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3 spin-off plays with potential
There are some good reasons to sign on to spin-offs, including outsized returns. Here's a look at deals to spin Discover cards, Expedia and American Express Financial Advisors from their parents.
By Michael Brush
When word leaked late last month that Morgan Stanley might spin off its Discover credit card business, investors jumped at the news. By the time the brokerage confirmed the rumors on April 4, buyers had pushed the stock up 11%, to $60.
For good reason. Spin-offs have a track record of rewarding shareholders handsomely. On average, their shares have chalked up a cool 73.7% return in the three years after they come out, beating peers by an impressive 29.5 percentage points, says J. Randall Woolridge, a finance professor at Penn State's Smeal College of Business.
With prospective returns like that, investors should be pleased to know that Morgan Stanley (MWD, news, msgs) isn't the only company mulling spinning off one of its business units. A wide range of businesses, including American Express (AXP, news, msgs) and WebMD (HLTH, news, msgs), plan to spin out divisions in the coming months.
Woolridge thinks the trend will continue because many companies have put more power in the hands of shareholders as companies take steps to improve corporate governance. "When stocks aren't performing, boards get pressure from institutions to get the stock moving," says Woolridge. "And everybody knows a spin-off attracts a lot of attention."
Related news and commentary on MSN Money
5 reasons spin-offs pay
Before we take a closer look at how to play the biggest three spin-offs on the horizon -- Morgan Stanley's carve-out of Discover, IAC/InterActiveCorp's (IACI, news, msgs) sale of its Expedia online travel group and the spin-off of an asset-management division by American Express -- let's see why spin-offs do so well.
Five reasons:- More focused leadership: Spin-offs come out with a fresh board -- and managers who are able to focus on the business since they are no longer just cogs in the wheel at a bigger company. What's more, these managers often have big options packages linked to stock price performance. The result: They typically do what it takes to increase sales and earnings faster than peers, says Woolridge. Along with fellow Penn State finance professor James Miles, Woolridge co-wrote a spin-off handbook: "Spin-offs and Equity Carve-Outs -- Achieving Faster Growth and Better Performance."
- They're takeover targets: Many spin-offs get scooped up by competitors -- at higher share prices. "You suddenly have a company that is a pure play, and it gets acquired by another company in that industry," says Woolridge. Spin-offs are three times more likely than their peers to get taken over.
- Plenty of fat to cut: Often, spin-offs get loaded down with debt, unwanted employees and other overhead on their way out the door. But as an independent company with more control over its destiny, the spin-off takes dramatic steps to cut those costs, pushing up profit margins over time.
- Little fanfare: Unlike initial public offerings, spin-offs don't have Wall Street analysts promoting them to investors. So they don't come out at excessive valuations.
- Natural selling pressure: Indeed, spin-offs usually sell off in the early days, and the reasons are simple. First, they're often carved out of mature companies paying a juicy dividend or trading as part of a major index like the S&P 500 ($INX, news, msgs). In contrast, the spin-off won't be part of the index. And it's unlikely to pay a big dividend. So index funds or funds that have to own dividend payers dump the shares. Other managers sell because the spin-off is only a small position and it's too much of a distraction to figure out whether it is worth buying more, says Les Satlow, a portfolio manager at Cabot Money Management in Salem, Mass. "You have to make a decision, and the easiest decision is to sell and revisit the issue."
Slow out of the gate
The bottom line: Institutional ownership of spin-offs typically falls to 19% of shares outstanding from 42% within three months, according to academic work reviewed by Bill Matson in Data Driven Investing. All that selling means spin-off shares typically lag the market by 8% in the first month. Many stay weak for three months. "That is a wonderful thing to take advantage," says Pat Dorsey, who follows spin-offs as director of equity research at Morningstar. "They are selling a business that may be the best business in the world, but they have no choice. They have to sell it."
