The Spin-Off Game Often undervalued, corporate castoffs can go on to post big gains.

When Pepsico spun off its fast-food division to shareholders in the fall of 1997 as Tricon Global Restaurants, the new stock landed with a thud, falling 11% in its first four months. Wall Street was worried that the Asian economic crisis would dampen demand overseas, profit margins were lagging, and investors who owned Pepsi because it was a beverage company dumped Tricon: They didn't care about Taco Bell or the company's other chains.

Last year, however, the stock jumped 72%, nearly triple the rate of the S&P 500. Tricon even trounced a newly resurgent McDonald's, up 61% in 1998. Tricon management cut costs, sold underperforming company-owned stores and boosted margins.

The company fits legendary fund manager Mario Gabelli's definition of the best kind of spin-off: "a diamond in the rough"--a good business that has room to improve and goes unrecognized by the Wall Street crowd.

Indeed, spin-offs, when they're the result of a parent company's repositioning of its business, not just an attempt to dump a poor-performing division or erase a heavy debt load from a balance sheet, are often worth a second look.

They tend to be undervalued during their first eight months or so, especially when the shares have been handed to the parent's existing shareholders, as in Tricon's case. "Wall Street isn't getting paid to tout the company as part of an initial public offering, so nobody pays attention," says Gabelli.

Additionally, the shares often go to uninterested investors who quickly dump them. That's especially true of index fund managers when the parent is in the S&P 500 but the spin-off isn't.

But freed from the corporate parent, a spin-off's managers can better concentrate on their business, take more risks and enjoy the fruits of their labor. (The new companies usually award stock options to executives who might not have gotten them before.) Spin-offs are also five times as likely to be taken over as other companies. The appeal: Their businesses tend to be narrowly focused, so they're easy for an acquirer to evaluate and then merge into its operations.

Rick Escherich, a managing director at J.P. Morgan, examined 33 spin-offs between 1995 and 1997 and found that the typical one outperformed the market by 2.6 percentage points during its first 18 months of trading (see the chart at left). Before 1995, the breed fared even better, but Escherich thinks that returns declined as more investors caught on to the strategy.

That said, there are still spin-off bargains to be had. (There were 45 such transactions last year, with a market value of $103 billion.) To find them, we talked to more than a dozen spin-off specialists, stock analysts and industry consultants and then boiled down their best ideas to the three discussed below. All carry little debt, have the potential for double-digit earnings growth and were spun off recently enough that their shares are still down and Wall Street isn't yet pounding the table for them.

That's the case with Chicago Title. Only three regional brokerage firms follow the company, even though it boasts $1.8 billion in annual sales and is among the nation's top three title insurers at a time when the mortgage market is booming. "This is an undiscovered gem," says Charles Rinaldi, the manager of Strong Small Cap Value Fund. Chicago Title is among his top 10 holdings. The company, spun off from Alleghany Corp. in June, offers a 3% dividend yield, and Rinaldi expects it to post 11% earnings gains on average over the next five years. At $44, the stock is trading at only 8.4 times estimated 1999 earnings; its peers, meanwhile, trade at 11 to 12 times earnings.

Even if interest rates rise and today's booming mortgage demand dulls, the company can still expand revenues at a 10% annual clip and grow profits at a slightly faster pace because computerization is cutting costs, says Joseph Cornell, head of Spin-Off Advisors, a Chicago research firm. Pete Leemputte, Chicago Title's CFO, figures that the company can cut at least $30 million from expenses over the next three years.

The big challenges for Rockwell International's former semiconductor division, now called Conexant Systems, are to diversify and grow revenues fast enough. Conexant is a leading provider of chips for analog modems. The company was profitable until last year, when a price war decimated margins. Not only that, analog equipment, while still widely used, hardly represents the future. Conexant is diversifying by developing chips for digital telecommunications and other digital products such as cameras. Its wireless communications sales jumped 49% last year to $168 million on the strength of its chips for digital cordless phones and the power amplifiers that strengthen the radio signals in digital cellular phones. True, the company faces stiff competition from the likes of Lucent and Texas Instruments, but "Conexant has some of the best minds in the business for the markets that it serves," says Duane Smith, president of telecommunications marketing research firm Telecom Tally and a former Rockwell executive who helped launch what became Conexant's wireless communications unit. Although modem chips still accounted for half of 1998's $1.2 billion in revenues, Conexant expects that portion to drop to 25% by 2001. The company is also taking pains to diversify its customer base--no one client provides more than 5% of revenues. What impresses Lehman Bros. analyst Dan Myers is that top executives have taken pay cuts of 10% to 20% until the company posts two profitable quarters. "Management and shareholders are aligned here," Myers says. He believes management will deliver on its promise to return to profitability later this year and thinks that shares, recently trading at $18.25, will climb to $25 by early 2000.

Mutual fund company Waddell & Reed is already solidly profitable, if unknown and relatively small. Long a cash cow for its insurer parent, Torchmark, Waddell manages $28 billion in assets. The company, which earned $88 million in 1998, sells 25 mutual funds as well as variable annuities through 2,300 salespeople, largely in the Midwest and Northeast. Now that Torchmark has spun off Waddell--selling a 36% stake in a March IPO and then giving the rest to Torchmark shareholders in December--the company should be able to expand. Pete Heckmann, an analyst at George K. Baum & Co. in Kansas City, Mo., thinks Waddell has a clear field because it targets customers that most brokers and financial advisers ignore--rural households with incomes of $40,000 to $100,000. "These are people who invest $2,000 to $10,000 a year and require a lot of hand-holding," Heckmann says.

Nevertheless, the company has fat profit margins because its customers rarely withdraw assets and its advertising and other expenses are low. Louis Harvey, president of Dalbar, a mutual fund consulting firm in Boston, believes that Waddell's customer base will grow for a generation. "We estimate that over the next 15 years, 60 million households will seek financial advice, up from 11 million today," he says, and the bulk of that growth will come from middle-class households. Another plus: In a consolidating industry, Waddell is a prime takeover target, says analyst Peter Doyle of the Spin-Off Report, a New York City research firm. At $20.75, the company trades at 14 times estimated 1999 earnings, 20% under its peers. Heckmann expects Waddell shares to hit $30 a year from now.

--SUSAN SCHERREIK