ONE OF THE most
memorable magazine covers I’ve ever seen was an issue of
Forbes from the late 60s with big, bold type that simply said
"1+1=3." Inside, there was a story about conglomerates
and how buying something, almost anything, could make a
company’s shares soar. Today you could capture the mood with a
similar headline, just different math. Maybe
"2–1=3."
Forget acquisitions and synergy; what counts now is focus.
Investors want pure plays, easy-to-understand companies that are
in just one business -- preferably anything to do with the
Internet. Shares bubble up on rumors of breakups, divestitures
or spinoffs. And when there’s a dot-com involved, gains can be
dramatic: Barnes & Noble (BKS)
moved up 20% on the news that it would sell part of its online
operations.
Conventional analysts are busy searching for situations where
the parts may be worth more than the whole. But some of the best
values can come long after the initial excitement -- if you know
what to look for. This month, I’ll explain the jargon that
pervades these deals, terms like carve-out, spinoff, tracking
stock and stub. In the accompanying table, I’ll also present a
roster of newly independent companies that may not look
glamorous today but have the potential to double or triple in
price over the next few years.
You’d think corporations would just sell a business that
they don’t want. That doesn’t always happen, mostly because
there are ways to achieve similar ends while avoiding capital
gains taxes. Three types of transactions are currently popular,
and I’ll start with the one that involves the most smoke and
mirrors.
Back in 1984, when Ross Perot sold Electronic Data Systems
(EDS)
to General Motors (GM),
he wanted something sexier than GM shares in payment. "You
don’t have to own the cow to get the milk," said Perot.
So Wall Street created GM-E certificates, then called
"letter" stock. Owners enjoyed the security of GM’s
balance sheet, the right to vote for the parent’s directors
and a claim on the earnings of its faster-growing EDS
subsidiary.
Spinoffs,
Carve-Outs and Stubs, Oh My
Nine new companies ready to grow.
Source: Smart Edgar;
StockQuest by Market Guide
C=carve-out; S=spinoff; NM=not meaningful, loss for most recent
four quarters; NA=not available. Prices as of 4/9/99
For more than a decade, letter stock was largely a curiosity.
But now, repackaged as tracking stock, it’s the currency of
many hot Internet initial public offerings. This structure is
the corporate equivalent of being divorced but living in the
same house -- with lots of the same headaches. To begin with,
proceeds from a stock offering don’t necessarily get
reinvested in the business that’s being sold. Ziff-Davis
(ZD),
for example, issued tracking stock in ZDNet (ZDZ)
and used the money to pay off the parent’s loans. Second, the
parent–subsidiary relationship is awkward, with mutual
responsibility for debt and a passel of never-litigated
potential conflicts. Finally, a takeover is possible but messy.
Think of tracking shares as bonded to the parent, for better or
worse.
Next comes the carve-out, or partial IPO. Recent examples
range from GM’s lumbering Delphi (DPH)
auto-parts business to CBS’s (CBS)
supercharged MarketWatch.com (MKTW).
The parent sells a piece of a subsidiary (for tax reasons,
rarely more than 20%) through a conventional stock offering.
Once the new company has a track record, the parent generally
distributes its stake as a dividend to its existing
shareholders. Advantages: The parent gets a higher price because
of the IPO hoopla, and its shareholders get stock in a company
that’s already well established in investors’ minds. With an
exception that I’ll explain later, buying a carve-out is like
buying any IPO -- shares are limited and go to favored clients,
and I worry that I don’t generate enough commissions to get
the good ones.
This is more a curiosity than a hot tip, but carve-outs can
also lead to occasional oddball situations. The Limited (LTD),
for example, was recently selling for less than the value of its
84% stake in Intimate Brands (IBI),
a 1995 partial IPO. So you could buy Limited and get Intimate at
a discount. In theory, you could even buy Limited, short
Intimate in the right proportion and get Limited’s operating
business, called the stub, for free. Such arbitrage isn’t as
easy as it sounds. But if you’re intrigued, start watching AMR
and Sabre (TSG),
CBS and Infinity Broadcasting (INF),
and Creative Computers (CAP)
and uBid (UBID).
I’m always nervous about getting something for nothing, but
I’m a sucker for cheap -- which is where traditional spinoffs
come in. They’re total, instant separation. The parent simply
hands a business to shareholders. No IPO, no salesman will call.
Consider Earthgrains (EGR),
an Anheuser-Busch (BUD)
spinoff and a star performer (up 200% since trading began).
Earthgrains is a baking company, and Busch’s idea of using its
beer distribution network to push cupcakes wasn’t working. So
a tiny position in Earthgrains popped up on the brokerage
statements of Busch shareholders. Unlike Busch, it had no
dividend and wasn’t in the Standard & Poor’s 500-stock
index.
At this point -- with Earthgrains and most spinoffs -- a
transition begins. Even though the new company typically has
eager managers delighted to be independent, it often doesn’t
"fit" its new shareholders. At Earthgrains, for
example, index funds and folks who wanted income gradually
bailed out. Who buys? Spinoffs tend to be a hard sell. They
rarely appear in standard databases, have minimal operating
history and receive scanty analyst coverage.
If you haven’t said "aha" yet, reread the
previous paragraph. Economists have studied spinoffs in detail,
and their research indicates that operating performance improves
sharply in the three years after separation takes place.
What’s more, share prices of spinoffs tend to do much better
than those of comparable companies (typically twice as well),
with the strongest gains coming in the second and third years.
For the 12 months or so after they begin life, spinoffs can be
among the world’s true bargains.
There were 45 spinoffs in 1998, with perhaps two dozen more
announced in the first three months of this year. Which are the
best buys? For some advice, I talked with two clever people who
specialize in this corner of the market: Joe Cornell, who runs
Spin-Off Advisors in Chicago, and Barbara Goodstein at
Rothschild Inc. in New York. The accompanying table is a
composite of their current favorites, with an emphasis on stocks
that are selling near or below their initial prices. I’ve also
included two carve-outs (Convergys (CVG)
and Waddell & Reed (WDR)),
which look attractive in part because former parents have just
divested all their shares -- meaning there may be lots of
perplexed new owners.
Some of these companies -- particularly Arch Chemicals
(ARJ)
and Park Place Entertainment (PPE)
-- are cash-flow and book-value bargains in depressed
industries. But they all have opportunities to cut costs and
improve efficiency. Pennzoil-Quaker State (PZL)
can meld two related brands. Vlasic Foods (VL)
can sell off its money-losing operations. Chicago Title (CTZ)
is networking its offices, and Varian (VARI)
can sell to electronics customers who were competitors of its
parent. Hussmann (HSM),
a leader in supermarket freezer displays, has major overseas
growth potential, while Waddell & Reed would be a choice
acquisition for several larger fund managers. There’s even a
spinoff growth star: Convergys is the largest provider of
billing services to cellular-phone companies, a market that is
expanding by 20% annually.
