Spinoffs make great opportunities, especially when many stocks seem expensive. Fortunately, the spinoffs just keep coming.
Before eating our dessert, we've got to eat our vegetables. So grab your copy of Joel Greenblatt's You Can Be a Stock Market Genius and turn to page 56, where we'll review some of the keys that make spinoffs great and helped Greenblatt earn 40% annual returns.
One reason companies spin off certain businesses is to get rid of redheaded stepchildren. That way, the unloved or "bad" business can stop taking time and resources away from the crown jewel. But, as Greenblatt points out, sometimes that is exactly what the bad boy needs in order to straighten his life out.
Even unloved businesses can thrive under these new circumstances, especially if management receives the right incentives. Before a spinoff, these businesses had to carry their weight as a part of a larger group, but afterward, they can sail alone with good captains who stand to make a bunch of money -- and that can be a precursor to investor success.
The prices we pay dictate the returns we generate. Many times, large institutional investors will simply sell a spinoff, sometimes indiscriminately. This tends to put pressure on the price of a spinoff in the first year, a good thing if you're looking to make oversized returns.
Leverage is a scary word. It can kick-start returns, but it can also suck the life out of them. Sometimes the parent business loads up the offspring with debt and then sets it free. It's important to understand whether the stand-alone business can handle the leverage. For example, Verizon (NYSE: VZ ) recently spun off Idearc (NYSE: IAR ) , the directory services company. It's almost completely capitalized with debt, yet that's probably a good thing, since the company is mature and generates plenty of cash to handle the interest payments.
A classic in the making?
Broadridge Financial (NYSE: BR ) sprung from the loins of Automatic Data Processing (NYSE: ADP ) in March. This one has all of the makings of a classic spinoff.
Broadridge is in the brokerage services support business. It has three businesses, listed in order of revenue generated: investor communications; securities processing; and clearing and outsourcing. Investor communication and proxy management is a lucrative business, but it's not a fast-growing one, and it faces some uncertainty as technology changes the nature of investor communications. That's why it was the unloved part of ADP.
Management didn't come with a huge ownership position, in contrast to another spinoff situation, Omega Flex, from a few years back. But it does have options grants and a little more freedom to allocate capital to new growth opportunities.
ADP did load the child up with debt -- $690 million worth. With this debt, Broadridge paid ADP a dividend, which ADP will use to return capital to its shareholders. With about four times more earnings before interest and taxes than interest payments, the debt-to-equity ratio of 0.73 is not that scary and could juice up returns.
Over the first few days of trading, the price dropped from $20 to as low as $18 per share. Some of that price pressure was due to index funds holding ADP dumping its newly acquired Broadridge shares. While I am sure there will be more selling, I don't know how far the price is likely to drop. Unfortunately, the cat is out of the bag about spinoffs (Greenblatt did write a book) and there's plenty of money looking for these kinds of opportunities. Still, keep your eyes open for attractive prices.
A couple to watch
There are some others on my watch list, too. Industrial giant American Standard (NYSE: ASD ) , which makes lots more than toilets, plans to sell its bath and kitchen business, spin off its vehicle control systems business, and keep its air conditioning business. Following the transactions, the air conditioning business will be renamed Trane after its main brand and the vehicle control system will be named Wabco Holdings. C'mon, management -- I think we can find a better name than Wabco.
Safari Holdings would be a head-turning name, but it's already taken. It is going to be an institutional pharmacy business created from spinoffs from Amerisourcebergen (NYSE: ABC ) and Kindred Healthcare (NYSE: KND ) . There's some leverage involved, so since Amerisourcebergen is a pretty big company, there may be some selling pressure.
To get the complete lowdown on these and other spinoff opportunities, go to the SEC's Edgar website and look for new 10-12B filings.
The Foolish bottom line
I don't think there are that many "great company, good price" bargains out there today. There are plenty of great companies, just not that many good prices. That's why I am looking for opportunities from spinoffs. They're known to beat the market, especially if you pick and choose from the best situations.
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Retail editor and Inside Value team member David Meier is ranked 992 out of 27,496 in CAPS and has a spinoff in his CAPS profile. He does not own shares in any of the companies mentioned. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.