It seems one form of special investing that doesn’t go out of style is investing in spin-offs. I first ran into this special investing style while reading Buffet’s original letters in his partnership. It seems this tactic is not new, but seems to be continuously explored by many value investors. Also notable investors such as Joel Greenblatt and John Keeley consistently buy recent spin-offs, and have had stellar returns. According to academic and Wall Street research spun-off companies for the first three years have an average return of 10% greater than the S&P 500 average. There are a number of reasons for this.

1. Unrelated businesses may be separated via a spin-off transaction so that the market can better appreciate the separated businesses. The market tends to value individual companies higher than conglomerates.

For example, a conglomerate in the steel and insurance business can spin off one of the businesses and create an in­vestment attractive to people who want to invest in either in­surance or steel but not both. A recent example would be the Altria spin-off of Kraft. This value “arbitrage” is the main deciding principal that most boards and companies think about spinning apart companies or splitting up into different companies.

2. Sometimes, the motivation for a spin-off comes from a desire to separate out a “bad” business so that an unfet­tered “good” business can show through to investors.

The “bad” business may be an undue drain on management time and focus. As separate companies, a focused manage­ment group for each entity has a better chance of being effective.

3. Sometimes a spin-off is a way to get value to shareholders for a business that can’t be easily sold.

Occasionally, a business is such a dog that its parent com­pany can’t find a buyer at a reasonable price. If the spin-off is merely in an unpopular business that still earns some money, the parent may load the new spin-off with debt. In this way, debt is shifted from the parent to the new spin-off company. With the recent credit markets, more companies might be forced to spin-off companies instead of selling them to different private equity groups.

4. Tax considerations can also influence a decision to pur­sue a spin-off instead of an outright sale.

If a business with a low tax basis is to be divested, a spin-off may be the most lucrative way to achieve value for share­ holders. If certain IRS criteria are met, a spin-off can qualify as a tax-free transaction – neither the corporation nor the in­dividual stockholders incur a tax liability upon distribution of the spin-off shares. A cash sale of the same division or subsidiary with the proceeds dividends out to shareholders would, in most cases, result in both a taxable gain to the corporation and a taxable dividend to shareholders.

5. A spin-off may solve a strategic, antitrust, or regulatory is­sue, paving the way for other transactions or objectives.

In a takeover, sometimes the acquirer doesn’t want to, or can’t for regulatory reasons, buy one of the target company’s businesses. A spin-off of that business to the target company’s shareholders prior to the merger is often a solution. In some cases, a bank or insurance subsidiary may subject the parent company or the subsidiary to unwanted regula­tions. A spin-off of the regulated entity can solve this problem.

6. The spin-off process itself is a fundamentally inefficient method of distributing stock to the wrong people.

Generally, the new spin-off stock isn’t sold; it’s given to shareholders who, for the most part, were investing in the parent company’s business. Therefore, once the spin-off’s shares are distributed to the parent com­pany’s shareholders, they are typically sold immediately without regard to price or fundamental value.

7.The initial excess supply has a predictable effect on the spin-off stock’s price.

Most of the time spin-off companies are much smaller than the parent company. A spin-off may be only 10 or 20 percent the size of the parent. Even if a pension or mutual fund took the time to analyze the spin-off’s business, often the size of these compa­nies is too small for an institutional portfolio, which only con­tains companies with much larger market capitalizations. Think about many of the mutual funds that you own; if its prospectus claims it is a US large cap focused fund then if one of its holdings spins off a small-cap stock, then the fund will be forced to sell the shares once they are delivered.

8.Many funds can only own shares of companies that are included in the Standard & Poor’s 500 index.

If an S&P 500 company spins off a division, you can be pretty sure that right out of the box that division will be the subject of a huge amount of indiscriminate selling.

