What Klarman And Greenblatt Have To Say About Investing In Spinoffs – PART II

Article by Richie, Stock Spinoff Investing

Superinvestors and Stock Spinoffs: What Buffett, Munger, Klarman, Greenblatt, Lynch, and Pabrai Have to Say about Investing in Spinoffs – See Part I here, stay tuned for Part III

(This article was originally published in February 2016, but I wanted to update it to add Warren Buffett and Mohnish Pabrai’s perspective on spinoffs)

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Check out our H2 hedge fund letters here.

Seth Klarman

Seth Klarman is another famous value investor. His investment firm is Baupost Group which currently manages approximately $30 billion in AUM.

Baupost’s performance is incredible. It is widely reported in the press that Baupost has generated ~17% net returns since inception. This is obviously very impressive performance, but what is even more impressive is that Baupost has generated this performance while holding a very large amount of cash, sometimes ~40% of its portfolio.

Now back to Klarman and his thoughts on spinoffs.

In 1993, Klarman published a book entitled Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor. The book is out of print and used copies of the book go for a cool $696 on Amazon.

Chapter Ten of the book is titled: “Areas of Opportunity for Value Investors: Catalysts, Market Inefficiencies, and Institutional Constraints.”

In this chapter (page 177), Klarman has a section called “Investing in Spinoffs.”

Klarman begins, “Spinoffs often present attractive opportunities for value investors.”

After describing what a spinoff is and then discussing why a company would spin off a subsidiary, he describes why spinoffs are interesting:

“Many parent-company shareholdings receiving shares in a spinoff choose to sell quickly, often for the same reasons that the parent company divested itself of the subsidiary in the first place. Shareholders receiving the spinoff shares will find still other reasons to sell: they may know little or nothing about the business that was spun off and find it easier to sell than to learn; large institutional investors may deem the newly created entity too small to bother with; and index funds will sell regardless of price if the spinoff is not a member of their assigned index.

For reasons such as these, not to mention the fact that spinoffs frequently go unnoticed by most investors, spinoff shares are likely to initially trade at depressed prices, making them of special interest to value investors. Moreover, unlike most other securities, when shares of a spinoff are being dumped on the market, it is not because the sellers know more than the buyers. In fact, it is fairly clear that they know a lot less.”

Also see Baupost Q2

He mentions some other interesting points as to why spinoffs are often initially undervalued:

• Wall Street analysts generally do not follow spinoffs as they are usually small with low trading volumes. As such, it is not worth the analyst’s time because his firm will not generate meaningful commissions from trading the stock. Also, the subsidiary that is spun off is usually in a different line of business than its parent. Thus, the analyst would have to spend considerable time to get ramped up on the new company. Analysts are stretched thin to begin with and aren’t eager to take on additional responsibilities.
• Spinoff companies often do not publicize the attractiveness of their business and undervaluation of their stock as they prefer to initially fly under the radar. Why is this? “…because management often receives stock options based on initial trading prices; until these options are, in fact, granted, there is an incentive to hold the share price down. Consequently, a number of spinoff companies make little or no effort to have the share price reflect underlying value.”
• There is typically a two to three month lag period during which the spinoff company’s financials have not been entered into financial databases. Thus, the stock could be the cheapest stock in the world, but investors that use screens would not be able to identify it until its financials are entered into the financial databases.

Klarman then walks readers through an example to illustrate the typical spinoff dynamics: InterTAN, a spinoff from Tandy Corporation.

Here are the salient points of his example:

• InterTAN had a book value of $15 per share.
• It had net net working capital of $11 and the stock traded at $11 at the time of spinoff in 1986.
• It had highly profitable Canadian and Australian retailing operations.
• The company reported a large loss in Europe which resulted in a small corporate loss and masked the profitability and value of the Canadian and Australian divisions.
• According to Klarman, it was obvious that the Canadian and Australian divisions were worth considerably more than the $11 price at which IterTAN traded.

He then walks readers through why institutional investors sold the stock indiscriminately, creating a supply demand imbalance and an attractive opportunity for savvy investors.

