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Thursday, August 27, 2009

Checklist for Evaluating Spinoffs

Spinoffs provide a great place for value investors to look for investment ideas. A 1988 study at Penn State showed that spinoffs outperformed the S&P500 by 10% per year in the three year period following the spinoff. Parents of spinoff companies outperformed their industry peers by 6%. I am a big believer in using lists when evaluating investments so I don't forget to check or think about something. This is also a good way to keep emotions in check. The following is a list I use based on Joel Greenblatt's book You Can Be A Stock Market Genius, Even if you're not too smart! Don't let the title fool you. Greenblatt has one of the best track records I've ever seen and the book is excellent. Here's the list: 1. Will the spin-off allow the separate businesses to be better appreciated? 2. Will the spin-off separate a lousy business from a good business? 3. Is the multiple of a great business being penalized by being combined with a good business which the spinoff will fix (AMEX spinoff of Lehnan Brothers)? 4. Does one business have steady earnings and one volatile? 5. Will the spinoff allow each business to be properly valued, for example one division would be better valued using cash flow and another using earnings? (In the example given by Greenblatt, large depreciation charges from its TV stations were obscuring Home Shopping's earnings.) 6. Does the spin-off allow the parent to rid itself of a business it can't sell and/or off-load debt? 7. Are there tax advantages to the spin-off such as avoiding a large capital gain? 8. Does it solve a problem, for example antitrust or regulatory, that paves the way for another transaction? 9. Are there reasons, unrelated to value, why the spinoff will fall in price making it cheap? A. the investment merits are obscured by complexity or what, upon superficial analysis, looks like a bad business B. removed from an index C. too small to be held by institutions

D. very different business from the original investment 10. What are the insider's motives? 11. Do insiders want the spinoff? A. Is the compensation of the new management strongly tied to that of the spinoff? B. What percentage of the company's stock is made available to compensate management and employees? C. Are key managers moving to the spinoff? D. Is the parent retaining stock in the spinoff? E. Does management have an incentive to do the spinoff at a low price to set option strike prices low? 12. Is the spinoff positioned to benefit from high leverage (see Host Marriot example on page 70)? 13. On a pro-forma basis, how does the value of the spinoff compare to it industry? A. Is the implied P/E lower than that of the peer group (see Value Line for industry group valuations)? B. Is there an identifiable future event that is not yet factored into the earnings that will drive a higher price and/or multiple, i.e. a new production unit, ship, contract, etc.? 14. Look also at the parent company. 15. Does a partial spinoff reveal that the parent is undervalued? A. Use ratios to compare the implied value of the parent with the value of peers. (The Sears partial spinoff of Allstate and Dean Witter revealed that Sears was trading at 6% of sales vs. 56% at J.C. Penny.) 16. Look at rights offerings. Posted by Gregory Speicher at 9:41 AM Labels: Checklists, Investment Process, Spinoffs