One more point: although most people take comfort in crowds, this is not where successful investors generally look for good investment ideas. Nevertheless, you may take comfort in the fact that the practice of investing in companies undergoing corporate change is not an alien concept to Buffett, Lynch, or Graham. Each of these great investors has spent some time investing in this arena. It's just that Graham was most concerned about passing on his wisdom to the individual investor; he felt accumulating a diversified portfolio of statistical bargains would be a more accessible way for most people to invest. Buffett and Lynch both had the problem of investing huge sums of money—billions of dollars. It is often difficult to take large enough positions in these special investment situations to make an impact on that size portfolio. For your first quarter billion or so, though, it's no problem. (Call me when you get there.)
So roll up your sleeves and put your thinking caps on — you’re going on a wild ride into the stock market's Twilight Zone. You'll go places where others fear to tread—or at least don't know about. When you enter these largely uncharted waters and discover the secrets buried there, you will finally know what it feels like to be one of the glorious few who climb Mount Everest, plant a flag at the North Pole, or walk on the moon. (Okay, okay—so it'll probably feel more like finishing a crossword puzzle. I've never done that earlier, but I’m sure that feels great too!)
In any event, let’s get going.
Chips Off the Old Stock
Spinoffs, Partial Spinoffs, and Rights Offerings
I lost a bet. The stakes—dinner at Lutece, loser treats. Being a bachelor at the time, my idea of living was to slap a slice of cheese on top of an uncut bagel (my own recipe—not one from the Beardstown Ladies). So, there I was, at perhaps the finest restaurant in the world, certainly in New York, looking over the menu. Over walks a gentleman in full chef’s garb to help with our order. Somehow, his outfit didn't tip me off that this was actually Andre Soltner, proprietor and head chef.
Pointing to one of the appetizers on the menu, I asked innocently, "Is this one any good?"
“No, it stinks!” came Soltner's reply.
Even though he was just kidding around, I did get the point. Pretty much everything on the menu was going to be good. Selecting Lutece was, the important culinary decision, my particular menu choices were just fine tuning.
Keep this concept in mind as you read through the next several chapters. It’s great to look for investments in places others are not, but it’s not enough. You also have to look in the right places. If you preselect investment areas that put you ahead of the game even before you start (the "Luteces" of the investment world), the most important work is already done. You'll still have plenty of decisions to make, but if you're picking and choosing your spots from an already outstanding menu, your choices are less likely to result in indigestion.
“The first investment area we'll visit is surprisingly unappetizing. It's an area of discarded corporate refuse usually referred to as "spinoffs." Spinoffs can take many forms but the end result is usually the same: A corporation takes a subsidiary, division, or part of its business and separates it from the parent company by creating a new, independent, freestanding company. In most cases, shares of the new "spinoff" company are distributed or sold to the parent company's existing shareholders.
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 really only one reason to pay attention when they do: you can make a pile of money investing in spinoffs. The facts are overwhelming. Stocks of spinoff companies, and even shares of the parent companies that do the spinning off, significantly and consistently outperform the market averages.
One study completed at Penn State, covering a twenty-five-year period ending in 1988, found that stocks of spinoff companies outperformed their industry peers and the Standard & Poor's 500 by about 10 percent per year in their first three- years of independence. The parent companies also managed to do pretty well-outperforming the companies in their industry by more than 6 percent annually during the same three-year period. Other studies have reached similarly promising conclusions about the prospects for spinoff companies.
What can these results mean for you? If you accept the assumption that over long periods of time the market averages a return of approximately 10 percent per year, then, theoretically, outperforming the market by 10 percent could have you earning 20-percent annual returns. If the past experience of these studies holds true in the future, spectacular results could be achieved merely by buying a portfolio of recently spun-off companies. Translation: 20-percent annual returns-no special talents or utensils required.
But what happens if you're willing to do a little of your own work? Picking your favourite spinoff situations-not merely buying every spinoff or a random sampling - should result in annual returns even better than 20 percent. Pretty significant, considering that Warren Buffett, everyone's favourite billionaire, has only managed to eke out 28 percent annually (albeit over forty years). Is it possible that just by picking your spots within the spinoff area, you could achieve results rivalling those of an investment great like Buffett?
Nah, you say. Something's wrong here. First of all, who's to say that spinoffs will continue to perform as well in the future as they have in the past? Second, when everyone finds out that spinoffs produce these extraordinary returns, won't the prices of spinoff shares be bid up to the point where the extra returns disappear? And finally-about these results even greater than 20 percent-why should you have an edge in figuring out which spinoffs have the greatest chance for outsize success?
O ye of little faith. Of course spinoffs will continue to outperform the market averages-and yes, even after more people find out about their sensational record. As for why you'll have a great shot at picking the really big winners-that's an easy one-you'll be able to because I'll show you how. To understand the how's and the why's, let's start with the basics.
Why do companies pursue spinoff transactions in the first place? Usually the reasoning behind a spinoff is fairly straightforward:
· Unrelated businesses may be separated via a spinoff transaction so that the separate businesses can be better appreciated by the market.
For example, a conglomerate in the steel and insurance business can spin off one of the businesses and create an investment attractive to people who want to invest in either insurance or steel but not both.
Of course, before a spinoff, some insurance investors might still have an interest in buying stock in the conglomerate, but most likely only at a discount (reflecting the "forced" purchase of an unwanted steel business).
· Sometimes, the motivation for a spinoff comes from a desire to separate out a "bad" business so that an unfettered "good" business can show through to investors.
This situation (as well as the previous case of two unrelated businesses) may also prove a boon to management. The "bad" business may be an undue drain on management time and focus. As separate companies, a focused management group for each entity has a better chance of being effective.
· Sometimes a spinoff is a way to get value to shareholders for a business that can't be easily sold.
Occasionally, a business is such a dog that its parent company can't find a buyer at a reasonable price. If the spinoff is merely in an unpopular business that still earns some money, the parent may load the new spinoff with debt. In this way, debt is shifted from the parent to the new spinoff company (creating more value for the parent).
On the other hand, a really awful business may actually receive additional capital from the parent- just so the spinoff can survive on its own and the parent can be rid of it.
· Tax considerations can also influence a decision to pursue a spinoff instead of an outright sale.
If a business with a low tax basis is to be divested, a spinoff may be the most lucrative way to achieve value for share holders. If certain IRS criteria are met, a spinoff can qualify as a tax-free transaction - neither the corporation nor the individual stockholders incur a tax liability upon distribution of the spinoff shares.
A cash sale of the same division or subsidiary with the proceeds dividend out to shareholders would, in most cases, result in both a taxable gain to the corporation and a taxable dividend to shareholders.
· A spinoff may solve a strategic, antitrust, or regulatory issue, paving the way for other transactions or objectives.
In a takeover, sometimes the acquirer doesn't want to, or can't for regulatory reasons, buy one of the target company's businesses. A spinoff of that business to the target company's shareholders prior to the merger is often a solution.
In some cases, a bank or insurance subsidiary may subject the parent company or the subsidiary to unwanted regulations. A spinoff of the regulated entity can solve this problem.
The list could go on. 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.
Many funds can only own shares of companies that are included in the Standard & Poor's 500 index, an index that includes only the country's largest companies. If an S&P 500 company spins off a division, you can be pretty sure that right out of the box that division will be the subject of a huge amount of indiscriminate selling. Does this practice seem foolish? Yes. Understandable? Sort of. Is it an opportunity for you to pick up some low-priced shares? Definitely.
Another reason spinoffs do so well is that capitalism, with all its drawbacks, actually works. When a business and its management are freed from a large corporate parent, pent-up entrepreneurial forces are unleashed. The combination of accountability, responsibility, and more direct incentives take their natural course. After a spinoff, stock options, whether issued by the spinoff company or the parent, can more directly compensate the managements of each business. Both the spinoff and the parent company benefit from this reward system.
In the Penn State study, the largest stock gains for spinoff companies took place not in the first year after the spinoff but in the second. It may be that it takes a full year for the initial selling pressure to wear off before a spinoff's stock can perform at its best. More likely, though, it's not until the year after a spinoff that many of the entrepreneurial changes and initiatives can kick in and begin to be recognized by the marketplace. Whatever the reason for this exceptional second-year performance, the results do seem to indicate that when it comes to spinoffs, there is more than enough time to do research and make profitable investments.
One last thought on why the spinoff process seems to yield such successful results for shareholders of the spinoff company and the parent: in most cases, if you examine the motivation behind a decision to pursue a spinoff, it boils down to a desire on the part of management and a company's board of directors to increase shareholder value. Of course, since this is their job and primary responsibility, theoretically all management and board decisions should be based on this principle. Although that's the way it should be, it doesn't always work that way.
It may be human nature or the American way or the natural order of things, but most managers and boards have traditionally sought to expand their empire, domain, or sphere of influence, not contract it. Perhaps that's why there are so many mergers and acquisitions and why so many, especially those outside of a company's core competence, fail. Maybe that's why many businesses (airlines and retailers come to mind) continually expand, even when it might be better to return excess cash to shareholders. The motives for the acquisition or expansion may be confused in the first place. However, this is rarely the case with a spinoff. Assets are being shed and influence lost, all with the hope that shareholders will be better off after the separation.
It is ironic that the architects of a failed acquisition may well end up using the spinoff technique to bail themselves out. Hopefully, the choice of a spinoff is an indication that a degree of discipline and shareholder orientation has returned. In any case, 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.
CHOOSING THE BEST OF THE BEST
Once you're convinced that spinoff stocks are an attractive hunting ground for stock-market profits, the next thing you'll want to know is, how can you tilt the odds even more in your favor? What are the attributes and circumstances that suggest one spinoff may outperform another? What do you look for and how hard is it to figure out?
