With a rallying market that has been driven more by valuation expansion than by earnings growth, bargains are getting more and more difficult to find. With little evidence of earnings acceleration and stocks more fairly valued in aggregate now, the hunt for value is more challenging and requires more effort. One area that has intrigued me recently with respect to potential opportunities is when companies have separate operating units performing differently from one another or have engaged in M&A with near-term dilution (which isn't always negative!). Because most investors apply valuation metrics to the overall company, this can lead them to miss out on a potential bargain, especially among smaller and less widely followed names. As I will describe, the opportunities arise potentially from M&A, expensive internal development or sub-par performance at an operating unit.
An Exaggerated Example
To illustrate the point, let's consider a hypothetical company that has:
- 10mm shares outstanding
- Net income of $5mm ($0.50 per share) expected over the next year
- Sales of $50mm
- Price of $10 ($100mm market cap).
- Cash of $20mm ($2 per share), earning no interest
Based on these assumptions, the stock trades at 20 PE ($10 price divided by $0.50 EPS) or 16 PE adjusted for cash ($10 less $2 is $8, divided by $0.50 EPS). The stock has traded 15-25 PE for the last 5 years, and EPS has grown 15% per year for the past several years and is projected to grow 15% over the next 3-5 years.
At this point, the stock is trading in the middle of its valuation range over the past five years. The company decides, however, to do an acquisition, spending all $20mm to buy out a rival that isn't run very well. In fact, the target company has sales of $25mm (1/2 the sales of this company), but it is losing $1mm per year. The company says that it expects the losses will persist for a year but that within three years, it expects to earn a similar 10% net-income margin ($5mm divided by $50mm is the calculation for the hypothetical company).
If we adjust for the acquisition, our net income drops by $1mm to $4mm for the company. Our PE, then, jumps to 25X ($100mm divided by $4mm or $10 divided by $0.40 per share). Worse, for those who thought that they were buying a stock with a 16 PE (netting out cash), the stock is suddenly 25 PE.
Any sort of screening tool will now show this stock as expensive based on the near-term numbers. Any sort of earnings momentum model will hate this scenario. If the company is really big and well followed, the damage might not be that great, but, more likely than not, that $10 price will drop following this kind of deal. It should rally if the management team can do what it says. 10% margins on $25mm in sales will yield $2.5mm in three years.
What Is "Sum-Of-The-Parts"?
The right way to analyze our example would be to use "sum-of-the-parts", which is an exercise that breaks the company down into components. The analyst then values the components and then adds them up to get a total.
In our example, we already had two parts: The cash and the operating business. Most investors are familiar with this exercise. The stock traded at 20PE to some, but, to those who understood how to value the cash, it really traded at 16PE plus $2 per share in cash. In my view, the right way to value the company going forward is to continue to value the core business but then to value the acquisition separately. It seems rather obvious that spending $2 per share today to generate potential after-tax earnings of $0.25 per share (8PE) within three years is likely value creation and not destruction.
Many machines (quantitative investors) will totally miss this and pick up on negative information of lower earnings in the near-term or less cash per share. Fundamental investors who look at the company but aren't aware of the underlying dynamics will view it as expensive a move in many cases.
To perform "sum-of-the-parts", one needs to be able to get information on each of the businesses. M&A can be evaluated based on information provided when the deal is announced (or by consulting filings if the target is public). When the businesses are operating within the company, often the SEC filings will provide details on the operating segments. As a caveat, one should be careful for unallocated corporate expense, as it needs to be included in the calculation.
Case Study: Synovis Life Technologies
In case you think that this is just theory, it actually can work. While it took longer than I thought for the market to appreciate the story fully, Synovis Life Technologies (SYNO) played out exceptionally well. I first discussed it in August 2009 and then reiterated it five months later, suggesting it could rally from 13 at the time to 30 within two years. In fact, the company was acquired by Baxter (BAX) for $28 per share two years later, so I was pretty close.
This was a small, rapidly growing manufacturer of biological materials used in surgeries like hernia repair. The company bought a company out of bankruptcy on the cheap, but it required an ongoing investment that served to depress the earnings. As I described, the hit was pretty big (a .29 hit to .67 EPS on the core), leading to the PE appearing abnormally high. My analytical approach was to consider the cash ($5.35 per share), the core business, and the newly acquired business (carried at the acquisition price, which I considered low) separately, which revealed a substantial undervaluation. This was readily apparent, as the acquisition had knocked the stock down by substantially more than cost of the acquisition and future investment.
Synovis, then, is a great example of how an acquisition that has near-term dilution can create a bargain when the market penalizes the company.
Two Recent Examples
I have written recently about a couple of companies with similar dynamics. Men's Wearhouse (MW) announced in March that they were considering selling their K&G unit, as I described here. While the company never really formally broke out this business from its core business, it gave enough information on the call for investors to see that it has been a real drag on earnings, with margins at less than half the margins of the core business. My analysis suggested that they might get $50-100mm, which they could use for share repurchases, and leave the rest of the business with higher margins following the disposition.
Perhaps an even better example is A.T Cross (ATX), which announced in February that it had engaged an investment banker. As I described (PRO subscription required), the pen business has EBITDA margins of about 4%, while its sunglasses business not only enjoys 18% margins but is also growing quite rapidly. It doesn't take a lot of imagination to see how this might play out. If the company is successful in divesting its Cross Accessories Division, it will likely add to its $1 per share cash balance (assuming they don't just give it away, which is highly unlikely given its profitability and strong brand recognition) and be left as a pure-play specialty sunglasses maker. 79% of the EBITDA and 100% of the Operating Income are derived from Cross Optical Group. In my view, with the stock trading at about 15PE, it's pretty clear the market isn't handling this one correctly. I added this one to one of my model portfolios a couple of weeks ago when it pulled back and believe the stock can trade to $18 over the next year based on 18PE, though I would expect potential upside if they are successful divesting CAD.
A New Opportunity Revealed
For my faithful readers, I don't want this article to be just a rehash of prior material, so let me tell you about a story I have been tracking for a while but feel now is the right time to begin discussing: ATMI (ATMI). For those who know the company, they are likely very familiar with the core semiconductor consumables business but probably not too aware of its Life Sciences business. Here is an example of internal development masking overall profitability. The company doesn't yet have scale, but they shared on their call the path to profitability in great detail and gave me confidence that this money-losing business could be worth a lot. I will likely write more specifically about the LS business, but my current take is that it could be worth about $100mm based on 2.5X sales, which is $3 per share. The company also has about $4.62 per share in cash and investments. This means that the rest of the company is worth a little over $14 or just over 5X EV/EBITDA, which is very low compared to any comparable I can find. It's clear to me that the market penalizes the company for their efforts in LS but that the company is creating value.
I have suggested that the market can sometimes undervalue companies that engage in dilutive M&A, are investing heavily in internal projects or that have poorly performing units and shared some examples for each of these scenarios. Investors should evaluate companies with disparate businesses by employing a "sum-of-the-parts" analysis rather than taking a short-cut and looking at just the bottom-line for the entire company.
Additional disclosure: ATX and MW are held in one or more model portfolios managed by the author at InvestByModel.com