In Joel Greenblatt's book, You Can Be a Stock Market Genius, he showed how investors could profit from spin-offs. The theory is that the new, spun-off company will be more nimble and entrepreneurial. Couple that with forced selling and a post-spinoff company has the potential to be a good investment.
First, the entrepreneurialism of the new company. The popularity of conglomerates come and go. There once was a time where the conglomerate model carried a premium in the market. No more. While that may come back in the future, faster growing companies are valued more by investors in today's environment. When a company is spun-off, management is now free to streamline decision-making, take risks that wouldn't have previously been allowed, and be more nimble. In theory, the bureaucracy has been shed.
Dr Pepper Snapple (DPS) is a good anecdotal example of this. They spun off from Cadbury (now Kraft (KFT)) in May 2008. The stock has risen 60% since being spun off, but if you were lucky enough to buy it in the post-spin drop, you might be looking at 150% gains. In the last four years Dr Pepper as a brand has taken risks with its advertising and introduction of new products. They've taken decisive steps to increase market share and, in general, management has simply cared more about the product. When they were part of Cadbury they were one of dozens of brands and they were neglected.
The second consideration is the post-spin pressure on the stock. Oftentimes shareholders don't care about the spin-off or it doesn't fit their investment criteria. If you're a large-cap mutual fund manager and you have Cadbury in your portfolio, Dr Pepper wouldn't have fit your guidelines and you would have been forced to sell. Additionally, you probably didn't invest in Cadbury to get access to Dr Pepper, so you don't have the interest in the spun-off company anyway. This often happens, and there can be selling pressure soon after the spin-off. That often is a good opportunity for savvy investors to buy in.
ITT (ITT) is a company that I owned pre-spin. They broke themselves up into three and now trade as ITT, Xylem (XYL) and Exelis (XLS). I'm not a fan of these Jetsons-style names. This was unique because there was obvious value before the breakup. I thought that value would be realized post-breakup, but it only has slightly so far. ITT, should be treated as a spun-off company. Xylem, which is the water technology part of the spin-off, actually replaced ITT in the S&P 500. Xylem's market cap is above $5 billion while ITT's is only about $2 billion. I've held my positions in all three companies.
For the purposes of the Greenblatt strategy, I consider ITT to be like a spin-off. The beauty of it in this case is that the expenses related to the transaction cloud the true picture of the financials. The new ITT now operates under four divisions: Industrial Process, Motion Technologies, Interconnect Solutions, and Control Technologies. The Industrial Process division generates the most revenue and has healthy margins. They create pumps for the energy, mining, and chemical industries. The Control Technologies division is the smallest in terms of revenue, but has the highest margins.
The stand-alone company released earnings in late February and results were very good. They have $690 million in cash and no long-term debt. However, ITT got the former company's asbestos liabilities. The net liability is $710 million, with annual provisions from $10 to $20 million. The company forecast 2012 EPS between $1.62 and $1.72. Operating earnings will be better: 13%, and organic revenue growth will be 5% to 7%. The stock looks now to be value fairly or slightly undervalued using the EPS forecast, but that understates the true value of the company.
ITT is certainly a cyclical company, and there are always macro concerns. So far they've seen strong revenue growth in the emerging markets and even saw 11% growth in Europe last year. With a more streamlined management team, I expect that strength to continue in 2012, though certainly we can't expect much in Europe.
I've been seeing a lot of overall market concerns about record margins. That's valid, and it obviously would greatly affect earnings. For ITT, margins are strong. I think the new ITT should be able to have a better chance at supporting their margins compared to other companies. This new ITT has certain one-time expenses in 2012 in order to establish offices throughout the world, but going forward they should have reduced overhead. They should be able to execute more efficiently than in the past. That's the advantage of a spin-off and what often leads to unexpected outperformance.
The exposure of Joel Greenblatt's methods has decreased their effectiveness in many cases. For ITT, the stock didn't seem to have much forced selling after the breakup, and it has performed well. Under $23 is still an attractive price, under 14 times forward earnings and about 9 times after cash is backed out. Operating earnings and free cash flow will be higher, though, and management's projections tend to the conservative side. This is all attractive for an investor, and I expect to see satisfactory returns.