Spinning cast-offs into cash

June 26, 2015 01:25 AM

The spin cycle is on high. Returns for many spun-out companies are trouncing the broad market. There are a growing number of large companies starting to question the benefits of scale. “Focus” is the latest boardroom buzzword as CEOs debate the wisdom of managing multiple, often wildly divergent, business units.  

Last year, 60 U.S. spin-offs were completed. That made 2014 the biggest year for spin-offs since 2000, when an astounding 66 were completed (see “Spinning momentum”). Spin-offs typically are done when one or more of a company’s disparate units don’t fit, and the combined market value does not fully reflect the value of the various businesses. They have long been a fruitful investment area that have historically generated far better returns than the overall stock market. 

The mechanics of a spin-off are simple. A parent company distributes its ownership in a subsidiary business via a dividend to existing shareholders. Once the spin-off is complete, there are two distinct, publicly traded companies with the same shareholder base.

On the whole, this type of corporate restructuring tends to be very lucrative for investors. Spin-offs are spinning into gold for investors so far this year. The Bloomberg Spin-Off Index has produced a total return of 10.3% in 2015 as of April 24 vs. 3.5% for the S&P 500.

One simple way to play the trend with a single security is with an ETF designed around the event. Investors can play spins by buying the Guggenheim Spin-Off ETF (CSD). The exchange-traded fund buys the spin-offs six months after the split and holds them for two years.  During the last five-, three- and two-year periods, CSD has gone up 133%, 79% and 41%, respectively. The ETF’s returns over all of these periods outpaced the S&P 500.

Despite this performance, there’s a strong argument for going with individual names, since much of the upside can take place in those first six months.

Much of the impressive performance comes from the altered dynamics of the spun-off business and its parent. Spins benefit from greater management focus and accountability as stand-alone public companies than they had when part of a larger firm. Many spin-offs were the larger companies’ neglected stepchildren.  Newly independent companies are no longer constrained by the overall strategic direction of their former parent. This independence forces them to develop their own roadmap for success. Managers have greater freedom to pursue new ventures, streamline production and pare overhead. Stock and stock options can more directly compensate management. This often leads to improved operating performance. 

Spin-off KLX Inc. (KLXI) emerged from B/E Aerospace (BEAV) in December. KLX — trading at $40.96 on Apr. 28 with a market cap of $2.1 billion — offers aerospace fasteners, logistic services and consumables to the global commercial, business jet and military sectors. KLX Energy Services unit offers oilfield services and provides rental equipment to oil and gas exploration and production companies. Prior to the spin-off, KLX made an ill-timed move into the energy sector, which now represents almost a quarter of its revenue. The selloff in oil is hurting revenues, but KLX remains attractive as airlines see record profits and passenger traffic grows. 

KLX’s stock price has dropped about 15% since it debuted in early December and should produce about $1.825 billion in revenue this year. Using a 8.9x FY15 EBITDA multiple suggest a market value of $2.8 billion or $54 per share.

It does not appear the spin-off trend will abate in 2015. Already, more than 45 companies have announced plans to complete spin-offs. That should give us a robust pipeline of new pure-play companies to evaluate in the coming months. 

Not only are there many coming spin-offs, there are several ways to play the game; betting that the sum-of-the-parts will be worth more than the whole.

About the Author

Joe Cornell is a chartered financial analyst, a finance MBA and the author of McGraw-Hill’s “Spin-Off To Pay-Off.” As the founder and publisher of Spin-Off Research (www.spinoffresearch.com) he is widely-regarded to be among the foremost experts in this specialized area. @spinoffresearch