9.Entrepenerurial Forces

When a business and its management are freed from a large corporate parent, pent­-up entrepreneurial forces are unleashed. The combination of accountability, responsibility, and more direct incentives take their natural course. After a spin-off, stock options, whether issued by the spin-off company or the parent, can more directly compensate the managements of each business. Both the spin-off and the parent company benefit from this reward system. In addition, the smaller company is no longer “fighting” for funds or capital to make the proper long-term investments.

 

In the Penn State study, the largest stock gains for spin-off companies took place not in the first year after the spin-off but in the second. It may be that it takes a full year for the initial selling pressure to wear off before a spin-off’s stock can perform at its best. More likely, though, it’s not until the year after a spin-off that many of the entrepreneurial changes and initiatives can kick in and begin to be recognized by the marketplace. So lets examine some past spin-offs and some recently announced spin-offs.

 

First some past spin-offs that might be interesting. Note, that there are many other spin-offs, these are just some that have caught my attention:

 

Altria-Kraft (KFT) Warren Buffet has taken a stake;

Tyco Splitting into three companies: Tyco (TYC), Covidien (COV), and Tyco Electronics (TEL) ;

Morgan Stanley spun-off Discover (DFS);

Walter Industries spun-off Mueller Water (MWS);

American Standard spun-off Wabco (WBC);

NCR spun-off Teradata (TDC);

Alberto-Culver spun-off Sally Beauty (SBH);

First Data spun Western Union (WU);

Verizon spun Idearc (IAR);

Duke Energy spun-off Spectra Energy (SE).

 

Recently Announced Upcoming spin-offs are:

Altria will spin-off its international diversion;

IAC is splitting off into five companies;

E W Scripps is splitting into two companies;

Cadbury Schweppes is spinning off its American Bottling Unit;

Belo is also splitting into two companies.

 

As always any comments or ideas are welcome. Please do your own due diligence before purchasing any equity position.

 

Full Disclosure: Long Western Union

Domtar Weyerhaeuser Exchange

 

Thesis:

The thesis of this trade is simple: take advantage of an odd-lot tender offer that will create a 10% price discrepancy.

“The exchange offer is designed to permit holders of Weyerhaeuser common shares and Weyerhaeuser exchangeable shares to exchange their shares for shares of Company common stock at a 10% discount to the calculated per-share value of Company common stock. Stated another way, for each $1.00 of Weyerhaeuser common shares or Weyerhaeuser exchangeable shares accepted in the exchange offer, the tendering holder will receive approximately $1.11 of Company common stock, based on calculated per-share values, subject to (i) a limit of 11.1442 shares of Company common stock for each Weyerhaeuser common share or Weyerhaeuser exchangeable share accepted in the exchange offer and (ii) proration.”

According to the prospectus filed by Weyerhaeuser on February 2 the stated goal of the transaction is to incentive current WY shareholders to tender their shares and participate in the Domtar spin-off.

How the Price is calculated:

The website, www.weyerhaeuserdomtarexhchange.com, determines the daily volume weighted average price (VWAP) of both stocks, and prices in the 10% discount. According to the prospectus the price will be set by:

The final calculated per-share values will be equal to (i) with respect to Weyerhaeuser common shares and Weyerhaeuser exchangeable shares, the simple arithmetic average of the “daily volume-weighted average price” (or daily VWAP) of Weyerhaeuser common shares on the New York Stock Exchange on the last three trading days (the “Valuation Dates”) of the exchange offer period, as it may be voluntarily extended, but not including the last two trading days that are part of any mandatory extension triggered by the limit; and (ii) with respect to Company common stock, the simple arithmetic average of the daily VWAP of common shares of Domtar Inc. on the New York Stock Exchange on each of the Valuation Dates. The Valuation Dates will be February 28, 2007, March 1, 2007 and March 2, 2007, unless the exchange offer is voluntarily extended. Those dates will not change if the exchange offer is extended solely as a result of any mandatory extension of the exchange offer triggered by the limit.

