As I analyzed the investment decisions that I have made last year, I’ve come to realize that the one that made me most money and the one that would have made me a lot of money had I not been sucking my thumbs while I should be acting are both spin-off situations. Come to think of it, there were actually a good amount of spin-offs last year, but I only took the time and effort to analyze a few. As Joel Greenblatt noted, “The spin-off process itself is a fundamentally inefficient method of distributing stock to the wrong people.” If the extra profits are inherently built into the system, why not spend more time fishing in this area? Therefore, I plan to dig a little bit more into spin-offs during 2014.
In this article, I will analyze a spin-off opportunity that I am currently watching closely. The final details have not come out yet but by preparing ourselves to the greatest extent, we will be ready to act when the opportunity comes.
I. The Announcement:
According to the press release dated May 23, 2013, Dover, a diversified global manufacturer with annual revenues of over $8 billion, announced that its board of directors has unanimously approved a plan to spin off certain of its communication technologies businesses into a standalone, publicly traded company.
Upon completion of the spin-off, the new company, Knowles Corporation ("Knowles"), will be an independent, global technology and market leader in the communication technologies space. Knowles will have significant product breadth in acoustic components, including MEMs microphones, speakers, receivers and transducers, as well as a solid position in communication infrastructure components.
Robert A. Livingston, Dover's president and chief executive officer, said, "Consistent with our strategy to create value by identifying and building leading brands and positions in growth markets, we have successfully built Knowles into a great business and an industry-leading enterprise. Given the evolution of their unique business model, these businesses can now pursue a more aggressive growth strategy together as a standalone company. Knowles will have the expertise, solid financial profile and operational flexibility to serve its global base of customers and their distinct product and technology needs. We expect this transaction will provide significant benefits for employees, customers and shareholders. This transaction will provide both Knowles and Dover greater flexibility to focus on and pursue their respective growth strategies, which will allow them to create significant value for shareholders.”
"Dover will continue to execute on its long-term strategy and commitment to industry leadership through innovation, leveraging its scale and focusing on its key end-markets. In addition to ongoing investments to support organic growth and value-added strategic acquisitions, we will continue our practice of consistently returning capital to our shareholders through dividends and share repurchases, including completion of our current $1 billion authorization."
Knowles, on a pro-forma basis for 2013, will have $1.3 billion in annual revenue, with about two-thirds derived from high-growth acoustic products. Prominent brands within the new company will include Knowles, Sound Solutions, Dielectric, Novacap, Syfer and Vectron. Knowles is expected to have a capital structure, balance sheet and financial policies consistent with investment grade credit metrics.
II. Reasons for Spinoff:
Management claims the following reasons for the spin-off according to the most recently filed form 10-12B.
- Enhanced strategic and management focus — The separation will allow each company to more effectively pursue its own distinct operating priorities and strategies, and will enable the management of both companies to pursue separate opportunities for long-term growth and profitability, and to recruit, retain and motivate employees pursuant to compensation policies which are appropriate for their respective lines of business.
- More efficient allocation of capital — The separation will permit each company to concentrate its financial resources solely on its own operations, providing greater flexibility to invest capital in its business in a time and manner appropriate for its distinct strategy and business needs. This will facilitate a more efficient allocation of capital.
- Distinct investment identity — Dover’s board of directors believes that Dover’s businesses and Knowles’ businesses appeal to different types of investors with different industry focuses, investment goals and risk profiles. Dover and Knowles have different investment and business characteristics, including different opportunities for growth, capital structures, business models and financial returns. The separation will enable investors to evaluate the merits, performance and future prospects of each company’s businesses and to invest in each company separately based on these distinct characteristics.
- Independent Equity Structure — The separation will create an independent equity structure that will afford Knowles direct access to capital markets and will facilitate the ability to capitalize on its unique growth opportunities and effect future acquisitions utilizing, among other types of consideration, shares of its common stock. Furthermore, an independent structure should enable each company to provide equity incentive compensation arrangements for its key employees that are directly related to the market performance of each company’s common stock. Dover’s board of directors believes such equity-based compensation arrangements should provide enhanced incentives for performance, and improve the ability for each company to attract, retain and motivate qualified personnel.
Although I usually take management’s assertions with a grain of salt, this is not a bad place to start. All of them are standard spin-off reasons that you can find in most of the spin-off filings so we have to dig a little deeper in order to rationalize the situation specifically to Dover and Knowles.
