Finding Value in Spin-Offs

One common lament I've heard recently from more than a few knowledgeable investors is over the relatively "flat" valuation of the market. Unlike 2000, when the market's overall rich valuation masked an enormous divergence between overpriced sectors like tech and telecom, and underpriced areas like REITs and small caps, there don't seem to be too many large pockets of opportunity in the market right now. Sure, there are interesting ideas scattered around--after all, we have about 50 5-star stocks right now--but not too much that's screamingly cheap, in my opinion.

The relative dearth of slam-dunk ideas led me to recently revisit a long-standing interest of mine--corporate spin-offs, which I regard as one of the few market inefficiencies still out there. In my experience, spin-offs are frequently undervalued and offer fertile ground for investors looking to buy dollars for $0.70 or $0.80. Although I've seen systematic studies that argue this topic both ways--some say spin-offs outperform the market in aggregate, and some present a more mixed picture--I'm not too interested in the aggregate data. After all, it would be silly to buy every spin-off blindly. The point is that they're frequently misvalued (more on why in a moment), and a little research to ensure that you're not buying a pig in a poke can go a long way.

Looking Back
I last wrote about spin-offs almost exactly a year ago, and so I thought I'd look back to see how the ones I mentioned have performed since then. The average return of the seven prospective spin-offs that I listed has been just under 20% since they started trading as separate companies, versus about 8% for the S&P 500. Even if you exclude Genworth Financial  (GNW), which has zoomed up 50% since it spun off from  GE (GE), the average return is still pretty respectable at about 15%. Genworth has been the best performer of the bunch, followed by Viad at 25%, Moneygram  at 21%, Freescale  at 20%, Hospira  at 15%, Neenah Paper  at 5%, and Assured Guaranty (AGO) bringing up the rear at about 2%. Not too shabby overall.

(In case you're curious, no, I didn't buy any of these myself--largely because I never got around to doing the level of research that would have made me comfortable buying them. Lesson: I should take my own advice more often.)

So why do spin-offs seem to do well? As with many things in investing, I think it starts with price.

No Hype
First, and most important in my mind, is the fact that spin-offs often don't receive much publicity or hype. Typically, the parent announces a spin, makes some filings over the ensuing few months, and then the spin-off's shares quietly show up in the accounts of people and institutions who own the parent. There's generally not much news coverage when a spin-off actually hits people's accounts, and the valuation of the shares is set by the parent.

Selling Pressure
Many stockholders who receive shares of a spin-off tend to sell the shares shortly after they receive them. Index funds that own the parent have to sell almost immediately, because the spin-off is usually not in the index being tracked. Individuals and other institutional owners often sell because the spin-off throws off their industry weightings, or because they don't have the time to research the new company. (In fact, this topic came up in a conversation just the other day with an analyst I know at a small buy-side shop, and when I brought it up, he said, "Yeah, we always dumped 'em. Didn't know the spin-offs ourselves, and no one on the Street covered them.")

Low Analyst Coverage
This is related to the "no hype" point, since having fewer analysts talking up the stock through their institutional salesforces can keep a temporary lid on valuation. (The lack of Wall Street research also means that investors who depend on Wall Street research are less willing to buy shares of spin-offs.) In fact, I remember that  Moody's (MCO) had only a handful of analysts covering it even six months after it had come to market, despite having stellar financial results. It takes a while for the Street to begin covering spin-offs because they're usually smaller firms, there was no IPO to drive commissions, and because--let's be blunt here--the odds that the spun-off company will need investment-banking services are relatively low, since it has just started existence as a standalone entity.

Limited Track Record
Spin-offs have a limited operating history, which means there's relatively little for investors to look at as benchmarks for future performance. Moreover, the track record that does exist is likely to be muddy and unimpressive, since the parent firm has a strong incentive to clean up its own books by allocating lots of "gray area" costs to the spin-off. With a limited and often unimpressive operating history, the market's expectations are relatively low, which again tends to lead to a lower valuation.

The trick is that the ugly-looking past may very well not be representative of the firm's future potential. There might be markets or customers that the newly independent firm can go after that it couldn't touch when it still had ties to its parent. The management team now has a stronger incentive to make operations more efficient, since better performance will increase the value of their (probably too large) option grants, whereas their previous compensation likely depended partially on how the former parent firms performed. 

Looking for Value
That's a long laundry list of reasons why spin-offs are often cheap when they first come to market. Notice, however, that every single one is temporary, and most have nothing to do with the underlying intrinsic value of the business. The hype will pick up if the company performs well, the selling pressure will abate as inattentive shareholders of the parent 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 the business dramatically after the first year or so. The result is improved cash-flow generation and sometimes a bit of valuation improvement as well, which often means a nicely appreciating stock price.

So what's on the spin-off radar screen right now? Here's a partial list, as fodder for further research:

 American Express (AXP) is spinning off AEFA, its financial advice unit. AEFA is a decent, though not fantastic business that can post midteens returns on equity when things are going right, and our rough estimate is that it would be fairly valued at around $9.5 billion. So if it's spun out of AmEx at around that price, there may be some opportunity.

Also on the high-profile list is  InterActiveCorp's (IACI) pending spin-off of its travel-related businesses, which we think account for about half the firm's current fair value. This one won't exactly be under the radar, but it still looks like it may be a good bet--especially if the spin-off ratio remains at 1:1, and IACI shares stay as low as they are now. The travel unit posts great returns on capital and has some growth opportunities in Europe and Asia that it may not have been able to take full advantage of while linked to the rest of InterActiveCorp.

One spin-off that's already trading is Novelis , a combination of the rolled-aluminum businesses of aluminum giants  Alcan  and Pechiney, which merged last year. Not an exciting business--the main use of rolled aluminum is beverage cans--but one than can produce decent, stable cash flows. However, Alcan loaded up Novelis with debt before the spin, and the firm is stuck between giant customers like Pepsi and Budweiser and giant suppliers like Alcan and  Alcoa .

Finally, some quick takes on a few others coming down the pike that could be interesting:  WebMD  will be spinning off its WebMD Health unit;  Dean Foods  will be getting rid of its Specialty Foods Group;  Williams (WMB) will be spinning off some of its pipelines and terminals into a master limited partnership; and  Pitney Bowes (PBI) will be dumping its capital services business, which does big-ticket commercial financing for things like airplanes, locomotives, and (surprise) postal equipment. The latter looks particularly interesting, because it's less well-known than the AEFA or Expedia spin-offs, so I think it's more likely to hit the market at a bargain price.