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The ¬rst unit to be “spun out” was Thermedics, which was sold in August 1983 for
$2.51 per share. In March 1994, Thermedic™s stock was valued at $12.13. In mid-1994
Thermo Electron had nine “pups,” as the spinouts became known on Wall Street. Most
had performed well following the initial offering. (See Exhibit 2 for details of stock per-
formance of these units following the spinouts). For example, Thermo Instrument Sys-
tems, Inc., which grew out of the successful instrument project with Ford and which was
spun out in 1986, was initially sold for $3.56 per share and in mid-1994 sold for more
than $32.
There were several differences between the spinout concept pioneered by Thermo
Electron and the more traditional spinoffs. First, under a traditional spinoff all of the sub-
sidiary™s equity was distributed to either the parent-company shareholders or to new share-
holders through an Initial Public Offering (IPO). In the Thermo spinout the parent company
sold off only a minority stake in the division, either through an IPO, a private placement, or
both. Second, traditional spinoffs typically arose when the parent wanted to raise cash, to
reduce debt obligations, or to rid itself of poor-performing units and focus on its “core”
competencies. Consequently, announcements of spinoffs tended to have a negative impact
on the parent company stock.2 In contrast, announcements of spinouts, or “equity carve-
outs” as they are sometimes called, usually had a positive 2 to 3 percent effect on the stock
of the parent company. Theo Melas-Kyriazi, Thermo™s treasurer explained, “We don™t sell
poor performers, the dogs; we sell our core technologies.”3 The cash generated from these
sales was then used to provide working capital for the spun-out units.
Dr. Hatsopolous believed that the company™s spinout strategy enabled it to combine
the vibrancy of a small high-growth start-up with the ¬nancial stability and research
strength of an established company. The structure provided strong incentives for man-
agement and key researchers, who were rewarded with stock options in the newly cre-
ated publicly traded subsidiaries. As a result, there was virtually no turnover among key
employees at Thermo Electron. In addition, Dr. Hatsopolous was convinced that, by
creating a series of “pure plays” on speci¬c technologies, the ¬rm helped investors to
better understand its business, and hence lowered its cost of raising capital.

.........................................................................................................................
1. Boston Business Journal 13, November 19, 1993, Sec. 1:3.

2. See Schipper and Smith, Journal of Financial Economics, 1986: 153“186.
3. Wall Street Journal, August 5, 1993: 1.
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Entity Accounting Analysis




Accounting for Spinouts
One issue that arose from the spinout strategy was how to account for the spinouts. There
was no FASB ruling on this accounting practice. However, two options were available to
Thermo Electron: (1) record any realized gain or loss on sale of shares in the spun-out
unit as an increase or decrease in equity reserves; or (2) report any gain or loss in the




Thermo Electron Corporation
income statement. The footnotes in the annual report explained that Thermo Electron
followed the second of these options:
At the time a subsidiary sells its stock to unrelated parties at a price in excess
of its book value, the Company™s net investment in that subsidiary increases. If at
that time the subsidiary is an operating entity and not engaged principally in re-
search and development, the Company records the increase as a gain.
If gains have been recognized on issuance of a subsidiary™s stock and shares
of the subsidiary are subsequently repurchased by the subsidiary or by the Com-
pany, gain recognition does not occur on issuances subsequent to the date of re-
purchase until such time as shares have been issued in an amount equivalent to
the number of repurchased shares.
The impact of this accounting decision was signi¬cant. Since the ¬rst spinout in
1983, 50 percent or more of the ¬rm™s net income arose from gains on spinouts. For ex-
ample, in 1993 the gain on sale (both before and after tax effects) was $39.9 million,
compared to net income of $76.6 million.
Management believed that the accounting policy has been critical in helping the com-
pany raise funds, since it enabled the ¬rm to generate smooth earnings growth in its in-
come statement. However, analysts remained concerned about the quality of the ¬rm™s
earnings.


