How to Handle Spinoff Shares

In this episode of Industry Focus: Energy, Nick Sciple and Motley Fool contributor Lou Whiteman do a deep dive into the spinoff of United Technologies and Raytheon Technologies (RTX -0.74%), Carrier (CARR 0.54%), and Otis (OTIS 0.32%). They rate them from most favorable to least favorable for investment and give a detailed analysis of each. They also suggest some other stocks to keep on your radar.

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This video was recorded on April 30, 2020.

Nick Sciple: Welcome to Industry Focus. It's Thursday, April 30. I'm your host, Nick Sciple. Joining me today is Motley Fool contributor Lou Whiteman. Lou, how's it going?

Lou Whiteman: I'm doing all right. How are you doing?

Sciple: You know, I'm hanging in there. I know you're in Atlanta, you know, craziness going on in that neck of the woods, you know, you've got family that works for the CDC, lots of stuff going on with opening up the economy over there. How are you feeling with the current state of the world over in your neck of the woods?

Whiteman: I’m going to steal this from someone on Twitter, but between us leading the way, shall we say, and reopening, and the fact that the governor just said teenagers don't need to take a driver's test to start driving to get their license. The one thing to come out of this pandemic is nobody's going to want to visit Georgia. [laughs]

Sciple: There you go. Yeah, watch out, everybody on the roads in Georgia, we’re going to have a lot of inexperienced drivers driving around.

Whiteman: I don't understand how that's a good idea, but yeah. [laughs]

Sciple: All right. We've got a fun show today. We’re going to be diving into United Technologies. We discussed this company a few times on the show in the context of this upcoming split-out of several different companies. Raytheon Technologies, Carrier Air Conditioning, and Otis Elevators are going to be spinning off of that company. And we got a question from Vinny, asking us to dive into some of those companies.

So Vinny asks, “Love the podcast, you guys are the most focused of the podcast from The Motley Fool and full of great nonconventional investment tips. I'm curious if you could do a podcast on Carrier and Otis. I'm sure many of us have inherited shares when United Technologies and Raytheon merger. I'm not sure what to make of their valuations and debt levels and whether to buy, sell or hold them. Thanks for continuing on in the age of coronavirus. Sending you a virtual Corona beer.”

Vinny, thanks for sending in that question. I just want to remind everyone to find your beach in this time of coronavirus, that's [...] So I think that's an important thing. But I think one of the points Vinny touches on is the idea of you're going to be holding these shares. You held United Technologies, and now you’re going to be left with shares of Carrier and Otis. It’s this conundrum that a lot of people have when they own shares in a spinoff. And that's part of the reason why there's a lot of famous investors that call off spinoffs as an attractive area to invest in.

There’s one quote from Peter Lynch that says, “Spinoff companies are often misunderstood and get little attention from Wall Street. Investors often are sent shares in the newly-created company as a bonus or a dividend for owning the parent company. And institutions, especially, tended to dismiss these shares as pocket change or found money. These are favorable omens for spinoff stocks.” That's a Peter Lynch quote.

So Lou, when you look at this, obviously, there's a natural constituency of sellers for these stocks. They get these new shares that weren’t in the company originally held, but there's not a natural group of people out there to buy the stock. When you get a spinoff stock pushed to your portfolio, how do you handle those shares yourself?

Whiteman: Well, I think it's important to look at the spinoff and look at what's going on in the company leading up to it. You know, we talk a lot about conglomerate discount, which is an outside looking in, where maybe the market doesn't fully value the sum of the parts. The important thing to remember with these companies is there is an internal tension too, where you have different businesses with different capital allocation needs, different growth trajectories, all kind of competing for resources and intention inside the parent. Often, a unit can get neglected, or its best interests may be sacrificed for the greater good. You see an opportunity but the capital isn't there because it's going elsewhere. These are the sort of narratives that can set up very interesting spinoffs. So when I look at spinouts, I think it's important to look at the narrative, look at what led up to it. Is this a viable stand-alone business that maybe has opportunities out on its own, or is this just a part they didn't want any more or a way to dump liabilities? It’s very important to look at the individual case and see what's going on.