You don't need special formulas or mathematical models lo help you choose the really big winners. Logic, common sense, and a little experience are all that's required. That may sound trite but it is nevertheless true. Most professional investors don't even think about individual spinoff situations. Either they have too many companies to follow, or they can only invest in companies of a certain type or size, or they just can't go to the trouble of analyzing extraordinary corporate events. As a consequence, just doing a little of your own thinking about each spinoff opportunity can give you a very large edge.
Hard to believe? Let's review some examples to see what I mean.
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.
Enter Stephen Bollenbach, financial whiz, with a great idea. Bollenbach, fresh from helping Donald Trump turn around his gambling empire, and then chief financial officer at Marriott (now CEO of Hilton), figured a way out for Marriott. The financial covenants in Marriott’s publicly traded debt allowed (or rather, did not prohibit) the spinning off of Marriott's lucrative management-contracts business, which had a huge income stream but very few hard assets. Bollenbach’s concept was to leave all of the unsalable hotel properties and the low-growth concession business—burdened with essentially all of the company's debt—in one company, Host Marriott, and spin off the highly desirable management-service business, more or less debt free, into a company to be called Marriott International.
According to the plan, Bollenbach would become the new chief executive of Host Marriott. Further, Marriott International (the "good" Marriott) would be required to extend to Host Marriott a $600-million line of credit to help with any liquidity needs and the Marriott family, owners of 25 percent of the combined Marriott Corporation, would continue to own 25-percent stakes in both Marriott International and Host. The spinoff transaction was scheduled to be consummated sometime in the middle of 1993.
Keep in mind, no extensive research was required to learn all this. The Wall Street Journal (and many other major newspapers) laid out all this background information for me when Marriott first announced the split-up in October 1992. It didn't take more than reading this basic scenario in the newspapers, though, to get me very excited. After all, here was a case where in one fell swoop an apparently excellent hotel-management business was finally going to shed billions in debt and a pile of tough-to-sell real estate. Of course, as a result of the transaction creating this new powerhouse, Marriott International, there would be some "toxic waste." A company would be left, Host Marriott, that retained this unwanted real estate and billions in debt.
Obviously, I was excited about... the toxic waste. "Who the hell is gonna want to own this thing?" was the way my thinking went. No institution, no individual, nobody and their mother would possibly hold onto the newly created Host Marriott after the spinoff took place. The selling pressure would be tremendous. I’d be the only one around scooping up the bargain-priced stock.
Now, almost anyone you talk to about investing will say that he is a contrarian, meaning he goes against the crowd and conventional thinking. Clearly, by definition, everyone can't be a contrarian. That being said . . . I'm a contrarian. That doesn't mean I'll jump in front of a speeding Mack truck, just because nobody else in the crowd will. It means that if I've thought through an issue I try to follow my own opinion even when the crowd thinks differently.
The fact that everyone was going to be selling Host Marriott after the spinoff didn't, by itself, mean that the stock would be a great contrarian buy. The crowd, after all, could be right Host Marriott could be just what it looked like: a speeding Mack truck loaded down with unsalable real estate and crushing debt. On the other hand, there were a few things about this situation beyond its obvious contrarian appeal (it looked awful) that made me willing, even excited, to look a bit further.
In fact, Host Marriott had a number of characteristics that I look for when trying to choose a standout spinoff opportunity.
1. INSTITUTIONS DON'T WANT IT (AND THEIR REASONS DON'T INVOLVE THE INVESTMENT MERITS)
There were several reasons why institutional portfolio managers or pension funds wouldn't want to own Host Marriott. We've already covered the issue of huge debt and unpopular real-estate assets. These arguments go to the investment merits and might be very valid reasons not to own Host. However, after the announcement of the transaction in October 1992 only a small portion of the facts about Host Marriott had been disclosed. How informed could an investment judgment at this early stage really be?
From the initial newspaper accounts, though, Host looked so awful that most institutions would be discouraged from doing any further research on the new stock. Since a huge amount of information and disclosure was sure to become available before the spinoffs fruition (estimated to be in about nine months), I vowed to read it—first, to see if I lost was going to be as bad as it looked and second, because I figured almost nobody else would.
Another reason why institutions weren't going to be too hot to own Host was its size. Once again, not exactly the investment merits. According to analysts quoted in the initial newspaper reports, Host would account for only about 10 or 15 percent of the total value being distributed to shareholders, with the rest of the value attributable to the "good" business, Marriott International. A leveraged (highly indebted) stock with a total market capitalization only a fraction of the original $2 billion Marriott Corporation was probably not going to be an appropriate size for most of Marriott's original holders.
Also, Host was clearly in a different business than most institutional investors had been seeking to invest in when they bought their Marriott shares. Host was going to own hotels; whereas the business that attracted most Marriott investors was hotel management. Though owning commercial real estate and hotels can be a good business, the Marriott group of shareholders, for the most part, had other interests and were likely to sell their Host shares. Sales of stock solely for this reason would not be based on the specific investment merits and therefore, might create a buying opportunity.
(Note: For reasons unique to the Marriott case, the spinoff was actually considered, at least technically, to be Marriott International—even though its stock would represent the vast majority of the value of the combined entities. For purposes of this illustration (and for the purposes of being accurate in every sense other than technical), it will be more helpful to think of I lost—the entity comprising 10 to 15 percent of Marriott's original stock market valuation—as the spinoff.)
2. INSIDERS WANT IT
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.
In the case of Host Marriott, something from the initial press reports caught my eye. Stephen Bollenbach, the architect of the plan, was to become Host's chief executive. Of course, as the paper reported, he had just helped Donald Trump turn around his troubled hotel and gambling empire. In that respect, he seemed a fine candidate for the job. One thing bothered me, though: It didn't make sense that the man responsible for successfully saving a sinking ship—by figuring out a way to throw all that troubled real estate and burdensome debt overboard—should voluntarily jump the now secured ship into a sinking lifeboat, Host Marriott.
"Great idea, Bollenbach!" the story would have to go. "I think you've really saved us! Now, when you're done throwing that real estate and debt overboard, why don't you toss yourself over the side as well! Pip, pip. Use that wobbly lifeboat if you want. Cheerio!"
It could have happened that way. More likely, I thought, Host might not be a hopeless basket case and Bollenbach was going to be well incentivized to make the new company work. I vowed to check up on his compensation package when the SEC documents were filed. The more stock incentive, the better. Additionally, the Marriott family was still going to own 25 percent of Host after the spinoff. Although the chief reason for the deal was to free up Marriott International from its debt and real estate burden, after the spinoff was completed it would still be to the family's benefit to have the stock of Host Marriott thrive.
3. A PREVIOUSLY HIDDEN INVESTMENT OPPORTUNITY IS CREATED OR REVEALED
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.
If the analysts quoted in the original press reports turned out to be correct, Host stock could trade at $3-5 per share but the new company would also have somewhere between $20-25 per share in debt. For purposes of our example, let's assume the equity in Host would have a market value of $5 per share and the debt per Host share would be $25. That would make the approximate value of all the assets in Host $30. Thus a 15 percent move up in the value of Host's assets could practically double the stock (.15 X $30 = $4.50). Great work if you can get it. What about a 15-percent move down in value? Don't ask.
I doubted, however, that Host Marriott would be structured to sink into oblivion—at least not immediately. I knew that all the new Host shareholders had good reason to dump their toxic waste on the market as soon as possible. With the prospect of liability and lawsuits from creditors, employees, and shareholders, though, I suspected that a quick demise of Host Marriott, the corporation, was not part of the plan. Add to this the facts that Marriott International, the "good" company, would be on the hook to lend Host up to $600 million, the Marriott family would still own 25 percent of Host, and Bollenbach would be heading up the new company—it seemed in everyone's best interest for Host Marriott to survive and hopefully thrive. At the very least, after I did some more work, it seemed likely that with such a leveraged payoff it had the makings of an exciting bet.
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 spinoffs 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.
In case you haven't been paying attention, we've just managed to build a very viable investment thesis or rationale for investing in Host Marriott stock. To review, Host could turn out to be a good pick because:
• Most sane institutional investors were going to sell their Host Marriott stock before looking at it, which would, hopefully, create a bargain price.
• Key insiders, subject to more research, appeared to have a vested interest in Host's success, and
• Tremendous leverage would magnify our returns if Host turned out, for some reason, to be more attractive than its initial appearances indicated.
If events went our way, with any luck these attributes would help us do even better than the average spinoff.
So, how did things work out? As expected (and hoped), many institutions managed to sell their Host stock at a low price. Insiders, according to the SKC filings, certainly ended up with a big vested interest, as nearly 20 percent of the new company's stock was made available for management and employee incentives. Finally, Host's debt situation, a turn-off for most people—though a potential opportunity for us—turned out to be structured much more attractively than it appeared from just reading the initial newspaper accounts.
So, how'd it work out? Pretty well, I think. Host Marriott stock (a.k.a. the "toxic waste") nearly tripled within four months of the spinoff. Extraordinary results from looking at a situation that practically everyone else gave up on.
Are you ready to give up? Too much thinking? Too much work? Can't be bothered with all those potential profits? Or, maybe, just maybe, you'd like to learn a little bit more.
DIGGING FOR BURIED TREASURE
So far the only work we've really discussed has been reading about a potentially interesting situation in the newspaper. Now (you knew there was a catch), it gets a bit more involved. You're about to be sent off on a mind-numbing journey into the arcane world of investment research, complete with multi-hundred-page corporate documents and mountains of Securities and Exchange Commission (SEC) filings.