“An institutional investor managing $1 billion might hold twenty-five security positions worth approximately $40 million each. Such an investor might have owned one million Tandy shares trading at $40. He or she would have received a spinoff of 200,000 InterTAN shares having a market value of $2.2 million. A $2.2 million position is insignificant to this investor; either the stake in InterTAN will be increased to the average position size of $40 million, or it will be sold. Selling the shares is the path of least resistance, since the typical institutional investor probably knows little and cares even less about InterTAN.

Even if that investor wanted to, though, it is unlikely that he or she could accumulate $40 million worth of InterTAN stock, since that would amount to 45 percent of the company at prevailing market prices (and that almost certainly would violate a different constraint about ownership and control).

Needless to say, the great majority of Tandy’s institutional shareholders simply dumped their InterTAN shares. InterTAN received no Wall Street publicity, and brokers had no particular incentive to drum up interest in the stock. As a result, a wave of institutional selling created a temporary supply-and-demand imbalance, and numerous value investors were able to accumulate large InterTAN positions at attractive prices.

By 1989 the company had turned its money-losing operations around, Wall Street analyst who had once ignored the stock had suddenly fallen in love with it, and investors no longer worried about what could go wrong, focusing instead on what might go right. The shares peaked that year at 62 1/2.”

Klarman closes by reminding investors that the parent company often times represents an attractive investment.

He apparently still believes spinoffs are a fertile ground for finding attractive investments. In a 2009 speech to the Ben Graham Center for Investing, he said: “Spinoffs are an interesting place to look because there’s a natural constituency of sellers and there’s not a natural constituency of buyers.”

Indeed, Baupost’s current portfolio (as of 12/31/17) of publicly traded stocks includes several spinoffs: SYF, FOXA, TBPH, and TMQ.

Joel Greenblatt

Joel Greenblatt is probably the most well-known proponent of investing in spinoffs. In his book, You Can Be a Stock Market Genius, Greenblatt dedicates a glorious 76 pages to a discussion of spinoffs. The title of this chapter is “Chip Off the Old Stock: Spinoffs, Partial Spinoffs, and Rights Offerings.”

If you are living under a rock and haven’t read this book, I recommend that you immediately stop what you doing, and buy the book.

Alright, let’s dive in….

Greenblatt begins the chapter by telling an amusing anecdote about losing a bet. As a result, he has to treat his friend to dinner at one of the best restaurants in New York City. At the restaurant, Greenblatt wonders if a certain entrée on the menu is any good. With a little help from the waiter, he remembers that everything on the menu is good. After all, he is eating at one of the best restaurants in New York City. The most important decision was deciding where to eat.

Greenblatt then ties this theme to investing. In investing, Greenblatt notes, “It’s great to look for investments in places other are not, but it’s not enough. You also have to preselect investment areas that put you ahead of the game.”

The point is obvious. If you are looking for investments in an area of the market that historically has outperformed (i.e. spinoffs), you have a much greater chance of picking a winner.

The best fisherman in the world will not catch anything if he is fishing in a pond without fish. As investors, we want to fish in a pond that is teeming with fish. That is why spinoff stocks are so interesting.

Greenblatt then goes on to describe what a spinoff is and continues, “There are plenty of reasons why a company might choose to unload or otherwise separate itself from the fortunes of the business to be spun off. There is only one reason to pay any attention when they do: you can make a pile of money investing in spinoffs. The facts are overwhelming. Stocks of spinoff companies, and even the shares of the parent companies that do the spinning off, significantly and consistently outperform the market averages.”

Next, Greenblatt quotes a Penn University Study that found stock spinoffs outperform the market by 10% per year. If you assume the market will return 10%, then theoretically, you can make 20% per year by just blindly buying spinoffs. But what if you selectively choose which spinoffs to invest in? Perhaps, you can even exceed 20% per year.

Next, Greenblatt discusses five reasons why a parent may spinoff a subsidiary:

1. Businesses are unrelated. Generally, conglomerates trade at a “conglomerate discount”. Thus, by separating the businesses, management can “unlock” value. Basically sum of the parts is greater than the whole.
2. Separate a “bad” business from a “good” business.
3. Realize value for a subsidiary that can’t easily be sold.
4. Recognize value while avoiding a large tax bill that would become due if the parents pursued a sale instead of a spinoff.
5. Solve a regulatory hurdle. For instance, a company may be in the process of being acquired. However, it may need to spinoff a subsidiary to address antitrust concerns.