Dover is a conglomerate that has four segments — Communication Technologies, Energy, Engineered Systems and Printing & Identification. Each segment is very different from another. Knowles resides in the Communication Technology segment, which accounts for 19% of total consolidated revenue and Knowles accounts for 63% of the segment revenue.
Dover’s serves industries ranging from aerospace and defense to refrigeration and food equipment. Its product mix is diverse, yet the brand recognition is weak. If you were to ask me what Dover does for business, the best answer I can think of is, “It does a little bit of everything.”
Now we can imagine the confusion out there when an analyst is trying to value Dover. The complexity of the organization makes it hard to evaluate the company on the whole so sum of the parts is the only way to go. However, even the parts themselves can be complex. For example, within the Engineered Systems segment, there are two sub-segments- Fluid Solutions and Refrigeration of Industrial and they have vastly different characteristics.
Given the confusion created by the organization structure, the best way to highlight a division is to set it free by spinning it out. Therefore, I think the separation makes sense for Knowles. It will make it a lot easier to value Knowles, but not necessarily Dover.
One added incentive for the newly appointed Knowles executives is the new compensation structure, which will be discussed in the next section.
III. New Compensation Structure
Dover’s compensation structure is typical for a public company. It includes salary, cash bonus, share based payments, pension and 401k, retirement plans and severance packages. By going through the SEC filing, I discovered that the biggest drawback of Dover’s compensation system, in my opinion, is the way that share based payments and specifically, performance shares, is designed. Under Dover’s policy, Dover issues performance share awards that may be earned over three years based on Total Shareholder Returns of Dover’s Stock relative to its peer group over that time period. Under this structure, the incentives are misaligned. To quote Buffett, “the sluggard receives rewards precisely as does the star.” We don’t know whether the newly appointed Knowles senior executives were starts or sluggards but we do know that if the Knowles division had a spectacular, they would have to share the standing ovation with free riders and if the Knowles division had a poor year, they could still be rewarded nicely by being the free riders.
The New Compensation Structure of Knowles will give the new executives massive incentives to run the business well because now the equity awards are directly tied to the business operational performance through a combination of options and restricted stock units. If Knowles does well, the executives and employees get all the rewards and if Knowles does poorly, the executives and employees will have to swallow the pain by themselves.
IV.Is Knowles a Great Business?
Knowles will be organized into two reportable segments based on how management analyzes performance, allocates capital and makes strategic and operational decisions. These include i) Mobile Consumer Electronics (“MCE”) and ii) Specialty Components (“SC”). The segments are aligned around similar product applications serving Knowles’ key end markets, to enhance focus on end market growth strategies.
- MCE designs and manufactures innovative acoustic products, including microphones, speakers and receivers, used in several applications that serve the handset, tablet and other consumer electronic markets.
- SC specializes in the design and manufacture of specialized electronic components used in medical and life science applications, as well as high-performance solutions and components used in communications infrastructure and a wide variety of other markets. SC’s transducer products are used principally in hearing aid applications within the commercial audiology markets, while its oscillator products predominantly serve the telecom infrastructure market and capacitor products are used in applications including radio, radar, satellite, power supplies, transceivers and medical implants serving the defense, aerospace, telecommunication and life sciences markets.
The latest filing lists the following competitive advantages of Knowles:
Leader in the communication technologies industry. Knowles has built an industry-leading enterprise in terms of brand recognition, technology and market presence in communication technologies. Based on market share, Knowles is a leading supplier of acoustic components to all major handset OEMs and hearing aid OEMs. Knowles also has a strong position in supplying oscillators and capacitors to customers in the telecommunications infrastructure, military/space and other industrial markets. Dynamic research and fast product development cycles, and high-volume, scalable manufacturing capabilities are characteristics that Knowles has developed and intends to continue to build upon.
Market leading product innovation. Knowles invests significant resources in research and development and brings significant application expertise with capabilities to quickly and effectively design, develop and manufacture new products to meet its customers’ needs. Knowles maintains design centers in multiple locations in North America, Europe and Asia, which enables Knowles to attract the best talent in every region of the world. Knowles has increased its spending by over 50% to support its research and development functions over the last three years and spends an average of 6.5% to 7.5% of revenue on an annual basis on projects intended to preserve and extend its technological advantage.
Operational excellence. Knowles has a proven track record of executing operational improvements, through cost reductions, increased yields and improving capacity utilization. Knowles’ diversified operations include high-volume scalable production capabilities, fully automated production lines and labor-intensive assembly processes. Knowles maintains major manufacturing facilities in three countries which are integrated through a centralized operating and supply chain.