Even though spin-off shares may sink in the early days, sometimes it's worth buying the whole company ahead of the spin-off. That's because spin-offs can simplify a business and unlock value in both the parent and the spin-off. That's the case with American Express and IAC/InterActiveCorp which look cheap right now, according to Morningstar analysts. Because Morgan Stanley looks more fully valued, it's probably better to wait until after the Discover spin-off to buy shares in this credit card company. Here's a closer look.
Discover: A little help from the court
Morgan Stanley's plan to sell its Discover Financial credit card unit may be little more than a last-ditch effort by chief executive Philip Purcell to fend off shareholders clamoring for changes to turn the stock around. But who cares. If it all works out, there will be an attractive, free-standing credit card company on the market worth buying, especially if shares dip in the early days of trading.
Why should anyone get excited about Discover? After all, it isn't the first credit card name that leaps to mind.
Here's one reason: The Supreme Court recently ruled that Visa and MasterCard can no longer order banks not to issue competing cards. This opens up doors for Discover and American Express, the two main competitors.
Having more cards in circulation will be a big plus because Discover controls its own processing network, just like American Express. That revenue will come in at very little cost, points out Ryan Batchelor, who follows credit card companies at Morningstar.
Like many spin-offs, Discover could get snapped up pretty quick -- another potential benefit to holding the stock. Big credit card issuers like JPMorgan Chase (JPM, news, msgs), Bank of America (BAC, news, msgs), Barclays (BCS, news, msgs) or Royal Bank of Scotland might buy Discover to build out their card divisions.
Morgan Stanley looks fully valued at $49, says Morningstar analyst Meghan Crowe. The stock recently traded for $55. So instead of buying shares of the brokerage now to get the spin-off shares, wait until Discover is actually set free.
IAC/InterActiveCorp: A two-for-one play
E-commerce juggernaut IAC/InterActiveCorp is a classic candidate for a spin-off because chief executive Barry Diller has collected so many unrelated businesses under one roof.
The jumbled collection makes it hard for investors to understand the true value of any single business, says Morningstar analyst Sanjay Ayer.
The hodgepodge includes the Home Shopping Network and ticket vendor Ticketmaster, as well as online travel sites such as Expedia and Hotels.com.
Spinning off Expedia and related travel services should help bring some clarity and reward shareholders, believes Ayer.
IAC/InterActiveCorp shares are so cheap it's smart to buy them now as a play on the Expedia spin-off, due out over the next three months.
Here's why: IAC/InterActiveCorp recently sold for $22. But Morningstar's Ayer thinks the shares should be worth $40 right now, based on expected earnings and cash flow. Roughly half of that $40 value lies in the travel division. The bottom line: If you buy IAC/InterActiveCorp shares now, you're getting half of the company "for free." (The parent of this Web site, Microsoft (MSFT, news, msgs), owned 51,700,000 shares of IAC/InterActiveCorp as of the end of 2004.)
Why does IAC trade at such a steep discount? Competitors are cropping up in online travel, and big hotel chains are selling more excess rooms on their own Web sites. But Ayer doesn't think these are problems. Expedia is still the online travel leader. As for hotels, Expedia gets more revenue from smaller chains that don't have the brand strength to sell online.
American Express: Worth the wait
Like IAC/InterActiveCorp, American Express seems to be getting a bum rap in the market. The company has two divisions: its famous credit card unit and a lower-growth asset-management division called American Express Financial Advisors.
Under one roof, they trade for about $51 per share. But if you split them up and give each side a valuation similar to free-standing competitors in the market, you get a much bigger potential valuation, says Edwin Groshans, an analyst at Fox-Pitt, Kelton, a brokerage specializing in financial institutions.
American Express plans to spin out the adviser unit in September. Groshans thinks it will take the market another year to fully recognize the value of both units. By then they should be worth $62 or $63 per share, or $54 for the card business and $8 or $9 for the asset-management side, for a 23% gain for anyone who buys shares today ahead of the spin-off.
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