Greenblatt continues by discussing why spinoffs have the potential to generate attractive returns for enterprising investors:

“It is interesting to note, however, that regardless of the initial motivation behind a spinoff transaction, newly spun-off companies tend to handily outperform the market. Why should this be? Why should it continue?

Luckily for you, the answer is that these extra spinoff profits are practically built into the system. The spinoff process itself is a fundamentally inefficient method of distributing stock to the wrong people. Generally, the new spinoff stock isn’t sold, it’s given to shareholders who, for the most part, were investing in the parent company’s business. Therefore, once the spinoff’s shares are distributed to the parent company’s shareholders, they are typically sold immediately without regard to price or fundamental value.

The initial excess supply has a predictable effect on the spinoff stock’s price: it is usually depressed. Supposedly shrewd institutional investors also join in the selling. Most of the time spinoff companies are much smaller than the parent company. A spinoff may be only 10 or 20 percent the size of the parent. Even if a pension or mutual fund took the time to analyze the spinoff’s business, often the size of these companies is too small for an institutional portfolio, which only contains companies with much larger market capitalizations.”

This is very similar to the InterTAN example that Klarman walked through above.

Indiscriminate index selling also contributes to initial downward pressure on spinoffs.

Another reason that spinoffs work really well? “because capitalism, with all its drawbacks, actually works.” In other words, once a spinoff is complete, management of the spinoff is free from the bureaucracy of the parent and is empowered to make changes that will create value. After all, management owns a significant portion of spinoff stock, and thus, they will benefit directly if they create shareholder value.

The last point that Greenblatt makes before moving on to how to pick the best spinoffs, is the following:

“….a strategy of investing in the shares of a spinoff or parent company should ordinarily result in a preselected portfolio of strongly shareholder-focused companies.”

You would think that most management teams are shareholder focused, but alas, that is not usually the case.  By proceeding with a spinoff, a management team has made a strong statement that it cares about shareholder returns.

Next, Greenblatt moves on to discussing how to pick the best spinoffs. This part of the chapter is most interesting to me. Here are the characteristics Greenblatt looks for when evaluating a spinoff:

1. Institutions don’t want it (and their reasons don’t involve the investment merits.)
2. Insiders want it.
3. A previously hidden investment opportunity created or revealed.

Case Study: Host Marriott / Marriott International

Greenblatt walks through a case study with Host Marriott / Marriott International to illustrate his point.  Here is Greenblatt on Marriott background:

“During the 1980s, Marriott Corporation aggressively expanded its empire by building a large number of hotels. However, the cream of their business was not owning hotels, but charging management fees for managing hotels owned by others. Their strategy, which had been largely successful, was to build hotels, sell them, but keep the lucrative management contracts for those same hotels. When everything in the real-estate market hit the fan in the early 1990s, Marriott was stuck with a load of unsalable hotels in an overbuilt market and burdened with the billions in debt it had taken on to build the hotels.”

What to do, what to do.

Marriott CFO, Stephen Bollenbach, came up with the plan to split Marriott into two different publically traded companies to separate the lucrative management contracts from the very hard to sell hotel assets.

The plan was to spin off all the lucrative management-contracts into a new company called “Marriott International”. The remaining company would be called Host Marriott and it would own “all of the unsalable hotel properties and the low-grow concession business.” It would also be responsible for all of Marriott’s debt.

So to summarize, after the spinoff you have Marriott International, the “good business”, with all the lucrative management contracts and no debt. And then you have Host Marriott, the “bad business”, with unsalable hotels, a low-growth concession business and mountains of debt. Greenblatt refers to this as “toxic waste.”

At this point, Greenblatt reveals that he was actually interested in Host Marriott (aka the toxic waste). It’s important to note, that technically, Marriott International was the spinoff, but Greenblatt viewed Host Marriott as the spinoff as it was the less attractive business, and he knew that institutional investors would have no interest in owning it.

Why did Greenblatt like it?

Well let’s follow his rules that I’ve outlined above.

