Unlocking Value with Spinoffs

by Scuttlebutt Investor

Spinoffs are all the rage right now.  Every day it seems like a new spinoff announcement hits the newswires. The technology sector has been especially active with spin off announcements over the last few weeks. Recent announcements include eBay's spin off of PayPal, HP's split of its PC/Printer and its Enterprise divisions and Symantec's split of its security and storage divisions.  Activist investors are getting in on the action as well with Elliott Management recently urging EMC to spin off VMware. With all of this action, I thought it would be an opportune time to discuss spin offs and how companies can unlock value through corporate spinoffs.  

To dive into this analysis of spinoffs, we will start with one of my favorite books in the investing genre - "You Can be a Stock Market Genius" by Joel Greenblatt (see more in Recommended Reading).  In the book, Greenblatt devotes several chapters to spinoffs as a way to unlock value.  While spinoffs are not a panacea for corporate underperformance, I am a strong proponent of Greenblatt's thesis that spinoffs often do create more focused companies and I would like to delve more into that over the coming weeks.  However, before we evaluate any specific spinoff ideas, let's first lay the groundwork - 1) What are spinoffs?; 2) Why are spinoffs good hunting grounds for value?; 3) How should we evaluate spinoff investment opportunities?  Here we rely on Greenblatt's analysis peppered with some of my own thoughts.

What is a company spinoff?

A spinoff is a divestiture where a company separates a portion of its business (a division or a subsidiary) from the parent company and organizes it as an independent company (that is often publicly traded).  Typically, a spin off is accomplished by distributing the ownership interest in the business division as a stock dividend to existing shareholders in a tax-free transaction.  Often times, this subsidiary is involved in operations that are seen as non-core to the parent company and a spinoff is preferred because an outright sale of the division can result in a big tax bill for the parent company.  In some ways, you can think of a spin-off as the opposite of a merger.  

Why are spinoffs good hunting grounds for value investments?

While spinoffs do result in smaller companies each with their own overhead costs like management, office space, etc. (often called dis-synergies), the research shows that spinoffs also result in leaner organizations that are better able to focus on their core competency.  Let's dig a bit deeper into why spun-off companies can make good potential investments.  It really boils down to two key drivers: 1) Smaller, more focused spinoff companies operate better; and 2) Spinoffs are often misunderstood and mis-priced making valuation attractive.

  • Spinoff companies operate better and have better managers

    • The effect of capitalistic forces: Employees of smaller, more focused companies can be more accountable, responsible and benefit more directly from the fruits of their own labor. For example, in a large company, a certain division can have stellar results, but overall bonus compensation for employees of that division could be dragged down by lackluster results in another division. By spinning these companies out from each other, the employees of each division can be more directly compensated based on the performance of their own division. This often improves employee performance and morale as employees feel that they have control over their own fate.

    • Management of companies that are spinning off a division tend to be better aligned with promoting shareholder interests. It is a rare management team that wants to decrease the size of its empire. Management teams often want to acquire companies to increase the size of their empire to feed their egos and their paychecks. But if management is intentionally reducing its scope of influence and control, this is an indication of a management team that has shareholder interests and increasing shareholder value as a top priority. And they can be trusted to act in such a manner in the future.

  • Spinoff companies become mis-priced by the market

    • The share prices of spun off companies often get depressed (and become better values) due to indiscriminate selling. Shares of the spun-off companies are often distributed to uninterested parties (institutional investors) that were mainly interested in the core business of the parent company so they sell the spun off shares. Institutional investors also have other reasons for selling the shares:

      • Spinoffs tend to be smaller companies that don't warrant the attention of institutional investors. Often times, the investment mandates of certain institutional investors won't even allow them to own companies with market caps below a certain size. Many funds have restrictions on ownership that may prevent them from owning companies with a market cap < $Xbn or companies that are not a member of the S&P 500. Additionally, institutional investors are often reluctant to buy smaller market cap companies because they can quickly reach the 5% ownership limit at which they have to file more onerous disclosures (13Ds) with the SEC.

      • Sell side equity research analysts often do not have the bandwidth to cover these smaller spun off companies leading to generally less awareness among and support for institutional buyers. Furthermore, buy-side research analysts often don't have the time to focus on these smaller companies that may not be large enough to move the needle on their large portfolios.

So now that we have established what spinoffs are and why they can be a great place to find underpriced investments, let's talk a bit more about how we can research them.  

Evaluating Spinoff Investments

  • The SEC Form 10 (which is often amended several times over) or a Proxy (in the case of a larger spinoff) are critical documents for our research. These documents that can be found among other SEC filings contain invaluable information about the motives for the spinoff, pro forma financial information (historical financials as if the company had operated independently) and management incentives.

  • Insider participation is one of the key areas to hone in on when evaluating spinoff investment opportunities. We want to know if management will receive a large part of their potential compensation in stock or options. In other words, are their interests aligned with shareholder interests? If they are also large shareholders, then their interests are usually aligned.