Before you panic, take a deep breath. There's no need to quit your day job. Sure there will be some work to do—a little sleuthing here, some reading over there—but nothing too taxing. Just think of it as digging for buried treasure. Nobody thinks about the actual digging—insert shovel, step on shovel, fling dirt over shoulder—when a little treasure is on the line. When you're "digging" with an exciting goal in sight, the nature of the task changes completely. The same thinking applies here.
Essentially, it all boils down to a simple two-step process. First, identify where you think the treasure (or in our case the profit opportunity) lies. Second, after you've identified the spot (preferably marked by a big red X), then, and only then, start digging. No sense (and no fun) digging up the whole neighborhood.
So at last you're ready to go. You're prospecting in a lucrative area: spinoffs. You have a plausible investment thesis, one that may help you do even better than the average spinoff. Now, it's time to roll up your sleeves and do a little investigative work. Right? Well, that is right—only not so fast.
In the Marriott example, the spinoff plan was originally announced in October 1992. Although the deal garnered plenty of press coverage over the ensuing months, the relevant SEC filings were not available until June and July 1993. The actual spinoff didn't take place until the end September—nearly a year after initial disclosure. While six to nine months is a more usual time frame, in some cases the process can stretch to over a year.
If you have m impatient nature and ate partial to fast action, waiting around for spinoffs to play out fully may not be for you. Horse racing never succeeded in Las Vegas because most gamblers couldn't wait the two minutes it took to lose their money. The same outcome, only more immediate, was available in too many other places.
The financial markets have also been known to accommodate those who prefer instant gratification. On the other hand, having the time to think and do research at your own pace and convenience without worrying about the latest in communication technologies has obvious advantages for the average nonprofessional investor. Besides, once you've spent a year prospecting in The Wall Street journal (or in countless other business publications) for interesting spinoff opportunities, there should, at any given time, be at least one or two previously announced and now imminent spinoffs ripe for further research and possible investment.
As a matter of fact, here comes another one now.
BRIGGS & STRATTON
In May OF 1994, Brigg & Stratton, a manufacturer of small gas-powered engines (used mostly in outdoor power equipment), announced its intention to spin off its automotive-lock division. The spinoff was slated to take place in late 1994 or early in 1995. The automotive-lock division (later to be named Strattec Security) was a small division representing less than 10 percent of Briggs & Stratton's total sales and earnings.
Since Briggs, the parent company, was included in the S&P 500 average with a market capitalization of $1 billion, it seemed that Strattec might turn out to be a prime candidate for institutional selling once its shares were distributed to Briggs shareholders. 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.
Although Strattec had the makings of a classic spinoff opportunity, it stayed on the back burner until November 1994 when something called an SEC Form 10 was publicly filed. In general, this is the public filing that contains most of the pertinent information about a new spinoff company. A Form 10 is filed in cases where the new spinoff represents a small piece of the parent company; smaller transactions do not require a shareholder vote. In cases where the spinoff represents a major portion of a parent company’s assets, a proxy document is prepared so that shareholders can vote on the proposed split-up. In those cases, the proxy contains most of the same information found in the Form 10. (Don't worry about taking notes now* How to go about obtaining these various filings and proxies will be well covered in chapter 7.)
Not until January 1995, however, when an amended Form 10 was filed, filling in some of the details and blanks left in the original filing, was it really time to do some work. According to this document, the spinoff was scheduled to be distributed on February 27. As my first move with any of these filings is to check out what the insiders—key management and/or controlling shareholders—are up to, it was nice to see part of the answer right on the first page following the introduction. Under the heading "Reasons for the Distribution," the Board of Directors of Briggs revealed the primary reason for the spinoff. The Board's motives were classic: to "provide incentive compensation to its key employees that is equity-based and tied to the value of [Strattec's] business operations and performance as a separately traded public company, not as an indistinguishable unit of Briggs."
According to this section of the document, a Stock Incentive Plan granting various stock awards to officers and key employees would reserve over 12 percent of the new company's shares to provide incentives for employees. 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. Investors might well be better off if the law actually granted top executives and key personnel a minimum ownership stake in their employer. As this sort of government intervention is probably as unlikely as it is unwise, you can accomplish much the same result by sticking to investments in companies like Strattec, where management can prosper only alongside shareholders.
In addition to checking up on the insiders, it usually pays to spend some time on the first few pages of any Form 10, proxy, or similar document. These pages usually contain a detailed table of contents, followed by a five- or eight-page summary of the next hundred or more pages. Here is where you can pinpoint areas of interest and choose where to focus your efforts selectively. Frankly, reruns of Gilligan’s Island hold more appeal than a page-by-page read-through of an entire proxy or Form 10—so selectivity is key. Not only do these documents have entire sections disclosing the various economic interests of insiders but, importantly, somewhere amid all the verbiage are the pro-forma income statements and balance sheets for the new spinoff. (Pro-forma statements show what the balance sheet and income statement would have looked like if the new entity had existed as an independent company in prior years.)
According to the pro-forma income statement found in the summary section of the Form 10, earnings for Strattec's fiscal year ending in June 1994 came in at $1.18 per share. Excluding some one-time expenses, earnings for the more recent six-month period, ended December 1994, looked to be up a further 10 percent from the same period in 1993.
Armed with this limited information, I tried to take a stab at what a fair price for Strattec might be when it finally started trading at the end of February 1995.
As primarily a manufacturer of locks and keys for new automobiles and trucks, Strattec, according to logic and the Form 10, fell under the category of original-equipment manufacturer (OEM) for the automobile industry. The next logical step was to find out at what price most other companies in the same industry traded relative to their earnings. Very simply, if all the OEM suppliers to the auto industry traded at a price equal to 10 times their annual earnings (i.e., at a price/earnings ratio or P/E of 10), then a fair price for Strattec might end up being $11.80 per share ($1.18 multiplied by 10).
Later in the book, we will cover several reference sources that provide the type of data we will need to do our comparative pricing. In this case, I used Value Line, as it is generally readily available and easy to use. Value Line's contents are organized according to industry groups. Under the grouping, "Auto Parts (Original Equipment)," I was able to determine that a range of roughly 9 to 13 times earnings was a reasonable range for P/E's within Strattec's industry group. That meant that a reasonable price range for Strattec might be somewhere between $10.62 per share ($1.18 X 9) and approximately $15.34 ($1.18 X 13). If I wanted to be more aggressive, since Strattec's earnings had grown approximately 10 percent in the six months since the year ended in June 1994, a range maybe 10 percent higher might be appropriate.
While all of this analysis was fine and dandy, unless Strattec started trading at $6 or $7 a share due to intense selling pressure, I wasn't going to get rich from anything discussed so far. Further, I didn't know much about Strattec's industry, but I did know one thing. Supplying parts to auto manufacturers is generally considered to be a crappy business. Certainly if I did decide to buy stock in Strattec, Warren Buffett was not going to be my competition. (Actually, as a general rule, Buffett won't even consider individual investments of less than $100 million; here the entire company was going to be valued at less than $100 million.)
The interesting part came when I was reading the few pages listed under the heading of "Business of the Company." This was not hard to find. It turned out that Strattec was by far the largest supplier of locks to General Motors, and that this business represented about 50 percent of Strattec's sales. Strattec also provided almost all of Chrysler's locks, and this business totalled over 16 percent of Strattec's total revenues. From this, I guessed that Strattec must be pretty good at making car locks. The next piece of information, though, got me very interested.
According to its filing, "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 section didn't feature banner headlines like the Wham!, Socko! and Blamo! from the old Batman TV. show—but it had almost the same impact on me. Since all of the revenue and earnings numbers discussed so far didn't include any Ford business, a new customer expected to order more locks than needed by the entire Chrysler Corporation was pretty big news.
As Chrysler was currently Strattec's second-biggest customer, accounting for over 16 percent of total sales, it made sense that for Ford to take over second place, its new business had to represent even more than 16 percent. (Since GM was the biggest customer with about 50 percent of Strattec's sales, it also meant that Ford's business had to be less than this amount.) In short, here was a very interesting piece of information that should substantially increase the value of Strattec's business. My hope was that this information would not be reflected in Strattec's stock price until I was able to make some bargain purchases.
From a qualitative standpoint, there was something else about Strattec's business that seemed attractive. Strattec was by far the biggest factor in the automotive lock market. With a majority of General Motor's business and all of Chrysler's, Strattec seemed to have a very strong niche. So, too, the addition of Ford's business meant that the quality and price of Strattec's products must be headed in the right direction. I figured most of the other OEM suppliers being used for comparison purposes were unlikely to have a better market position than Strattec. All of this combined meant I hat a P/E multiple for Strattec at the higher end of the industry range might be appropriate.
Of course, I had no intention of buying my stock at the top end of the industry P/E range, justified or not. However, if it were possible to buy Strattec at the low end of industry valuations (nine times earnings or so), without taking into account the new Ford business, that might be a very attractive investment.
The outcome? For several months after Strattec began trading, the stock traded freely between 10-1/2 and 12. This was clearly at the low end of the industry range—before taking into account (1) the Ford business, (2) Strattec's far better than average market niche, and (3) the recent 10 percent profit increase during the most recent six months. In short, it was easy to buy shares in Strattec at a very attractive price. This was confirmed as Strattec traded to $18 per share before the end of 1995—a 50 percent plus gain in less than eight months. Not too bad—and fortunately, far from an unusual spinoff opportunity.
Okay, I know what you're thinking. The money's all fine and good—but auto parts—sheesh—they're so dam boring'. No problem. You can have it all—money and excitement—because our next stop is the wonderful world of home shopping!
