Spin-offs frequently represent some of the most compelling opportunities available for active investors. They have historically outperformed the index on average but have a high degree of variance. This dynamic is attractive for active investors because it means there is an opportunity for fundamental stock picking.
It is crucial to study the top performing spin-offs from the past in order to identify the important, recurring characteristics. Investors can then use this knowledge to better analyze and understand future spin-offs. These characteristics can be boiled down to three broad areas.
- Attractive business
- A misunderstanding at the time of separation
- Talented and incentivized management team
A spin-off does not require all three characteristics to be successful, but a combination of these characteristics can lead to extraordinary investment outcomes.
Note: Many of the companies used in this article embody multiple characteristics, but are listed only once.
For a stock to generate high returns for shareholders over the very long-term, the company first-and-foremost must be an attractive business. This is a ‘squishy’ qualitative description, but an attractive business is one that has a high-quality business model, is durable, and grows over time.
High-Quality Business Model
A high-quality business model can mean a lot of things, and different things to different people, but we prefer to keep it brief. Simply put, a high-quality business model generates an attractive (and preferably improving) return on invested capital (ROIC) and unit economics while efficiently converting its revenue and earnings into free cash flow.
A durable business is one that has a sustainable competitive advantage (‘moat’) which allows the business to maintain its ROIC over time. This type of business can be the result of owning unique assets (tangible or intangible), customer relationships, and/or operational scale.
Ability to Grow
A high quality, durable business is valuable, but a high quality, durable business that can grow at an attractive incremental ROIC is extremely valuable. Growth can come from company-specific factors and/or industry growth.
Company-specific growth drivers include pricing increases, volume increases in excess of industry growth (gaining share), and acquisitions.
The most valuable growth for a company is where growth comes at an incremental ROIC in excess of the company’s historical ROIC (greater than cost of capital for an attractive business). This can be the result of many things but is normally from leveraging fixed costs (‘operating leverage’) or pricing increases.
A valuation discount to the peer group can be very attractive for a re-rating of the shares in the short-term. However, for a company to sustain performance over many years, there is frequently a fundamental misunderstanding of the business or growth opportunity by the investment community.
This misunderstanding can come from the business being an orphan, lacking publicly traded peers, and/or the historical financials not telling the whole story.
Orphan businesses are unique, special companies. They might be one of the few or even the only business in the world that performs a certain service, serves a certain end market, owns unreplicable assets (tangible or intangible), and/or has a beloved brand name.
By the very nature of the business, these companies do not easily fit into a peer group for comparison purposes or are natural for a sell-side analyst to plug into their coverage universe. As a result, these businesses are often compared to companies that do not have similar competitive positions or growth opportunities. This creates the misunderstanding and opportunity for investors.
Orphan Spin-Off Examples:
Ferrari is a luxury high-performance car manufacturer that was carved-out from Fiat Chrysler in 2015. While they are one of the most recognized automobile brands in the world, the business is more akin to a luxury goods company than an automobile manufacturer. Their reputation for quality, performance, and exclusivity results in die-hard fans and long wait lists to purchase vehicles. This allows Ferrari to operate a low volume, high price business model. Needless to say, there are few, if any, comparable companies in the world.
PayPal is a digital payments company that was spun-off from eBay in mid-2015 after pressure from Carl Icahn. PayPal is a unique company in that they are not a payments network, merchant acquirer, or a bank. This has caused confusion for analyzing their competitive position and unit economics.
BWX Technologies (“BWXT”) is the sole manufacturer of naval nuclear reactors for submarines and aircraft carriers as well as provides services and components to the commercial nuclear power industry. They were the parent company when Babcock & Wilcox (“B&W”) spun-off their Power Generation business in 2015 (the RemainCo was renamed BWX Technologies after they spun the business off). BWXT is a very unique business that has a dominant competitive position in their niches and has few, if any, competitors. This causes confusion when analysts compare it to defense contractors and engineering & construction businesses.