Well-established, collaborative relationships with leading customers. Knowles’ close relationship with its customers enables it to develop critical expertise regarding its customers’ requirements and needs. Knowles uses that expertise and application knowledge, coupled with its research and development to design differentiated products that are used to enhance the end users’ acoustic interface with their mobile devices or ensure performance in mission critical applications. Knowles’ products have been designed into multiple generations of its customers’ products.
Executive management team with proven history of success. Knowles’ CEO and his direct reports and the core operational team have worked together for a significant number of years. The executive management team has driven Knowles’ strong history of profitability and cash flow generation, and demonstrated a proven ability to execute under multiple ownership structures, including private equity and as part of the segment company structure within Dover. In addition to Jeffrey Niew, who will be Knowles’ President and Chief Executive Officer after the separation, Knowles’ named executive officers include John Anderson, Michael Adell, Raymond Cabrera and Gordon Walker, who have all held senior positions of responsibility at Dover prior to the separation.
Strong financial performance allows Knowles to exceed customer demands. The Knowles business model has evolved as its end markets have developed and grown over the years. Its strong history of profitability and cash flow generation, supported by a strong and flexible balance sheet, will enable Knowles to continue to invest in new products and technology at a rapid pace in order to meet and exceed customer demands.
While the above chants by management are likely to be true, I do not regard Knowles as a great business mainly because it lacks pricing power, which Warren Buffett considers as the single most important moat indicator. Knowles clearly lacks pricing power. As disclosed in the SEC filings, Knowles has been cutting the prices of its products in the past three years.
Nine Months Ended September 30, 2013 Versus Nine Months Ended September 30, 2012
Knowles’ revenue for the first nine months of 2013 increased $63.0 million, or 7.7%, compared to the same period of 2012, due to an increase in volume of $91.8 million, partially offset by a decrease of $30.1 million related to pricing concessions.
2012 Versus 2011
Knowles’ 2012 revenue increased $134.7 million, or 13.7%, to $1.1 billion from $983.3 million in 2011. The overall increase in revenue resulted primarily from increased MEMs microphone volumes, due to new product introductions and overall smartphone market growth which resulted in an increase in revenue of $89.6 million. In addition, Sound Solutions contributed an increase of $134.0 million in acquisition-related revenue in the first half of 2012 as compared to the first half of 2011. The increase in 2012 revenue was partially offset by $30.8 million as a result of OEM market share shifts for the speaker and receiver product lines, $26.4 million related to pricing concessions for components serving the mobile consumer electronics and medical technology markets corresponding to normal product life cycle maturities within these markets and $25.0 million due to reduced demand within the telecommunications infrastructure market.
2011 Versus 2010
Revenue increased $252.9 million, or 34.6%, for 2011 from $730.4 million in 2010, with $190.2 million of the increase in revenue attributable to the 2011 acquisition of Sound Solutions, whose speaker and receiver product lines supplemented Knowles’ existing product offerings in the growing handset market. Organic revenue growth of approximately 9% was largely due to continued strong demand for MEMs microphones for use in the smartphone market, which grew $110.2 million year over year. The increase in 2011 revenue was partially offset by $25.6 million due to strategic pricing initiatives for components serving the mobile consumer electronics and medical technology markets, corresponding to normal product life cycle maturities, as well as $23.6 million due to weak demand for products serving the medical technology and telecommunication infrastructure markets.
Knowles market share has also been dropping in the MEM segment, which will account for about 60% of Knowles revenue. According to JP Morgan’s analyst report, Knowles’s market share in the MEM market has shrunk from 91% in 2010 to merely 59% in 2012. This sharp decline clearly should cause some concern.
Furthermore, some preliminary calculation based on the unaudited financial statements revealed that Knowles’s most recent ROA is approximately 4% while ROE stands less than 7%. The ROE is not in line with those of great businesses.
V. Forced Selling Opportunity
Dover is part of the S&P 500 index with a current market cap of more than $16 billion. Knowles, after the spinoff, will almost certainly not be included in the S&P 500 index, which may cause some forced selling by index tracking mutual funds and ETFs. Current shareholders who want nothing to do with Knowles may also happily sell Knowles after the distribution of shares.
The separation of Knowles from Dover is slated to happen during the first half of 2014. The effect on the parent is not material and may have been recognized in DOV’s share price already. Knowles, however, may represent an interesting opportunity depending on the pitch from Mr. Market at the time of the separation. I will encourage the readers to watch the development of the situation more closely. As more details emerge, I will come up with valuation scenarios.