HOME SHOPPING BONANZA—THE CARTWRIGHTS WERE NEVER THIS RICH
I didn't think my trip into the world of home shopping was going to be that exciting. Of course, every third trip flipping through the cable box, like everybody else I would catch a glimpse of a porcelain dog or some other useless item. As my house is filled with ridiculous gizmos and gadgets—most hidden from view for face-saving reasons—and I wasn't a customer, I really had no idea who was buying this stuff. Because the stock had been a notorious high flyer in the 1980s and I routinely flipped past its channel, I never considered the Home Shopping Network as a potential investment situation.
An article that appeared in the premiere issue of Smart Money magazine in April 1992 changed that. In an article entitled "10 Stocks for the '90s," one of the ten choices turned out to be the Home Shopping Network. The basic premise of the article was that by studying the attributes of the biggest winners of the 1980s—by examining what they looked like back in 1980—a list of winners for the '90s could be compiled. There were several reasons why one of the choices, the Home Shopping Network, caught my eye.
First, most of the selection criteria for making the top-ten list involved Ben Graham's value measures (low price-to-earnings and/or cash-flow ratio, low price-to-book-value ratio, etc.). It was a surprise that a former high flyer like Home Shopping Network had fallen far enough to be considered a value stock. Second, Home Shopping's stock was priced just over $5 per share. While a single-digit stock price, in and of itself, should be meaningless, many institutions don't like to buy stocks priced under $10. Since in the United States most companies like their stocks to trade between $10 per share 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 final reason Home Shopping Network looked to have potential was that—surprise, surprise—a spinoff was involved. (That's why we're here in the first place, remember?) According to the article, Home Shopping had plans to spin off its broadcast properties "to improve the quality of earnings." What this meant, I would find out later. It certainly looked like both the parent company, Home Shopping Network, and the spinoff, Silver King Communications, were worth some more study.
According to the Form 10, filed in August 1992, under the heading "Reasons for the Distribution," Home Shopping's management stated:
[M]anagement believes that the financial and investment communities do not fully understand how to value HSN [Home Shopping Network], in part because HSN is both a retail-oriented company and a broadcast company. Broadcast companies are typically valued based on cash flow while retail companies are typically valued on an earnings-per-share basis. The categorization of HSN as either a broadcast concern or a retail-oriented company results in the application of a single valuation methodology when a combination of the two valuation methods would be more appropriate. For instance, the valuation of HSN's retail business and, likewise, the valuation of HSN as a retail-oriented business is severely discounted by the impact of the substantial depreciation and amortization costs associated with the broadcast assets of the Stations. HSN's Board of Directors believes that the separation of HSN and the (broadcast) Company would allow potential investors to more clearly understand the business of each company and may serve to attract increased investor interest in, and analyst coverage of, each company.
It turned out that Home Shopping Network had purchased twelve independent UHF television broadcast stations during the 1980s in an effort to expand the reach of its home-shopping program. According to the SEC filing, these stations reached approximately 27.5 million households representing "one of the largest audience reaches of any owned and operated, independent television broadcasting group in the United States/' The only problem was, HSN had paid a lot of money for these stations. That wasn't so bad, but television stations don't have much in the way of assets. Their value derives from the cash stream received from advertising revenues (in Home Shopping's case, one never-ending commercial), not from the amount of broadcasting equipment used to transmit the program.
Unfortunately, paying a large purchase price for something that relies on a relatively small amount of fixed assets and working capital to generate profits usually results in a large amount of goodwill being placed on the balance sheet of the purchaser. 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 excess in purchase price over the value of these identifiable assets must be amortized (an expense similar to the depreciation charge for plant and equipment) over a period of years. Like depreciation, amortization of goodwill is a noncash expense that is deducted from reported earnings. (See chapter 7 for a full explanation of these terms.)
Since a broadcast property is the classic example of a business whose value is not closely tied to the amount of assets employed, broadcasters are generally valued on their cash flow (which adds back the noncash charges of depreciation and amortization to earnings), not on their reported earnings. Retailers, on the other hand, are valued based on their earnings. Home Shopping's SEC filing stated that figuring out the proper earnings multiple (P/E ratio) for the combined businesses was very difficult. According to the filing, the retail business should be valued based on a multiple of earnings, the broadcaster on a multiple of cash flow.
A quick look at Silver King's income statement highlighted this point very clearly. Silver King's operating earnings were slightly over $4 million for the most recent year. Its cash flow, however, totalled over $26 million ($4 million in operating earnings plus roughly $22 million of depreciation and amortization). Since broadcast equipment doesn't have to be replaced that often, capital spending on new plant and equipment was only about $3 million. This meant that, before accounting for interest and taxes, Silver King was actually earning nearly $23 million in cash from its operations: operating earnings of $4 million plus depreciation and amortization of $22 million, less $3 million in capital spending. (If you're a little lost, feel free to check out the cash-flow section of chapter 7.)
Of course, you wouldn't know that Home Shopping's broadcast division was such a big cash generator merely from looking at earnings. The broadcast properties contributed only $4 million to operating earnings, but as we've already seen, they added over $26 million to Home Shopping's operating cash flow. Since HSN had over 88 million shares outstanding, $4 million amounted to only about 4.5 cents per share of operating earnings lost from spinning off the entire broadcast division. But, wait, that's not the whole story.
Home Shopping, according to the SEC filings, was going to shift more than $140 million of debt over to Silver King as part of the spinoff process. At an interest rate of 9 percent, this meant that HSN was going to be relieved of over $12.6 million in annual interest costs (.09 X $140 million). The bottom line was that as far as much of Wall Street was concerned, the Home Shopping Network would earn more without the broadcast properties than with them! (Reported earnings before taxes would be approximately $8.6 million higher after the spinoff—$12.6 million less of interest expense, now on Silver King's books, while forgoing only $4 million in operating income by spinning off Silver King.)
Of course, given the huge cash-generating ability of HSN's TV stations, this wasn't the right way to look at things. But that was Home Shopping's point. They believed that investors were not including the value of the TV. Stations in HSN's price. In fact, considering the debt load taken on to buy the stations, investors may have been subtracting for them. (Since HSN borrowed heavily to buy the stations, investors may have subtracted the high interest costs from the stock's value—while only giving credit for the $4 million of operating income, not for the full cash flow.)
The whole situation had opportunity written all over it. Clearly, Silver King had the makings of an underfollowed and misunderstood spinoff situation. Silver King was going to have over $140 million of debt on its balance sheet. The value of the spinoff was going to be small relative to the value of each shareholder's stake in Home Shopping—hopefully making it inappropriate or unimportant to the shareholders receiving it. (The terms of the spinoff called for a one-for-ten distribution—meaning for every ten shares an investor held in Home Shopping Network, he or she would receive a distribution of only one share of Silver King Communications.) Moreover, Silver King was in a different business—broadcasting—than the retail business originally favored by the parent company's shareholders. And, perhaps most important, Silver King was earning a ton of cash that most of Home Shopping's shareholders, the ones receiving Silver King's shares, were unlikely to know about.
The investment opportunities didn't end there. The parent company, Home Shopping Network, was also worth a look. Since an investor who purchased HSN's stock based on reported earnings was probably not placing much value on the broadcast properties, maybe HSN stock wouldn't go down much after the spinoff. If that happened, the combined value of HSN and the spinoff could be more than the pre-spinoff price of HSN. It was even possible that, since Home Shopping's reported earnings would actually go up as a result of the spinoff, HSN's stock could trade higher without the broadcast properties than with them.
Before we get to the outcome, one more quick point. 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.
In Home Shopping's case, there may have been some connection between the decision to pursue the spinoff route and merger discussions. In March 1992, just days after merger talks broke off with its rival in the home-shopping business, QVC Network, Home Shopping announced the spinoff of another division, a money-losing maker of call processing systems, Precision Systems. The Silver King spinoff announcement followed several weeks later. At the time merger talks were called off, some analysts speculated (in The Wall Street Journal) that QVC did not want to buy these extraneous operations. While there were good business reasons for both spinoffs outside of making HSN a more attractive takeover target, the spinoffs certainly had the effect of making HSN a simpler and more appealing acquisition candidate.
Okay, the outcome. In December 1992, even before the spinoff transaction was consummated, Liberty Media (itself a spinoff from Tele-Communications, the country's largest cable provider), signed an agreement to purchase voting control of Home Shopping Network from its founder and largest shareholder, Roy Speer. Days earlier, Liberty had also acted to take control of QVC. The Silver King spinoff was scheduled to proceed as originally planned, though Liberty had now reached agreement to purchase Speer's shares of Silver King, subject to Federal Communications Commission (FCC) approval. Due to regulations restricting ownership by cable operators of broadcast stations, the ultimate control of Silver King was left uncertain. In fact, on the eve of the spinoff, Silver King announced it was unlikely that Liberty Media would ultimately be allowed to purchase the Silver King stake.
It was in this fast-changing (and confused) environment that the Silver King spinoff took place in January 1993. The stock traded at approximately $5 per share in the first four months after spinoff. This appeared to be an enticing bargain. Although highly leveraged (sometimes an advantage for us), a price of $5 per share meant that Silver King was still trading at less than five times cash flow after interest and taxes. It was unclear, however, what the future of Silver King would look like.
In the past, Silver King's television stations had received a percentage of sales from Home Shopping Network in exchange for airing its shows. What would happen if the Home Shopping Network no longer required Silver King's stations to air its shows? Liberty Media, the new controlling shareholder of HSN, had excellent connections in the cable industry. Maybe HSN could be aired on cable stations directly without using Silver King's stations. Then, Silver King would be left with nothing but a network of major-market television stations reaching 27.5 million homes. Hey, that didn't sound too bad, either.
