Buy The Bust-Ups

By Daniel Kadlec

Corporate takeovers get all the attention. How could they not? Billions of dollars and thousands of jobs are at stake. Then there's the rock-star status of dealmakers like GE's Jack Welch. But the ugly truth about mergers, running at a record clip again this year, is that a great many don't work out. It should be no surprise, then, that amid so much merger mayhem, company divestitures are running high as well.

That often gets overlooked, and it's a shame because investors can really make a killing in bust-ups. I'm not talking about AT&T, by the way. That's a bust-up with problems, not the least being that it will take a numbing two years to get done. But Ma Bell's latest split makes the subject topical, especially with WorldCom's having just announced a split as well. I'm not talking about letter stocks either. Those are bust-ups in name only. Management of companies with a tracking stock still answer to the parent's boss. What's the point?

In general, though, breakups are a good thing for investors. The best tend to be tax-free spin-offs of 100% of a subsidiary. A company spins off a division for lots of reasons--maybe because it needs to get out of a business to avoid conflicts with other pursuits. Or maybe because it screws up and those synergies never surface. Hello, AT&T.

Usually, though, spin-offs are about dumping a distracting but often healthy operation to focus on a core business. In such cases, not only does the spin-off stock tend to beat its peers, but the parent stock does too. Why? In the case of the parent, investors value that sharpened focus. In the case of the spin-off, management doesn't have to compete for the parent company's attention and capital. Set free, managers can explore new products and markets.

In a study, James Miles and J. Randall Woolridge, finance professors at Penn State, found that on average, management spends more to improve its business after it's been spun off than it did when it was part of a larger entity. They also found that spin-off companies have a better than average chance of being taken over. By their calculations, spin-offs outperform a peer group by 30 percentage points over three years, parent companies by 19 points.

The results are similar in cases in which a subsidiary is only partly divested. Known as equity carve-outs, these divestitures tend to be IPOs of less than 20% of a business. The parent retains the bulk of the stock--and control--but often later gives that stake to shareholders as a tax-free dividend. Early this year 3Com sold 17% of its white-hot Palm unit in an IPO, then gave the rest to shareholders in July. The average carve-out does well. Palm has doubled since July, although it remains below March's mania levels. But parent companies tend to lag in this case (not so 3Com), probably because they have left a sexy business.

Not all spin-offs soar. Look out for junky companies created to separate legal liability or off-load debt from the parent. And some carve-outs simply don't make good stand-alone companies, like Barnesandnoble.com and other dotcoms that are really just brand extensions designed to cash in on the Internet bubble. Such IPOs may get a lot of attention, but that's not where you find the big money.

See time.com/personal for more on M&A trends. E-mail Dan at [email protected] See him on CNNfn Tuesdays at 12:20 p.m. (E.T.)