In some ways, you could call it a no-brainer. Playboy Enterprises Inc. wants to spin off its money-losing Web division. The move will generate capital to run the new E-division and get its ongoing development costs off Playboy's books. Moreover, says CFO Linda Havard, the company will attract new
technology stockholders who have a higher threshold for losses. Playboy Enterprises's shareholder value stands to benefit through association with a successful initial public offering. And the new currency could help attract and retain top management.
Playboy.com holds great promise, even though the division racked up $9 million in losses on revenues of $16.9 million in 1999. On the other hand, Playboy Enterprises is a mature entertainment company with slow growth--and it is hard- pressed to absorb the losses. Revenue growth in its core publishing business was flat last year. Gains in the company's other product lines (its gaming, entertainment, and online divisions) were responsible for boosting the overall growth rate to 9.5 percent. Why not, then, let the investing public provide the financial tonic for Playboy's Internet adventure?
And Havard offers pragmatic financial logic: "Playboy can't afford the losses, and our shareholders don't want us to continue to pile up the losses. To grow it quickly, we have to spin it out."
But in spinning it out, Playboy will off-load a big chunk (a figure undisclosed at press time) of its fastest- growing division. While the move may help the company reap the short-term benefit of a hot Internet play, there's the value proposition of the somewhat aging parent to consider. In addition, both entities will face complications from sharing--and trying to extend-- such a well-known brand. In the end, is Playboy selling off a sizable piece of its future?
Welcome to the joys and perils of Web spin-off mania. Twenty- nine companies completed E-business spin-offs in 1999, up from 7 in 1998, according to Spin- Off Advisors LLC, a Chicago-based research firm. And several have demonstrated that a well-structured spin-off can be a wildly successful value creator for both parent and subsidiary. Take, for example, Net2Phone, the Web telephony software firm spun off from IDT last July. In April, the spin-off's stock was up 240 percent over its IPO price, and parent IDT's stock had jumped 70 percent over the same period. Meanwhile, Digex, the Web- site hosting company spun off from Intermedia Communications, was up more than 800 percent from its opening price in July. And parent Intermedia's was up 100 percent.
But pitfalls and unintended consequences abound as well. Consider iTurf, a Web site for young girls spun off from retailer dElia's. It was trading under $10 in April, down more than 50 percent from its opening price of $22. Tracking stocks ZDNet, spun off from Ziff-Davis, and DLJdirect, spun off from Donaldson, Lufkin & Jenrette, are both trading well below their opening prices. And overall, pure Web-site spin-offs completed in 1999 have fared worse than spun- off Web consulting, hosting, or Web- based software divisions.
The disparity in shareholder return seems to lie in that some companies, eager to cash in on Internet multiples, are rushing their E-divisions to market without thoroughly analyzing the implications for both the spun-off division and the remaining parent. The first impact of such decisions is shareholder value, which obviously doesn't always go up. McKinsey & Co. recently conducted a survey comparing the combined performance before and after the issuance of stock in a subsidiary that had a market cap greater than 10 percent of the parent's. Half of the companies surveyed showed worse performance against their peers, half showed better.
"It's amazing how often the result is not 'everybody's a winner,'" says Patricia Anslinger, a principal in McKinsey's New York office.
Shareholder value drops are just the beginning. Often, spin-offs create long-term structural problems that are difficult, if not impossible, to fix once the deal is completed. These include territorial and competitive issues between parent and sub, conflicts of interest among board members and management serving two groups of stockholders, and complex transfer-pricing agreements. There's also the unpleasant possibility that the future of the parent company may get spun right out the door.
It's hard to resist the temptation of spinning off entities to follow in the footsteps of highly valued Internet plays. Barnes & Noble Inc., for example, had to risk cannibalizing itself with an Internet offering after the world watched Amazon.com begin to eat the bookseller's bricks and mortar. But in terms of pure shareholder value, its spin-off hasn't fared well. Although Barnes & Noble raised more than $480 million in capital when it took 20 percent of the Internet-based book retailing division public in a carve-out in May 1999 (remaining ownership is split evenly between Bertelsmann AG, the German publisher, and Barnes & Noble Inc.), the stock has dropped well below its opening price of 18, trading as low as 8 in April. Parent company Barnes & Noble Inc. stock has tumbled since the IPO as well, down to around 20 in April from a pre-IPO high of 44. In fact, the combined market cap of both companies is below that of Barnes & Noble Inc. alone before the IPO. Amazingly, BarnesandNoble.com CFO Marie Toulantis isn't all that worried.
