Spin-offs are one of the most overlooked opportunities the stock market may present. Lead mostly by mature companies, often neglected by the institutionalized investors, Spin-off stocks make perfect sense for the small investor.
Q1 hedge fund letters, conference, scoops etc
A spin-off is the separation of a subsidiary from the parent company by distribution of shares as dividends to shareholders of the parent company, or, alternatively, by selling shares to the public in an IPO. In both cases, it means the spin-off company changing from a private company into a public one, whose shares are traded on the stock exchange, similar to the common IPO process.
In his excellent book, “You can be a stock market genius”, Joel Greenblatt explains very coherently the main points that must be examined when looking at spin-off shares, and also presents a number of case studies in which he had invested. This is an excellent book for investors who wish to enter the field. Still, since any spinoff needs to be analyzed and evaluated in depth, it is necessary to carefully study the entire picture as it appears in the prospectus published by the parent company prior to the separation. In the case of US companies, the prospectus published to the US Securities and Exchange Commission (SEC) is called a 10-12B form.
Similar to the financial reports of any public company, the separation document opens with a description of its activity – what products or services it provides, who are its customers, and who are the major competitors. The company’s financial statements from several years back are than presented with pro forma statements, which are supposed to reflect what would be the financial report of the company once it is independent. This is the major financial data with which it is possible to assess the potential of the company, the financial risk inherent in its activities, and of course, the fair price of its shares.
As an example, take the recent attractive spin-off of the coal miner CONSOL Mining (CEIX). The separation document starts with a description of the spin-off (The Separation and distribution). Then you can see a selected historical combined financial data – this allows us to understand past year's growth and profitability of the company. It should be read along with the "Unaudited pro forma financial statements" as it adjusts the numbers to reflect their values after the spin-off. For example, in CEIX case it inherited a $580 million of long-term debt, thus interest expenses in the 6 months ended June 2017 were increased by $33.2 million, lowering net income.
Another point worth noticing is who the managers of the spin-off are, and what is their compensation plan. In many cases, senior officials from the parent company move on to manage the spin-off company, whose activity is often significantly smaller compared to that of the parent company. Why would the CEO of a major company give up a central role and a high salary and move on to manage a small, anonymous company? Many times it is fair to assume that he believes he could turn the small company into a large one, and receive a notable financial reward for it. A specification regarding the compensation policy can be found in the separation document.
In the case of CEIX, the CFO of the parent company moved to the spin-off company. Also, the CEO of CEIX was former Chief Operating Officer in the parent company. If you check out the compensation plan of CEIX executives, you find that most of their upside comes from stock awards based on company success and not their salaries. This creates highly motivated executives who desire to grow operations and increase return on capital.
It is important to note that the separation document, as is the case with the IPO prospectus, is not a simple document – usually is deals with an unfamiliar, small company, with limited financial data, so the analysis of a spin-off requires not only knowledge of reading financial statements, but expertise dedicated to the field. This is the reason only few investors look at spin-off companies that are just starting out, causing them to be temporarily traded too low. However, investors who do choose to examine spin-offs can detect that valuation distortion and earn big time when the shares return to their fair price.
About the Author
Yinon Arieli is an acclaimed value investment manager and the owner of the popular investments site https://longrunplan.com/.
