It’s been roughly 4 years since the 2014 spin-offs have become stand-alone public companies. Over this time period, some companies have gone on to be very successful investments while others have generated exceedingly poor returns.
In aggregate, spin-offs have historically been an attractive area for investors to look for opportunities. However, the combined performance of the 2014 spin-offs was bad. The cumulate average returns were well below the S&P 500, the hit rate (percentage of spin-offs that outperformed vs underperformed the S&P 500) was poor, and there were a handful of spin-offs down over 50%.
Despite the performance, 2014 is an especially important year to study because it provides plenty of case studies on the characteristics to avoid.
For 2014, we were able to find 30 separate spin-offs. Since 6 of these companies were acquired, we only analyze the returns data on 24 spin-offs. These 24 companies participate in a wide range of different industries and span the market capitalization spectrum.
With a small sample size of only 24 companies, the data is hardly statistically significant as the overall returns can be materially impacted by just one or two companies. Nevertheless, it is valuable to analyze the performance of historical spin-offs in order to learn from the past and better understand what type of opportunities to look for in the future.
As discussed above, the average performance of the 24 spin-offs from 2014 has been terrible. The cumulative average returns have been roughly flat vs the S&P 500 up nearly 40% since the middle of 2014. The worst performing company was down 100% (declared bankruptcy) while the best performing company was up over 250%.
The Range of 2014 Spin-Off Returns
In the chart below, you can see the individual spin-off returns. The vast majority of 2014 spin-offs underperformed the S&P 500 (green bar) as measured by the S&P 500 ETF’s (SPY) return since 7/31/2014. This is similar to the performance of the 2013 stock spin-offs.
Since the middle of 2014, the S&P 500 has compounded at ~7.8% annual rate. Nineteen of the spin-offs have compounded at a lower annual growth rate and 5 have compounded at a higher annual growth rate.
As we know from the historical spin-off performance results, it is not unusual for the median spin-off company to underperform the index and the hit rate to be under 50%. However, it is unusual to have this many horrible performers (8 of the companies are down by more than 50%).
Deteriorating Energy Markets Impacted the 2014 Spin-Offs
The main reason for the terrible aggregate performance is due to a number of the spin-offs being energy and commodity companies. 2014 was right as the energy markets began to collapse. These companies’ business models are highly dependent on energy prices and many were poorly capitalized at the time of separation. As a result, the share prices were punished.
On the other hand, there were some significant positive outliers with 5 spin-offs’ equity valuation increasing at a 17% CAGR or higher. You can see a summary of all this information in the histogram below.
Many spin-offs from 2014 were burdened with significant debt loads and other liabilities. These liabilities became crushing when the end markets deteriorated and profits declined. On the other hand, some spin-offs from 2014 had many unique characteristics that made them very interesting opportunities and allowed investors to purchase above average businesses at below average prices.
Let’s take a look at the best and worst performing spin-offs from 2014.
#8 NOW Inc. (DNOW)
Now Inc. is a distributor for the oil and gas industry, primarily in the United States and Canada. They spun-off from National Oilwell Varco at the end of May 2014. Since the spin-off, the shares have declined over 50% or ~16% annually.
The spin-off timing was terrible as it came right at the peak of oil. The ensuing collapse in energy prices led to field activity slowing and the rig count collapsing. This severely impacted revenue and operating profits turned negative.
Luckily, Now Inc. was spun-off debt-free so they were able to maintain their solvency during the industry downturn.
#7 California Resources Corporation (CRC)
California Resources is an independent oil and gas exploration and production company with assets in California. They spun-off from Occidental Petroleum at the end of November 2014. Since the spin-off, the shares have declined ~60% or ~21% annually.
The spin-off timing was very unfortunate as it came right as oil prices were collapsing. The continued decline in oil prices led to deteriorating profitability and made projects uneconomic. This severely impacted revenue and operating profits turned negative.
Unfortunately, they were spun-off with significant debt. Management deserves a lot of credit for the company not going bankrupt. They have worked to deleverage the balance sheet while limiting the amount of equity dilution.
#6 Rayonier Advanced Materials (RYAM)
Rayonier Advanced Materials produces cellulose specialties which are used as raw materials to manufacture a wide variety of consumer products. They spun-off from Rayonier Inc. in June 2014. Since the spin-off, the shares have declined over 60% or ~21% annually.
The business has been devastated by weak cellulose pricing and declining volumes. This pushed gross margins down from over 21% in 2014 to ~14.5% in 2017. While their business requires operational expertise and qualifications with customers, the industry dynamics are not strong. They are hindered by high customer concentration and competitors adding capacity despite GDP like demand growth. This has resulted in an oversupplied market.
These negative industry dynamics were amplified as RYAM spun-off with ~$950 million of debt.
#5 TimkenSteel Corporation (TMST)
TimkenSteel manufactures alloy steel as well as carbon and micro-alloy steel. They spun-off from The Timken Company on June 30, 2014. Since the spin-off, the shares have declined over 68% or 23% per year annually.
The business has been hurt by the slowdown in the energy markets and more recent declines in U.S. auto production. Also, the balance sheet has been burdened with debt and pension liabilities.
