Joel Greenblatt made a killing finding spinoff opportunities, and he wrote about some of them in his book You Can Be a Stock Market Genius. I promised some readers I would keep my eye out for some interesting spinoff opportunities, and I think I have come across one.
Under the terms and conditions, shareholders will get one share in Omega Flex for every share of Mestek they own. Omega Flex is a flexible metal hose manufacturer that supplies product to the residential and commercial construction industries. It's not a sexy business by any stretch of the imagination. And the industry is very fragmented, meaning a high degree of existing competition (at least 20 competitors in the field).
Mestek's performance hasn't been very good over the past few years. But if you look at Omega's past performance, separated from Mestek's, as well as its pro forma, Omega Flex appears to be a treasure buried within Mestek's walls. Sales have grown at a rate of 17% for the past few years. Gross margins have expanded from 47.5% in 2002 to 51.4% in 2004. Omega Flex is not a capital intensive business. It has expanded returns on net assets from 59.1% to 63.3% (based on the company's definition in the Form 10). This has translated to free cash flow generation of slightly more than $4 million in 2004.
The Form 10 also contained information that Greenblatt says to look for, namely the reason for the spinoff and the insider's incentive compensation. As for the reason, it's to get Omega Flex out from under the internal competition for capital at Mestek. Management believes that Omega Flex can access the capital markets on its own and, as a result, it can make better strategic decisions. I take that to mean management is looking to defragment the industry. And if free cash flow continues to grow after paying off the intercompany receivable to Mestek, Omega Flex may not need to access the capital markets.
As for the right incentives, CEO Kevin Hoben and SVP Mark Albino will own 14% of the company after the spinoff occurs. Both are staying with Omega Flex as a part of the deal and will get the opportunity to run the company unencumbered.
Please note that this is going to be a very tiny company. Omega Flex comprises a bit less than 10% of Mestek's $409 million in sales (on a trailing 12-month basis). Currently, Mestek trades at a price-to-sales ratio of just over 0.5 (and has a market cap of $221 million). So, even if Omega Flex, which has a similar debt-to-equity ratio, trades at a P/S of 1, the company will only have a market capitalization of about $50 million -- making it highly susceptible to fluctuations based on trading activity.
Here is my advice: Let's use this as a case study for Greenblatt's idea. It will be interesting to see how it all plays out, especially since there is no analyst coverage for Mestek and there is only 36% institutional ownership. Remember, one of the things Greenblatt considers is that institutional investors will immediately sell the stock because it has such a small market cap. We'll see if that happens here with such heavy insider ownership. So let's learn from the opportunity before dipping our toes in the spinoff water, especially in water as shallow as this.