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March 1, 2002

Enron Spin-off Clouds

By Colleen Marie O'Connor

The stakes are growing for spin-offs, an increasingly popular IPO vehicle used by corporate conglomerates to raise cash. Some six IPO spin-offs are expected this year, including deals by PricewaterhouseCoopers and Merck & Co. Each is expected to raise over $1 billion.

Over the last two years, spin-offs have outperformed the market, according to Spin-Off Advisors LLC, a Chicago-based firm that tracks spin-offs and manages The Spin-Off Fund hedge fund.

"If the company valuation, in the opinion of the parent, is below the intrinsic value of the parts separated, that is the primary reason for a spin-off," said Mark Minichiello, a principal at Spin-Off Advisors.

There are many other reasons why corporations use spin-offs. In some, management believes the value of the parts need to be unlocked. Sometimes, as in the case of Lucent's Agere spin-off, debt needs to be unloaded.

In the wake of the Enron disaster, however, and the ensuing scrutiny of accounting practices, the latest spin-off announcements have set rumors swirling that could hurt the accounting industry.

Nonetheless, PricewaterhouseCoopers plans to spin-off its consulting arm, PwC Consulting, in an IPO. While the firm has been looking to divest the unit for two years, the Enron debacle may speed up the process.

Samuel DiPiazza Jr., the firm's chief executive, called the IPO announcement a "response" to the crisis surrounding the Enron failure, aimed at restoring confidence in the accounting profession.

PricewaterhouseCoopers said it would endorse proposals aimed at banning accounting firms from providing both consulting services and internal-audit to the same client.

According to Minichiello, the IPO market is more receptive to larger spin-offs than in the past. As a result these IPOs are heftier in dollar terms, even if the number of transactions is smaller in some cases.

For example, 1999 produced 30 carveouts that raised $91 billion in market value. By comparison, 2001 saw just 11 carveouts but these produced almost as much, $86 billion in market value. And the year 2000, considered an aberration, produced 25 carveouts that created $142 billion in market value.

Another trend, said Minichiello, has been a rise in two-step spin-offs. That's where the parent first floats a portion of its ownership in an IPO. Some months later, the company is handed complete independence. The advantages of the two-step process are the creation of immediate capital and a public market for the stock, which has several months of trading before the company becomes independent.

That allows Wall Street time to become comfortable with the new company before it completely separates from its parent. This approach is favored by Merck. The company announced its intention to spinoff its Merck-Medco subsidiary by mid-year. Merck plans to establish the unit as a separate, publicly-traded company within 12 months of the IPO.

A pharmacy benefits management company and an industry powerhouse, Merck acquired Merck-Medco for $6.6 billion in 1993.

While the acquisition did little in a strategic sense for Merck, the PBM had a tremendous increase in revenue, growing to $26 billion in 2001 from $2.2 billion in 1992. However, in a conference call, Merck management offered no IPO details.

Strategic Review

"It is clear that Merck-Medco is a much different company than it was nine years ago, and the environment in which it operates has also changed dramatically," said Merck's CEO Raymond V. Gilmartin. The decision was the result of a four-month strategic review conducted by Merck's management and board of directors, he said.

The pharmaceutical developer is at a crossroads, say analysts, with few "blockbuster" drugs in its pipeline. In the meantime, as patents expire, generic drug manufacturers continue to eat away at Merck's branded drug sales. By extrapolating the PBM unit from itself, Merck could be making room for a strategic acquisition that better fits its drug research focus, most likely in the biotech arena, say analysts.

Colleen Marie O'Connor is an associate editor at The IPO Reporter, published by Venture Economics, a Thomson Financial Company.