An Investment Opinion
The Spin on Palm
Seems kind of goofy, doesn't it? I mean, what's so different about math here in the Western Hemisphere than back in the Old Country? Sure, they switch their commas and periods around (or do we switch ours around?), but last time I checked the multiplication tables were essentially the same.
However, when I look at the equity markets, I see real "New World Math" at work.
I'll give you an example. A really, really fresh one.
Yesterday Palm, Inc. (Nasdaq: PALM), the leading manufacturer of electronic organizers, held its long anticipated IPO. Palm, as you are probably aware, was spun off by 3Com (Nasdaq: COMS). Well, maybe the term "spin-off" is a bit aggressive, because 3Com only sold 5% of its stake in Palm, maintaining 95% ownership. (Though the company is expected to continue to divest itself of Palm shares through further sale and distribution to 3Com shareholders a Palm stock dividend).
Palm's IPO went very well for 3Com, as the shares nearly tripled in value from their offer price of $38 to close just over $95 per stub. I say that the IPO went well for 3Com, but, as I have stated before, I am completely unimpressed with the benefit to the company holding the IPO to leave that much money on the table. At one point yesterday the stock traded at $145.
So 3Com holds 95% of Palm, a company valued at its close today at $53.5 billion dollars. A little back of the envelope math tells us that 3Com's portion of this (95%) is worth in excess of $48 billion. But the entirety of 3Com, including its publicly held assets, only has a market capitalization of $28 billion. So somehow (and this is the New World Math part), the operational component of 3Com is worth -$20 billion dollars.
Those critical of 3Com, as well as those unreformed cynics among us, would probably agree with this valuation of its operations. 3Com is a company that has operational profits. But somehow these profits are so unsustainable that the company's discounted cash flows aggregate to massive losses from operations. Unless, of course, it's the Palm side of things that is out of whack.
Throughout the investing world there are examples of companies that have holdings valued higher than the whole company. Safeguard Scientific (NYSE: SFE) has a smaller market cap than its 13% holdings in Internet Capital Group (Nasdaq: ICGE), IDT Corporation (Nasdaq: IDTC) is worth less than its holdings in Net2Phone (Nasdaq: NTOP), 48% of the total. What's going on here? How is it that the stock values of these holdings are so discounted when they are included in the overall value of these companies? And why does the IPO suddenly add so much value to these formerly subsumed subsidiaries? Think about it -- on Wednesday 3Com was worth $36 billion. On Thursday, after an IPO that added $800 million in cash to 3Com, the market caps of the no-longer linked 3Com and Palm is worth a combined $76 billion? Talk about creating wealth out of thin air.
In actuality, there is a bit of logic as to why this is so. The parent companies hold very large percentages of the spin-offs. These stakes are, however, not liquid in a practical sense. If 3Com were to suddenly place all, or even a large portion of its shares for sale on the public market, the float for Palm would surge and the per share price would drop like a stone. As such, even though the securities are liquid, and they have a market value, the parent company could not hope to get that present value.
So even if the valuations seem completely out of whack, there is a bit of fair market discounting going on. These assets, because they no longer add to the operating revenues for the parent company, are not really, from an ongoing operations sense, all that helpful to the parent company. Unless the subsidiary company is paying dividends, the parent company can only derive benefit if it sells some shares. But to put those shares out on the open market risks upsetting the equilibrium of supply and demand for the subsidiary.
At least that's the theory. And, given the Palm example, where the stock was many times oversubscribed, this makes a great deal of sense. No Fool would sneeze at the intelligence of a company holding on to the equity of another public corporation; in a sense, these companies are doing something very intelligent, they are increasing their own values through the operations of another company. Intel (Nasdaq: INTC) does it, so does Microsoft (Nasdaq: MSFT), and Berkshire Hathaway (NYSE: BRK.A). Holding equity in a company that you (as an individual or a corporate entity) have intimate knowledge of and confidence in makes good fiscal sense.
So how do the parent companies unlock the full value of these public holdings? In all likelihood, they cannot without selling them. But the action surrounding IDT last week gives us a good idea of how the handicapping works. Last week several media outlets announced that AOL (NYSE: AOL) intended to acquire a controlling portion of Net2Phone. Net2Phone's share price has risen in the intervening time since the announcement, but IDT's shares have rocketed up more than 45%. Why? Well, because the beneficiary to the purchase will be IDT, which is who AOL would have to buy the Net2Phone shares FROM. This does a few things: First, it allows IDT to get cash from its Net2Phone holdings, which, depending on the level of the purchase, could mean upwards of a billion dollars in cash to IDT. Second, by selling the stake en masse to AOL, IDT avoids roiling Net2Phone's share float on the open market, since the transfer of the stake would be directly between the two companies.
Very, very good for IDT. Very, very good for Net2Phone as well. And obviously beneficial to shareholders, too. The most serious risk at this point is that IDT would be selling an undervalued asset, though certainly the belief is that an increased level of interest from AOL would be accretive to all parties, including IDT, as it would undoubtedly not be selling its whole stake.
But shareholders in most companies should not count upon large scale transactions to derive full value from their large holdings. In these cases, the valuations would continue to make little sense. As such, we can resort to New World Math to calculate them. Sometimes in the logic of equity valuation 2+2 really does equal 2.
Bill Mann (TMF Otter on the boards)