Below is the chart that can be found on the website:

wy-dtc.JPG

Proration:

The reason that a mispricing will occur to small investors is because of this odd-lot preference. The reason that companies have odd-lot preference is to get ride of people holding 100 or less shares because of the expense that it costs the firm to service the smaller shareholders. Below is WY’s description of the proration and odd-lot preference:

Any proration of the number of shares accepted in this Exchange Offer will be determined on the basis of the proration mechanics described under “This Exchange Offer—Terms of this Exchange Offer—Proration; Odd-Lots.” An exception to proration is that shareholders who beneficially own “odd-lots,” that is, fewer than 100 Weyerhaeuser common shares or 100 Weyerhaeuser exchangeable shares. Beneficial holders of less than 100 Weyerhaeuser common shares or 100 Weyerhaeuser exchangeable shares who validly tender all of their shares of the class in which they hold less than 100 shares may elect not to be subject to proration with respect to that class.

Risks to Investment:

This is not an arbitrage situation but a simple mispricing scenario. The reason this mispricing exists is to give an incentive to smaller investors to get ride of their WY shares, and because larger market markers cannot be guaranteed to partake in the deal. The odd-lot and proration rules of the deal limit the total investment to less than $10,000 dollars, thus making it a waste of time and effort by most professional investors who would be likely to participate. The first risk is that DTC price goes down past the 11.1442 threshold thus eliminating the benefit of the transaction. Looking at the recent price performance of the two stocks this has happened but is currently at 10.0545, so it is unlikely that would happen. If it did happen the tender-offer can be remove all the way up to March 2, 2007, so that is the price moves in the wrong way you don’t have to participate. In other words it is a free option. The next risk is that the performance of the market outpaces the return from the deal. Another risk is that once you have tendered the shares, the price of DTC continues to decline so that it destroys all of the value created from the tender and possible some of the original equity investment. This is a real possibility since most spin-offs have intense selling pressure after the transaction is completed. However, since this transaction is a spin-off merger, the selling pressure should not be as a normal spin-off.

Expected Returns:

This is a strait forward calculation of returns. Since the transaction has to be an odd-lot, which requires that the number of shares controlled or owned is less than 100. Simply stated, the maximum number of shares you can purchase is 99 shares of WY. So that would be of an cash outflow of ($8,175.42),(99*$82.58). Then based on the last three days average of VWAP is 10.1764 shares of DTC for each share tendered share of WY. This would result in receiving 1,007.46 shares of DTC. The last step would be to sell those shares which at close were $8.91 per DTC share, which would value at $8,976.47. The net result of the transaction would be $801.05, or a return on investment of 9.79% in a just two weeks. This return annualized would be 238.22%. This is based on current prices and the last three days average VWAP, thus this would not be the actual result. However, one can expect that a total the actual results would be within plus or minus 4%.

Timing of Events:

The timing of the events in this spin-off are strait forward. The first event is that one has to be a shareholder of WY. The second event is that the shares have to be tendered by March 2, 2007. The third event will be the acceptance of the odd-lot tender share, which will be in the after market of March 2, 2007. The last event is that the exchange is accepted and one receives their DTC shares. The last step to make the thesis that is not included in the transaction is to sell the shares in the open market.

 

Locking in the Gains:

I was thinking more about the risks in this transaction and wanted to update you on some of my thoughts.  First is that I think there will be significant selling pressure on DTC on the first trading day post-spin-off.  This should make the return smaller; however I still think with the 10% margin of error, we should still end up in the green.  The easiest solution would be to take advantage of the fact that DTC is currently being traded.  What one could do is to simple use the expected share conversion rate based on the WY-DTC website and sell the DTC shares short at the end of the day Friday.  This would lock in the gain and significantly reduce the risk.  This would simply cover the transaction with the new shares issued through the spin-off.  It would be fairly accurate to predict the distribution amount within a few DTC shares rate based on Wednesday’s and Thursday’s conversion rate and the trading action of WY and DTC on Friday.  One could clean up the transaction on Monday if they had too, by selling or buying a few DTC shares in the open market.  I think this approach makes the return much more probable and will lock it in before the market opens on Monday. 