1. Institutions don’t want it (and their reasons don’t involve the investment merits.)
   • It was clear that institutional investors would not want to touch Host Marriott. Why? Because it had a huge debt load, low growth prospects and unpopular real estate.
   • Also, Host Marriott would represent only about 10 or 15 percent of the total value of Marriott pre-spin (about $2bn market cap). It was likely that many institutional investors could not (and would not want to) own such a small company.
2. Insiders Want It.
   • Here’s Greenblatt: “Insider participation is one of the key areas to look for when picking and choosing between spinoffs— for me, the most important area. Are the managers of the new spinoff incentivized along the same lines as shareholders? Will they receive a large part of their potential compensation in stock, restricted stock, or options? Is there a plan for them to acquire more? When all the required public documents about the spinoff have been filed, I usually look at this area first.”
   • With regard to Host Marriott, insiders were definitely well aligned. Specifically, Stephen Bollenbach, the CFO Marriott Corp. and the architect of that plan decided to stay with Host Marriott. Generally, the CFO and CEO are more concerned with managing a larger business so it was notable that Bollenback stayed with Host Marriott.
   • According to SEC filings, 20 percent of the new company’s stock was made available for management and employee incentives.
   • The Marriott family, who owned 25% of Marriott Corp., would continue to own their shares of Host Marriott. Obviously, it was in the best interest of the family if Host Marriott thrived.
3. A previously hidden investment opportunity created or revealed.
   • Here’s Greenblatt: “This could mean that a great business or a statistically cheap stock is uncovered as a result of the spinoff. In the case of Host, though, I noticed a different kind of opportunity: tremendous leverage.”
   • From what analysts in the press were saying, Host Marriott would likely begin trading around $5 per share. At the same time, Host would have $25 per share of debt. “Thus a 15 percent move up in the value of Host’s assets could practically double the stock (.15 x $30 = $4.50).”
   • This leverage set up an asymmetric return opportunity.

The investment worked out as planned as it tripled within four months. Not too shabby.

Before I move on to the next topics that Greenblatt discusses, I want to dedicate a little more time to leverage.

Greenblatt writes:

“Believe it or not, far from being a one-time insight, tremendous leverage is an attribute found in many spinoff situations. Remember, one of the primary reasons a corporation may choose to spin off a particular business is its desire to receive value for a business it deems undesirable and troublesome to sell. What better way to extract value from a spinoff than to palm off some of the parent company’s debt onto the spinoff’s balance sheet? Every dollar of debt transferred to the new spinoff company adds a dollar of value to the parent.

The result of this process is the creation of a large number of inordinately leveraged spinoffs. Though the market may value the equity in one of these spinoffs at $1 per every $5, $6, or even $10 of corporate debt in the newly created spinoff, $ 1 is also the amount of your maximum loss. Individual investors are not responsible for the debts of a corporation. Say what you will about the risks of investing in such companies, the rewards of sound reasoning and good research are vastly multiplied when applied in these leveraged circumstances.”

I think this point is super interesting and is definitely still the case with spinoffs today. The challenge in my opinion is deciding what is “toxic waste” and what only appears to be “toxic waste” and thus, a good potential opportunity.

Because while spinoffs as a group outperform, many underperform severely or even go bankrupt.

Just look at Lone Pine Resources (2011 spinoff from Forest Oil) and Orchard Supply (2012 spinoff from Sears), which both went bankrupt.

In fact, the Edge Group and Deloitte partnered to conduct a study on spinoff performance and found that 4 out of 10 investments do not generate a positive return in their first 12 months of trading. The study also found that bottom quartile performance spinoffs generate a -39% 1 year return.

Case Study: Strattec Security / Brings & Stratton

Here are the key points:

• Briggs & Stratton was a manufacturer of small gas-powered engines.
• The company announced in May 1994 that it intended to spin off its automatic-lock division, Strattec Security (“Strattec”).
• Briggs & Stratton was a $1bn market cap company and the spinoff would be a division that represented less than 10% of the parent’s earnings.
• Reason why it could be interesting: “Not only was manufacturing locks for cars and trucks unrelated to Briggs’s small-engine business, but it appeared that Strattec would have a market value of under $ 100 million— a size completely inappropriate for most of Briggs & Stratton’s institutional shareholders.”