Sciple: Absolutely. You mentioned that increased focus, and that's part of another quote that I pulled from Michael Mauboussin, and a lot of people would be familiar with his work, he does a lot of deep research into the factors that drive returns for stocks, and he says, on the spinoffs, “As researchers who do a meta-analysis, more than 25 papers in the spinoffs literature summed up their findings this way. The main conclusion is consistent; spinoffs are associated with strongly significant abnormal returns. And they suggest the factors that explain these wealth effects include sharpened focus, better information, and in some cases, tax treatments.” So in the cases of these spinoffs, and we'll talk about some later, their position to take the cash that they're producing in their business and focus it toward the priorities relevant to that, what was once a subpart is now its own company on its own.

I do want to, before we go into these three companies coming out from United Technologies -- you mentioned cases where sometimes a spinoff is some asset that the company can't find a market for, they choose to spin it out just to, kind of, get it off their books and remove that anchor from the core company. Given these new spinoff shares, how do you decide or reach the conclusion that this is an attractive company to hold on to or not? And do you have any examples of cases in the past where, “Hey, this spinoff was a clear case of the company cutting loose some deadweight?”

Whiteman: Sure. Well, like I said, I think it's important to look at the narrative, to really look at what's going on. A good example from recently, in the same sort of sector, is Honeywell Technologies. In 2018 they spun-off two businesses, just like United Technologies is doing, and in a way, they were at least a little similar. Garrett was an auto company, but Resideo is somewhat similar to Carrier, and it was home automation tools, things like that. Garrett is off 71% since the spinoff. Resideo, I think, is down over 80%. The auto business wasn't where Honeywell wanted to be. They had an activist breathing down their neck, there were calls for them to sell the entire company, to do something. They took two parts of the company that were maybe less attractive and basically said, “Shareholders, it's your problem.”

Garrett is in litigation with Honeywell, claiming that Honeywell basically used it to dump their asbestos liabilities on them. I mean, this was just -- hindsight is 20/20, of course, but you could look at the pressure the company was on, look at the type of business where you spun out and say, “You know what, they don't want these businesses, why should I?” And that's certainly not always the case with the spinout, but that does happen with spinoffs, and it's something that investors need to look at.

Sciple: Yeah, Lou, we talked before the show. You had mentioned Ed Breen. He is someone who is known as, kind of, the king of spinoffs. How has he used spinoffs in the past?

Whiteman: So yeah. Ed Breen is the god among us in this topic. Old-timers will remember, he took over Tyco International company, I think, 2002 he stepped in. That was right around the time that company was floundering. Dennis Kozlowski was famously on his way to jail. A lot of people, myself included, thought that Tyco’s best days were over. Breen came from Motorola, another company long gone, to organize the company, which was a very sprawling list of assets, split it into three companies. The one part he stayed with, he split into another three. And we have five, six companies there that most of them are still out there as independents. It's everything from security systems, healthcare. He turned what looked like manure at the time into gold.

He then turned around and did the same thing. He took over DuPont a few years ago, merged it with DOW. The new DowDuPont then split into three companies, and he's still with the new DuPont, and they're looking at splitting again or divesting again. He has a real track record of -- he sees businesses that should be together and sees businesses that would be better off on their own. Frankly, given his track record, I give the benefit of doubt that anything he wants to do in terms of corporate reorganizations. [laughs]

Sciple: Right. And so, Ed Breen isn’t associated directly with this United Technologies spinoff, but he's just an example of someone who, over years and years and years, can use this strategy to create lots of value for shareholders. And you know, as the quotes I mentioned earlier for Michael Mauboussin and Peter Lynch suggest, that this is an area where a lot of legendary, sophisticated investors look for value.

And so, going into these United Technologies companies. Now, today, since there's three of them, I thought it would be fun to use the whole good, bad, and the ugly framework to talk through how we're viewing these companies. And that's not to say that I think all of these companies could be good investments under the right circumstances, but given the market environment today, as these companies come spinoff, if we had to force these companies into these three categories: good, bad and ugly of Otis, Carrier, and Raytheon Technology.

So first, we got to start with the good news first. Who would you label the good from the United Technologies spinoff?

