Monday, October 6, 1997

Why Catch a Knife?

The best time to buy spinoffs is often
six months after they start trading


By Andrew Bary


Maybe investing in spinoff companies is getting a bit too popular for its own good. Once considered fairly novel, these corporate castaways have become all the rage lately. It's easy to see why. Many of them have scored big gains in the stock market after starting life on their own. The biggest winners include Allstate, which was spun off by Sears Roebuck & Co.; Lucent Technologies, which was jettisoned by AT&T, and Dean Witter/Discover, which was set free by Sears and then merged with Morgan Stanley this past May.

Magazine and newspaper articles periodically sing the praises of spinoffs, and such heavyweights as former Fidelity Magellan manager Peter Lynch have endorsed the concept. Academic journals analyze spinoff returns and assert that their repeated success offers further proof that financial markets are inefficient. In the past few weeks, two books on the topic have appeared: Spin-Off to Payoff, by Joseph Cornell, and Break-Up, by David Sadtler, Andrew Campbell and Richard Koch.

All this attention, however, means that bargains are harder to come by. That's not to say spinoff investing can't be lucrative, it's just that buyers now need to be choosier.

As the accompanying table shows, there's plenty to pick from. There have been about a dozen spinoffs of at least $1 billion so far this year. One of the most talked-about deals is scheduled to happen today as PepsiCo spins off of its underperforming restaurant operations: Pizza Hut, KFC and Taco Bell. The new company, to be called Tricon Global Restaurants, has been trading on a when-issued basis for three weeks and closed Friday at 31 1/4.

Later this year, Westinghouse will shed its industrial operations and become a pure play on broadcasting with control of the CBS network and the largest group of radio stations in the U.S. Next year, Campbell Soup is due to part company with such low-profit food divisions as Swanson and Vlasic pickles.

All told, an estimated $44 billion of spinoffs are due to hit the market this year, down from the record $93.6 billion in 1996 and $51.6 billion in 1995, according to J.P. Morgan.

Rick Escherich, a managing director at J.P. Morgan, explains that spinoff activity, while still robust, is down from last year's record pace because major corporate restructurings are winding down.

Morgan studied the performance of spinoffs that have occurred since the beginning of 1995 and those that occurred from 1985 through 1994. The result: The latest crop isn't beating the overall stock market by as much as the earlier group. Post-1995 spinoffs topped the S&P by an average of 2.6 percentage points in their first 18 months, while the pre-1995 collection clobbered the index by 18.5 percentage points.

"Like anything in the marketplace, a good thing doesn't last forever," Escherich observes. One institutional investor who used to often buy them grouses that "spinoffs are getting so hot, we're not playing much anymore. You're not getting the big discounts you used to."

In defense of investing in spinoffs, it should be noted that they're still ahead of the S&P since early 1995 -- something relatively few fund managers can boast. And even as spinoff performance has moderated, there have been such big winners in the past year as Earthgrains, a baking company shed by Anheuser Busch, whose stock has risen sixfold since its was set free in March 1996, and Payless ShoeSource, an offshoot of May Department Stores, whose shares have doubled. Losers include Tupperware and TCI Satellite Entertainment.

The market performance of this year's spinoffs has been underwhelming so far (see accompanying table), but that doesn't dent the case for buying them. Spinoff performance often is weak in the first three to six months as shares migrate from holders of the former parent company to new investors. Also, it takes time for firms to adjust to being on their own.

Steven Bregman, a senior analyst with the Spin-Off Report in New York, one of the few research publications devoted to the genre, asserts that spinoffs remain a fertile source of investments. He's partial to Tricon and NextLevel Systems, the maker of cable TV set-top boxes and other telecommunications equipment, formed when General Instrument separated into three companies this summer. Other potential winners include B.J.'s Wholesale Club, a warehouse club chain shed by Waban, and TCI Ventures, a collection of valuable non-cable investments spun off last month by Tele-Communications Inc., the nation's No. 1 cable company.

Bregman argues that several factors favor investing in spinoffs. For starters, the companies being shed generally aren't the parent's crown jewels. This often turns out to be a plus because the new managers of the company, spurred in part by stock options, generally find ways to cut costs, improve margins and generate better financial performance. Such could be the case with Tricon, which Pepsi is shedding so it can focus on its more profitable soft-drink and snack-food businesses.