What happened? After a few months of trading in the $5 area, Silver King moved up to trading in the $10-to-$20 range over the next year. This was due partly to the lifting of the usual post-spinoff selling pressure and partly to speculation (reported in The Wall Street Journal) that Silver King was considering joining with others to form a fifth television network. Several years later, Barry Diller, the well-known media mogul, took control of Silver King to use it as a platform for his new media empire. 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.
Oh, yes. Home Shopping also had some interesting price movement after the spinoff. Its stock actually went up the day the Silver King spinoff was distributed to HSN shareholders. Usually, when a spinoff worth fifty cents per share (one tenth of a share of Silver King selling at $5 per share) is made to the parent company's shareholders, the parent company's shares should fall about fifty cents on the day of the distribution. Instead, Home Shopping's stock went up twenty-five cents per share. If you owned Home Shopping Network stock on the day prior to the distribution, the very next day you were actually paid for the privilege of taking Silver King shares off its hands. The combined value of Home Shopping Network stock and the spun-off Silver King shares created a one-day gain of 12 percent for HSN shareholders. No matter what the academics may say about the efficiency of the stock market, clearly, there are still plenty of inefficiently priced opportunities available—to investors who know where to look, that is.
I almost forgot. Remember Precision Systems? You know, the money-losing maker of call-processing systems that HSN spun off before Silver King? Well, I'm still trying to forget. I never looked at it. After being spun off and trading below $1 per share for several months, within a year the stock traded to $5 and then doubled again over the next two years. You can't win 'em all. (But it would be nice.)
THE TEN COMMANDMENTS
One of the Ten Commandments is "Honor thy father and thy mother." So, logically it follows that paying attention to parents is a good thing. As it happens, this same advice also seems to work well with the parents of spinoffs. Coincidence? I think not.
In the Home Shopping situation, although I was attracted to it partially due to the spinoff, after reading the Smart Money article and doing some of my own work I decided to also buy stock in the parent, Home Shopping Network. At a purchase price of $5 before the Silver King spinoff, this worked out to a net purchase price of $4.50 per share after subtracting the initial trading value of Silver King. Looking at the spinoff highlighted the fact that the parent company, Home Shopping Network, was trading at a cheap price. Also, looking at the investment merits of Home Shopping caused me, for comparison purposes, to study its main rival, QVC Network. While I felt Home Shopping was cheap, QVC actually looked even cheaper! Both stocks turned out to be doubles in the next year.
The point here is not to tell you about some more big winners. (Believe me, I've had my share of losers.) 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. Having said that, let's charge ahead.
In January 1994, in a widely heralded move, American Express announced its intention to spin off its Lehman Brothers subsidiary as an independent company. The Lehman Brothers spinoff was actually the vestiges of an old-line Wall Street investment-banking partnership that American Express had purchased in the early 1980s. At the time of the purchase, under the leadership of a previous CEO, the idea was to turn American Express into a "financial supermarket/' Since after a decade of trying no one could figure out what this meant, the board of American Express had decided to spin off the remains of Lehman to shareholders. When the appropriate filings were made in April 1994, 1 decided to take a closer look at the "new" Lehman Brothers.
According to the filings and extensive newspaper accounts, Lehman Brothers had the highest expenses per dollar of revenue in the investment industry, had lost money in the last year, and had an extremely volatile earnings history. In addition, insiders, while highly paid as far as salaries and bonuses were concerned, held relatively few shares of stock in the new spinoff. In most companies, and especially on Wall Street, employees act to maximize their compensation. The senior executives of Lehman did not have most of their net worth tied to the fortunes of Lehman's stock. My translation: There was a good chance that when it came time to split up profits between employees and shareholders, shareholders would lose. (You know the drill: two for me—one for you, one for you—two for me, etc.) Unless or until Lehman traded at a big discount to book value and to other investment firms, I wasn't going to be that interested.
But something else caught my eye. According to newspaper accounts, one problem with American Express had been that large institutional investors had no idea what its earnings were going to be for any given period. The main culprit was Lehman's volatile earnings track record. The only thing Wall Street hates more than bad news is uncertainty. Overcoming the problem of unpredictable earnings was precisely the goal of the Lehman spinoff. This was also the reasoning behind American Express's earlier sale of its Shearson subsidiary. After the spinoff, American Express would be down to two main businesses, both of which appeared to be less volatile than Lehman.
The first business, categorized by American Express as "Travel Related Services," included the well-known charge card and the world's largest travel agency, as well as the traveler’s-check business. Under the new CEO, the plan was to concentrate on and develop these core franchises. Although competition from Visa and MasterCard had eroded some of American Express's business over the last several years, it appeared that much of the problem was due to management inattention. There was clearly going to be a new focus on the basic businesses. As American Express's main product was a charge card requiring full payment every month, its revenues were largely based on fees paid by cardholders and merchants. This seemed more attractive than the credit-card business, which required undertaking greater credit risk. In short, American Express appeared to have a niche in the higher end of the market, with a franchise and brand name that was very hard, if not impossible, to duplicate.
The second business, Investors Diversified Services (IDS), had been growing its earnings at a 20-percent rate for almost ten years. This business consisted of a nationwide group of financial planners who provided clients with overall investment and insurance plans based on the clients' individual needs. The planners often recommended and sold many of the company's own product offerings, such as annuities and mutual funds. Since the financial-planning business is a largely unregulated business dominated by single or small-group practitioners, IDS (now American Express Advisors) was able to provide the comfort, resources, and depth of financial products not easily found in other organizations. This ability to provide services all in one package had allowed IDS to grow its assets under management at a very fast rate. Its revenues were largely derived from the annual fees generated from the investment and insurance products sold to its customers. The bottom line was: IDS also seemed like a valuable and fast-growing niche business.
The exciting thing was that for several months before the spinoff of Lehman Brothers in May 1994, you could buy American Express at a price of $29 per share or less. This price included the value of the Lehman spinoff, estimated in the newspapers to be worth $3 to $5 per American Express share. This meant that the "new," post-spinoff American Express was actually being created for a price between $24 and $26 per share. Since published estimates were that American Express would earn approximately $2.65 per share for 1994 without Lehman Brothers, this worked out to a purchase price of less than ten times earnings.
A look (in Value Line) at some large credit-card companies showed their average P/E to be in the low teens. Although I wasn't sure this was the perfect comparison, it appeared that American Express could be priced, on a relative basis, as much as 30 to 40 percent too low. Even though the main charge-card business, under previous management, had suffered some reversals, a new focus on American Express's irreplaceable brand name and high-end market niche gave me some comfort. Also, as previously mentioned, the fee-based nature of American Express's charge card and related businesses seemed more attractive than the greater credit risks being undertaken by the credit-card companies I was using for comparison.
Certainly, IDS, which accounted for approximately 30 percent of American Express's income, looked like a business worth much more than only ten times earnings. After growing at 20 percent per year for such a long time and having a steady income stream from the assets under management, buying this business at a huge discount to the market multiple (of between fourteen and fifteen) seemed like a steal. Although American Express also owned an international bank (most probably worth just ten times earnings), this accounted for less than 10 percent of its total profits.
The bottom line was: At less than ten times earnings, American Express looked very cheap. Once Lehman's confusing and volatile earnings were removed from the picture, I thought that this would become evident to other investors. The only question was, since I wasn't that interested in Lehman, should I buy stock in American Express before or after the spinoff was completed?
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. Often institutional buying of the parent's stock immediately after a spinoff has a tendency to drive the price up. That's why, if the parent company appears to be an attractive investment, it is usually worthwhile to buy stock in the parent before the spinoff takes place. Although it is a little more trouble to "create" the bargain purchase by buying stock in the parent before the spinoff is completed, it is usually worth the extra effort—even if you don't get a great price when selling the spinoff shares.
In Lehman's case, since I was happy to "create" American Express at a price between $24 and $26, it was an easy decision to buy it at $29 before the spinoff. The Lehman stock, which I ended up keeping (I hate selling spinoffs), started trading at about $18.50 per share. (As one share of Lehman was distributed for every five shares of American Express owned, this worked out to a value of about $3.75 per American Express share.) American Express stock did rise 1% the first day of trading after the Lehman distribution, so buying before the spinoff was a good move. It was also a good move for the long term. American Express proceeded to reach $36 per share in the first year after the spinoff, for a gain of over 40 percent in one year.
By the way, a little over six months after the spinoff, Warren Buffett announced that he had purchased just under 10 percent of American Express. Apparently, the spinoff and sale of unrelated businesses had unmasked American Express to be a "Warren Buffett" company—a compelling bargain with a strong brand name and an attractive market niche.
See—paying attention to parents—who'd 'a' thunk it?
I never like to work too hard to understand an investment. So if a potential investment is too complicated or difficult to understand, I'd rather skip it and find something easier to figure out. That's why this next area, partial spinoffs, is so attractive to me. Here is an area where boning up on first-grade math skills (especially subtraction) is the key to success.
In a partial spinoff transaction, a company decides to spin off or sell only a portion of one of its divisions. Instead of spinning off 100-percent ownership in a division to its shareholders, only a portion of the division's stock is distributed to parent-company shareholders or sold to the general public; the parent company retains the remainder of the division's stock. For example, if XYZ Corporation distributes a 20-percent interest in its Widget division to its shareholders, 20 percent of Widget's outstanding shares will trade publicly while 80 percent will still be owned by XYZ.