Whiteman: Well, I think good in terms of just set it and forget it, right now it has to be Otis. This is a $13 billion-sales elevator manufacturer and maintainer. I think everybody knows the Otis name. We’ve all used their products a lot. This is a company that you know exactly what you're getting. It’s slow growth, but it is huge, huge aftermarket sales. All of their 2 million units installed internationally have to be serviced. You can't really skimp on that with regulations. Service makes up more than half of their revenue and 80% of adjusted operating profit. Their service margins are north of 20%, new equipment is less than 10%. This is a company that you know what you're going to get. They aren’t a fast grower, but they generate cash, they return that cash to shareholders, and it is a really interesting company for someone who is income oriented or looking for a dividend payer.

Sciple: Yeah, Otis is a really interesting company to me. The elevator industry, very sleepy, old industry, has been around for 100 years. When you look at the market share in the industry, it's really, kind of, there's a lot of players, but really there's four dominant people in the industry. There's Otis that is the leader in market share. And then there's Schindler, Kone, and ThyssenKrupp that kind of round out that top four. And they really, really dominate this market. So you have a tight oligopoly market.

And then, as well, something that helps this business, you mention the servicing aspect of the business, which gives them an opportunity to earn revenue that is much higher margin than you would expect from someone making these giant industrial products like elevators. And so that's an opportunity for growth and recurring revenue for them over time. There's a flywheel of you install the elevator, and then you have servicing that creates dependable revenue over time.

But what's particularly interesting about the servicing to me is given the safety concerns throughout elevators, they’re in lots of buildings, there are requirements, regulatory requirements, to have these machines serviced on a regular, consistent schedule. So you've got this industry that's very consolidated, that gives this opportunity for servicing revenue, and then your customers are required to pay for that servicing.

Whiteman: In good times and in bad too. In this environment right now, all of the Fortune 500 are looking for ways that they can save money, nobody is going to say, “Let's just put off servicing the elevators for a couple of years.” [laughs]

Sciple: Exactly. One of the greatest things to have as a business is a revenue stream that the law says, “Your customer must pay.” And there's a few of them out there. You look in the financial services industry, you know, you're not going to stop getting your trash collected. There's a few out there. And I think Otis is in one of those categories. And you know, one of the things I have joked about when I’ve talked about this company in the past, is you throw this servicing in there, it's an EV-as-a-service, right? It's elevator-as-a-service, which you know, when you have an elevator company, you don't think of recurring revenue and all these sorts of things.

You did mention, Lou, that this is the type of stock that could be good for someone who is interested in income. When you look at the dividend for Otis today, does anything stand out to you about that at all?

Whiteman: Well, I mean, their commitment to the dividend I think is worth mentioning. You know they are a new company, so they had to lay out what they see for the future. Their goal is a 40% dividend payout ratio. So basically 40% of their net income is going to go to the dividend.

The bad news there is, there's not a lot of R&D going on, there's not a lot of growth potential there. As you say, this is an industry that has consolidated down. You're not going to see a big jump when they get bought out by a competitor. There's not much chance they're going to buy a competitor. But I mean, their revenue is not going to grow year to year that much, but they have money coming through the door, and they are very good at turning around and giving that money back to shareholders.

Sciple: Right. Yeah. So particularly on the equipment side of the market, there's not going to be a lot of room for growth just because we're not throwing up tall buildings every other day. There is demand for replacement on this equipment, you know, as these things are getting more modern. They’ve actually talked about -- I think in recent earnings call were talking about that they’re getting some software-as-a-service revenue from things like these updated elevators, where if you want to be able to call the elevator for your apartment on your phone while you're still in your apartment, that they can charge servicing revenue. So I think the real opportunities for them are going to be -- another thing to note as well is that the servicing market is a little bit more fragmented than the original equipment manufacturing market. So it's not just these big four players that are playing in the servicing market. But I think, really, the story for this company is that, you know, the equipment side of the market, actually, physically making the elevators is going to be pretty steady over time, I don't think it's going to change. Where they could have some outsized returns will be if they could grab market share in servicing.

And I think if you look -- you know, we talked about earlier, when you come out of these spinoffs, increased focus on the core business can be an advantage. And I think if you look over the past several years, Otis has trailed its competitors in sales growth, that sort of thing. Maybe that's because it was already very large, and so there's just limits in how much more you can grow, but there are some prospects for this company now that's spun off, independent, on its own to maybe pick up some of that lost ground on its competitors when it comes to growth rate and that sort of thing. We'll have to see, but I think this is one of those companies that you can see how on its own it can be a little bit more attractive than when you have this asset buried inside with lots of other assets, because you can't really see some of these flywheels from the recurring revenue and that sort of thing.

