Fundamental Analysis: Spin-Offs

I was poking around a few months ago and I noticed that $DHR had announced the spin-off of its water business Veralto (VLTO). Caveat, I spent about 3 minutes digging in, but for a company that management is guiding to MSD organic revenue growth and 30-40bps implied margin expansion, 18x EBITDA didn't scream bargain.

What gives?

I have had a long journey investing in spin-offs, and I'd like to share what I've learned along the way. And, more importantly, how I think dynamics around spin-off equities have shifted over the years.

The classic theory around spin-off investing is this: the parent company will spin-off a non-core segment into a market where owners of the orphaned equity become forced sellers (for example, S&P 500 index holders or large cap mutual funds who can't hold the new mid-cap spin, and must sell). Often, that segment didn't receive the resources it needed internally - either R&D support or executive focus on innovation & cost structure. And the newly public entity run by newly energized and economically aligned management will unlock that potential.

Depressed starting point valuation (via forced selling) meets fundamental improvement = a recipe for nice returns on the stock. Early in my investing career, I covered situations like MJN (spun from KMB) and ZTS (spun from PFE) both that followed the classic playbook. I caught the Joel Greenblatt special sits bug and figured I'd have a long and successful career investing in spins.

Then things started to get complicated.

Starting in 2013-2015 timeframe, I started seeing some spins come out and irrationally high valuations. The first spin in my coverage that seemed to make no sense was HYH (spun out of KMB) that spun with a $1.7bn MCAP and ultimately sold for $700m. Then CYH spun out QHC at a $700m MCAP, and eventually went bankrupt. Then LLY spun out ELAN in 2018, and the stock is off a lot since then.

What was happening? I'm not sure, but here are my thoughts.

1. I think we have seen an increased distortion in price discovery in the when-issued market for spin-offs. It's no secret from anyone participating in markets that spin-offs were a nice source of long alpha for 15+ years. However, markets are adaptive. Successful strategy --> more capital investing in that strategy at T-zero. My hunch is that more systematic/quantitative capital has come into this sleeve of investing, elevating starting valuations and thus compressing prospective IRR. Spin-offs are no longer the "forgotten, orphaned" equities they once were, but have actually attracted a large pool of alternative capital.

2. My observation has been the quality of spin assets (at least in my coverage) has deteriorated. MJN and ZTS were high quality assets spun because they were non-core to the enterprise. Later spins seemed to be more of an exercise to flatter the pro-forma top-line dynamics, i.e. the dreck was being spun off simply for optics or a good bank / bad bank approach. Also, increasingly, it seemed the leverage on spins was higher (just my observation, not a study). Buying "bad bank" with leverage = no bueno.

With this distortion in the when-issued market that seemed to cause upward bias on valuations, my idea gen playbook increasingly shifted with a bias to shorting spins. There were obviously exceptions (i.e. CHNG spun from MCK at $13 and I thought it was worth $30). But of the last dozens spins I looked at, I came away with a short bias on 70%+ of them.

Does that mean time is wasted in looking at spins? Absolutely not. Despite what I believe is structurally upward valuation bias in the when-issued market, the reality exists that the market's price discovery mechanism on spins in the first 0-24 months is less efficient - less sell-side coverage, less structural long term LO support, less retail awareness, likely less liquidity/MCAP, new management team still earning credibility and no index bid. Combine this with increasing leverage loads on the SpinCo. This is a messy mix of dynamics that can lead to some really gnarly sell offs.

CVET spun from HSIC is an example that comes to mind. It was a solid asset (vet distribution - levered to "humanization of pets" theme). But spun at just a stupid valuation. I thought it was worth $25. Stock went from $43 at spin to $6. Eventually sold to PE last year for $21.

This to me, is your modern alpha curve in spins, and was my default idea gen lens.

1. find and short the upward spin valuation distortion if your work supports that view,

2. understand given the dynamics discussed above the bottom can fall out on a spin (granted CVET catalyst was COVID),

3. be prepared to flip and buy the disappointment. The same curve happened on NVST (spun from DHR).

"How You Can Be a Stock Market Genius" by Joel Greenblatt needs a revision on spins, in my opinion. Markets have caught on to spins, and alpha is two-sided.

IN SUMMARY

1. MARKETS ARE ADAPTIVE. I believe the when-issued market for spin-offs has been increasingly (upward) distorted by program-driven investors

2. SPINS ARE A TWO-SIDED ALPHA SOURCE. The upward valuation distortion on many spins and the narrative that "spins are easy money" is something to think about fading. On the downside, pay close attention to situations where poor biz quality is paired with higher leverage paired and high valuation. Bargains still exist, but they are rarer than they used to be.

3. DO THE WORK AND BE PREPARED. Given the structural inefficiency on price discovery of spins in the first 12 months, the stock prices can do weird things. That's your opportunity to pounce. Be patient, be prepared.

HOPE THAT IS HELPFUL! Not a statistical analysis...just my experience as a spin-happy investor (who learned the hard way buying some spins blindly).