Reviewing 2015 Spin-Offs For Value Investing Opportunities In 2016

|
Includes: AWI, CC, DD, FLOW, FSV, HZN, TRS, VSTO
by: The Value Pendulum

Summary

It is an opportune time to review the 2015 spin-offs for investment opportunities, in light of the recent sell-down in the market.

26 of the 37 spin-offs in 2015 that I tracked, are currently trading below their respective share prices on the first day of trading.

Armstrong World Industries's upcoming spin-off of its flooring business in 2016 is one I am watching closely.

Spin-offs have traditionally been a fertile ground for value investing opportunities, since Joel Greenblatt first introduced the topic to the investing community in his book "You Can Be A Stock Market Genius." I previously listed spin-offs either trading below book value or boasting returns on invested capital in excess of 30% in my article "Spin-Offs As A Source Of Wide Moat And Deep Value Investment Opportunities" published here. With the stock market off to a rocky start in 2016, it is an opportune time to revisit the "new companies" spun off in 2015.

2015 Spin-Offs

There were 37 spin-offs in 2015 that I tracked, of which 26 of them are currently trading below their respective share prices on the first day of trading. The five worst-performing spin-offs are World Media & Technology Corp. (OTCPK:WRMT), The Chemours Company (NYSE:CC), Talen Energy Corp (NYSE:TLN), South32 Ltd. ADR (OTCPK:SOUHY) and NRG Yield, Inc. (NYSE:NYLD), whose share prices are down by 84%, 76%, 64%, 51% and 51% respectively.

For certain of these spin-offs, the sell-off may be justified. For example, DuPont (NYSE:DD) spun off its performance chemical business, Chemours in July 2015, enhancing the valuations of the parent company. Investors could have picked up a few indicators that hint of the spin-off rationale and the relative lower quality of the spun-off entity. Firstly, Chemours held highly cyclical businesses with lower margins. Its overall trailing twelve months EBITDA margin was approximately 12%, including its Chemical Solutions business, which sported a 2% EBITDA margin and produced chemicals used in gold production, oil refining, agriculture, industrial polymers and other industries. Secondly, DuPont highlighted in a 2013 presentation on the proposed spin-off that "DuPont maintains A/A2 credit rating...Performance Chemicals targets low investment-grade rating...DuPont's existing financial obligations to be apportioned between DuPont and Performance Chemicals in line with credit rating objectives." This has been the case with Chemours assuming a significant amount of DuPont's debt and environmental liabilities as well.

Other underperforming spin-offs, which I wrote about previously, include SPX Flow (NYSE:FLOW) and Horizon Global (NYSE:HZN), whose share prices have fallen by 39% and 38% respectively since the separation from their parent companies.

SPX Flow is a pure-play flow company focused on highly engineered flow technologies, solutions, process equipment, turn-key systems and aftermarket parts and services for food and beverage, power and energy and industrial applications. Depressed oil prices are the key reason for SPX Flow's share price decline; its organic revenues for Q4 2015 decreased 8.7% year on year, due primarily to lower power and energy revenue. However, it must be noted that while SPX Flow derives approximately 31% of its revenues from the Power & Energy end-market, upstream oil & gas only contributes a mere 12% of the top line. I am confident in the mid-to-long term prospects for the stock, considering its mission-critical solutions, growing aftermarket business and secular growth drivers (e.g. dairy industry for its food & beverage segment). Catalysts for the positive re-rating of the stock include operating margin expansion (3-year operating margin target of 15%-17%), the initiation of a regular dividend, and the acquisition of complementary businesses with higher margin, recurring aftermarket revenues.

Horizon Global is a designer, manufacturer and marketer of towing and trailer accessory products. It represents the "bad business" in a classic spin-off situation, evidenced by its lower profit margins as compared to the "new" TriMas Corporation (NASDAQ:TRS) comprising original Packaging, Aerospace, Energy and Engineered Components businesses. The fact that certain mutual funds and other institutional shareholders holding significant amount of shares in TriMas had to offload shares of Horizon Global due to its smaller market capitalization was another contributing factor to the weak share price performance post-spinoff. Acknowledging that Horizon Global is not a great business, its future valuation will be dependent on its ability to improve its financial performance via revenue growth (eCommerce platform and geographic expansion plans), margin expansion (various initiatives to streamline operations) and M&A (small manufacturers in China and South America with bite sizes between $50 million and $150 million).