Whiteman: Sure. Yeah, and I do think there is opportunity. I mean they haven’t -- China is where the growth is for the industry, and I don't think that they would consider themselves -- I think they can do a better job in China with the new equipment sales, and that, of course, could trickle down to more servicing. So there is incremental growth. And as you say, with better focus, there are opportunities.

Sciple: Yeah. We shall see. So moving along in our framework of good, bad, and ugly from this spinoff, who would be the bad in this framework for you, Lou?

Whiteman: Well, with the bad, we're going to have to go with Carrier. And being in Georgia, I can't really say too much bad about Willis Carrier, the guy who invented the air conditioner and the reason we're all here. Carrier is that HVAC company to this day: They are heating, ventilation, air conditioning, cooling. They have expanded into, they're already selling building owners and building managers, building construction. So they also sell other tools for the building. They have a fire and security. They have diversified into commercial refrigeration of the air conditioning. This is an $18 billion company. HVAC is about 50% of sales. They are pretty well diversified globally. About half of their business is in the Americas and another 30% Europe.

This is also an industry that should benefit from a lot of so-called megatrends. We're urbanizing, which is bigger buildings, more commercial air conditioning systems. The middle class; the emerging middle class around the world, air conditioning is something that you associate with people coming into the middle class. Global warming, both as an opportunity of the world is getting hotter but also on the regulation side, we need more efficient systems and it's causing older buildings to need to overhaul their HVAC. There's a lot going for this industry in the addressable market.

Unfortunately, this is also sort of viewed as the weak link inside United Technologies. This company, for one, they're coming out with a lot of debt. They’re going to have about $11 billion, $11.4 billion in gross debt. This is a company that was in need of a turnaround. They'll now have the attention on it. Management hopes to take out about $600 million in costs by 2022; that was prior to the pandemic, and who knows what that means now. But this is a company in an interesting market, but a company that is in need of a turnaround or needs a fresh start.

Sciple: So Lou, when we talked about Otis just a second ago, we mentioned that consolidation in the market. Are there any similar dynamics at play in this air conditioning market that the Carrier plays in in the HVAC market?

Whiteman: I think there is potential there. We have seen some deals. I mean, I've been covering United Technologies for years. I believe they shopped Carrier pretty heavily before the spinout. There's some language in some of the regulatory filings that almost suggests that, I mean we can't prove that, but suggests that. You know, the issue for them -- I just talked about their debt. In this macroeconomic environment and with their debt, they can't be a buyer, and they're not very attractive as a target. I mean, I think they would work so well with the newly reconstructed Johnson Controls. Johnson Controls has shed their auto business, they've shed a lot of their conglomerate. That's another interesting spinoff that we get into sometimes. Johnson Controls would fit in very well with what Carrier is doing and create a real powerhouse that, kind of, goes well in this industry. It's hard to imagine that happening for a few years. I still think that could happen, but you know, for now, this is an industrial manufacturer in need of a restructuring and a high debt load heading into a potential recession. And that's a tough place to be.

Sciple: Yeah, Lou, you mentioned that picture, obviously, relayed only at the bad in this case. So of these three, probably the least excited about owning, I would say, Carrier would be. However, you know, we were talking before the show. Stephen Tusa, who's an analyst at JPMorgan Chase, has done some great work on GE over the years, has come out with a note a week or two ago. Where he called Carrier “once-in-a-generation opportunity, focusing on its trading at a significant discount to its peers.” Calling out that Carrier as a brand is very well-known in its space, you know, a very strong company.

One of the important tenets of his once-in-a-generation opportunity thesis, however, is that Carrier could be divesting some assets to get that debt picture under control. So I know you've read some of Stephen Tusa’s analysis, what are your thoughts on his arguments that this actually could be a great opportunity to buy Carrier today?