Companies may pursue a partial-spinoff strategy for several reasons. Sometimes a corporation may need to raise capital. Selling off a portion of a division while still retaining management control may be an attractive option. At other times the motivation for pursuing a partial spinoff is to highlight a particular division's true value to the marketplace. Its value may be masked when buried among the parent company's other businesses. A separate stock price for that division enables investors to value the division independently. It also allows for incentive compensation for the division's managers to be based directly on divisional performance.
The benefits of investigating partial spinoffs arc twofold. First, in the case where shares in the partial spinoff are distributed directly to parent-company shareholders, spinoff shares should perform well for most of the same reasons that 100-percent spinoffs do. In the case where a partial stake in a division is sold directly to the public (through an Initial Public Offering, known as an IPO), your opportunity is probably not as good. This is because the people who buy stock in the public offering are not being handed stock they don't want. A stock price depressed by indiscriminate selling is therefore not likely.
Your second opportunity comes from something else. Here's where you break out your first-grade math skills. Once the stock of the partial spinoff is publicly trading, the market has effectively valued the spun-off division. If the Widget division of XYZ Corporation has 10 million shares outstanding and 2 million are sold to the public for $20 per share, that means XYZ still owns 8 million shares of Widget. The value of those shares works out to $160 million (8 million shares multiplied by a $20 share price—okay, second grade math).
Now comes your second opportunity. By doing this simple math, you now know two things. Of course, you know the value of XYZ's 80-percent stake in Widget-$160 million. However, you also know the value the market places on all the rest of XYZ's businesses: that value is equal to the market value of XYZ less $160 million. Here's how it works: If XYZ has a market value of $500 million, and its 80-pcrccnt Widget stake is valued by the market at $160 million, that implies a net value of $340 million for the rest of XYZ's businesses.
Where will that little piece of trivia get you? Let's see.
THE CHEAPER SIDE OF SEARS
In September 1992, Sears announced its intention to sell a 20-percent stake in two of its subsidiaries to the public. Sears's management had been under pressure to improve the performance of its stock price for years. It was Sears's contention that the value of the two subsidiaries, Dean Witter (including Discover) and Allstate Insurance, was not adequately reflected in Sears's stock price. In the case of Dean Witter, Sears also announced its intention to distribute its remaining 80-percent interest directly to shareholders at a later date, some time in 1993.
Why was this interesting? After all, before the announcement, Sears was a conglomerate that owned Dean Witter, Allstate, and the well-known department store chain. It was no secret that Sears had owned all of these businesses for years. Sears was widely followed by Wall Street analysts. So why, all of a sudden, was this an investment opportunity? Sears was merely selling or distributing businesses it already owned.
The answer is that not only was Sears going to be highlighting the market value of Dean Witter and Allstate—through the public trading of these two divisions—it was also going to be revealing something else. By taking Sears's stock price and subtracting the market value of its remaining stakes in Dean Witter and Allstate, a value for the rest of Sears's assets, primarily the department store, could be calculated. Big deal? A very big deal. Let's see why.
A 20-percent stake in Dean Witter was sold by Sears in February 1993. Sears's stated intention was to spin off (by a distribution directly to Sears shareholders) its remaining 80-percent interest in Dean Witter in the next several months. In the beginning of June, Sears sold a 20-percent stake in Allstate for $27 a share. By the beginning of July, just before Sears's distribution of its remaining stake in Dean Witter, this is how things stood: Dean Witter's stock was trading at approximately $37 per share; Allstate's stock was trading around $29; Sears's stock stood at about $54.
The math worked like this. Sears had announced that it would distribute its remaining 80-percent stake in Dean Witter. According to the announcement, this meant that, for every 100 shares of Sears, a distribution of 40 shares of Dean Witter would be made. (Sears was distributing 136 million shares of Dean Witter and had approximately 340 million shares outstanding—so the distribution ratio was 136/340 or .4.) Therefore, in mid-July, each Sears shareholder would receive shares in Dean Witter worth approximately .4 (the announced distribution ratio) multiplied by $37 (the trading price of Dean Witters stock), or approximately $15 worth of Dean Witter stock for each share of Sears owned.
Since Sears was trading at $54 per share before the distribution, this translated to a net price of $39 for the remainder of Sears. What was that remainder? Primarily, it was Sears's remaining 80-percent stake in Allstate, its foreign and domestic department-store business, and various real-estate businesses (including Coldwell Banker). However, we also knew something else: the market value of Sears's 80-percent stake in Allstate.
Sears owned approximately 340 million shares of Allstate. Sears, itself, also happened to have approximately 340 million shares outstanding. This meant that if you owned a share of Sears you also indirectly owned a share of Allstate. With Allstate at about $29, for about $10 per share ($39 net stock price less $29 price of Allstate), you were getting the foreign and domestic Sears department-store business and its real-estate business. Was this a bargain?
Michael Price, a well-known fund manager, sure thought so. In a Barron's interview (July 5,1993), he laid out the case straightforwardly:
That $54 a share includes one share of Allstate, which is at $28. So that leaves $26. Then you get 0.4 share of Dean Witter, which is $15. That leaves $10 or $11. About $2 or $3 of that is Sears Mexico and Sears Canada. That leaves about $8. Coldwell Banker is worth $2 or $3 a share. So that leaves $5 a share, or a market cap of about $1.5 billion for the retailer—with $27 billion in sales. The new management seems very focused. It's an almost debt-free retailer with huge real-estate opportunities.
I told you, I never like to work too hard to understand an investment. A quick check revealed that indeed Price was right. Sears was cheap. With $27 billion in sales and 340 million shares outstanding, Sears had $79 per share in sales. If those sales could be purchased for $5 a share (pretty much debt free), then that worked out to a purchase price of just over 6 percent of sales (5 divided by 79). On the other hand, a look at J. C. Penney showed sales of about $78 per share and a market price of about $44 per share—that was over 56 percent of sales. Of course, there are many other measures of relative value (earnings, for instance), but all indications were that the domestic retail business of Sears could be created at an incredibly cheap price.
By the way, although I am a strong advocate of doing your own work, this doesn't mean I'm against "stealing" other people's ideas. It's a big world out there. You can't begin to cover everything yourself. That's why, if you read about an investment situation that falls into one of the categories covered in this book, it's often productive to take a closer look. If either the logic of the situation is compelling or the advice comes from a short list of reliable experts (to be named later), "stealing" can be a profitable practice.
Of course, "stealing" refers to stealing an idea (technically, without the use of deadly force). Unfortunately, you still have to do your own homework. In the Sears case, in addition to the Barron's article, Michael Price gave a similar interview to Fortune magazine in mid-June. So even if you hadn't followed the Sears spinoff story for the many months it appeared in the business press—or you followed the story but neglected to do the math yourself—there were at least two widely available opportunities to pirate a good idea. If you know the types of situation you're looking for, such as partial spinoffs, these type of opportunities are much easier to spot.
Buying Sears stock also worked out quite well. (We'll get to some losers . . . later.) After the Dean Witter distribution, the $39 remaining investment in Sears was up 50 percent over the next several months. Allstate was only up from $29 to $33 during this period. Obviously, the market finally took notice of the inherent value of Sears's other assets.
(For the advanced students: Yes, it was possible to simultaneously buy Sears stock and short Allstate stock, creating only the portion of Sears that was clearly a bargain. In some cases, this is a smart way to play, especially when the value of the cheap portion—a $5-per-share department-store purchase—is a small part of the purchase price: $39, post Dean Witter distribution. However, in this case, the disparity between the bargain purchase price of the department-store segment and true value was so huge, no such fancy tactics were necessary.)
INSIDER TIPS: A DO-IT-YOURSELF GUIDE
Insiders. I may have already mentioned that looking to see what insiders are doing is a good way to find attractive spinoff opportunities. (Okay, so maybe I've beaten you over the head with it.) The thinking is that if insiders own a large amount of stock or options, their interests and the interests of shareholders will be closely aligned. But, did you know there are times when insiders may benefit when a spinoff trades at a low price? Did you know there are some situations where insiders come out ahead when you don't buy stock in a new spinoff? Did you know you could gain a large advantage by spotting these situations? Well, it's all true.
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 spinoffs 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. If you are attracted to a particular spinoff situation, it may pay to check out the SEC filings for information about when the pricing of management's stock options is to be set. 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. Eventually, management and shareholders will be playing on the same team, but it's often helpful to know when the "game" begins.
There are very few investment areas where insiders have such one-sided control in creating a new publicly-traded company. Because of this unique quality, analyzing the actions and motives of insiders in spinoff situations is of particular benefit. Since all shareholders of a parent company either receive shares in a new spinoff or have the equal right to buy shares in a new spinoff, there are few fairness issues that come up when dividing assets and liabilities between parent and spinoff. There are, however, ways that insiders can use their relatively unchecked ability to set the structure and terms of a spinoff to gain an advantage for themselves. Of course, by focusing on the motives of management and other insiders you can turn this advantage for insiders into an advantage for yourself. This is particularly true when it comes to analyzing this next method of establishing a new spinoff company.
BUY ALL RIGHTS
Occasionally, instead of merely distributing the shares in a spinoff to shareholders free of charge, a parent company may give its shareholders the right to buy stock in one of its subsidiaries or divisions. One way to accomplish this is through something called a rights offering. Most rights offerings, at least the type that most investors are familiar with, do not involve spinoffs. However, on the rare occasions that a rights offering is used to effect a spinoff, it is worthwhile to pay extra close attention. Why? Come on—you should know this one by now. (Oh, all right—psst—because you can make a lot of money!)