Lack of Publicly Traded Peers
There are many spin-offs that operate in a niche industry, have competitors that are private, and/or compete with smaller sub-segments of larger public companies. As a result, these new stand-alone companies cannot be easily compared to a set of public company peers for valuation comparison purposes. This could result in market participants comparing the spin-off to an erroneous peer group and a mischaracterization of the business.
Also, there could be a mismatch in sell-side analyst coverage. This could happen because the spin-off is in a different industry than the parent company or the spin-off does not fit cleanly into an industry group for analyst coverage.
Lack of Peers Spin-Off Examples:
Allegion is a global provider of access control security products and solutions (think locks, latches, deadbolts, monitoring controls, etc) for residential and nonresidential buildings. They were spun-off from Ingersoll-Rand in 2013 after Trian Partners obtained a board seat.
For the most part, their competitors are European, one of which is a Swedish company (Assa Abloy) and the other is a Swiss company (Dormakaba Group). While there are certainly U.S. based competitors, they are subsidiaries of larger conglomerates for the most part.
The peer group most analysts use to compare Allegion are other building products suppliers or security and protection companies. While they share many of the same end markets with these companies, Allegion has a much different financial profile and key drivers. Consequently, comparing the business to these other companies is not relevant.
GCP Applied Technologies
GCP is a supplier of admixtures and additives for concrete and cement as well as construction products that protect structures from water, vapor, air, and fire damage. They were spun-off from W.R. Grace & Co in early 2016.
Their competitors are either smaller regional players, subsidiaries of larger companies (BASF, RPM, Carlisle), or international (Sika). Analysts compare GCP to chemical companies and building products suppliers. Similar to Allegion, just because GCP shares the same end market as another company or also produces ‘chemicals’ does not mean they generate a similar financial profile or have the same key drivers.
SiteOne Landscape Supply
While not a true spin-off, SiteOne is an interesting example of a business carved out of a larger company. SiteOne is the largest and only national wholesale distributor of landscape supplies in the U.S. SiteOne was established in the early 2000s by Deere & Company. Then in late 2013, the private equity firm Clayton Dubilier & Rice (“CD&R”) acquired a majority stake and carved it out of John Deere. SiteOne hit the public markets as an IPO in 2016 with Deere and CD&R as the sellers.
They do not have any national publicly traded competitors. Their competition is small, local private companies as well as some regional players.
Historical Financials Don’t Tell the Whole Story
“100% of the information you have about a company represents the past, and 100% of the value depends on the future.”
The new management team at a spin-off no longer needs to report to the parent company or send cash flow back up to be allocated by corporate. As a result, they can change operating procedures, go-to-market strategies, employment levels, and pricing as they see fit to optimize the business. Since their compensation is directly tied to the company they now have control over, they are highly incentivized to make improvements.
In other words, the future could be much different than the past.
Spin-Off Examples of Operational Improvement:
CDK provides software and technology solutions for automotive dealerships. They were spun-off from ADP in October 2014. Soon after the spin-off, a handful of activist investors recognized the opportunity, bought shares in the company, and obtained board seats. CDK has improved margins through restructuring, optimizing the sales process and customer service, outsourcing, and consolidating facilities.
Since they spun-off, adjusted EBITDA margins have improved from the low 20% range to the mid-30% range.
Zoetis develops and manufactures medicines and vaccines for the animal health market. They were carved-out of Pfizer in 2013. Similar to CDK, an activist investor recognized the opportunity, this time Pershing Square, and purchased shares in 2014. Since the spin-off, Zoetis eliminated lower margin SKUs, improved their sales model, reduced corporate G&A, optimized R&D, and improved their supply chain. This resulted in operating margins improving from around 20% to the mid-30% range.
Black Knight, Inc
Black Knight is a provider of software, data and analytics for mortgage and consumer loan, real estate, and capital markets industries. Their products are used by mortgage originators and servicers, financial institutions, investors, and real estate professionals. They were carved-out from Fidelity National Financial (“FNF”) through an IPO in 2015 followed by the distribution of FNF’s ownership to shareholders in 2017 (note the company name changed from Black Knight Financial Services (“BKFS”) to Black Knight Inc (“BKI”)).