"The whole retail space is in a funk right now," says Toulantis, who conducted the IPO as CFO of Barnes & Noble Inc., then jumped to the new subsidiary. "If you look at E-tail companies, they're all down, including Amazon. I think we're in a very strong position. We have an incredible brand, a terrific balance sheet, and the market will recognize that over time."
Who knows how the market would have treated Barnes & Noble Inc. if it hadn't spun off B&N.com? Barnes & Noble bookstore sales rose 8.5 percent in 1999, although earnings were down slightly. B&N.com had 1999 revenues of $202.6 million, more than three times net sales of $61.8 million in 1998. Both companies have strong balance sheets--far stronger than their chief Web rival. Yet, the stocks of B&N Inc. and B&N.com are still in a funk.
Barnes & Noble isn't the only company suffering from spin-off birthing pains. Some spin-offs can leave the parent behind. In March, Banyan, an Internet consulting and services firm, spun off 23 percent of its Switchboard Inc. subsidiary, which it jointly owns with CBS and AOL as minority stakeholders. The market was so enamored of the online directory and local-merchant service, shareholders staged a sweeping sell-off of Banyan stock in the days following the IPO that sent it plummeting to pre- IPO levels. As of March 15, the market cap of Switchboard.com at $730 million was nearly twice that of Banyan's $420 million. Like all things dot-com, these valuations fluctuate wildly from day to day.
"We did not anticipate that level of reaction," says Banyan CFO Rich Spaulding. "We expected that it would be an enhancing event for the Banyan shareholder. The halo effect around the Internet properties is high. But you do suffer some attention deficit when you do these. It's a challenge for us to get the right level of attention."
On the plus side, the company's stock ran up significantly in days preceding the IPO, then crashed, but it is still double its value prior to the IPO announcement. However, as a longtime tech stock, Banyan should have expected some defections by tech investors jumping to Switchboard.com, a phenomenon referred to as "empty-nest syndrome."
Will the bunny hop?
Playboy has already felt the fickle finger of the market. Havard was banking that Playboy's Class A and B stocks would get a big boost through association with a successful E-IPO. And, in fact, shortly after the IPO announcement, both classes rose sharply. Subsequently, however, they dropped off, trading at around 20 in April from a high of 36 a year earlier.
Havard hopes to raise a reported $50 million in Playboy.com's upcoming IPO, all of which will go to the spin-off. "There will be no ongoing funding from Playboy Enterprises," she says. But that's about the only separation. With its IPO, the size and price of which has not yet been determined, Havard says that Playboy Enterprises will retain a majority ownership position in the resulting company. However, due to accounting rules, as long as Playboy Enterprises is a majority shareholder, it will continue to account for Playboy.com in its consolidated financial statements, integrating all income and expenses, rather than taking only a pro-rated portion of the profit or loss. That won't get any of Playboy.com's ongoing losses off the books, but at least Playboy won't be funding its development any longer. Playboy Enterprises has already sunk $23 million into the Web site. Playboy will retain the 80 percent needed for the company to execute a tax-free spin-off to stockholders, which Havard has no plans to do.
"We would never spin it off completely," says Havard. "We have to keep control of the brand. Playboy.com touches every aspect of our business. It's important that we retain the close relationship."
The company is grappling with the fact that the spun-off entity will rely utterly on the company's brand--and it will be in almost direct competition for Playboy's existing customer base. Moreover, it will depend on the parent company's administrative support and product distribution network. One result of this is a series of intercompany transfer-pricing deals covering everything from brand licensing to administrative duties that Playboy Enterprises will still provide for the subsidiary, including treasury, tax, insurance, financial reporting, investor relations, some legal services, accounts payable, and payroll.
"That's where we're spending most of our time right now," says Havard. "The trademarks are the hardest. If we don't license the trademarks to Playboy.com, it won't exist. We want to treat our shareholders fairly, but we also don't want to undervalue the trademarks."
Some analysts are left wondering why Playboy is spinning the division off, considering the many points of contact, the shared customer base and brand, and the higher potential for growth in the E-division. "If you're sharing the same customer base and the same customer facing, you share the same brand. There are touch points everywhere along the way; you have agreements all along the way; funds being transferred all along the value chain. At that point, you've created an unnatural separation," says McKinsey's Anslinger. "You have to figure out whether the business is a new line that you've incubated, or is it the future of the core business? If it's the future, you shouldn't be spinning it off."