Bregman likes to distinguish between pure spinoffs like Tricon, which land in the laps of Pepsi stockholders, and so-called carve-outs, like Lucent. With carve-outs, the parent company first sells a 20% interest in a division, establishes a market for the securities, and then distributes the remaining 80% of the company to stockholders, completing the spinoff.

"You often don't have a lot of organized support for spinoffs. An analyst might be covering 20-30 companies and suddenly a spinoff comes along. The question is: Does the analyst spend 15 hours going through all the pro formas for a company that often doesn't have any earnings, or wait three or four quarters, and be able to spend 15 minutes analyzing it?" Bregman says. "There's a powerful set of reasons why inefficiencies will remain."

Bregman just completed one of the most comprehensive studies of pure spinoffs -- involving more than 100 companies -- and found they generated an annualized return of 37.2% from 1991 through 1996, more than double the 17.5% advance in the S&P 500. The outperformance of spinoffs versus the S&P index, he says, typically peaks in the second and third year after the spinoff takes place.

Does anything look good now? Tricon has received so-so reviews from Wall Street restaurant analysts, and many feel that Pizza Hut, KFC and Taco Bell are mediocre participants in the viciously competitive fast-food business. Moreover, Tricon will be saddled with a heavy debt load because of a $4.5 billion payment to Pepsi. Morgan Stanley's Howard Penney pegged fair value at around 25, six points below the current price.

But Bregman says Tricon's weak margins are a plus because they provide substantial room for improvement. Tricon has operating margins of about 10% on its company-owned restaurants, one of the worst levels of profitability in an industry that averages around 20%. McDonald's is up at 30%. Bregman points out that NPC International, the largest independent operator of Pizza Hut restaurants, achieves 17% margins. If NPC can get 17% margins, why can't Tricon?

If Tricon is able to achieve average restaurant margins in the next few years, it could earn over $3 a share and its stock could hit 60 by the year 2000, Bregman says. The company's operating net is expected to be around $1.70 per share in 1997.

[SpinOff Chart]
Last year's volume of spinoffs swelled to more than $90 billion. This year's volume should be $44 billion or so. The drop-off could be seen as a sign that Corporate America's restructuring is nearing an end. But given their popularity in the stock market, don't be surprised to see them continue at a fairly brisk pace.

NextLevel, the General Instrument offshoot, "is a real growth stock," Bregman asserts. The company, he says, is the leader in several hot areas: the production of digital set-top boxes for cable TV, the equivalent boxes for satellite TV and digital-data transfer equipment. The company has ambitious revenue goals for the next few years. But even if NextLevel generates half its projected 25% growth, it could earn $1.70 in the year 2000, up from an estimated 50 cents this year. Bregman believes the stock could double over the next three years. NextLevel has been disappointing so far, however, dropping to 16 from 19 in July.

B.J.'s Wholesale Club appeals to Todd Slater, the retailing analyst at Lazard Freres. Slater says B.J.'s, a small but solid No. 3 in an industry dominated by Costco and Sam's Club, boasts higher margins than Costco, is expanding more rapidly and trades at a markedly lower P/E. B.J.'s, at 29, now fetches about 16 times projected 1997 profits, below the P/E of 22 on Costco and an average P/E of 20 in the retailing industry. B.J.'s has a strong base in the Northeast and could eventually attract the interest of Wal-Mart, owner of Sam's. B.J.'s market value is a digestible $1.1 billion, compared with $8 billion for Costco.

Meritor Automotive, a profitable maker of auto and truck parts, was jettisoned by Rockwell International last week. Despite the roadshow by company brass in recent weeks, the stock has fallen to 23 from 27 5/8 in initial when-issued trading. Bregman of the Spin-Off Report says the selloff offers a buying opportunity because he believes the company is worth over $30 a share. Meritor now trades for less than 12 times projected 1998 earnings.

One of the biggest winners so far this year, Monterey Resources, got a takeover offer from Texaco in August, valued at about $21 per share.


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