Whiteman: Well, first of all, I should say, Tusa has been right about GE every step of the way, and people should follow him very closely there. And I have all the respect in the world for him. All I'd say about his report is, I think his quote was, “Management has some wood to chop,” was how we put it. And, yeah, I think he's right. If everything goes well, he called the balance sheet stretched today and recommended divestitures, recommended a lot of work. Yes, he is correct. If all goes well, if they get the debt down, maybe if they trim some assets, maybe if they find some opportunities, this is a strong brand and can be a good company. Just don't underestimate the word “if” in that sentence; there is a lot of work to do to get there. Not saying Carrier should be shorted down to zero. Of these three, though, clearly, to me, this is the least attractive to hold for the next few years.

Sciple: Yeah, I agree with you much, Lou. By process of elimination, good, bad, and the ugly. Well, we've already gone through two, so that means the ugly is Raytheon Technologies, the company that is formed out of the merger of Raytheon and the aerospace division of United Technologies. When you look at this company, why is it the ugly, Lou?

Whiteman: This is by far the biggest of the three companies. With the Raytheon assets included, this is a $74 billion company. And interestingly enough, United Technologies -- we talked about Honeywell was the target of activism. United Technologies was too. Bill Ackman was very much involved in what was going on. And Ackman really liked the aerospace business and really didn't want to see the Raytheon deal done, because he thought we were going to dirty this commercial business with a lot of defense business. And boy! Has the world changed [laughs] in a short amount of time there.

United Technologies makes Pratt & Whitney engines. We know about that very well. A few years ago, they bought Rockwell Collins. So they also are very big in commercial, especially interiors, but also the cockpit systems for defense applications. Raytheon was missiles, sensors, a lot of space. Raytheon is the rare defense contractor that doesn't make a lot of heavy equipment, but they do make a lot of the brains and a lot of the sensors that go into this equipment.

The argument for this deal was, we would combine a strong commercial business with a strong defense business to have a more stable long-term play. The commercial people didn't like it, the defense people didn't like it. United Technologies looks really smart doing this, Raytheon maybe not so much, because with this pandemic, we're seeing aircraft demand go to near zero. We've been talking a lot about Boeing. Boeing is seeing three to five years before commercial airspace recovers.

All of a sudden, this is still a great business. Pratt & Whitney engines aren't going anywhere, but all of a sudden, this legacy United Technologies aerospace business has just got a difficult road ahead. I mean, a lot of these commercial suppliers are down 50% or more year to date. Having this Raytheon asset, this is a great time for them to have it. It’s attractive, it's interesting, but for the next couple of years between the integration and the commercial slowdown, it could be ugly.

Sciple: Yeah, well, on the commercial part of this business, the analogy I keep thinking about is like, you know, when you go out for New Year's Eve and you get really dressed up and, you know, you're going to be really fancy and you’re going to go out to your New Year's Eve party and you’re having a good time.

Whiteman: No, I have no idea about that, but go ahead. [laughs]

Sciple: Yeah. Well, and you have a really good time on New Year's Eve, and then you wake up New Year's Day, maybe 11:00, 12:00, maybe if you had a really good time, 1:00 in the afternoon, and you're looking really rough. I would explain that analogy of, like, the pre- and post-COVID of what these United Technologies assets are really. I mean, it’s the same assets, but you went from looking as best as you possibly could with airline travel probably as good as it's been in years, the economy going on all cylinders, to nobody's going anywhere, everything is shut down, and just overnight how quickly that narrative shifted.

When you look at the debt profile of these companies as well, you had some notes on how these sing together. The commercial part of the business was much more levered up than the defense part of the business of Raytheon. Can you talk about that a little bit?

Whiteman: Yeah, I think coming into the deal, the legacy United Technologies, they had brought about $24 billion worth of debt to the combination. Raytheon had about $2 billion, so that's $26 billion in total debt on about $75 billion of sales; it’s manageable. But yeah, no, I mean, imagine this business, as you said, the hangover or the morning after, if United Technologies stand-alone commercial was out there today with $35 billion, $40 billion in mostly commercial sales and $24 billion in debt, and really just falling off a cliff revenue-wise for the next few years, that would be a very different situation. Now, suddenly, you have a +$70 billion military backlog to fall back on.

The new Raytheon Technologies just beat out Lockheed Martin in a big missile competition. The Pentagon ended it two years early because they were winning. So let's get going with it.

The combination looks pretty darn good right now versus United Technologies stand-alone. I would argue for Raytheon holders 5, 10 years down the line, commercial will come back and you'll be glad you're part of this business then too. But the payoff for United Technologies holders is immediate.

