Spin-offs are something of the corporate transaction du jour. Conglomerates are being broken up (Fortune, ITT), oil majors switching up their business models (Marathon, Conocco Phillips), companies just shaking things up (Mittal, ThyssenKrupp, Cablevision). Some are forced, some are out of the blue, some a long time coming. Greenblatt rightly points to spin-offs as a fertile hunting ground for undervalued companies in "You Can Be a Stock Market Genius." It's worth reviewing why spin-offs are worth keeping an eye on and a pitfall I've encountered in the past with spin-offs.
Spin-offs allow a larger company to jettison a smaller subsidiary for any number of reasons — underperforming, focus on core competencies, activist rumblings. One less advertised benefit is a tax efficient way to return money to shareholders. Spin-offs are usually tax free for the corporation and shareholders. Since the spin-off is usually a relatively small company it is more likely to be acquired in a broad statistical sense.
There are several aspects of spin-offs that increase the likelihood of it being acquired. As I've said, it's smaller. While not universal, spun off divisions tend to be underperformers. This is probably more attractive to acquirers because they can a) strip out costs and b) an underperforming company will not be as highly valued by the market so the potential returns will be greater. Conversely, there's a decent chance that nobody wants it. Why is this tax efficient for generating shareholder returns? Well, if the parent company sold X division for $1 billion and wanted to return all the proceeds to shareholders, there would be a huge gain on the sale if the division grew organically over the years, say $500 million. This would get taxed at 35%. Corporate proceeds would only be $825 million. Then when the company returns this as a special dividend, shareholders get $700 million.
But if instead the subsidiary is spun off and sold as a separate entity for $1 billion and shareholders pay a 15% long-term capital gain on it, shareholders get $850 million, or a 21% boost for what is fundamentally the same. As we saw with [url=http://www.marketwatch.com/story/kraft-sweetens-cadbury-terms-with-pizza-sale-deal-2010-01-05]Buffett%27s+criticism+of+Kraft%5B%2Furl%5D during the Cadbury deal, the disposal of the pizza business was a point of contention. It largely rested on the fact that it was a highly tax inefficient way of creating shareholder value.
The above is something of a stretch. It's certainly not a reason to buy a spin-off. It's one of those hidden, intangible benefits that you can't bet on, but shouldn't be surprised by. It is very rare that someone gives away something that they actually want. It is even more rare to be given something that will potentially benefit the receiver in the future with no benefit to the giver. I need to be more aware of that, because I'm often drawn to things that nobody else wants.
While I rarely attribute malice where stupidity will suffice, managers are very rarely concerned with such a benefit for anonymous individuals. Seeing as the future is notoriously difficult to predict, I can't claim that Pride International was being malicious in spinning off Seahawk Drilling. It was I who was stupid. In fact, I indeed thought it was quite hard to kill and would be fine — I was wrong. It started life with tons of cash, a huge discount to book value, and was in a super distressed segment of an industry. Why wouldn't I be convinced it was a great buy?
There were plenty of elements I should have identified — rapid cash burn, lack of interested buyers in old dry stacked rigs, difficulty in predicting a turn in demand for shallow water natural gas drilling — but one thing that made my simple mind have a click, whirr moment (Cialdini reference, read his book if you don't get it) that made me comfortable buying the stock was that it was a spin-off. This is the absolute dumbest reason to buy a spin-off. I simply extrapolated occasional past successes in spin-offs with the idea that by virtue of the transaction it would work out fine — similar to a mutual thrift conversion where there really are mechanisms that can minimize downside risk and offer nice upside by virtue of the transaction.
Another spin-off that caused me to have a click, whirr moment was Artio Global, which has been as much of a dog as Seahawk. I wrote them up a few months back. They were spun out of Julian Baer, a Swiss bank. It was cheap on a P/E basis, management owned a good chunk of the company, and I was hot on the idea that asset managers were cheap/good businesses. There are broader mistakes I made than just assuming that since it was a spin-off and had an odd share structure it was misunderstood by the market. I was the one with the misunderstanding since it was facing headwinds with the two flagship funds that made up essentially all of its underperforming and bleeding assets. Still, not all spin-offs are worthwhile investments — most in fact aren't, although you probably realized this already.