They have been improving margins through restructuring the business (integrating the technology business and analytics businesses), changing the way they go to marking, and generating high incremental margins on investments in property records.
Ingevity Corporation is a manufacturer of specialty chemicals and high performance activated carbon materials. Their products are used in a variety of different applications including gasoline vapor emission control systems, asphalt paving, adhesives, oil exploration, and lubricants, among others.
The business was spun-off from WestRock (the byproduct of the merger of MeadWestvaco and Rock-Tenn) in May 2016.
Since the spin-off, they have taken out $30 million of costs and continue to continuously improve the business. At their 2018 investor day, they discussed targeting 30%+ EBITDA margins which represents an 800 basis point margin improvement from the level when they spun-off in 2016.
Investors need to understand who the individuals are that are actually running the company as well as how the executive compensation plan incentivizes those persons. This requires investors to learn about decisions the management team has made in the past as well as understanding their incentives.
Investors should target managers with a history of creating value through both efficient operations and diligent capital allocation as well as having their incentives aligned with shareholders.
Spin-Off Examples: Talented and Incentivized Management Team
Howard Hughes Corporation
Howard Hughes is a real estate developer and operator of master planned communities and mixed-use properties across the United States. They spun-off from General Growth Properties in 2010.
The CEO of the company since the spin-off has been David Weinreb. He has had a long, successful career in real estate going all the way back to the 1970s in New York City. Along with being named CEO of the company back in 2010, he spent $15 million of his own money to purchase warrants to acquire 2.37 million shares of Howard Hughes at an exercise price of $42.23 which became exercisable in November 2016. In some ways this was a negative sign-on bonus to join the new company but worked very well to align his interests with shareholders. This investment by Weinreb ended up being very successful as Howard Hughes’ share price was comfortably above $100 when he exercised the warrant.
More recently in 2017, Weinreb again spent his own money (this time a $50 million investment) to purchase warrants to acquire 1.97 million shares of Howard Hughes with a strike price of $124.64 and a term of six years. Impressively, he did not sell any of his owned shares to fund the purchase of the warrants and has agreed to hold a minimum of over 400 thousand shares until at least 2022.
This is an example of a talented CEO investing significant capital alongside shareholders.
Fortive is a diversified industrial company that has leading positions in instrumentation, transportation technology, sensing, automation, and franchise distribution. They spun-off from Danaher in 2016 and recently split-off their A&S platform and merged it with Altra Industrial Motion (subscribers only research report).
Danaher, built by the Rales brothers, is one of the most successful industrial companies over the last 30 years. The company was built through making acquisitions and continuously improving the businesses.
Fortive’s CEO, James Lico, is a very experienced operator. He was part of Danaher from 1996 until the spin-off in 2016. During this time, he worked in many different business areas and implemented the famed “Danaher Business System” to great success.
Both Rales brothers, Mitchell and Steven, are involved at Fortive through serving on the board and combining to own over 40 million shares (just under 12% of the company).
The combination of experienced operators and significant insider ownership at Fortive as led to a very attractive outcome.
Many of the most successful spin-offs in recent history have the same characteristics of all great investments. This includes an attractive business and a talented and incentivized management team. After all, it is difficult to generate attractive long-term returns by investing in poor businesses, even if they were initially purchased very cheaply on statistical metrics.
“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns.”
Also, great companies that are being spun-off have the benefit of a potential misunderstanding at the time of separation. This can occur because the company is an orphan business, there is a lack of publicly traded peers, and/or the historical financials don’t tell the whole story.
These characteristics could give investors the opportunity to purchase unique, attractive companies at only average prices. There can also be other characteristics, such as market factors, that drive initial valuations down well below fair value.
In summary, the best performing spin-offs over the long term are also the best businesses, but in many cases, they were not initially priced as such.
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