  • The largest gains for spinoffs often take place in year 2 post spinoff when selling pressure from institutional investors wears off and management incentives begin to kick in.

  • Outside of the fact that these companies are being spun-off, we are evaluating them based on same criteria that we use for any other value investment - primarily do they benefit from a durable or defensible competitive advantage. Other criteria that I use to evaluate all investments can be found in Investment Philosophy.

Bringing it all Together

Now that we have established that spin offs are generally a good hunting ground for value investments and set some criteria for evaluation, let's make a list of companies that have recently spun off or plan to spin off divisions in the near term. While most of my ideas come from reading the Wall Street Journal, Stock Spinoffs is also a great resource for discovering new spinoff situations.  

My goal is to choose one of the spin off situations from the initial list below to analyze further in depth over the coming weeks. I've already culled down the list a bit based on situations that I don't understand or companies that I don't believe demonstrate a durable competitive advantage.  As you can see, I have intentionally chosen not to focus on some of the high profile technology company spinoffs announced recently.  My reasons for this are twofold: 1) I am reluctant to invest in technology companies where I can't reliably predict where earnings will be 5 years from now (see my investment philosophy); 2) Many of these spinoffs have not yet released any documents/information with which we can conduct our research.  While we will focus primarily on the spun off entity for our analysis, sometimes the leaner parent company can also present an interesting investment opportunity.  

  • ADP spinoff of CDK Global (spun off on 9/30/14)

    • ADP is primarily in the business of business outsourcing solutions and more specifically, providing payroll and HR solutions to large companies.  CDK Global (formerly ADP Dealer Services) provides car dealers (think your local Toyota dealership) with software solutions to manage both supply and demand.  The pro forma company will have revenue of ~$2bn.  While I have not done any research on the company yet, I have a natural predisposition for software business models because they are high margin, scalable and often generate a reliable recurring revenue (RRR) stream.  Furthermore, there is a high likelihood that CDK will not be a part of the S&P 500, likely making it the target of some indiscriminate selling by institutional investors.

    • Our key research documents:

  • Kimberly Clark spin off of Halyard Health (spin off slated for 11/1/14)

    • Kimberly Clark is a consumer products company that mostly produces paper based products (toilet paper, tissues, diapers, etc,) that include brands like Cottonelle, Kleenex, Huggies). Halyard Health (currently known as K-C Health Care) manufactures medical devices and surgical and infection-prevention products. At first blush, some of Halyard Health's infection-prevention products like surgical gowns and latex exam gloves seem like commodity products, but more analysis is necessary. The medical devices segment seems like the more interesting, more durable segment. Total pro forma revenue is ~1$.7bn.

    • Our key research documents:

  • Agilent spin off of Keysight Technologies (spin off slated for November 2014)

    • Agilent's core business is making testing equipment and instrumentation for laboratories (pharmaceutical companies, biotechnology companies, food companies, chemical companies). Agilent is spinning off its electronic measurement products business (now called Keysight Technologies) which creates products like oscilloscopes and spectrum analyzers that are used by technology device companies and aerospace and defense companies. Total pro forma revenue is $2.9bn. While operating margins of ~20% are decent revenue has declined ~13% yoy. We need to understand the drivers behind this decline a bit more.

    • Our key research documents:

  • DuPont spin off of Performance Chemicals division (slated for Q2 2015)

    • DuPont is one of the world's largest chemical companies and produces everything from Kevlar (that goes into body armor) to genetically modified seeds. The Performance Chemicals division comprises ~20% of total revenue and primarily deals in Titanium Dioxide (used as a whitening pigment by paint manufacturers) and fluorochemicals (used as refrigerants). Significant capacity additions by manufacturers over the last several years have hurt pricing for these chemicals and margins have declined substantially as a result. DuPont announced a spin off of the division back in October 2013, but has since stated that it is also evaluating other alternatives like a Reverse Morris Trust. Meanwhile, the activist investor Nelson Peltz is pushing for an entire breakup of the company. It is likely too early to conduct thorough research on the prospects of the spin off given that a definitive decision has not yet been made, but here is some background.

  • eBay spin off of PayPal (announced 9/30/14; slated for 2nd half 2015)

    • eBay is an online auction and shopping website founded in in the 1990's. Having survived the first dot com boom, eBay has been successful in growing its marketplaces business as well as incubating several other higher-growth businesses like Stubhub and PayPal. PayPal is primarily a platform for online payments and was acquired by eBay in 2002, as it was at that time, the primary payment vehicle on the site. In recent years, PayPal has grown much faster than its parent and eBay has rebuffed pressure from activist investors like Carl Icahn to spin off PayPal. More recently, the company announced that it would spin off PayPal into an independent entity. While technology investments like PayPal are not an area where I like to play, the payments industry is an area of particular interest for me. Furthermore, I think that PayPal has tremendous strategic value to other payment companies. At this point, it is a bit early to do research since there is no Form 10 or spin off presentation, but here is some additional background.