I recently wrote about Treasury Wine Estates, a spin-off from Fosters. It was underperforming and causing tons of goodwill write-downs at the parent company. Combined with a strong AUD and glut in Australian wine, the business is suffering. It has very little debt, similar to Seawhawk, but it is currently profitable and not in financial danger despite a weak market for its goods. It was a division not wanted by the parent company, like Artio, but the tangible assets on the balance sheet makes it hard for it to wither away like Artio's intangible business managing money. Even on an intangible basis, Artio doesn't have a brand like Beringers, Penfolds, etc., like TWE, that gives it an edge over other competing products.
This brings me to a group of spin-offs that have caught my eye. The break up of the ITT conglomerate looks to be in shareholder's interests. ITT has long been a well run company focused on various industrial businesses. The conglomerate has three divisions: water, defense and industrial products. These are all fundamentally well managed businesses each with their own attractions — long growth runway, defense and high barriers to entry. Michael Price pitches ITT in an issue of Graham and Doddsville, although it is a few months old and the price is now 20% lower. I will delve into more details in the coming days.
What I find intriguing about the spin-off is it's cheap after the recent sell off and all the businesses are fundamentally strong even with recessionary headwinds. Without the $150 million in transformation costs so far this year, ITT has earned $400 million in the first six months of the year, $681 million in the TTM net income, and a $340 million pretax charge for asbestos liabilities in the thirdquarter of 2010 is depressing that figure. Depending on how generous with excusing these one-time charges, the stock trades at 10-15x earnings.
All of the businesses are going to be distinct and cater to specific investors, potential acquirers, and analyst coverage. Most importantly, all the businesses look like they are worth owning with lots of free cash flow, conservative balance sheets, and ability to grow organically and with bolt on acquisitions with which they have a good track record. The division of liabilities and debt is being done in an equitable way that doesn't seem to favor any business. It will be interesting to see what the market does after the split up in terms of which division(s) get dumped by current shareholders and which division(s) draw the most attention. There's a benefit of it being bundled together right now though, because there is no market price to distract you from valuing the business.
Spin-offs allow a larger company to jettison a smaller subsidiary for any number of reasons — underperforming, focus on core competencies, activist rumblings. One less advertised benefit is a tax efficient way to return money to shareholders. Spin-offs are usually tax free for the corporation and shareholders. Since the spin-off is usually a relatively small company it is more likely to be acquired in a broad statistical sense.
There are several aspects of spin-offs that increase the likelihood of it being acquired. As I've said, it's smaller. While not universal, spun off divisions tend to be underperformers. This is probably more attractive to acquirers because they can a) strip out costs and b) an underperforming company will not be as highly valued by the market so the potential returns will be greater. Conversely, there's a decent chance that nobody wants it. Why is this tax efficient for generating shareholder returns? Well, if the parent company sold X division for $1 billion and wanted to return all the proceeds to shareholders, there would be a huge gain on the sale if the division grew organically over the years, say $500 million. This would get taxed at 35%. Corporate proceeds would only be $825 million. Then when the company returns this as a special dividend, shareholders get $700 million.
But if instead the subsidiary is spun off and sold as a separate entity for $1 billion and shareholders pay a 15% long-term capital gain on it, shareholders get $850 million, or a 21% boost for what is fundamentally the same. As we saw with [url=http://www.marketwatch.com/story/kraft-sweetens-cadbury-terms-with-pizza-sale-deal-2010-01-05]Buffett%27s+criticism+of+Kraft%5B%2Furl%5D during the Cadbury deal, the disposal of the pizza business was a point of contention. It largely rested on the fact that it was a highly tax inefficient way of creating shareholder value.