Sciple: And then the question I have, Lou, is obviously, we've labeled this Raytheon Technologies companies, the ticker is RTX, I just want to note that, because there's been a change since the merger was completed. But, obviously, we've labeled it the ugly. There's a lot of uncertainty around when commercial air travel could return to where it was pre-coronavirus or if it ever will return to that peak after this, but when you're -- you know, obviously, there's a scale. How ugly would you say this business is right now, given those question marks? You know, how much would you have to hold your nose to go buy the stock right now?

Whiteman: So I have no doubt commercial air traffic will return, and feel free to email me on that, because [laughs] I know it’s far from certain, but it will return. It is going to take time. To buy it today, here's how I would look at it. And I follow airspace pretty closely. I look at, you know, some of my favorites, Lockheed Martin, I look at General Dynamics that is somewhat beaten down due to Gulfstream, so they have some of these issues too, but they are in a much better place.

Raytheon Technologies today, for the next year, holding it in next year to two years when these other opportunities are out there is pretty unattractive to me. Over the long-term, if you have these shares, I would hold it. I really believe that the combined company, they will get it right, and over the long term this will be an outperformer. But you know, it's a 3 or 4 out of 10, tops, as far as just buying in now instead of buying some of these other companies that just don't have the challenge.

You know, the integration alone, even in good times would be, you know, a challenge, and who knows how those go, add in this commercial issue. Why sit on these shares for now? You’ll probably buy them for the same price a year from now?

Sciple: That's a great point -- the integration. You think about, you’re coming together with your new coworkers and, you know, all your offices are closed and all that sort of thing. I mean, that's got to add a whole 'nother layer of complexity to this. As far as holding your stock, what you would do going forward, to go back to Vinny's question off the top of the show; if you're someone who held United Technologies coming into this spinoff, given the discussions we've given around Otis, Carrier, and Raytheon Technologies, the successor company, you get these spun-off shares, what are you doing with them right now? Are you holding them all? Are there any that you're selling? What would you do?

Whiteman: You know for me, personally, if there's any I sold, it would probably be the Otis, just because that's not the profile of a company that I'm interested in. I don't necessarily think I'd be in a hurry to sell any of them. I wouldn't be in a hurry to buy any of them, because again, the dividend play with Otis is not really what I'm looking for. But there isn't a stinker in this bunch. I don't think this is going to be a repeat of what we saw with Honeywell and its spinoffs. And I think over time, all of these businesses can become something. I mean, even in the worst case, I think Carrier will end up in the arms of someone else, or it will work out.

So I would probably just hold tight to all three and see how it goes. They may not be the best performers for the next six months, but that's not the game we're playing.

Sciple: Absolutely. Long term is the only game that matters. So finally, Lou, before we go away, I know you follow a lot of different stocks, a lot of different spinoffs. Any other of those, any other spinoff companies that our listeners should be aware of to keep on their radar?

Whiteman: So here's one for the radar only, because you should not buy this company right now, period, today, based on what we just talked about with commercial airspace. But it's a company called Howmet Aerospace, HWM is the ticker. And you don't know this company, but you know it's legacy. Alcoa, the aluminum maker, last decade had this idea that they wanted to get into more finished products. So instead of just making the raw material, they bought up a lot of companies that make things with aluminum, including a lot of aerospace assets. That didn't go so well, so they spun that off into something called Arconic, which also didn't do so well, so now Arconic has split in two, and Howmet is the remaining aerospace business. They were always good assets.

The guy in-charge of Alcoa, way back when they put it together, did a terrible job integrating them. This is a turnaround story in a bad environment, but long term, I really like the assets they have and it should have worked out; with better management, quite frankly, it would have worked out better back in the beginning. And I think there is great potential for this business. I just don't really have any desire to buy into a commercial-focused airspace business until we have more clarity about what's going on.

Sciple: Right. So Howmet Aerospace -- can you give us that ticker one more time?

Whiteman: HWM. Brand new in the last few weeks.

Sciple: HWM. All right, folks, add that one to your watch list. Lou, thanks for coming on the show, as always.

Whiteman: Thank you.

Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear.

Thanks to Austin Morgan for his work behind the glass. For Lou Whiteman, I’m Nick Sciple. Thanks for listening, and Fool on!