May 24, 2008

The Value in Spin-offs

I have written and evaluated spun-off companies as value ideas. In this post I want to elaborate on the rationale and the value in spin-off investing. A good book that details this subject is Joel Greenblatt's book "You can be a stock market genius". If you can bypass the book's over-the-top title, it is actually a very good book in value investing with case studies and good search strategies for undervalued investments.

Joel argues that spin-offs are good hunting ground for value and his three criteria for picking good spin-off companies are:

  1. Institutions don't want it not because of investment reasons,
  2. Insiders participation, and
  3. Hidden investment opportunity is revealed.

Security holders often times invest in parent company for a variety of reasons that may not hold true in the spin-off company, for example, industry, size, leverage...etc. So those holders are motivated to get out from the spun-off company as soon as possible. Typically in the few months after the spin-off there is tremendous selling pressure on the spun-off company for no economic reasons. Selling is done due to investors policies and other limitations.

The rest of the post is an article I saved awhile back but I did not source, so for the author, Please forgive me for not posting credit.

Fundamentals

Spin-offs have a limited operating history, which means there’s relatively little for investors to look at as a benchmark for future performance. Moreover, the track record that does exist is likely to be unimpressive, since the parent firm has a strong incentive to clean up its books by allocating lots of ‘grey area’ costs to the spin-off. With a limited and often unimpressive operating history, the market’s expectations are relatively low, which again leads to a lower valuation.

Analysts usually apply a premium to ‘pure play’ niche businesses which spin-off represent. However, this said, analysts will almost certainly never pick up initial coverage. Why? because, the spin off entity does not fall under the initial analyst who covers the parent company’s coverage. E.g. a medical company spinning off a chemical division. The chemical maker will not be under the medical analysts coverage and be too small, or go unnoticed to fall into another’s. This period of ‘wilderness’ for the divested entity is typically 0-9mths after spin occurs. Interesting to note, spin-offs typically appreciate 30% or more in this time. Then a re-rating begins.

Spin-offs are often cheap when they come to the market. Every single one is temporary and most will have nothing to do with the underlying intrinsic value of the business. The hype will eventually pick up if the company performs well, the selling pressure will abate as shareholders of the parent company finish dumping the spin-off’s shares. Analysts will eventually pick up coverage, the company will develop a track record and management generally finds a way to improve a business dramatically after the first year or so. The result is a improved cash-flow generation and sometimes a bit of a valuation improvement as well which often means a nicely appreciating stock price.

  • Often, spin-offs are a growth story. If the old management was holding back expansion and the new team has a clear strategy for building businesses that were starved for capital, you can bet the market will reward the risk. Also frequently, there are hidden assets, not reflected in book value, such as land holdings or lucrative brands.

Don’t forget carve outs! They are often a prelude to a full spin-off. In about half of carve outs, the parent eventually leaves the picture.

And don’t forget the parent either! Value can often be released in the parent. It will often set a business free for the most obvious reason. It’s troubled and unprofitable. Usually, the parent unloads the spin-off with baggage ranging from heavy debt to rusting plant and machinery. Incidentally, big debt isn’t a killer if the new company has the earnings to carry it.

Spin-Off Pricing Inefficiency/Technicals

Spin-offs don’t receive much publicity or hype. Typically the parent announces a spin, makes some filings, AGMs, shareholder meeting happen for approval etc.. Then the spin-offs shares quietly show up in the accounts of investors and institutions who own the parent. There’s generally not much news coverage when a spin-off hits the investor’s accounts and the valuation is set by the parent.

The spin-off process itself is a fundamentally inefficient method of distributing stock to the wrong people. Once the spin-off’s shares are distributed to the parent company’s shareholders, they are typically sold immediately without regard to price or fundamental value.

Structural selling of spin-offs happens due to index fund selling (because the spin-off is not in the index) Lack of yield limited old lot selling and limited liquidity.

  • In the Penn State study, the largest stock gains for spin-off companies took place not in the first year after the spin-off but in the second. It may be that it takes a full year for the initial selling pressure to wear off before a spin-off’s stock can perform at its best. Most likely, though, it is not until the year after a spin-off that many of the entrepreneurial changes and the initiative can kick in and begin to be recognised by his marketplace. Whatever the reason for this exceptional second-year performance, the results do seem to indicate that when it comes to spin-offs, there is more then enough time to do research and make profitable investments.

Insiders

When a business and its management are freed from a large corporate parent, pent-up entrepreneurial forces are unleashed. The combination of accountability, responsibility, and more direct incentives take their natural course. After a spin-off, stock options, whether issued by the spin-off company or the parent, can more directly compensate the management of each business.

  • Shares of a spin-off are distributed directly to parent-company shareholders and the spin-off’s incentives-stock-option plan is based on this initial trading price. The lower the price of the spin-off, the lower the exercise price of the incentive option. To promote interest in the spin-off’s stock after this price is set by the market, not before.

    Do not expect bullish pronouncements or presentations about a new spin-off until a price has been established for management’s incentive stock options when the price of management stock options is to be set.

    There are few investments areas where insiders have such one-sided control in creating am new publicly-traded company.

Many spin-offs are run a lot better as independent companies than as wards of huge corporations. You attract far better managers to a spin-off than to a division of a company. People can really see they’re making a difference in the value of the stock and their own stock options.

These four criteria can hint at an attractive spinoff:

  • Unattractive factor. Something unattractive is a plus. Too small, too obscure, or too different from the parent -- something that makes investors want to sell. Sometimes it's because investors are only interested in owning the parent; other times, it is because institutional investors have strategies that don't allow for holding companies below a certain size or outside of their area of focus. The end result of their disinterest is to sell, which can temporarily depress the price of even a very good business. For this reason, you want to closely track a spinoff in the first few weeks after it begins trading. But when it really gets interesting is when the spinoff has one of the following traits as well.
  • Growth. Some spinoffs are simply freeing a growth business to shine. The beauty of these spinoffs is often that they are free of the parent's capital allocation decisions. Once spun off, the growth business is free to retain the cash flow it generates and plow it back into the growth opportunities it sees. This was part of the strategy behind Sara Lee spinning off Coach (NYSE: COH) a number of years ago.
  • Leverage. Parent companies often use their spun-off children as a way to unload debt. It's somewhat counterintuitive, but a spinoff that is saddled with debt can be a very good investment, because that leverage amplifies the impact of sales growth and margin improvement, promoting debt repayments and lowering future interest expenses. Debt also unquestionably makes the spinoff a riskier investment, because if sales or margins fall, the interest payments get tougher to cover. Hanesbrands(NYSE: HBI), another company sprung from Sara Lee, fits this mold with $2.5 billion in debt and a sliver of equity.
  • Incentives. To catch this one, you have to be paying attention to the prospectus and filings of a spinoff. Many times, management has plenty of incentives in place to make sure the stock price of a spinoff performs. This can be an ownership stake, options, restricted stock, or stock appreciation rights. Just because incentives are in place doesn't mean a spinoff will be successful, but it increases the odds that management will be keen to decrease costs and take other actions that increase shareholder value.

5 comments:

Jim said...

I now invest exclusively in spin-offs and their parents. Good post.

Sami said...

Thanks Jim.

The case for spin-offs is good and academic research backs it up. another benefit is you do not have to search and screen for companies all over the place, just concentrate on spinoffs.

johnny said...

how do you guys find the spin-offs?

Sami said...

reading the news mainly. you can also sift through the Sec web site for spin offs announcements.

do a Google business news search for stock spinoffs you will get a lot of hits.

johnny said...

ok thanks!