Ultimately, Briggs & Stratton filed its Form 10 for the spinoff. Greenblatt highlights the following from the Form 10:

• 12% of shares outstanding was reserved for employee equity compensation.
  • Here are his thoughts: “While this amount of stock incentive may seem generous to an outside observer, as far as I am concerned the more generous a Board is with its compensation plans, the better— as long as this generosity takes the form of stock option or restricted stock plans. In fact, a theme common to many attractive investment situations is that management and employees have been incentivized to act like owners.”
• Pro-forma earnings for Strattec for June were calculated to be $1.18 per share and earnings had grown 10% during the first six months of the year.
• Greenblatt was able to determine that comparable companies in the Auto Parts (Original Equipment) industry traded at 9x to 13x earnings. So a reasonable range for Strattec might be $10.62 ($1.18 × 9) to $15.34 ($1.18 × 13).
• About 50 percent of Strattec’s sales were to General Motors.
• About 16 percent of Strattec’s sales were to Chrysler.
• In the filing, Greenblatt read the following: “based upon current product commitments, the Company [Strattec] believes Ford will become its second-largest customer during fiscal 1996 [year ended June 1996], if such commitments are fulfilled as expected.”
  • This was big news. To overtake Chrysler, Ford would have to represent at least 16 percent of sales. If Ford became a customer as expected, sales and earnings would increase meaningfully.
• Because Strattec General Motors, Chrysler and Ford (expected in the near future) were customers, Greenblatt got the impression that Strattec had a strong market position and maybe deserved to trade at the high end of industry range.

What happened?

• The stock initially traded at a price of between $10 ½ and $12.
  • According to Greenblatt this valuation was cheap given: 1) Strattec had grown earnings 10% in the first six months of the year 2) the new Ford business 2) Strattec’s better than average market position.
• The result: 8 months later, Strattec traded at $18 per share.

Home Shopping Bonanza – The Cartwrights Were Never This Rich

Background:

• In April 1992, Greenblatt started looking at the Home Shopping Network (HSN), a former high flying stock that had gotten very cheap and was trading at a low valuation (price-to-earnings, low price-to-book value, etc).
• The stock was trading at $5 per share. This was interesting in and of itself as “many institutions don’t like to buy stocks priced under $10.” Greenblatt continues: “Since in the United States most companies like their stocks to trade between $10 and $100, a stock that trades below $10 has, in many instances, fallen from grace. Due to a lower market capitalization at these prices, or the fact that stocks that have fallen from a higher price are inherently unpopular, opportunities can often be found in single-digit stocks as they are prone to be underanalyzed, underowned, and consequently mispriced.”
• The stock also looked interested because it was pursuing a spinoff of its broadcast properties. The spinoff would be named Silver King.

 

Once the Form 10 was filed, management revealed why it was pursuing a spinoff. Management believed the analyst community did not know how to properly value the company because HSN consisted of a retail-oriented company and a broadcast company.

Additional context:

• Retail companies are typically valued on a price to earnings metric.
• Broadcast companies are generally valued on a cash flow basis.
  • HSN had purchased twelve television broadcast stations to expand the reach of its home-shopping program. Because television assets don’t have many hard assets, HSN’s purchase created substantial goodwill on the balance sheet. To borrow from Greenblatt, “Goodwill arises when the purchase price exceeds the value of the acquired company’s identifiable assets (i.e., assets that can be identified-like broadcast equipment, receivables, and programming rights). This goodwill must be amortized over a period of years, creating a non-cash charge that reduces reported earnings.
  • Broadcast companies’ valuations are generally directly related to the cash flow that they generate not the number of hard assets that they employ. Thus, non-cash charges such as amortization and depreciation are added back to earnings.
• Silver King (the broadcast spinoff) earnings vs. cash flow
  • Silver King generated $4mm of operating earnings in a given year.
  • However, it generated $26mm of cash flow. Capex was only $3mm per year because the broadcast equipment does not need to be replaced very frequently. Thus, cash flow after capex was $23mm.
  • In addition, HSN planned to shift $140mm of debt to Silver King. At an interest rate of 9%, that debt resulted in an annual interest expense of $12.6mm. So by spinning off Silver King, operating earnings would actually go up at HSN! HSN would lose $4mm (the operating earnings generated by Silver King annually), but save $12.6mm of interest expense, resulting in a net increase of operating earnings of $8.6mm.

