May 15, 2000

Carving Out IPO Profits
Forget Krispy Kreme. Cabot Microelectronics offers a lesson in how to make money in the IPO aftermarket--with less risk

Take it from one who knows--my mind harbors some strange combinations. Tied up in there right now are recent initial public offerings from Krispy Kreme Doughnuts and a gritty industrial company called Cabot. Why? Because now that the breathtaking, triple-digit first-day pops are so much late 20th-century history, there's value to be had in the IPO aftermarket again--if you know where to look. One who does is Joseph Cornell, whose Spin-Off Advisors in Chicago researches and invests in all sorts of corporate divestitures. What I like best about Cornell is how he finds what he calls ''the cheapskate's way to play.''

To Cornell, that means watching the interplay between a parent company's shares and those it sells in one of its units via a two-step spin-off. Wall Street's lingo for this kind of deal is ''carve-out,'' and the recent IPO of Cabot Microelectronics, a unit of Cabot, makes a perfect, and potentially profitable, case study.

HEAVY-DUTY STUFF. Anybody with taste buds knows why Cabot's Apr. 4 sale of shares in its Cabot Microelectronics unit was overshadowed by Krispy Kreme's deal the next day. A very Old Economy company, Cabot's chief product is carbon black, used to make tires and other heavy-duty stuff. Cabot lately has been drawing cash from carbon black and other plodders to fund zippy New Economy products.

That's where Cabot Microelectronics comes in. It's now speeding along, leading the market in ''slurries,'' specialized polishing chemicals used by more and more semiconductor makers, including Intel. Sales in fiscal 1999, ended Sept. 30, grew 68%, to $98 million. Net neared $8 million. This year, sales are set to grow 50%, and net income could top $20 million. An expansion of its plant in Japan is done, and a big new one in Illinois cranks up in June. With all this new capacity, chief financial officer Mack McCarthy told me he won't need to raise more capital by selling stock or taking on new debt ''for the next few years.''

GOOD BET. As Krispy Kreme shares have more than doubled since debuting, Cabot Microelectronics' have gained 65%. But rather than buying its shares, a lower risk way to invest may be to buy stock in its parent. That's because Cabot still owns 80.5% of Cabot Microelectronics. And by this time next year, it expects to have distributed those shares to Cabot stockholders in a tax-free special dividend. Buy Cabot now, and it's a good bet that in under a year you'll own shares in Cabot, plus Cabot Microelectronics.

Why is this a better way? First, the value of Cabot's stake in Microelectronics isn't fully reflected in its stock (table). With Microelectronics stock at 34, each share in the parent represents almost $9 worth of Microelectronics stock. Subtract that from Cabot's stock price of 27, and the parent's implied market value is 18. That's about 11 times the $1.60 a share I figure it will earn, not counting its Microelectronics profit, this fiscal year. Rivals' shares go for 14.5 times profit. That discount pencils out to $5 per Cabot share--a gap that should close once the spin-off is finished.

Second, such value investors as Kevin Risen, co-manager of Neuberger & Berman Guardian Fund, find plenty to like in the parent. ''I took as much as I could get'' of the Microelectronics IPO, Risen told me. But the fund also owns a big Cabot stake. ''If you look under the hood,'' he said, ''it has lots of good businesses,'' including some for inkjet printers and oil drillers. If these pan out, Cabot could carve them out, too.

Investing in IPOs this way may seem strange, but it figures to get less so. Cornell notes that 1999 saw 71 spin-off announcements. This year's first quarter alone brought 40, including one from another Old Economy name, Eaton. It aims in June to pull off an IPO of its chip-equipment unit. If that catches your eye, just remember: Investing in the parent may be a lower-risk way to play in today's IPO aftermarket.

Questions? Comments? Send an e-mail to barkerportfolio@businessweek.com or fax (321) 728-1711

By ROBERT BARKER