Severed Ties Make Good Buys

By Steven T. Goldberg

Ignored by most investors, corporate orphans like these may be real bargains.

So it's not surprising that spinoffs are often slow starters when they first go public. But guess what? Numerous studies have found that over one to three years, stocks of spinoffs excel, while IPOs generally just keep pace with the overall market after their first-day bounce. A recent study by accounting professors Hemang Desai of Southern Methodist University and Prem Jain of Tulane University found that spinoffs beat similar companies by 15.7% over one year and 36.2% over two years. "These are very, very high numbers," says Desai.

Selling a gift horse. Part of the reason that spinoffs do so well is that they do fall initially, sometimes too far. Professional managers may dump their spinoff shares because they don't fit their particular style or investment objective. Individuals, who may receive a tiny number of shares in the new company, often see a spinoff as found money and sell rather than try to analyze such a small holding. "Spinoffs generally look kind of ugly," says Steven Bregman, editor of the Spinoff Report, a newsletter for institutional investors. "You don't give away something for free unless you don't like it."

A new spinoff will often trade at a large discount to other companies in its industry. But with newly independent managers who now have stock options and thus more incentive to see the now-independent company prosper, a spinoff can catch up with its peers in sales, earnings and stock price.

Rebound buying. Not every spinoff is a winner, of course. Joseph Cornell of Chicago-based Spin-Off Advisors looks for spinoffs that have fallen in price in the first month or so but that have good business prospects. Among his favorites is Avaya (AV), a maker of phone equipment for businesses, which was spun off by Lucent Technologies (LU) at the end of September (see Tech Titans).

Avaya's stock seems a likely candidate to founder upon liberation. It faces stiff competition, carries $700 million in debt and suffers from slow sales growth. "This is viewed as a doggy business and no one will want to own it," says Cornell. "But management is going to rev up to get revenue and earnings growth going."

Cornell also likes Stilwell Financial (SV), the Kansas City Southern Industries (KSU) spinoff that owns Janus Capital, sponsor of the Janus funds. The stock is cheap relative to other publicly traded fund companies, yet Janus's assets are growing faster than almost all other asset managers.

John Keeley, manager of Keeley Small Cap Value (4.5% maximum sales charge; 800-533-5344), likes spinoffs so much that he invests at least half the fund's assets in them. Ironically, one of his favorites is Kansas City Southern. While technically the parent, the railroad company is actually much smaller than its offspring, Stilwell. Keeley argues that Kansas City Southern's 39% stake in the Mexican railroad, Grupo TFM, will prove increasingly profitable as trade continues to grow between the U.S. and Mexico. Cornell sees Kansas City Southern as a takeover candidate.

A favorite of both Keeley and newsletter editor Bregman is Key3Media (KME), spun off by Ziff-Davis (ZD) in August. Key3Media runs trade shows for the technology industry. Bregman says it's selling at a 20%-to-30% discount to similar companies.

Keeley and Cornell also both like Moody's Investors Service (MCO), a major credit-rating agency that was scheduled to separate from Dun & Bradstreet on October 2. With gross profit margins of more than 40%, Moody's "is definitely a good business," Cornell says. He expects the stock to be weak initially, but he's bullish because "Moody's will be able to control its own destiny rather than being tied to slower-growth Dun & Bradstreet."

Shares of Visteon (VC), the auto-parts maker spun off by Ford last June, have been hurt by a slowdown in orders from its former parent and a weak euro (see There's Trouble in Motor City). But analyst Greg Salchow of Raymond James & Associates says these are short-term issues and rates the stock a buy. "It's going to take a little time to get these things straightened out, but we like the stock," he says. So does Lehman Brothers analyst Darren Kimball, who is telling clients: "We cannot even come close to justifying its discounted valuation."