Additionally, the value of the spinoff was going to be small relative to the value of HSN. For every ten HSN shares owned, the shareholder would receive one share of Silver King. Greenblatt was hopeful this distribution ratio would lead to indiscriminate selling.

In this situation, the parent company also looked interesting. Because reported earnings would actually be higher after the spinoff, it was possible that HSN would actually trade higher.

Another interesting point was that the parent company, HSN, was spinning of Silver King, a division that operated in a highly regulated industry (broadcasting).

Greenblatt notes: “Whenever a parent company announces the spinoff of a division engaged in a highly regulated industry (like broadcasting, insurance, or banking), it pays to take a close look at the parent. The spinoff may be a prelude to a takeover of the parent company.

Of course, the spinoff may merely be an attempt to free the parent from the constraints that go along with owning an entity in a regulated industry. However, takeovers of companies that own regulated subsidiaries are very involved and time consuming. One (unspoken) reason for spinning off a regulated subsidiary may be to make the parent company more easily salable. In other instances, the creation of a more attractive takeover target may just be the unintended consequence of such a spinoff.”

What happened?

In December 1992, before the spinoff took place, Liberty Media announced its intention to buy HSN, however, the spinoff would proceed as planned.

In January 1993, the spinoff occurred and traded at ~$5 per share for its first four months as an independent company. This price looked compelling as it was trading for less than 5x cash flow.

Over the next year, Silver King appreciated to the $10 to $20 range once selling pressure was lifted and the WSJ began to speculate that Silver King would partner to form a fifth television network. A few more years down the road, Barry Diller (media mogul) purchased Silver King and used it as a platform to help build his media empire.

In summary, Greenblatt writes, “Certainly, I didn’t buy Silver King anticipating this particular series of events. However, buying an ignored property at a low price allowed a lot of room for good things to happen and for value to be ultimately recognized.”

Pay Attention to Parents

Next, Greenblatt writes that paying attention to parent companies can also be lucrative.  He notes that Home Shopping was very cheap after the spinoff of Silver King. And it also caused him to research a competitor, QVC Network which was even cheaper. Both stocks ended up doubling over the subsequent year. In summary, Greenblatt writes, “The point is that looking at a parent company that is about to be stripped clean of a complicated division can lead to some pretty interesting opportunities.”

Case Study: American Express / Lehman Brothers

In January 1994, American Express (“AXP”) announced its intention to spin off its Lehman Brothers subsidiary.

As Greenblatt analyzed the situation, here were some of his thoughts:

• Lehman Brothers (“LB”) had the highest expenses per dollar of revenue in the investment industry.
• LB insiders were highly paid but held relatively few shares of stock in the new spinoff. LB management wasn’t incentivized to act like owners so this was definitely a negative.
• From reading about the proposed spinoff in newspapers, Greenblatt learned that a complaint of institutional investors was that they never knew what American Express’ earnings would be. They were very volatile. And this was primarily a result of LB’s volatile business results. “The only thing Wall Street hates more than bad news is uncertainty.” After the spinoff, AXP would have a significantly more stable revenue and earnings trajectory.
• AXP’s core business looked attractive.
  • The first part of the AXP’s business was its charge card business and traveler’s-check business. This segment had suffered from competition from Visa and MasterCard, but this was due to management distraction not a flaw in AXP’s product. AXP’s main product, the charge card, required full payment every month, and so there was minimal credit risk. Revenue was generated primarily by cardholders and merchants paying fees. AXP had a very strong brand in the market.
  • The second part of AXP’s business was called Investors Diversified Services. This segment had been growing earnings for 20% for ten years. It consisted of a nationwide group of financial planners who sold investment and insurance plans to clients. It appeared that this segment was a “valuable and fast-growing niche business.”

In May 1994, before the spinoff, AXP was trading at ~$29 per share. Press estimates suggested the Lehman spinoff was worth $3 to $5 per share. So investors could “buy” the AXP core business for ~$24 to ~$26 per share. Analysts estimated that AXP’s core business would generate $2.65 in earnings after the spinoff. Thus, you could buy “new” AXP for a ~9.4x P/E ratio.

According to Value Line, large credit card companies were trading in the low teens on a P/E basis. Thus, “new” AXP appeared to be trading at a 30% to 40% discount to fair value. Greenblatt then had to make the decision whether to buy AXP before or after the LB spinoff.