The combination of declining end market demand, pricing pressure, and a weak balance sheet have hurt the company since the spin-off.
#4 Washington Prime Group (WPG)
Washington Prime Group is a REIT that owns, develops, and manages a portfolio of malls and shopping centers. They spun-off from Simon Property Group in May 2014. Since the spin-off, the shares have declined by nearly 70% or 23% annually.
Shortly after the spin-off, in January 2015, they acquired Glimcher Realty Trust in a deal valued at $4.3 billion. This deal weakened their credit profile by increasing the debt burden and encumbering assets.
Net operating income growth has been challenged as the business has been impacted by the weak retail environment and tenant bankruptcies.
#3 New Senior Investment Group (SNR)
New Senior Investment Group is a REIT that owns a portfolio of senior housing properties in the United States. They spun-off from Drive Shack Inc, formerly Newcastle Investment Corp, in November 2014. Since the spin-off, shares are down more than 70% or nearly 28% annually.
The business has struggled with decreased occupancy and increasing costs. This has resulted in net operating income declining on a same-store basis. These issues are compounded by a highly levered balance sheet and a dividend payout ratio that exceeds their adjusted funds from operations.
#2 Civeo Corporation (CVEO)
Civeo is a provider of workforce accommodations, logistics, and facility management services to the natural resource industry. They mainly provide “man camps” near oil fields and mining operations. They spun-off from Oil States International in May 2014. Since the spin-off, the shares are down by nearly 90%.
The business has been crushed by falling oil prices and the resulting drop in field activity. This has caused occupancy rates and revenue per room to fall. These end market issues have been compounded by a large debt load.
#1 Paragon Offshore
Paragon Offshore was a global provider of offshore drilling rigs. Their fleet included jackups, drillships, and a semisubmersible. They spun-off from Noble in August 2014. Since the spin-off, the company has declared bankruptcy, wiping out equity holders. It was eventually acquired by Borr Drilling in February 2018.
The spin-off timing was very unfortunate as it came right at the peak of oil. The ensuing collapse in energy prices led to fleet utilization and dayrates declining. As a result, they could not service their large debt load and had to file for Chapter 11 bankruptcy protection.
It is a good exercise to go through the worst performing spin-offs from prior years to learn the characteristics that made them poor investments.
Characteristic #1: Commodity Business Risks
Each of the poor performers highlighted above except for the two REITs had commodity end markets that deteriorated.
Commodity-driven businesses face a “triple whammy” if/when their end markets turn against them.
- Pricing Declines
- Volume Declines
- Operating profit declines more than revenue because the company still has fixed costs
The table below demonstrates this dynamic.
In this example, pricing falls 10% and volume falls 5% which results in revenue falling ~15%. However, operating profit falls by nearly 30% because fixed costs do not decline as revenue declines (increase as a % of sales from ~33% to 39%).
As a result, these businesses are very difficult to forecast and can result in permanent losses of capital for investors if purchased at expensive valuations.
Characteristic #2: Poor Balance Sheets
Each company highlighted above except for NOW Inc. had balance risk when they spun-off. Balance sheet risk can come in the form of high levels of debt or other liabilities (environmental, pension, etc) that have a claim on the company’s assets before equity holders.
When analyzing companies that are being spun-off with a large debt load, it is important to not only analyze the leverage ratios to understand the balance sheet risk, but also to think through the business model. Two companies with the same leverage ratios can be vastly different credit risks.
Investors need to consider a company’s cyclicality, how well they convert EBITDA into free cash flow, competitive threats, and capital needs.
A company with recurring revenue and recession resistant business model that efficiently manages its invested capital is a very different credit risk than a capital-intensive, cyclical company that is completely driven by commodity prices despite having the same leverage ratio.
Characteristic #3: Commodity Business + Poor Balance Sheet = Wide Range of Outcomes
This is another way of saying that the equity of a company which has both operating and financial leverage is very difficult to value. This point is best illustrated in the table below where the financials are the same as the table from Characteristic #1, but now with debt in the capital structure.
In this example, sales declined ~15%, operating profit declined ~29% (because of the negative operating leverage from the fixed costs), and the company continued to trade at a multiple of 10.0x EV/EBIT. This combination of factors will lead to an even greater decline in the equity value of the business (-45%) because of the debt load.
Furthermore, the company’s credit profile became even riskier as Total Debt/EBIT increased from 4.0x to over 5.5x. This could increase the company’s borrowing cost and push them to raise capital through more expensive securities such as convertible bonds, preferred equity, and/or common equity.
The reason why the 2014 worst performing spin-offs are down 70%+ plus is because they are commodity businesses with operating and financial leverage. It just so happened that they spun-off at a time when their end markets took a turn for the worse.
#5 CDK Global (CDK)
CDK provides software and technology solutions for automotive dealerships. They were spun-off from ADP in October 2014. Since the spin-off, the shares have compounded at a ~17% annual rate.
Soon after they spun-off from ADP, a handful of activist investors recognized that CDK was significantly underearning relative to their potential. The activist investors bought significant positions in the company and obtained board seats. Over the last few years, CDK has improved their margins through restructuring, improving the sales process and customer service, as well as outsourcing and consolidating facilities.
