Avoid These Cash Machines

I love nothing better than finding a company that pours buckets of cash into my portfolio. Private-equity funds do, too, but often the cash they're angling for is yours. They love to make public companies into their own ATMs through a shrewd device that you should beware, and their plundering of companies offers a key lesson for investors like us. Buying the latest IPO from private equity is a mug's game, but another type of company just coming to market – spinoffs – offers investors a serious chance to profit.

Like an ATM, but better
One legendary private equity shop, Kohlberg Kravis Roberts (KKR), has perfected the ability to extract exorbitant sums of cash from companies in a perfectly legal way. Take a look at the recent stunt it pulled on Dollar General (NYSE: DG  ) .

KKR and fellow investors Citigroup and Goldman Sachs took Dollar General private in July 2007 at a cost of $7.3 billion. They released the company back to the public markets in November 2009, offering about 10% of the shares in an IPO and retaining the rest. Following its launch, the company was valued at $7.2 billion.

Now, it looks like Dollar General's investors lost $100 million on the deal, so where's all this profit I'm talking about?

For that, you have to examine how Dollar General was used while it was private. When KKR bought Dollar General in 2007, it and fellow investors put up just $2.8 billion and borrowed the remaining $4.5 billion. At that time, Dollar General had just $260 million in debt, the interest on which it could easily cover with its earnings.

Fast-forward to November 2009 and the IPO. Dollar General suddenly had about $4.2 billion in debt, and its ability to support its own debt was severely crimped. In fact, the business had to pay about 39% of its operating income just in interest. Ouch!

That sudden debt spike shows that KKR and its co-investors simply transferred their borrowings of $4.5 billion onto Dollar General's balance sheet. For their efforts, they took home a 150% paper profit (based on the IPO price), excluding fees and the costs of some rather minimal work they performed in reorganizing Dollar General -- much of which was charged to Dollar General.

As a final kick to the curb, just before making it a public company, the private-equity giant paid itself and other investors a fat dividend, to the tune of $239 million -- more than double what Dollar General earned in that quarter. As a public company, Dollar General doesn't even pay a dividend. And that's not the amazing part.

The amazing part
Of the IPO, Bloomberg quoted one analyst as saying, "It's a good price for investors." If by investors, he means KKR and its cronies, then this analyst is spot-on. But for individual investors like you and me, the deal is an awful mess.

What is utterly astounding, mystifying, and discombobulating about this whole process is that investors buy what KKR is selling. After all, no one's under duress to buy a second-tier retailer, and you could even more easily pick up shares in slow-growing cash cows such as Verizon (NYSE: VZ  ) or Johnson & Johnson (NYSE: JNJ  ) and be none the worse off. Each company has a defensible competitive position, pays a tasty dividend, and has a lower valuation than Dollar General.

But, again, why buy Dollar General? If you must have a retailer, there are quite a few financially sound organizations with good competitive advantages available at cheaper prices. Certainly, that's one reason superinvestor Warren Buffett bought shares of Wal-Mart instead of the latest IPO peddled by private-equity firms.

The key lesson: Beware not only what you buy, but from whom you buy.

When Dollar General hit the markets again, it sported a 26.9 P/E ratio -- a stunning 77% higher than that of Wal-Mart, the world's biggest retailer. Even after it reported substantially increased quarterly income, Dollar General still trades at more than 19 times earnings, still higher than the well-heeled and more secure Target (NYSE: TGT  ) . That's expensive for such a leveraged deep discounter, especially one poised to lose its attractiveness as we pull out of our economic slump and customers return to full-price and "plain ol' discount" retail.

It's little surprise that KKR waited until November 2009 to unleash Dollar General. After all, private equity sells when it estimates the market is highest, and KKR is a private-equity leader for just that very reason. And the unattractive position of Dollar General likely explains why KKR did not spin out the entire company: Investors simply wouldn't stomach this stinky investment in one gulp. Private equity can really pump up a company, but another entity emerging on the market -- spinoffs -- can give investors a big opportunity to profit.

Whither my investment dollars?
In a spinoff, a parent company simply distributes shares in the new business to existing shareholders. According to a study by Lehman Brothers, 88% of spinoffs between 2000 and 2005 outperformed the S&P by an average of 45% in their first two years as stand-alone businesses. Here are some interesting spinoffs that have performed solidly:

Parent

Spinoff

Spinoff's Return

Transaction Date

Altria (NYSE: MO  ) Philip Morris International 37% March 2008
Sara Lee Coach (NYSE: COH  ) 2,311% October 2000
Cablevision Madison Square Garden 24% January 2010

Although spinoffs of large companies can be profitable, you're much more likely to find explosive returns in spinoffs of little-understood small caps, especially if they come from a huge parent such as Altria. Sara Lee's spinoff of the small-cap Coach -- with its 2,311% return in just a decade -- is the poster child here. Cablevision's spin of the much smaller Madison Square Garden has some promise, too. Spinoffs also allow both companies to focus on their operations and allow investors to more accurately value each business.

Even non-conventional spinoffs can be profitable. In mid-2010, Verizon sold assets to Frontier Communications (NYSE: FTR  ) , which was in small-cap territory then. Frontier bought the assets by giving Verizon a massive stake of Frontier's newly issued stock, which Verizon then distributed to its own shareholders. Frontier has gone on to perform well since the deal – up some 30% -- and pays out a hefty dividend near 8%.

Unlike companies pumped by private equity, spinoffs are often in solid financial shape and poised to profit but they're under the radar of most investors. All the better for us!

Come dig with us
While some lucrative spinoffs are high profile, there are many more under-the-radar stocks that offer even better opportunities. If such special situations intrigue you, then take your investing to the next level in 2011 with Motley Fool Special Ops. Membership is strictly limited, so enter your email address in the box below to receive your invitation!

Fool contributor Jim Royal, Ph.D. owns shares in Frontier, Philip Morris, and Johnson & Johnson. Johnson & Johnson and Wal-Mart are Inside Value recommendations. Coach is a Stock Advisor pick. Philip Morris International and Wal-Mart are Global Gains recommendations. Johnson & Johnson is an Income Investorrecommendation. Motley Fool Optionshas recommended a diagonal call position on Johnson & Johnson. The Fool owns shares of Altria, Coach, Johnson & Johnson, Madison Square Garden, Philip Morris International, and Wal-Mart. Motley Fool Alpha owns shares of Johnson & Johnson. The Fool has a disclosure policy.


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