Greenblatt writes: “As a general rule, even if institutional investors are attracted to a parent company because an undesirable business is being spun off, they will wait until after the spinoff is completed before buying stock in the parent. This practice relieves the institution from having to sell the stock of the unwanted spinoff and removes the risk of the spinoff transaction not being completed.”

It worked out just as Greenblatt planned. AXP increased 1% on the day of the spinoff, so buying before the spinoff was a good idea. AXP ended up eventually appreciating to ~$36 within one year for a return of 40%.

Partial Spinoffs

Why would management pursue a partial spinoff?

• To raise capital
• To highlight a particular division’s true value in the marketplace

Partial spinoffs can be interesting because the spinoff will be valued by the market after the spinoff takes place. But often times the parents will still own 80% of the spinoff.  Using first grade math skills, enterprising investors can back out the parent’s 80% ownership stake of the spinoff to determine the value at which the market is valuing the parents remaining business. Oftentimes, obvious values can be identified this way.

Case Study: The Cheaper Side of Sears

Next Greenblatt takes us through an opportunity in which an obvious value in Sears’ stock was highlighted by a partial spinoff.

In September 1992, Sears announced it would be selling 20% of its two subsidiaries, Allstate Insurance and Dean Witter, to the public. At a later date, Sears would distribute to its shareholders the remaining 80% stake of Dean Witter.

After the partial spinoffs took place, one could subtract Sears’ ownership stake in both businesses to determine the market value at which the market was valuing Sears’ core business. Greenblatt walks through some basic math and shares that Sears had $79 per share in sales and those sales could be purchased for $5 per share (~6% of sales). A close comparable, J.C. Penny had $78 per share in sales and was trading at ~$44 per share (56% of sales). According to Greenblatt, Sears was very cheap on earnings and cash flow based multiples, as well. This trade worked out well for Greenblatt as Sears appreciated by ~50% after the distributions of Dean Witter.

Insiders Tips: A Do-It-Yourself

Analyzing insider incentives is one of the most important areas of focus for Greenblatt when he is evaluating a spinoff.

In Margin of Safety, Klarman highlights that spinoff insiders actually have an incentive for the new company to initially trade at a low price. Greenblatt makes the same point:

“Spinoffs are a unique animal. In the usual case, when a company first sells stock publicly an elaborate negotiation takes place. The underwriter (the investment firm that takes a company public) and the owners of the company engage in a discussion about the price at which the company’s stock should be sold in its initial offering. Although the price is set based on market factors, in most cases there is a good deal of subjectivity involved. The company’s owners want the stock to be sold at a high price so that the most money will be raised. The underwriter will usually prefer a lower price, so that investors who buy stock in the offering can make some money. (That way, the next new issue they underwrite will be easier to sell.) In any event, an arms-length negotiation takes place and a price is set. In a spinoff situation, no such discussion takes place.

Instead, shares of a spinoff are distributed directly to parent-company shareholders and the spinoff’s price is left to market forces. Often, management’s incentive-stock-option plan is based on this initial trading price. The lower the price of the spinoff, the lower the exercise price of the incentive option. (E.g., if a spinoff initially trades at $5 per share, management receives the right to buy shares at $5; an $8 initial price would require management to pay $8 for their stock.) In these situations, it is to management’s benefit to promote interest in the spinoff’s stock after this price is set by the market, not before.

In other words, don’t expect bullish pronouncements or presentations about a new spinoff until a price has been established for management’s incentive stock options. This price can be set after a day of trading, a week, a month, or more. Sometimes, a management’s silence about the merits of a new spinoff may not be bad news; in some cases, this silence may actually be golden.”

Greenblatt then recommends looking through the SEC filings to see if management will have a substantial option package. Greenblatt explains: “In a situation where management’s option package is substantial, it may be a good idea to establish a portion of your stock position before management becomes incentivized to start promoting the new spinoff’s stock.”