These efforts have helped to improve adjusted EBITDA margins from the low 20% range to the mid-30% range since the spin-off.
#4 Keysight Technologies, Inc. (KEYS)
Keysight is test and measurement company for electronics and communications equipment that serves a wide variety of end markets. They spun-off from Agilent in November 2014.
Since the spin-off, the shares have compounded at a ~17% annual rate. Historically the business did not grow much as it was run purely for its cash flow. However, Keysight has transformed as a stand-alone company.
They have increased research and development spending and reorganized their business groups to better serve their customers. These investments, along with favorable end markets, have greatly impacted results with the revenue increasing, margins improving, and the bottom line growing at a double-digit rate. Also, they are investing in developing software solutions (the number of software engineer employees increased by ~65% from FY 2014 to FY 2017) in order to offer additional services to customers and improve their revenue mix.
#3 KLX Inc. (KLXI)
KLX Inc. is a distributor of aviation parts and services to the aerospace industry. The business also contained an energy services segment.
KLX Inc. was spun-off from B/E Aerospace in December 2014. The aerospace business slowly grew, but the energy services business was severely impacted by the weak energy markets.
Then in May 2018, they agreed to sell themselves to Boeing for $63 per shares following the spin-off of KLX Energy. This was the next step for the Chairman and CEO Amin Khoury, who also founded B/E Aerospace.
The shares compounded at a ~18% annual rate (including the KLX Energy spin-off) from the time of the spin-off through being acquired by Boeing on October 9th, 2018.
#2 ONE Gas Inc. (OGS)
ONE Gas is a regulated natural gas utility in the United States. They distribute natural gas to primarily residential customers in Oklahoma, Kansas, and Texas. ONE Gas spun-off from ONEOK, Inc. in January 2014.
Since the spin-off, the shares have compounded at a nearly 20% annual rate. This is remarkable performance for a utility company. ONE Gas benefits from operating in some of the best states for utilities and low natural gas prices which makes it the cheapest source of electricity in many of their markets. This has allowed them to slowly narrow the gap between their earned ROE and allowed returns.
However, there is a premium priced into the shares from the flight to safe dividend stocks in this low interest rate environment and an M&A premium from other natural gas local distribution companies being acquired by larger utilities.
#1 Kimball Electronics (KE)
Kimball Electronics is a contract manufacturer of electronic components used in automotive, industrial, medical, and public safety industries. They spun-off from Kimball International at the end of October 2014.
Since the spin-off, the shares have compounded at a ~38% annual rate. The contract manufacturing industry isn’t known for producing high-quality businesses. In general, the industry is plagued by intense competition and low margins. With these industry dynamics, how has Kimball Electronics been able to return multiples since the spin-off?
First, the economy has been good which has allowed sales to grow at a nice rate since 2014. Second, the company was spun-off with significant cash and no debt. Lastly, it traded at a rock-bottom valuation post-spin-off.
The combination of a stable economy, healthy balance sheet and a cheap valuation led to an attractive rate of return despite the average business quality.
It is very helpful to go through the best performing spin-offs from prior years in order to learn the characteristics of these companies. This gives investors different frameworks to draw from when analyzing upcoming spin-offs.
Characteristic #1: Above Average Businesses that Weren’t Valued as Such
Both CDK Global and Keysight Technologies are above average businesses but were valued as merely average businesses when they spun-off. In the case of CDK Global, there was a large margin opportunity that wasn’t initially recognized. At Keysight, the business has been able to grow at much higher organic growth rates than anticipated.
Characteristic #2: Strategic Assets
ONE Gas’ assets are in some of the best states and they are an attractive asset for larger utilities (as evidenced by the recent M&A in the space).
Characteristic #3: Insider Interest in the Spin-Off
When KLX Inc. spun-off from B/E Aerospace, the Founder, Chairman, and CEO of the company went with it despite it being much smaller than the Parent Company. Given his involvement in the new company, it didn’t take a leap of faith to believe that he would do everything he could to position KLX Inc. for future success.
Characteristic #4: Cheap Absolute Valuation
Kimball Electronics spun-off with a significant amount of cash and at a very cheap absolute valuation. The parent company, Kimball International was an oddball company with two very different segments, Kimball Electronics and a furniture business. The cheap initial valuation could have been due to a few characteristics found with spin-offs including the dynamics of a small market capitalization, analysts that weren’t going to cover it post-transaction, and significant cash on the balance sheet.
The overall performance of the 2014 spin-offs was terrible. Nineteen of the twenty-four (~79%) spin-offs tracked underperformed the S&P 500. While it’s not uncommon for the hit-rate to be below 50%, the results from 2014 really stood out. The common themes from the worst performing companies were risky balance sheets, cyclical businesses, and poor timing (top of the commodity cycle).
The characteristics of the best performing businesses were more widespread but attractive initial valuation and opportunities for improving fundamentals were the most common.
Similar to the review of the 2013 spin-offs, this study stresses the importance of understanding the business model, capital structure, and incentives of the insiders when analyzing spin-off investment opportunities.
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