Spinoffs are offering investors purer investment exposure and market-beating gains.
It wasn’t a total surprise when Hewlett-Packard (NYSE: HPQ) announced plans to split into two separately traded public companies last October. After all, the company has talked about splitting up before.
But this time around, current CEO Meg Whitman appears to hold the master plan that her predecessor Léo Apotheker lacked. And though the stock has been a poor performer of late, the proposed plan has won widespread support from a market that has fallen back in love with corporate spinoffs.
HP’s plan is to break up the company into two separate entities this year. One, HP Inc., will be focused on the PC and printer businesses. The other, HP Enterprise, will focus on enterprise infrastructure, services and software.
I think this spinoff will serve as a catalyst for shares of both companies. And at the moment I see at least 30% upside in shares of Hewlett-Packard. I believe long-term investors would be wise to buy shares now, and hold on through the pending split.
The spinoff is decidedly back in vogue. Just four years after the Great Recession, U.S. corporate spinoffs have rebounded to near record highs. And returns for many spun-out companies are trouncing the broad market.
Last year 60 U.S spinoffs were completed. That makes 2014 the biggest year for spinoffs since 1999 and 2000, when an astounding 66 were completed in each year.
Some may interpret the spinoff trend as a sign that capital markets are becoming frothy, with too much excess capital sloshing about. And some may interpret it as a signal that the era of the conglomerate is officially dead.
Regardless of interpretation, one thing is crystal clear – spinoffs are on the rise and investors are more than happy to snap up shares of companies with more of a pure-play focus.
In layman’s terms, the mechanics of a spinoff are simple. A parent company distributes all of its ownership interest in a subsidiary business via a dividend to existing shareholders. Once the spinoff is complete, there are two distinct, publicly traded companies with the same shareholder base.
This ownership base changes once the public markets take over and the respective companies’ shareholder bases evolve.
There are a number of reasons companies justify completing a spinoff.
Skeptics will say that the primary beneficiaries are the Wall Street M&A advisers who collect fat fees when a company embarks on a major restructuring. But in truth, the reasons can be far more investor-friendly. A successful spinoff can unlock dormant value in a business unit that can go forth and flourish on its own.
Free from the weight of a corporation with several divisions, managers and strategic directives, a pure-play spinoff can focus on its core business and pursue its own growth path, while providing the market with a clearer understanding of its underlying value drivers.
From a managerial perspective, a pure-play business may have more flexibility to pursue value-creating initiatives within its own industry.
From a capital perspective, a pure-play can establish a capital structure that is appropriate for its line of business. For example, a slow growth manufacturing company may want to use more leverage than a fast growth software company.
And from a financing perspective, a pure-play can better use its stock as currency to fund future acquisitions.
It used to be that conglomerates were sought after for the security that came with diverse operations in a single company. But over the last 20 years, and with the evolution of easily accessible and open markets, more pure-play business models have been sought after by investors.
It’s now far easier for individual investors to gain diversification, with low transaction fees, by buying shares of individual stocks rather than conglomerates.
Whatever the precise reasons for the trend, one thing is clear – this market likes companies with a more singular focus. Over the past five years a Bloomberg index of spun-off companies has returned over 180%, versus roughly 90% for the S&P 500.
While not every spinoff is a roaring success, it’s not hard to find examples of what has worked. Murphy USA (NYSE: MUSA) is up 90% since being spun out of Murphy Oil (NYSE: MUR) in August 2013.
More recently, in September 2014, Citizens Financial Group (NYSE: CFG) was spun out of Royal Bank of Scotland (NYSE: RBS). Citizens is up 17% thus far, as compared to a 4.9% gain in the S&P 500.
And Kraft Foods Group (NASDAQ: KRFT) is up over 100% since it was spun out of its parent company, now known as Mondelez International (NASDAQ: MDLZ), in October 2012. A hefty portion of Kraft’s post-spinoff return is due to H.J. Heinz’s offer to buy Kraft at a valuation of $50 billion. That offer added over 35% to Kraft’s market value on the day it was announced.
The Kraft deal highlights another trend in corporate activity: spinoffs that are subsequently acquired or taken private.
Consulting group Edge Consulting reports that around 20% of spinoffs are subsequently acquired around the two-year mark, at which point tax penalties are less likely to apply. Their research, completed with Deloitte, focused on 800 spinoffs over the last 15 years.
For investors the message is relatively simple – buy quality companies that are spun out and hold them. They will often do well on their own, and many will be acquired within a few years, often at a healthy premium.
On your radar should be pending splits for companies that are already doing well, and which could do even better once more focused companies emerge.
Keep an eye on Madison Square Garden (NASDAQ: MSG), which has talked about splitting its professional sports franchises (New York Knicks, Rangers and Liberty) and live production facilities (Madison Square Garden, Radio City Music Hall) into one company, and its entertainment businesses (MSG Network and other television channels) into another.
EBay (NASDAQ: EBAY) is also worth watching. It has announced plans to split off PayPal in 2015.
And then there’s General Electric (NYSE: GE), which just announced plans to sell most of its financial management assets, known as GE Capital. While this isn’t technically a spinoff, management shares the same goal of returning the company to its core focus.
The big picture goal for GE is to return the company to its focus on high-value and growing industrial divisions, which are expected to generate over 90% of earnings by 2018.
Echoing familiar reasoning, GE management has justified the move by saying a return to its core business will allow for a more focused company that will be better positioned to grow, increase profit margins and return capital to shareholders.
One simple way to quantify the performance of spinoffs, or to play the trend with a single security, is with an ETF designed around the event. The Guggenheim Spin-Off ETF (NYSE: CSD) is rebalanced semiannually and only includes companies that were spun off six to 30 months prior to the rebalance date.
The performance of this ETF has been exemplary. Over the last five-year, three-year and two-year periods it has risen by 138%, 94% and 41%, respectively.
The ETF’s returns over all of these periods outpaced the S&P 500, which rose by 76%, 55% and 33%, respectively, over the comparable periods. Year-to-date the Guggenheim Spin-Off ETF is leading again, rising by 9.3% versus 2.3% for the S&P 500.
While comparable performance obviously fluctuates over time, the potential value derived from a spinoff is clearly tantalizing for managers and investors alike. So much so that even large-cap names such as Hewlett-Packard and General Electric are getting into the game.
I don’t think the spinoff trend will abate in 2015. Already, more than 45 companies have announced plans to complete spinoffs. And it’s easily possible that 50 or more will be completed before year’s end.
That should give us a robust pipeline of “new” pure-play companies to evaluate in the coming months. While not all will be good investments, I expect that investors who are early to buy into healthy and growing spun-out companies will be well positioned to profit over the coming years.
In my Game Changers investment newsletter I’m constantly on the hunt for spinoffs that are poised to thrive once they are free to pursue their own growth path. Currently, our best performing spinoff is up 34% in just four months.
In the coming months, I expect to add more positions to play this trend. And if you’d like to get in on the ground floor with these investments I’d love to have you try out the service. Just click here now to start a zero-risk, free trial. If you’re unsatisfied for any reason, simply cancel at any time in the first 30 days and request a 100% refund.