Recent Financial Performance
In Fortune magazine™s 1994 ranking of the nation™s top 500 industrial companies, Ther-
mo Electron was ranked number one for largest growth in earnings per share from 1983
to 1993. The company also ranked twenty-ninth on the Fortune list of ¬rms with the
highest total return to investors over for the last ten years. “We attribute our success in
large part to our strategy of spinning out promising businesses that serve energy, envi-
ronmental, and biomedical markets,” said Dr. Hatsopolous. “By forming these entities,
we are able to tap the capital markets and create an entrepreneurial environment that
spurs ingenuity.”4
For its ¬scal year ended January 1, 1994, Thermo Electron reported its ninth consec-
utive year of record ¬nancial performance. Its revenues were $1.2 billion and income
before an accounting change was $76.6 million, or $1.75 per share. See Exhibit 3 for a

.........................................................................................................................
4. Wall Street Journal, August 5, 1993: 1.
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Entity Accounting Analysis




8-25 Part 2 Business Analysis and Valuation Tools




ten-year summary of the company™s ¬nancial data and Exhibit 4 for its most recent ¬-
nancial statements.
Despite its impressive record, John Kolmanoff was uncertain about whether he
should continue to recommend the stock to his clients. Many analysts were forecasting
that the company™s earnings would grow at a rate of 18 to 22 percent for the next ¬ve
years. Given the stock price in early July 1994 of $24.75, the company was trading at
Thermo Electron Corporation




1.38 times its book value. However, others were more cautious, and questioned the qual-
ity of the ¬rm™s earnings, given that much of its income was derived from gains on
spinouts. Short sales in the company™s stock had grown 21 percent in the previous six
months, to approximately 11 percent of its outstanding stock. Given the mixed opinions
on the company, Kolmanoff decided that he should undertake a complete review of its
business, accounting, and valuation.5




.........................................................................................................................
5. In early July 1994, Thermo Electron™s equity beta was 1.1, the 3-month Treasury Bill rate was 4.2%, and the 30-year
Government Bond Rate was 7.68%.
302 Entity Accounting Analysis




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Entity Accounting Analysis




EXHIBIT 1
Five-Year Summary of Stock Performance: Thermo Electron and SPX

Percentage Change




Thermo Electron Corporation
140%




120%




100%




80%



TMO
60%
SPX



40%




20%




0%




“20%
6/30/89
9/29/89
12/29/89
3/30/90
6/29/90
9/28/90
12/31/90
3/28/91
6/28/91
9/30/91
12/31/91
3/31/92
6/30/92
9/30/92
12/31/92
3/31/93
6/29/93
9/30/93
12/31/93
3/31/94
6/30/94
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Entity Accounting Analysis




8-27 Part 2 Business Analysis and Valuation Tools




EXHIBIT 2
Stock Performance for Thermo Electron Spinouts

3/3/94
...................................
Split-adjusted Shares
Thermo Electron Corporation




IPO Date IPO Price Price Outstanding CAGR
Company
...................................................................................................................................................
Thermedics 8/10/83 $2.51 $12.13 31,978 15.40%
Thermo Instrument Systems 8/5/86 3.56 32.25 45,865 31.70
Thermo Process Systems 8/21/86 1.83 9.00 16,041 22.00
Thermo Power 6/26/87 8.50 8.75 12,232 0.50
Thermo Cardiosystemsa 1/12/89 2.27 19.25 n/a 51.70
Thermo Voltek 3/19/90 2.56 9.00 3,929 36.90
ThermoTrex 7/24/91 7.92 15.50 17,093 25.10
Thermo Fibertek 11/2/92 8.00 14.63 26,832 82.90
Thermo Remediationb 12/16/93 12.50 14.13 6,503 15.00
...................................................................................................................................................
a. Reflects combined ownership by Thermo Electron and Thermedics
b. Reflects ownership by Thermo Process
Source: Centre for Research in Security Prices.
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Entity Accounting Analysis




EXHIBIT 3
Thermo Electron Ten-Year Financial Summary

(in millions except
1993a 1992b 1991c 1990d
per-share amounts) 1989 1988 1987 1986 1985 1984
.......................................................................................................................................................




Thermo Electron Corporation

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