A rights offering is most commonly used when a company seeks to raise additional capital. In the usual case, rights are distributed to a company's current shareholders. These rights, together with cash or securities, allow shareholders to purchase additional shares (usually at a discount to the current market price). By giving all shareholders the right (but not the obligation) to buy stock at a discounted price, a company can raise needed capital while giving all shareholders an equal chance to buy the newly issued stock. If current shareholders choose to participate in the rights offering by exercising their right to buy additional stock, their interests are not diluted by the company's sale of new stock at a low price. Alternatively, if shareholders do not wish to purchase additional stock, they can often sell the rights they've received to participate in the bargain purchase on the open market. Rights that are not exercised or sold expire worthless after a set time period.
Rights offerings are also unhappily familiar to owners of closed-end funds. Closed-end funds, whether equity bond funds, are like mutual funds except that the amount of fund shares issued is fixed (e.g., 20 million shares are sold at $10 per share in a public offering and those 20 million shares are bought and sold just like a common stock). One way for a closed-end fund to raise additional capital (and thereby raise the fund manager's advisory fees) is to issue more shares through a rights offering. As a general rule, only the fund manager of the closed-end fund benefits from this type of rights offering.
But now for the good news. When it comes to the spinoff area, rights offerings can be an extraordinary opportunity for enterprising investors like you. Rights offerings are obscure and often confusing. Throw in the neglect and disinterest displayed by most institutional investors towards spinoffs, and you have an explosive combination. Generally, a parent company will distribute to its shareholders rights (free of charge) to buy shares in a spinoff. Holders of the rights will then have the right to buy shares in the spinoff for the next thirty or sixty days at a fixed dollar price or for a specified amount of other securities. The rights are usually transferable, which means that shareholders who do not wish to purchase shares of the spinoff can sell their rights in the open market and investors who are not shareholders of the parent can participate in the rights offering by buying rights in the marketplace.
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. You won't have to waste too much effort either. Before you get knee deep into the intricacies of a particular situation, a quick examination of some superficial aspects of the rights offering and the motives of insiders will either get you excited enough to do some more work or persuade you to spend your time elsewhere.
So why does combining a spinoff with a rights offering create such a profitable opportunity? After all, the bargain element of a standard spinoff—indiscriminate selling of the unwanted spinoff stock by parent-company shareholders—is not present in a rights offering. In fact, in a rights offering almost the opposite takes place. Shareholders who use their rights to purchase shares are actually making an affirmative choice to buy stock in the new spinoff Even the bargain element of a standard rights offering is not present in this situation. Unlike the usual rights offering, the rights do not ensure a bargain purchase. This is because, at the time of the offering, it is not known whether the spinoff will trade above or below the purchase price set in the rights offering. So where does the profit opportunity come from?
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 spinoffs 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 spinoffs 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.
While there is a general tendency for a spinoff to be offered at an attractive price in a rights offering (note: investors who buy rights in the open market must add the purchase price of the rights to the offering price to figure out their total cost), examining the structure of a rights offering can give important additional clues. One telltale sign of a bargain offering price is the inclusion of oversubscription privileges in a rights offering. 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. Since rights are obscure, require the payment of additional consideration, and usually trade illiquidly for small sums of money (relative to the value of parent-company holdings), there are often times when rights holders neither exercise nor sell their rights. In a case where rights to buy 1,000,000 shares are distributed, but rights to buy 1,000,000 shares expire unused, oversubscription privileges allow those rights holders who purchase stock in the offering an additional opportunity to purchase the remaining 1,000,000 shares on a pro-rata basis.
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. The implications of this type of disclosure are obvious. Keep one more point in mind: When oversubscription privileges are involved, the less publicized the rights offering (and the lower the trading price of the rights), the less likely it is for rights holders to purchase stock in the rights offering, and the better the opportunity for insiders and enterprising investors to pick up spinoff shares at a bargain price.
While we could review other ways the rights-offering process can result in big spinoff profits, it is more important to remember one simple concept: no matter how a transaction is structured, if you can figure out what's in it for the insiders, you will have discovered one of the most important keys to selecting the best spinoff opportunities. In this next example—one of the most complicated and lucrative spinoff transactions of all time—practically the only way to figure out what was going on was to keep a close eye on the insiders.
In fact, the spinoff was structured in such a complex and uninviting fashion that 1 wondered whether the insiders had actually planned it that way. While I usually try to avoid investment situations that are difficult to understand, in this case there was a good reason to make an exception. After I determined that insiders had every reason to hope I wouldn't buy stock in the new spinoff, I had every reason to put in the time and effort required to understand what was happening.
While this situation may be too complex for most investors, that's not the important point. Even the experts blew this one. The only point you really need to take away is this: Don't forget to check out the motives of insiders. That point should come through loud and clear.
So let's see how to make some real money.
Question: How do you make a half billion dollars in less than two years?
Answer: Start with $50 million and ask John Malone. He did it.
John Malone, CEO of Tele-Communications, took advantage of the spinoff process to create a situation that proved to be one of the great spinoff opportunities of all lime. 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. Although all shareholders of Tele-Communications (TCI), the parent company, had an equal opportunity to participate in the rights offering (and the whole world had the ability to purchase these same rights), the offering was artfully designed to create the most upside potential for those who participated, while simultaneously discouraging most investors from taking advantage of the opportunity.
The entire spinoff was followed closely by The Wall Street Journal (much of it on the front page), yet almost everyone in the investment community missed this chance to make a quick fortune. Hopefully, the next time an opportunity like this rolls around, everyone will pass right by it again—everyone, that is, except for you.
The whole scenario began in January 1990. Tele-Communications, the country's largest cable operator, announced its preliminary intention to spin off its programming assets (like QVC and the Family Channel) and some of its minority interests in cable-television systems—assets estimated to be worth nearly $3 billion. The announcement was made in response to continuing pressure from Washington to lessen the influence of large cable operators, and Tele-Communications in particular, on the cable industry. Under the leadership of John Malone, Tele-Communications had become a behemoth in the industry, wielding its considerable power to, among other things, dictate which program providers would be carried on its cable systems and on what terms. Due to its size (almost 25 percent of all cable households), TCI was often in a position to make or break the launch of a new cable channel and in some cases to use its clout to purchase equity interests in new channels. In response to what was perceived to be Malone's tight control over the industry, one proposal much discussed in Washington was legislation to limit the ability of cable system operators to own interests in program providers.
The stated hope of the spinoff was to alleviate some of the pressure from Washington, and to give Tele-Communications greater flexibility, by separating the company's programming assets from its controlled cable systems. The other announced reason for the spinoff was more typical—shareholder value. The hope was that the spinoff would highlight the value of the parent company's ownership stakes in programming assets and its minority stakes in other cable systems. It was thought that these stakes had been lost amid TCI's large portfolio of cable properties.
In March of 1990, The Wall Street Journal reported a new development. Rather than proceed with a usual spinoff, Tele-Communications had chosen to use a rights offering to effect the spinoff of its programming and other cable properties. Shareholders were to receive rights that would entitle them to exchange some of their TCI stock for shares in the new company. The rights offering was selected primarily for lax reasons. (If a rights offering is structured correctly, shareholders are only taxed based on the value of the rights received.)
The March announcement also disclosed something else. The spinoff would not be nearly as large as initially suggested. TCI was no longer planning to spin off its $1 billion stake in Turner Broadcasting. In October 1990, just before the preliminary SEC filings were made, the distribution of Tele-Communications's 50-percent stake in the Discovery Channel was also taken off the table. The value of the entity to be spun off had shrunk to well under 50 percent of original expectations. In fact, SEC filings made in November of 1990 and revised in January 1991 disclosed that the estimated value of the assets to be spun off into the new entity, Liberty Media, were down to approximately $600 million. As; TCI had a total market capitalization of approximately $15 billion (about $6 billion of equity value and $9 billion in debt), the size of the Liberty spinoff was going to represent a drop in the bucket relative to the whole of Tele-Communications. In other words, Liberty was going to be an unimportant sideshow as far as most institutional investors were concerned (and potentially a classic spinoff opportunity for us).
According to newspaper accounts in January 1991, Liberty's portfolio of assets was going to include minority interests in fourteen cable franchises serving 1.6 million subscribers, and interests in twenty-six other entities including eleven regional sports networks, as well as minority interests in The Family Channel, American Movie Classics, Black Entertainment Television, and the QVC Shopping Network. These assets were estimated by Tele-Communications to have a value of approximately $600 million, more or less equally divided between cable and programming interests. The Wall Street Journal reported that ''Liberty will be a much smaller company than some had expected, issuing only about two million shares. On a fully diluted basis, Tele-Communications has about 415 million shares outstanding." According to the Journal, analysts described the almost-400-page prospectus as "one of the most complex transactions of its kind" and a cause of confusion to investors. Due to the exclusion of TCFs interests in Turner Broadcasting and the Discovery Channel, some analysts felt that "Liberty may be perceived as a less attractive investment." The Journal went on to report, "On a pro forma basis, for the nine months ended Sept. 30,1990, Liberty reported a loss of $20.4 million after a preferred stock dividend requirement, and a $9.77 a share loss."
In sum, the picture of Liberty painted for most investors did not exactly shout, "Come on in, the water's fine!" If this basic description wasn't discouraging enough, there was still plenty more to come. Tele-Communications's shareholders were to receive one transferable right for every 200 shares they owned. Each right, together with sixteen shares of Telecommunications, could then be exchanged for one share of Liberty Media* (The rights expired after thirty days.) At a price of $16 far t share of TCJ, this, translated to a purchase price of $256 per share of Liberty (sixteen shares- of TCI at $16 each). As stated, there were approximately 415 million fully diluted shares of TCI, a distribution of one right (to buy one share of Liberty) for every 200 TCI shares held translated into the approximately 2.1 million shares of Liberty to be issued.
