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]](SB875938455897417000.gif)
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.
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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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