarter report showed Vestis is having trouble keeping customers. CEO Kim Scott said the workplace supplier was going to limit raising its prices to improve customer retention, showing just how hard the economic environment is for businesses. But it doesn’t explain how Cintas, the industry leader with about a 20% share of the market, continues growing. Vestis is the second-largest player but trails far behind with a 6% share.
There may be leverage Vestis can use to improve its position. It could cross-sell customers other services, such as floor care, restroom supplies or first aid supplies, though it hasn’t worked out that way. At least not yet.
Vestis has only been on the market for less than a year so it may take time. Depending upon whose research you look at, it may take a couple of years for a spinoff to finally pay off. Or the promised shareholder value may never get unlocked.
On the date of publication, Rich Duprey held a LONG position in SOLV, MMM, WBD, T, ONL and O stock. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