 

 

 

Links:

http://www.weyerhaeuserdomtarexchange.com/

As previously stated by the blog’s philosophy statement, Purecapitalism will try to seek out good value investment strategies. One of these strategies is based on the concept of risk arbitrage other known as merger arbitrage. This opportunity is created by many different factors such as: time value of money, risk that the deal falls through, the underlying change in the value of the stock market, or regulatory restrictions. It first is imperative to examine the process of a merger. The first step is the agreement in principal and then the definitive agreement. After the definitive agreement, the firms file a SC 14D1 agreement and files according to the Hart-Scott-Rodino act. Then the firms wait for the shareholder vote and the HSR approval. Examining this current deal, Western Refining (WNR) agreed to buy Giant Industries (GI) for $83 per share. Then bad luck struck the early arbitrageurs; Giant Industries had not one, but two fires at their refineries. This obviously reduced the value of the sale and on November 13, the two firms agreed to a new selling price of $77 per share. The prices of GI on the previous closing date, November 10, was $80.95 and closed on November 13, at $76.25, a loss of 5.8%. A merger arbitrageur is trying to make small amount of money on many transactions, so this one day could set them back for the whole year. This caused most of the original arbitrageurs to sell and take their losses. Fast forward to today, GI is trading at $75.22 and the shareholder meeting is convening on February 27 to approve the merger. WNR is still going ahead of the deal, and has announced how it is going to retire GI’s debt. So the deal is still on and is supported by both boards. The next step is to value the situation and deal. There are three main elements to a risk arbitrage situation. First, is to look at the annualized expected return, risk, and the probability. Below are the calculations for expected return, using three different closing dates. First is using Friday March 2, the closing date. Second is using a 15 days after, and lastly using 30 days after that. Most probable will be the March 2 date since the shareholder meeting is on February 27, which should approve the merger and the deal should close shortly after. The rest are less likely but regulatory hang-ups could happen and could delay the close for a short period of time. I calculated the return on these three methods and also if 50% leverage was involved. Here are the results:

graph1.JPG

The next step is to determine your risk, which includes your up-side price and down-side price. For the upside we will use the deal price of $77 per share. For the downside we will use the pre-announcement price range of around $68 per share. One also has to account for the fires and also that is trading at around 11X next years earnings so that the downside is limited. I will give the probability that the deal goes through at 70% and the stock falling to $68 at 30%. Here is the output for this calculation. I based the annualization on 55 days in this example.

gi-2.JPG

If you make the annualization to the first and second scenarios then the risk adjusted return goes to 77.37% and 30.9% respectively. This is the type of situation I like to invest in. The risk adjusted return is great compared to the downside risk. It seems the early arbitrageurs have been burned so that this provides an excellent chance for special situation investors to make an outsized risk adjusted return. The deal is all cash deal also so keep that in mind for taxable accounts. As always this is merely a single person’s written opinion, not a suggestion or advice to buy or sell any securities. Please do your own research. I will be waiting for others input and questions.

Introduction

February 11, 2007

I am starting this blog as a way to scribe my own thoughts for future reference and also for other people to use my research. I am relatively new to the world of investing, and have much to learn, however starting a blog will enable me to keep a living journal of my thoughts. In addition, I hope that people will give insight, suggestions, and critique my ideas and strategies. I am going to focus on a few types of opportunities: arbitrage, miss pricings, spin-offs, re-caps, merger arbitrage, and long-term core holdings. My investing philosophy is evolving, but I believe it is possible for a small investor to beat the market. Though the task will be extremely hard, I believe it can be done through special situation investing in combination with a long-term buy and hold strategy. I hope that other readers will help me identify different opportunities and also give any insights on strategies that I suggest. Hopefully this can be a forum in which people can profit from people’s best ideas.

Welcome,

Michael Cricenti

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