Spun off--and sold
Not all spin-offs come with such complications. In fact, the most successful tend to occur when a company spins off a noncompeting division that does not share a brand. This was the case when Sterling Software Inc., an $807 million (FY'99 sales) software and tech services firm based in Dallas, spun off its B2B E- commerce division in 1996. It went public with 18.6 percent of Sterling Commerce, one of its decentralized divisions devoted to E-commerce, electronic data interchange, and bulk file transfer applications and services. The spin-off not only involved no branding issues, it also avoided customer cannibalization and infrastructure problems. And the Commerce spin-off allowed investors to be involved in a pure-play stock, says Julie Kupp, vice president of investor relations at Sterling Software.
Yet, Sterling Software experienced some of the same post- IPO pains seen at Banyan and elsewhere. Shortly after the spin-off, Sterling Commerce shares soared from 30 to 45, and Sterling Software's plummeted-- from more than 40 to 15 in two days. "After we sold off our crown jewel," says Kupp, "analysts looked at what was left and said, 'How do we value that? Do we do a sum-of-its-parts analysis?' They struggled for a while about how to do a valuation." Both companies have been acquired--Sterling Commerce by SBC Communications in an all- cash deal, and Sterling Software by Computer Associates in a stock swap.
But one needn't look far for spin-offs that have sputtered, or have not even gotten off the ground. Spin-offs are almost always internal and external political events, and sometimes power struggles can cripple the process, as the Toys "R" Us Inc. Web effort demonstrates. Even before Toys "R" Us announced its venture partner for toysrus.com (a commonly used first step to creating spinnable Web divisions), the company was encountering major problems regarding independence, competition, and cannibalization--the bane of spin-offs, experts say.
Toy "R" Us's highly publicized venture partnership with venture capital firm Benchmark Partners fell apart when the two companies could not agree on the ownership structure, which was followed by the dismissal of Benchmark's preferred toysrus.com CEO, Robert Moog.
In published reports, Moog claims the deal breaker was his demand that Toys "R" Us give its Web- site division preferential pricing, below the amount the franchise stores paid, which he felt was necessary to compete against rival eToys. Toys "R" Us said no; it didn't want to alienate its franchise store owners or store managers--a problem faced to varying degrees by every retailer seeking to open up new sales channels to compete with existing ones.
The company just announced a new VC deal with Softbank Corp.'s venture capital division, valued at an estimated $60 million. But this is the sort of issue that makes industry watchers cringe.
"If executive teams are overly concerned with cannibalization, we feel they are missing the boat. Cannibalization will occur," says Jim Breyer, a managing partner at Accel Partners, a venture capital firm in Palo Alto, California. "The best companies realize that even with cannibalization, the best Web initiatives are additive, both to overall revenue and to shareholder value."
When Breyer encounters a parent company that wants to do a spin-off, but chafes against letting the new company operate completely independently, he simply refuses to work with the parent. "If there's anything that prevents the carved- out company from pursuing an independent entrepreneurial position, it won't attract the team you need," he says. "There cannot be anything structural that prevents the carved-out company from building a large, successful, stand-alone business."
Accel recently partnered with Wal-Mart Inc. to develop the company's new Wal-Mart.com Web site, with an eye toward an eventual carve-out IPO. Breyer acknowledges that parent companies that do spin-offs are sacrificing a piece of the profit pie they could retain if they did not do a spin-off. But by spinning it off and attracting Internet talent with valuable stock options, "our bet is that we can help increase the size of the pie dramatically," he says.
However, as long as the spin- off bears the same brand, the goal of a truly independent spin-off seems unrealistic in most cases. Many companies don't even try. Instead, carved-out companies often install several parent-company executives on the sub's board of directors to ensure that the sub still keeps its parent's best interests close at heart. In others, key parent-company executives do double duty at the spin-off. In addition, extensive competition agreements are often the largest part of IPO registration statements, say analysts.
Some industry watchers think that asking management to answer to two sets of shareholders is unwise. What's even more unwise, adds Douglas Smith, managing director of Chase H&Q, an Internet investment bank and venture capital firm formed when Chase Manhattan Corp. bought Hambrecht & Quist last December, is sharing a brand between parent and sub. "The reality is that Playboy.com, for instance, doesn't control how the brand is used otherwise, and if the people who control the brand decide to use it in a different way, that could be deleterious to Playboy.com," he says. "The biggest issue with these types of spin- offs is, whose brand is it anyway? "
Structuring a mutually beneficial incentive program between the parent and the spin-off can alleviate many of these problems, says Breyer. One method is granting dot-com options to parent-company employees who will be contributing to the success of the spin-off. Barnes & Noble Inc. gives options to store managers, and Playboy.com plans to grant options to some staffers in Playboy Enterprises's TV, product licensing, and finance departments.
