December 13, 1999
Ferreting Out Stealth Spin-Offs
These offerings tend to fall through the cracks

Ever hear of Conexant Systems (CNXT)? You probably wish you had. When the little-known former subsidiary of Rockwell International (ROK), made its debut back in January, only seven analysts followed the semiconductor maker, vs. the 15 that do today. The stock dropped 11% in the initial six weeks. But buoyed by an upturn in the semiconductor industry, Conexant has since rocketed from a split-adjusted 9 13/32 at its launch to 62 15/16 recently--a stratospheric 569% gain.

Conexant represents the kind of unglamorous orphan that may offer the greatest opportunity for individual investors. Known as a ''straight spin-off,'' Conexant became a public company with little fanfare when its shares were quietly handed to Rockwell shareholders. By contrast, the Nov. 18 market debut of Agilent Technologies (A), Hewlett-Packard's (HWP) former test-and-measurement equipment division, couldn't have been more different. The 15% of Agilent shares Hewlett sold via an initial public offering shot up 47% during the first trading session, to 44.

JUICY RETURNS. High-profile IPO ''carve-outs'' such as Agilent's are good news for Wall Street underwriters, but not for individual investors, who rarely have the pull to get a piece of a hot new offering. It's much easier to get in on the ground floor of a straight spin-off. Like Conexant, prices of such spin-offs tend to stagnate or decline for a few weeks to up to eight months. Only then do they start to outperform the market. Indeed, thanks to their underwhelming debuts, straight spin-offs often wind up delivering juicier returns than carve-outs and tracking stocks. A recent study by management consultants McKinsey & Co. examined 168 spin-offs, carve-outs, and tracking stocks launched between 1988 and 1998. McKinsey found that straight spin-offs gained an average of 27% annually during their first two years as public companies, with the bulk of those gains from small-cap rather than large-cap companies. By contrast, carve-outs delivered a 24% annualized return, while tracking stocks--equities tied to the performance of a corporate unit--were up 19%. Similarly, a J.P. Morgan study that examined 231 spin-offs and carve-outs between 1985 and 1998 found that during their first 18 months of trading, straight spin-offs beat the Standard & Poor's 500-stock index by 11.3%, vs. 10.1% for carve-outs.

ANALYST OVERSIGHT. Starting a spin-off with an IPO helps the parent raise capital. It also lets the market set the unit's value before additional shares are typically given to parent-company stockholders a few months later. Straight spin-offs, by contrast, initially get less analyst coverage than carve-outs. ''Wall Street isn't paid to tout these stocks, so they initially tend to fall through the cracks,'' says Joseph Cornell, president of Spin-Off Advisors, a research firm in Chicago. Moreover, shareholders who get spin-off stock may not be interested in owning the shares because the company doesn't meet their investing objectives. That's especially true of index-fund managers. If the parent company remains in the S&P 500 but the spin-off doesn't, index funds dump the spin-off and thus put downward pressure on its price.

But out from under the thumb of the corporate parent, many spin-offs quickly become leaner and meaner as managers better focus their businesses. Another incentive: The new companies usually award stock options to executives who might not have gotten them before. ''Managers are much more challenged to perform because shareholders will hold their feet to the fire if they don't make their quarterly numbers,'' says Patricia Anslinger, an author of the McKinsey study and a partner at the consulting firm. Anslinger found that straight spin-offs dramatically boost productivity during the first two years, with return on invested capital up an average 74%.

Carve-outs didn't see sizable productivity gains during that period, but revenues jumped an average 32%, vs. 9% for straight spin-offs. Why the difference? ''Carve-outs are growth stories, so they lend themselves to being sold as IPOs,'' Anslinger says. By contrast, many straight spin-offs are in sluggish industries or a cyclical slump, which is often why the parent opts to give the new shares away. As a result, straight spin-offs tend to focus on cost-cutting to lift profit margins, she says.

The trick for investors is to find a good business that has room to improve, not just a poorly performing division that a corporate parent is unloading on stockholders. ''Investing in spin-offs isn't free money,'' warns Rick Escherich, a managing director at J.P. Morgan. ''You have to do your homework.'' For instance, shares of Octel (OTL), which makes lead used in gasoline, have slipped 57% to 9 3/4 since the company was spun off from Great Lakes Chemical (GLK) in May, 1998. Why? Octel's core business is evaporating as nations ban leaded gasoline.

DON'T BELIEVE THE HYPE. What spin-offs look promising now? Spin-Off Advisors' Cornell favors Lanier Worldwide, the former office-equipment division of Harris Corp. (HRS) Harris spun off Lanier in November to focus on its core communications business. Lanier shares, recently at 4 13/16, are up from 2 13/16 at their launch. But Cornell, who is launching a hedge fund focusing on spin-offs, figures the stock is worth as much as 8, based on its brightening prospects overseas and what investors are paying for its competitors.

Another company Cornell believes is worth a look is Too Inc., a clothing retailer that caters to preteen girls and was spun off from The Limited (LTD) in August. The company's strong management team and fairly novel retail niche should make it a winner, he says. Cornell also likes Triad Hospitals, a chain of small-city hospitals largely in the South and West, which Columbia/HCA Healthcare (COL) spun off in May. Triad is improving its balance sheet by unloading unprofitable hospitals and using the proceeds to pay off debt, he notes. The prices of these two stocks have barely budged from their spin-off levels.

If you do want to buy a new carve-out or tracking stock sold via an IPO, experts suggest that you wait until after the initial offering to allow the effect of the underwriters' sales hype to fade. For example, Barnesandnoble.com (BNBN), which was partially spun off from the country's biggest bookseller in May, shot up 27%, to 22 15/16 on its first trading day. Recently, however, shares were going for 20 5/16.

Showing patience with carve-outs can have its virtues, but many pros think you may be better off shopping for an underappreciated straight spin-off or two. Just ask the folks that got into Conexant when it was a Wall Street orphan.

By SUSAN SCHERREIK