| SmartMoney
HAVE YOU HEARD the one about the economist who sees a $20 bill on the sidewalk? "I'm not picking that up," he says. "Theoretically, it shouldn't be there." Free money is something that many economists — particularly efficient market advocates — believe shouldn't exist theoretically or otherwise in today's competitive investing climate. But the latest corporate fad is providing an investing opportunity that sure comes close. This month, I'm going to discuss how to take advantage of this Wall Street trend — selling shares in a slice of a particularly glamorous subsidiary. You know what I mean: Microsoft (MSFT) recently offered up 15% of Expedia, its online travel service. Hewlett-Packard (HWP) issued stock in its test and measurement division, Agilent, late last year. Even J.C. Penney (JCP) is selling off a stake in its faster-growing drugstore unit, Eckerd. The object of these deals — called carve-outs, a term I'll define later — is to give investors pure plays in businesses that trade at higher earnings multiples than the parent. Announcing such a proposal typically provides a pop for the parent's shares, and the subsequent public offering enriches its coffers. But because of quirks in today's market, the link between parents and subsidiaries can also create unusual bargains. In what follows, I'll explain them — as well as a trading strategy that can offer rewards better than finding a $20 bill on the sidewalk. Unfortunately, it isn't for everyone. So I've also included a table of parent/subsidiary stocks that look ho-hum from the outside and considerably more attractive when you separate the pieces. To profit, you'll have to understand the maneuvers Wall Street investment bankers have conjured up to help companies profit from subsidiaries. First, there was the classic spinoff, simply a process in which a company gives 100% of a subsidiary to shareholders. Spinoffs are often doggy businesses. They tend to be ignored by investors and can become good contrarian buys. We're interested in the innovation that came after spinoffs: carve-outs, also called partial spinoffs. In a carve-out, the parent sells a minority interest in a particularly glamorous sub with all the hoopla of an initial public offering. Once the new company has a performance history, the parent distributes its remaining stake as a dividend to shareholders. The idea here is to boost the value above a simple spinoff. American Airlines (AMR) is in the final phase of this process now — handing over shares in its Sabre electronic travel reservation business, which went public in a 1996 carve-out. Don't confuse carve-outs with tracking stock — what Disney (DIS) issued for its Web portal, Go.com (GO), and what AT&T (T) plans for its wireless business. Tracking shares aren't true divestitures, but a way of letting investors buy the earnings of a subsidiary without really owning it. Some trackers have been stellar performers (Sprint PCS (PCS) is up roughly 250% in the past year), but I don't like them. They're oddball creations of investment bankers. What's more, tracking stock is rarely the first step in a total separation. No wonder prices fall if a company announces a tracking issue when the market has been expecting a carve-out. Here's where understanding the investment-banking lingo comes in handy. Ignore the glamorous carve-out for a minute and switch your focus to the parent. It's the stock market's equivalent of a two-fer. Here's why: You're buying a controlling stake in a subsidiary (often a high-growth, high-tech outfit with minimal earnings) and you're getting 100 percent of the parent's basic business. In today's environment, the parts can add up to substantially more than the whole. Take Williams Cos. (WMB), a world-class pipeline operator with substantial natural gas reserves. The sexy part is its 85% of Williams Communications (WCG), a 26,000-mile fiber-optic network — initially constructed along pipeline right-of-way — that will soon offer service in 125 cities. Even though the fiber-optic business is losing money, it trades at 10 times revenue, and Williams's shares in this subsidiary are worth 90% of the parent's market cap. That means investors are valuing Williams's energy business at only two times earnings, while comparable companies sell for 12 times earnings. Cheap? Well, I think so. But it's not the only example. Take a look at Daisytek International (DZTK), a distributor of office supplies. Its stake in its PFSweb (PFSW) subsidiary, which sells e-commerce transaction-management services, is worth about 30% more than the market value of the parent company. So investors get Daisytek's profitable office-products distribution business for free. Similar how-can-this-be relationships (negative numbers in the implied-value column of my table) currently exist for HNC Software (HNCS), IDT (IDTC), Seagate (SEG) and Telephone and Data Systems (TDS). Don't assume that selling off the family jewels is a sign of weakness. Even though HNC's Web-oriented Retek (RETK) subsidiary gets lots of glory, the San Diego-based parent is a leader in customer-relationship software. Clients include MasterCard, Visa and nine of the nation's 10 largest banks. Sure, IDT's Net2Phone (NTOP) subsidiary is sexy. But before it was even a dream, 10-year-old IDT had become a global leader in discount long-distance phone cards; that business is profitable and isn't going away. Seagate, meanwhile, is the world's largest manufacturer of disk drives. This is another burgeoning market, and one that can be brutally competitive. But in good times, profits are massive. Telephone and Data, finally, gets lots of press because of its cellular holdings. Still, the company's roots are in local telephone service, and it has over 500,000 customers in 28 states. Hardly a throwaway asset. And there's more money on the sidewalk for aggressive investors. The math is easy for Daisytek. It owns 82% of PFSweb, and every Daisy share is a claim on 0.82 shares of PFS along with Daisy's basic business. If you buy 100 Daisy shares (cost, $2,263 at current prices) and short 80 PFS shares (proceeds, $3,070), you take in about $800 and wind up owning only Daisy's distribution business. Arbitragers call this creating a "stub." When Daisy distributes the balance of its PFS stake, you get the stock to cover your short position. Final profit: the $800, plus whatever Daisytek shares are worth after the spinoff. TWO-FOR-ONES
Data: Spin-Off Advisors, LLC; Zacks Investment Research This isn't a game for everyone, but the rewards can be significant. Joe Cornell, who heads Chicago-based Spin-Off Advisors, started a hedge fund late last year to invest in stubs and other related situations. So far, his portfolio has gained 11% during a period when the market is up 2%. Before you get too excited, remember that many Web stocks are difficult to short. That can make it tough to create stubs. Even worse, big traders earn interest on the proceeds from their short positions, while you and I usually don't. There are two other risks: If the price of a subsidiary soars, short sellers get margin calls even if they're covered — in theory — because they own the parent, too. More trouble comes if the parent doesn't have a separation timetable. Daisytek, HNC and Metamor (MMWW) all intend to distribute subsidiary shares later this year. Signals from companies such as IDT and Seagate are less definite. When values are out of whack, however, shareholders often push management to act faster. In January, for example, General Motors (GM) bowed to pressure and agreed to distribute shares in its Hughes Electronics subsidiary. Don't get discouraged, though. There's a safer, more conservative way to profit from today's out-of-kilter relationships between parents and subsidiaries. If you're comfortable owning stocks such as PFS, Net2Phone, Williams Communications and the other subs in my table, don't buy them. Buy the parent companies instead. And from now on, when you see news stories about a carve-out, keep an eye on the parent's shares. You may be able to get something for nothing — or at least very cheap. And in theory, at least, I think you'll come out ahead. -- By Paul Sturm
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