But overall, this combination of agreements, incentives, and competitive conflicts makes some dubious about the long-term success of these brand- sharing spin-offs. Specifically, some investors believe that shareholders in "Internet sales channel" spin-offs, like BarnesandNoble .com, and impending IPOs from Toysrus.com and Nordstrom.com could face troubled times. "The Nordstrom.com thing is a fleeting phenomenon," says Smith. "It's just another channel, and the market is already refusing to reward that kind of tactic, because it knows that it's just another channel. It's not the place to be for market purposes."
Just say no
Some companies, faced with all the legal machinations of spin- offs and their uncertain value-creation effect, are choosing to avoid them. Instead, these companies are integrating the Web division into the company's basic business plan.
The Charles Schwab Corp., for example, "embedded the Internet into everything we do," says CFO Christopher Dodds. "It's part of our company. We don't look at our Web business separately. We ask how our retail business is doing. Spinning off Schwab.com would be like spinning off Schwab from Schwab." He says that he's not hearing any cries from the company's shareholders to do anything differently.
Dodds wonders if perhaps the recent dot-com spin-off hysteria is due in part to the lack of attention by the investment community and a lack of clarity by the companies themselves. "Maybe a certain slice of the analyst constituency doesn't have as clear a view of a company's strategy as they should. What they say is, 'I do understand tracking stock.' Companies say, 'If we do tracking stock, we'll get premium valuation.'" Dodds says he ensures that Schwab's Internet assets are valued properly by bombarding analysts and investors with detailed monthly, quarterly, and annual financial data, and performance information on everything from net new assets to new account flows.
Even the staunchest proponents of Web spin-offs agree that an integrated approach is probably the best long-term strategy. "The value of the business sits at the intersection of the online and offline world," says Breyer.
Breyer says that although spin-offs help companies get their Web sites to profitability quickly, generate some short- term cash, and attract top-quality talent, they're probably not sound arrangements over the long-term, especially when the Web subsidiary becomes highly profitable. In fact, Breyer predicts that in 5 to 10 years, the market will see companies spinning their Web divisions back in.
"It's in the first five years that most of the heavy lifting occurs on these Web sites," says Breyer. "Over a long period of time, the advantages of the structure definitely diminish."
Based on the continuing flurry of IPOs, it appears that, for now, many investors don't seem to care. Which is sure to be good news for Linda Havard. "Short-term, the value of the stock that Playboy will still hold will overcome the losses it's going to continue to recognize," says Dennis McAlpine, an analyst with Ryan Beck Southeast Research Group, who covers Playboy Enterprises. "As long as you can separate out Playboy.com and put a value on it, its books will look a lot better." S
Kris Frieswick is staff writer at CFO.
Most companies carve out, rather than fully spin off, their Web divisions. These carve-out IPOs are done with an eye to eventually distributing the remaining shares to their stockholders in a tax-free spin-off. But before that can happen, the Internal Revenue Service has a few hoops companies must jump through.
The first rule of tax-free spin-offs is that the distributing company must control the ownership of stock, possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote. Also, the parent must control 80 percent of the total number of shares of each class of nonvoting stock, according to an interpretive white paper prepared by Robert Willens, an accounting analyst with Lehman Brothers.
That does not mean the company must own 80 percent of the value of the company. This language lets companies issue two classes of stock, one with more voting power than the other, which allows them to sell off the maximum amount of a sub in an IPO while retaining enough voting stock to execute a future tax-free spin-off. This tactic was used by DuPont when it spun off Conoco in October 1998.
"The idea is to make sure the distribution of a stock is not being done as a substitute for a dividend distribution, which would be taxed at ordinary income rates," says an IRS spokesman.
A trickier, secondary requirement, however, stipulates that the company being spun off to shareholders must have been an active business for more than five years prior to the spin-off date. This is called the active business requirement, and presents some obvious challenges for any company attempting to spin off a Web division--which probably didn't exist even two years ago. Fortunately, the IRS will grant an exception to this rule if a company can show that the subsidiary is an expansion of the parent company's original business, and if the parent has been around for at least five years.
Finally, although companies that own more than 50 percent of a subsidiary can file a consolidated financial statement with the sub, they must own at least 80 percent of both voting power and value in order to file a consolidated tax return. -K.F.