For an institution that owned stock in a corporation with over 400 million shares, a stock with a capitalization of only 2 million shares would generally be considered not only risky and inappropriate, but entirely too illiquid to be included in its portfolio. A price of over $250 per share is also considered very awkward. Very few institutions would be willing to trade a very liquid stock with over 400 million shares outstanding for a small amount of a very illiquid stock. A search through the SEC filings for an explanation for the desire to have only 2 million shares of Liberty outstanding priced at $256 per share—as opposed to a more usual 20 million shares priced at approximately $26, or 40 million shares priced around $13—revealed the following clarification: "The exchange rates at which shares of [Liberty stock] will be issued in exchange for [TCI stock] were selected solely for the purpose of limiting the aggregate number of shares of [Liberty] common stock initially to be issued to a maximum of approximately 2,000,000 shares. The exchange rates are not intended to be any indicator of the value of [Liberty's] securities;" My translations "We picked 2,000,000 shares because we wanted Liberty stock to appear unattractive to TCI shareholder
Why do I say this? What advantage was there for Liberty to appear unattractive? For starters, the rights offering was structured so that the amount of Liberty shares issued would be equal to the amount of rights exercised. In other words, if only I million rights were exercised to purchase Liberty stock, only 1 million shares of Liberty would be issued—not the theoretical maximum of 2 million shares, if all TCI holders exercised their right to purchase stock. A sale of 1 million shares in exchange for $256 worth of TCI stock would equal a purchase price of $256 million for all of the common equity in Liberty Media (instead of a potential $512 million cost if all 2 million shares were purchased). Since Liberty would still own the same assets, regardless of whether 1 million shares of common stock were issued or 2 million shares, anyone primarily interested in Liberty's upside potential would much prefer to split that potential among fewer shares.
The deal had still another twist. Any common stock (the stock entitled to all upside appreciation in the value of Liberty) not sold in the rights offering would be replaced by preferred stock to be owned by Tele-Communications. Since, as stated, TCI was transferring the same assets to Liberty regardless of whether $250 million worth of Liberty stock was sold for $500 million, this $250 million shortfall was to be made up through the issuance of $250 million of Liberty preferred stock to TCI. The terms of the preferred stock to be issued were very advantageous to Liberty. The bottom line was: The fewer shareholders that participated in the Liberty offerings, the more leveraged the upside potential for Liberty’s stock. Better still, this leveraged upside would be achieved not through the issuance of debt but through the issuance of low-cost preferred stock. Since this preferred stock required no cash payments for fifteen years, carried a low rate of 6 percent, and had a fixed redemption price (i.e., no upside potential), this was clearly an attractive way to achieve the benefits of leverage for Liberty common stock—without the risks of taking on debt.
What were TCFs insiders doing in the midst of all this confusion? For one thing, they weren't giving away free advice. According to The Wall Street Journal, "Tele-Communications' top two executives, Chairman Bob Magness and President John Malone, have advised the company they each currently intend to exercise at least 50 percent of their exchange rights/' Certainly not a rousing endorsement. But if you looked a bit closer there were some helpful hints available.
In the prospectus issued for the rights offering, located under the heading "Executive Compensation," the following statement was found: "Pursuant to Dr. Malone's employment agreement, in lieu of cash compensation for his services to [Liberty], Dr. Malone will be granted non-transferable options to purchase 100,000 shares of [Liberty stock] at a price per share equal to $256." This translated to an option, not including any shares of Liberty purchased by Malone in the rights offering, for over $25 million worth of Liberty stock. Since, according to the same SEC filing, Malone owned approximately $50 million worth of TCI stock, the success of Liberty was going to be of material significance even to John Malone. If 2 million shares of Liberty were issued, an option on 100,000 shares was equal to an option on 5 percent of the total company. At 1 million shares of Liberty outstanding, this translated to a 10-percent share of Liberty's upside.
Looking a bit further, Liberty wasn't nearly as bad off as the newspaper summaries made it appear. The pro forma loss of $9.77 per share for the most recent nine-month period wasn't the whole story. The earnings (or lack of earnings) shown in the pro forma statements included the operations of only a very small portion of Liberty's assets. Since the bulk of Liberty's assets were made up of equity stakes in other companies, the revenues and earnings of most of these interests were not consolidated into Liberty's income statement. (These stakes merely appeared on Liberty's balance sheet at cost.) Even Forbes magazine (which I enjoy reading) completely blew it. Citing Liberty's low level of revenues and earnings (I guess they didn't read the SEC filing), Forbes stated, "If you're a TCI shareholder, pass on the swap [exchanging TCI shares for Liberty shares through the rights offering]. If you're considering buying Liberty [stock]..., don't chase it." So, while it's great to read business publications to find new ideas, it still pays to remember Rule #1: Do your own work. (I'm sorry, but this work does include at least reading the pro forma financial statements.)
There was something else about Liberty that looked very exciting. According to the prospectus, management of TCI had the "expectation that [Liberty's] Common Stock will initially represent only an interest in any future growth of [Liberty]". What was this worth? Well, let's see. Telecommunications held approximately $15 billion of cable assets. Liberty was going to be controlled by the same group of managers as Tele-Communications. Liberty was set up as a vehicle for TCFs programming ventures. If John Malone was going to receive a big chunk of Liberty's upside, maybe TCI could use some of its considerable muscle to help out little Liberty. Certainly, a new cable channel might benefit from cutting Liberty in for a piece of its equity. Perhaps this would help the new channel's chances of being carried over Tele-Communications's vast cable network. Maybe Liberty could start up its own cable channels. These new cable channels would also have a huge head start if made available to all of TCI's subscribers. Hmmm . . . so how many ways would all this upside be split?
The answer was, it depended on how many of Tele-Communications's shareholders decided to use their rights to exchange shares of TCI for shares of Liberty. One press report summed up the general consensus nicely: "Liberty's problems include an illiquid stock, a terribly complicated asset and capital structure, and lack of initial cash flow from its investments." A Bear Stearns analyst added, "We view this offer as having very limited appeal for most fund managers." Shearson Lehman stated, "to give up [TCI] to participate in Liberty, a highly uncertain value with limited liquidity, doesn't strike us an especially good trade at virtually any price for most institutional investors." It should have been no surprise, then, when only about 36 percent of eligible rights to buy Liberty stock were exercised, resulting in only slightly more than 700,000 Liberty shares of a possible 2 million being issued.
The rights to buy shares in Liberty for $256 worth of TCI stock were freely traded and could have been purchased by anyone who so desired for a period of thirty days. The rights were available at a price of less than $1 per right—meaning the owner of 200 shares of TCI ($3,000 of TCI stock) received a right worth less than $1.
Most shareholders of TCI neither exercised nor sold their rights. Of course, Tele-Communications's top two executives, Bob Magness and John Malone, did end up exercising all of their rights to buy shares in Liberty after all. Together with his 100,000 options, Malone had been able to keep nearly 20 percent of Liberty's upside for himself, compared with his participation in less than 2 percent of TCFs upside. Although CEO of both entities, Malone was clearly incentivized to use TCFs considerable clout in the cable industry to make sure that Liberty thrived. Then again, all TCI shareholders had had an equal opportunity to participate in Liberty's future—even if they weren't exactly led by the hand.
According to Multichannel News, a publication covering the cable industry,
TCI officials expected fewer than 50 percent of the eligible shares to participate. But as TCI disclosed details of the plan, Wall Street soured on Liberty's illiquid stock, complicated asset and capital structure and lack of initial cash flow.
John Malone, chairman of Liberty and president and CEO of TCI said he was indifferent to, not disappointed by, Wall Street's lack of enthusiasm.
Even though Liberty's shareholder meetings can be held "in one telephone booth," Malone said that in structuring the deal, TCI executives realized it wouldn't be for everybody.
"People had to make up their own minds," Malone said. "You can get yourself into trouble convincing people to get into things."
Sure. That makes sense. When you make ten times your initial investment in less than two years (to be fair, an outcome not even Malone could have expected), think of all the horrible tax problems you could cause unsuspecting investors.
P.S. Less than a year after the rights offering, Liberty split its stock—twenty for one—the greater liquidity attracting both institutional investors and analysts.
SPINOFFS: A QUICK SUMMARY
Before we leave the spinoff area, let's take a moment to review some highlights:
YOU CAN BE A STOCK MARKET GENIUS
1. Spinoffs, in general, beat the market.
2. Picking your spots, within the spinoff universe, can result in even better results than the average spinoff.
3. Certain characteristics point to an exceptional spinoff opportunity:
a) Institutions don't want the spinoff (and not because of the investment merits).
b) Insiders want the spinoff.
c) A previously hidden investment opportunity is uncovered by the spinoff transaction (e.g., a cheap stock, a great business, a leveraged risk/reward situation).
4. You can locate and analyze new spinoff prospects by reading the business press and following up with SEC filings.
5. Paying attention to "parents" can pay off handsomely.
6. Partial spinoffs and rights offerings create unique investment opportunities.
7. Oh, yes. Keep an eye on the insiders. (Did I already mention that?)
And some additional points:
1. Reruns of Gilligan’s Island are boring.
2. "Stealing" can be a good thing.
3. Don't ask stupid questions at Lutece.
Hey. Why didn't I just say it like this in the first place?
 Patrick J. Cusatis, James A. Miles and J. Randall Woolridge. “Restructuring Through Spinoffs, “ Journal of Financial Economics 33 (1993)