The above is something of a stretch. It's certainly not a reason to buy a spin-off. It's one of those hidden, intangible benefits that you can't bet on, but shouldn't be surprised by. It is very rare that someone gives away something that they actually want. It is even more rare to be given something that will potentially benefit the receiver in the future with no benefit to the giver. I need to be more aware of that, because I'm often drawn to things that nobody else wants.
While I rarely attribute malice where stupidity will suffice, managers are very rarely concerned with such a benefit for anonymous individuals. Seeing as the future is notoriously difficult to predict, I can't claim that Pride International was being malicious in spinning off Seahawk Drilling. It was I who was stupid. In fact, I indeed thought it was quite hard to kill and would be fine — I was wrong. It started life with tons of cash, a huge discount to book value, and was in a super distressed segment of an industry. Why wouldn't I be convinced it was a great buy?
There were plenty of elements I should have identified — rapid cash burn, lack of interested buyers in old dry stacked rigs, difficulty in predicting a turn in demand for shallow water natural gas drilling — but one thing that made my simple mind have a click, whirr moment (Cialdini reference, read his book if you don't get it) that made me comfortable buying the stock was that it was a spin-off. This is the absolute dumbest reason to buy a spin-off. I simply extrapolated occasional past successes in spin-offs with the idea that by virtue of the transaction it would work out fine — similar to a mutual thrift conversion where there really are mechanisms that can minimize downside risk and offer nice upside by virtue of the transaction.
Another spin-off that caused me to have a click, whirr moment was Artio Global, which has been as much of a dog as Seahawk. I wrote them up a few months back. They were spun out of Julian Baer, a Swiss bank. It was cheap on a P/E basis, management owned a good chunk of the company, and I was hot on the idea that asset managers were cheap/good businesses. There are broader mistakes I made than just assuming that since it was a spin-off and had an odd share structure it was misunderstood by the market. I was the one with the misunderstanding since it was facing headwinds with the two flagship funds that made up essentially all of its underperforming and bleeding assets. Still, not all spin-offs are worthwhile investments — most in fact aren't, although you probably realized this already.
I recently wrote about Treasury Wine Estates, a spin-off from Fosters. It was underperforming and causing tons of goodwill write-downs at the parent company. Combined with a strong AUD and glut in Australian wine, the business is suffering. It has very little debt, similar to Seawhawk, but it is currently profitable and not in financial danger despite a weak market for its goods. It was a division not wanted by the parent company, like Artio, but the tangible assets on the balance sheet makes it hard for it to wither away like Artio's intangible business managing money. Even on an intangible basis, Artio doesn't have a brand like Beringers, Penfolds, etc., like TWE, that gives it an edge over other competing products.
This brings me to a group of spin-offs that have caught my eye. The break up of the ITT conglomerate looks to be in shareholder's interests. ITT has long been a well run company focused on various industrial businesses. The conglomerate has three divisions: water, defense and industrial products. These are all fundamentally well managed businesses each with their own attractions — long growth runway, defense and high barriers to entry. Michael Price pitches ITT in an issue of Graham and Doddsville, although it is a few months old and the price is now 20% lower. I will delve into more details in the coming days.
What I find intriguing about the spin-off is it's cheap after the recent sell off and all the businesses are fundamentally strong even with recessionary headwinds. Without the $150 million in transformation costs so far this year, ITT has earned $400 million in the first six months of the year, $681 million in the TTM net income, and a $340 million pretax charge for asbestos liabilities in the thirdquarter of 2010 is depressing that figure. Depending on how generous with excusing these one-time charges, the stock trades at 10-15x earnings.
All of the businesses are going to be distinct and cater to specific investors, potential acquirers, and analyst coverage. Most importantly, all the businesses look like they are worth owning with lots of free cash flow, conservative balance sheets, and ability to grow organically and with bolt on acquisitions with which they have a good track record. The division of liabilities and debt is being done in an equitable way that doesn't seem to favor any business. It will be interesting to see what the market does after the split up in terms of which division(s) get dumped by current shareholders and which division(s) draw the most attention. There's a benefit of it being bundled together right now though, because there is no market price to distract you from valuing the business.
