In this edition of Investing chronicles, Lockstep CEO Paul Farah explains what spin-offs are and how to take advantage of them, referencing the recent example of Grail.

What is a spin-off?

A spin-off occurs when a parent company separates a portion of its business or a subsidiary into a new, independent company. This involves splitting out all the new entity’s assets, liabilities, and operations so it can operate independently from the parent company.

If the parent company is listed on a stock exchange, the new business will be listed as a separate entity.

Mechanics of a listed spin-off

Shareholders of the parent company receive shares of the new entity. The distribution ratio (e.g., one share of the new company for every five shares of the parent company) is predetermined and announced during the spin-off process. 
The new entity is then listed on the stock exchange and trades independently of the parent company.

Valuation of the two separate companies

On the day the new entity is listed, the new entity’s value is determined by the market. So, the share price the new entity trades at is the value of the business the market believes accurately represents the company’s prospects.
The parent company’s value typically drops by an amount roughly equivalent to the market value of the new entity. 
Initially, the new company’s share price might be quite volatile as existing shareholders sell the business if it doesn’t meet their investment criteria. And therein lies the opportunities for astute investors.

Index tracking fund (you’ll need this for later)

An index tracking fund is designed to replicate the performance of a specific market index, such as the S&P 500. These funds aim to mimic the returns of their chosen index by holding a portfolio of securities that mirrors the index composition.
If the index constituents change or the weighting within the index changes, the index tracking funds have to adjust their fund accordingly. 
 

Illumina and its “holy” Grail

Here’s an example of a recent spin-off

Illumina, Inc. (ILMN): Illumina is a leading genomics company that develops and manufactures technology for genetic analysis. It is a listed company and is part of the S&P 500.

Grail (GRAL): Grail is a subsidiary of ILMN. It focuses on early cancer detection through blood tests.
 

The backstory

In 2016, ILMN spun off GRAL to raise capital for the business and had notable early investors, including Jeff Bezos and Bill Gates.
In 2021, ILMN reacquired GRAL for $8 billion. However, the company didn’t follow due process, such as seeking EU approval for the acquisition. The EU launched an antitrust investigation, causing multiple years of headaches for ILMN and GRAL and ultimately leading to a fine. 

This multi-year legal battle has resulted in GRAL being unable to reach its potential due to regulatory barriers. It has concluded with ILMN being forced to spin off GRAL again.

Source: European Commission
For a complete history, read here.

The opportunity

ILMN doesn’t want to spin off GRAL, as it clearly sees potential in the business. Fortunately for ILMN, it will retain a 14.5% ownership stake. 
Furthermore, GRAL has been unable to achieve its potential due to regulatory barriers. The spin-off should be the final catalyst for regulatory approval of its cancer tests.

Since ILMN is part of the S&P 500 index, funds tracking the index (told you you’d need this 😉) will have to sell GRAL shares, as it will likely have too small a market cap to be part of the S&P 500. 
Vanguard owns 11.4% of Illumina, and BlackRock owns 8.4%. So, over 20% of Grail’s shares might be sold upon listing. This selling will be done regardless of GRAL’s share price, which could result in the company being oversold. 

We don’t have these restrictions and can buy shares in GRAL regardless of size if we believe it to be a good investment.

Risks

As always, there are risks involved, and the following are my two main concerns:

• Grail is not yet profitable and is burning through cash, estimated at around $250 million for 2024. However, ILMN is funding GRAL with almost $1 billion as part of the spin-off agreement, giving it about four years of operating cash. 
• The potential for Grail’s cancer tests is significant, but commercial success is uncertain.

My next move

Despite the uncertainty, I believe it’s worth taking a small bet (a small position in my portfolio) if GRAL’s shares are heavily sold down upon listing – it could take a few days to happen, so I am not in a rush.
The spin-off should clear the way for regulatory approval of its tests, unlocking value in the business. As things progress and if the company can improve its profitability, I may look to increase my investment.

There’s plenty more to discover with Lockstep. 
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DISCLAIMER
Paul Farah has worked in financial markets since 2006, holding positions at prestigious firms from New York to South Africa. Now, he manages his own money and provides access to his entire portfolio through his company Lockstep Investing. The views and opinions shared are his own and are for informational purposes only, they are not intended to serve as investment advice and do not represent the views or opinions of Standard Bank. This information should be used as a starting point for generating investment ideas, and should not be relied upon as the sole basis for making investment decisions. Lockstep Investing (PTY) LTD and the Standard Bank of South Africa Limited will not be responsible for the results of any investment decisions made based on the views provided.