The best way to quickly analyze insider incentives is to do the following:

1. Find the spinoff’s Form 10 Filing. You can do so by going to the following website: https://www.sec.gov/cgi-bin/srch-edgar?text=form-type+%3D+10-12b+OR+form-type%3D10-12b%2Fa&first=2009&mode=Simple
2. Once you’ve opened up the Form 10 filing, search for “executive compensation”
3. In the executive compensation section, you should be able to find how many shares of the spinoff are reserved for management and employee incentives.
4. To give you an example, one of the stocks that we wrote up (NVTR) had the following in the Form 10:
   • “The aggregate number of shares that may be issued pursuant to incentive awards under the Equity Plan is the sum of (i) 1,128,550 shares….” 1,128,550 represents 11% of shares outstanding.

Buy All Rights

Greenblatt notes that you should pay attention whenever a company uses a rights offering to effect a spinoff because it can oftentimes represent a very good investment.

He writes: “The timing, terms, and details of each rights offering are different. The important thing to remember is this: Any time you read about a spinoff being accomplished through a rights offering, stop whatever you’re doing and take a look. (Don’t worry, they’re quite rare.) Just looking will already put you in an elite (though strange) group, but— more important— you will be concentrating your efforts in an area even more potentially lucrative than ordinary spinoffs.”

Why are rights offering spinoffs so attractive?

“The answer lies in the very nature of a rights offering. If stock in a new spinoff is sold by the parent company through a rights offering, the parent company has, by definition, chosen not to pursue other alternatives. These alternatives could have included selling the spinoff’s businesses to another company or selling the spinoff to the public at large through an underwritten public offering— both of which require the directors of the parent company, as fiduciaries, to seek the highest price possible for selling the spinoff’s assets. But if the parent company uses a rights offering to sell the spinoff company to its own shareholders there is no need to seek the highest possible price.

In fact, limiting initial buyers of the spinoff to parent-company shareholders and to investors who purchase rights in the open market is not usually the best way to maximize proceeds from the sale of the spinoff’s businesses. However, in a rights offering, since all shareholders of the parent have an equal opportunity to purchase stock in the spinoff— even if a bargain sale is made— shareholders have been treated equally and fairly.”

When analyzing a rights offering spinoff, look for an “oversubscription privilege” clause.

“Oversubscription privileges give investors who purchase spinoff stock in the rights offering the right to buy additional spinoff shares if the rights offering is not fully subscribed…..Insiders who wish to increase their percentage ownership in a new spinoff at a bargain price can do so by including oversubscription privileges in the rights offering. In certain cases, insiders may be required to disclose their intention to oversubscribe for shares in the new spinoff in the SEC filings.”

Case Study: Liberty Media / Tele-Communications

Next, Greenblatt walks readers through an example of a rights offering spinoff. He writes: “Anyone who participated in the Liberty Media rights offering, a spinoff from Tele-Communications, was able to earn ten times his initial investment in less than two years.”

The entire spinoff was closely followed by the financial media, but due to its complicated structure, the vast majority of investors missed the opportunity.

In January 1990, Tele-Communications (TC) announced its intention to spin off its programming assets (estimated to be worth $3bn). This was a result of pressure from Washington which viewed Tele-Communications as a monopoly with too much influence on the cable industry.

In March of 1990, the Wall Street Journal reported that TCI would be utilizing a rights offering to effect the spinoff.

Additional news came out that the spinoff would also be much smaller ($600mm of value) than originally anticipated ($3bn).At the time, TCI had a total enterprise value of $16bn and so this situation had the makings of a classic spinoff opportunity.

Also, TCI shareholders would receive 1 transferable right for every 200 that they owned. Each right plus 16 shares of TCI could be exchanged for 1 share of Liberty Media. TCI was priced at $16 so this translated to a purchase price of $256 for Liberty Media. There would only be 2.1 million shares of Liberty Media outstanding. It appeared as if the transaction was structured so that most investors would ignore the rights offering.

What were insiders doing? In the prospectus, it said that John Malone would be granted options to buy 100,000 of Liberty Media stock at $256 in lieu of cash compensation for services provided to Liberty Media. This translated to over $25mm of Liberty stock!

Due to the complicated and confusing structure, few investors (36 percent) participated in the rights offering. Of course, John Malone exercised all his rights and when you combine his shares with the 100,000 that he received in lieu of cash compensation for his management of Liberty, he owned roughly 20% of the company.

John Malone and all the investors that were smart enough to exercise their rights and hang on for two years earned a 10x return on their investment.

I have 6 years of public equity research experience and 5 years of private equity experience – SpinoffInvesting