Spin-offs Spin Value

 | Oct 18, 2011 | 1:00 PM EDT
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Corporate spin-offs can often create opportunistic trades for investors. On the surface, it almost often appears that spin-offs are best left alone. When a company spins off a business, that is usually a signal to investors that management of the parent company believes the core business will function better when separated from the subsidiary business or businesses.

Businesses are also spun-off as a way to reward shareholders by giving them a publicly traded stub. Most investors, of course, sell the stub to monetize the asset since they want to own the core business and not the spun-off entity. This immediate sell-off can often lead to significant undervaluation.

Huntington Ingalls (HII) is the premier naval shipbuilder for the U.S. Navy and Coast Guard and the only supplier of U.S. Navy, nuclear-powered, aircraft carriers and their refueling services. It is one of two companies constructing the Virginia-class, nuclear-powered submarines, one of only two builders of the Arleigh Burke-class destroyer and the primary provider of Navy fleet maintenance and overhaul services.

The defense giant Northrup Grumman (NOC) spun off Huntington in March 2011. At that time, Huntington shares began trading at $37 and have climbed as high as $42 since then. Today, they trade at $26, valuing the business at roughly 7x trailing and forward earnings. As is often the case with spin-offs, Huntington raised $1.7 billion via a debt offering, of which, Northrup was paid $1.4 billion, while Huntington retained the remaining $300 million. Huntington is levered with an enterprise value of $2.8 billion against a market cap of $1.3 billion.

The sell-off in Huntington is likely due to reasons, such as NOC shareholders selling shares to monetize assets, currently depressed operating margins at HII and a current lack of interest from the investing public. Most investors in NOC are interested in the higer margin aerospace and electronic systems business, not the lower margin shipbuilding and maintenance business. Yet, given Huntington's vital importance to the U.S. Navy, its operations will likely remain solid for years to come. And, given the quick sell-off, investors may want to keep an eye on this recent carve-out.

Other spin-off opportunities come about when a conglomerate decides to separate its divisions into new and separate businesses. Fortune Brands is a recent example of this type of spin-off.  The company consisted of three vastly different businesses: golf, spirits and home security and related products.

The company sold the golf business for $1.2 billion; the spirits business became Beam (BEAM); and, the final division was named Fortune Brands Home & Security (FBHS). Prior to the spin-off, Fortune Brands shares could have been purchased at prices ranging from $45 to $55 per share. Today, BEAM trades for $47, FBHS trades for $14, and the company was paid a cash dividend from the sale of the golf business.

Investors could have a similar opportunity with the industrial conglomerate ITT (ITT), which will separate into three, publicly traded business by year-end. The new businesses will be a leading water technology company, a leading defense business and an industrial business. Today, ITT trades for about $44 a share. Based on comparable industry multiples for the three separate businesses, these new businesses could command an aggregate value of more than $60 a share.

Spin-offs are an interesting way to capture hidden value. The difficulty in valuing a complex conglomerate is eliminated when businesses are allowed to separate and trade at comparable multiples with their peers. More so, analysts like clarity, and spin-offs create more clarity. Not all spin-offs work, but spin-offs create opportunities that should be exploited. 

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