Feasting at the Carve-Out Buffet

April 1, 1999

DO YOU LICK your lips at the thought of owning a stake in Hewlett-Packard's (HWP) market-leading equipment business? Are you hungry for stock in CBS's (CBS) Web sites, without all the network and broadcast-station fat? Then you’ve got a sweet tooth for a subspecies of spinoffs called carve-outs, which are very much in vogue these days.

Companies have always sought to improve their units’ value through spinoffs, in which they distribute equity in certain divisions to existing shareholders, who then trade the new stock. A carve-out adds the spice of an IPO. A company offers up to 20% of a division, holds the rest of the new (presumably richer) stock for a while, and then distributes it to shareholders. Companies plagued by stubbornly low stock prices, like Hewlett-Packard, are pursuing this strategy; so are big media companies eager to taste the market’s mania for all things Internet. We expect at least two other big carve-outs to happen this year. They can produce satisfying returns -- if you select carefully at the buffet table.

The carve-out porterhouse must be Lucent Technologies (LU), which was AT&T’s equipment business before it started trading independently in 1996. According to Raymond Duffy, CEO of spinoff investment boutique Horizon Asset Management Services, it reflects a classic scenario in which the new company won contracts from AT&T’s long-distance competitors, who once shunned it in order to avoid sending income to the parent. Lucent’s stock has appreciated 500% from its debut three years ago today.

Pretty strong nutrients. Since then, four of the seven biggest spinoffs in history have occurred as carve-outs, according to Chicago’s Spin-Off Advisors. It’s too early to tell whether Lucent was an aberration, because none of the new stocks is older than six months, and none has completed its spinoff. They include a nibble of Rupert Murdoch’s Fox Entertainment Group (FOX), which has zigzagged to a 27% return since November, and the Pepsi Bottling Group (PBG), which opened this week to losses. We see at least two more carve-outs taking shape this year. How’s an investor supposed to order?

One thing to bear in mind is that companies tend to hold on to profitable divisions or seek instant cash by privately selling whole divisions. Another is that a spinoff doesn’t need an IPO to be a good buy; Tricon Global Restaurants (YUM), the restaurant division of Pepsico (PEP) before its 1997 distribution, has emerged from Duffy’s characterization as a stock of "Pepsi-dispensing machines" to gain 110% in 19 months. This case is instructive for carve-outs. Even with the rush of an IPO pop, most spinoffs are last resorts by companies seeking better valuations. As such, they can bring investors a first crack at major earnings growth -- and at a pretty cheap price.

Which brings us to our first spinoff candidate: Ralston-Purina (RAL). Here’s a profitable firm that owns the pet-food business; it also makes Energizer batteries, where it grapples with Gillette's (G) Duracell unit in a withering price war. Prudential’s John McMillin has predicted a battery spinoff this year if the division doesn’t turn profitable; Merrill Lynch’s Eric Katzman, who’s bullish on the stock, advised clients in two recent reports that the firm would be segmenting its battery business but didn’t mention anything about spinoffs. We suspect a spinoff would help Ralston-Purina shake the malaise currently gripping food stocks. A carve-out, more particularly, could deliver cash to the company, which has slowed down sales 13% in the past three years.

Ralston-Purina showed up on one of our screens as a $4 billion-plus company with a debt/equity ratio above the S&P mean and price and earnings growth below it. Many firms on our screen represent industries like banking, which tend to seek better margins through mergers. In sectors where the core business is getting much more research-intensive -- say, telecom in an age of convergence or pharmaceuticals in an age of genetic engineering -- companies may get a short-term fix from a carve-out.

There are several theoretical reasons for this; better focus, firmer understanding of capital needs, clearer management incentives. One concrete benefit comes from increased analyst coverage. After a spinoff, "the combined parent and subsidiary receive 25% more coverage in the two years after a transaction," reports an upbeat new study by elite consultants McKinsey & Co. "By contrast, the overall number of U.S. equity analysts rose by just 2% a year in the 1990s."

Analysts steer fund managers toward big blocks in favored sectors. At the moment, many companies are looking at carve-outs as pipelines to Internet stocks’ outlandish valuations. Barnes & Noble (BKS) plans to carve out a stake in its online venture. CBS CEO Mel Karmazin seems to delight in dangling hints about some kind of spinoff of all CBS’ Internet brands. Even Time Warner (TWX), whose stock has practically doubled this year, has been overheard mulling an Internet-related carve-out. All these deals are vulnerable to Net stocks’ elusive fundamentals and insane pricing. We got a better read on an announced carve-out from a company that may be able to improve a division’s earnings by setting it free. That’s Viacom (VIA and VIA/B), owners of Paramount movies, Blockbuster Video, and MTV Networks. To be fair, Viacom is murmuring about a possible IPO for its MTV and Nickelodeon-derived Internet brands. That satisfies our other screen, for divisions whose competitors draw multiples greater than Microsoft’s, but the announced carve-out of Blockbuster shows more star power. With a modest IPO multiple of nine times operating earnings, writes Merrill Lynch analyst Jessica Reif-Cohen, Blockbuster could bring its parent around $1 billion. That’s nice for the debt-saddled Viacom: It could also be nice for shareholders. Under a new revenue-sharing agreement with studios, on Duffy’s logic, Blockbuster might maneuver more nimbly without the impression that its profits revert to the studio-owning parent.

But that’s a business proposition for the long term. "Spinoffs have to go to the capital markets, hire their own ad agencies, and develop their own identities," says Duffy. "By definition, you’re looking at a three- to four-year holding period where nobody understands what was spun off." You can bet on an IPO pop in Internet-related carve-outs, if that’s your thing. Otherwise, be as patient with carved-out stocks as other new issues; you can’t dial up Lucent every time.