At the other end of the spectrum, FirstService Corporation (NASDAQ:FSV) and Vista Outdoor (NYSE:VSTO), which were the subject of my articles, are among the top five best-performing spin-offs in terms of share price performance, up by 19% and 14% respectively. Journal Media Group Inc (NYSE:JMG), Baxalta Inc (NYSE:BXLT) and PJT Partners (NYSE:PJT) are the other three companies among the top five best-performing spin-offs.

Vista Outdoor is a leading manufacturer and seller of both shooting sports and outdoor recreation products, spun off from Alliant Techsystems in February 2015, as part of the merger with Orbital Sciences Corporation to form Orbital ATK (NYSE:OA). I was positive on Vista Outdoor, given its moat and the long-term opportunity set. Its market leadership in the shooting sports market is defensible, thanks to scale economies and high entry barriers associated with the industry. It also boasts a strong balance sheet and prodigious free cash flow generation. Vista Outdoor's net debt-­to-­trailing twelve months EBITDA is low at under 0.5 times, while its historical capital expenditures-to-sales ratio has been low at around 2%. In terms of future growth, Vista Outdoor's products only contribute slightly more than 10% of the estimated $14 billion hunting and shooting sports industry, and there are many adjacent areas of growth such as the camping, cycling and trail sports markets where Vista Outdoor can capitalize on via M&A.

FirstService was spun-off in June 2015, following the split of its former parent's residential and commercial (Colliers International Group (NASDAQ:CIGI)) property services businesses. FirstService sports attractive financial characteristics with a long growth runway. FirstService Residential (provision of property management and recurring ancillary services to residential communities) generates approximately 90% of its fees from recurring revenues; while FirstService Brands (provision of property services like restoration services, maintenance services via its franchise network) derives significant recurring revenues from upfront franchise fees and royalties from franchisees. With respect to growth opportunities, FirstService Residential only has a mere 5% market share of its total addressable market of housing managed by various community associations in the U.S. Its future growth prospects look promising taking into consideration the growing number of community association and the trend of increased outsourcing to professional property management firms.

My key takeaway from the performance of 2015 spin-offs is that spin-offs are to be assessed and evaluated as either deep-value or wide-moat investment candidates, just like any other stocks. While it is important to understand the motive and the background behind any spin-off, high-quality, durable (lower cyclicality and higher level of recurring revenue streams are favored) businesses with a significant opportunity set and a long growth runway will do well.

2016 Spin-Offs

Two spin-offs have already started trading in 2016, namely OncoCyte Corp (NYSEMKT:OCX) and GCP Applied Technologies Inc (NYSE:GCP). I expect more spin-offs to come to the market in the coming months, as companies explore various opportunities to create value for their shareholders.

The 2016 spin-off I am anticipating is that of Armstrong World Industries' (NYSE:AWI) flooring business, which I believe will bring the quality and value of its ceiling business into the spotlight. Armstrong World Industries' ceiling business accounted for slightly over 50% of its FY2014 revenues, but contributed almost three-quarters of its FY2014 EBITDA, which speaks volumes about the lower profitability of its flooring business to be spun off. Following the spin-off of the flooring business, I expect Armstrong World Industries' ceiling business to be valued at a higher valuation multiple as an independent entity, while it can also potentially benefit from a more favorable capital structure by the transfer of a certain amount of the current holding company's debt to spun-off entity. The spin-off is scheduled to occur in March 2016.

I will be tracking the 2016 spin-offs closely and I hope to write about some of them in the near future.

As a special bonus for my subscribers, they will get access to the full list of the 2015 spin-offs, their share price performance post-spinoff and their key financial metrics in a separate bonus watchlist article. My subscribers also get to read the Seeking Alpha PRO articles (currently archived) which I have written on five of these 2015 spin-offs.

Note: Subscribers to my Asia/U.S. Deep-Value Wide-Moat Stocks exclusive research service get full access to the list of deep-value & wide moat investment candidates and value traps, including "Magic Formula" stocks, wide moat compounders, hidden champions, high quality businesses, net-nets, net cash stocks, low P/B stocks and sum-of-the-parts discounts.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.