Community Health Systems (NYSE:CYH) has been on a secular downtrend since 2015. Fortunately, current shareholders were pleasantly surprised by the recent spinoff of Quorum Health Corporation (QHC).
Investors such as Warren Buffett and Mario Gabelli have stated many times that spinoffs continue to be an easy way to find undervalued assets. Spinoffs can be an attractive investment strategy for value investors. A spinoff is when a subsidiary of a parent company has been sold off, creating two new independent companies. When dissimilar assets sit within one entity, it can be difficult for the market to properly assess the value. Spinoffs tend to create more value for investors over the long term.
The primary driver for spinoffs is for management to unlock value by splitting up assets. This gives investors the ability to value both companies separately. There are two reasons why a spun off entity sells below intrinsic value: 1) The new stock is not covered by institutional analysts and 2) spin offs have a smaller market cap than the parent company, forcing some institutions to sell off the stock. The confusion presented from spinoffs is your opportunity to invest.
Is the Quorum spinoff profitable?
The newly spun-out Quorum Health Corp. is a group of 38 hospitals, or 3,582 licensed beds, in 16 states, primarily in areas with a population of 50,000 or less. The spinoff also includes the hospital consulting subsidiary from Community Health Systems. Quorum Health Corporation is projected to deliver $2.1 billion in revenue and $255 million in EBITDA. These new shares began trading on Monday May 2nd for record holders as of April 22nd. CYH will continue to own and operate 160 hospitals after the spinoff. Below is a map of the new QHC hospitals.
Source: Community Health Systems proposed spinoff of Quorum presentation - August 2015
CYH was smart to postpone the spinoff until equity markets stabilized since the healthcare sector experienced significant outflows in the first quarter of 2016. Segmenting its hospital assets will give CYH a better ability to focus on its larger hospitals. According to CYH's management presentation in August 2015, they plan to implement two separate business strategies for the shares.
Source: Community Health Systems proposed spinoff of Quorum presentation - August 2015
The CYH management team should be able to execute with fewer distractions now. For unaware readers, publicly traded health facilities have been under fire from lower reimbursements across the country. Rising interest rates have also put on added stress for many leveraged companies such as CYH and THC.
Source: Community Health Systems proposed spinoff of Quorum presentation - August 2015
Following the spinoff, Community Health Systems released a weak earnings report as net income dropped from $92 million to $12 million, year over year. While CYH shares dropped 10% after hours, they seemed to have recovered within the past few days. QHC on the other hand has fallen 25% within the same time period. While I am still finishing up the due diligence on QHC, this variance may have produced an opportunity unseen by many investors.
What is the past success of spinoffs?
Earlier this week, Barron's released an article about the value found in spinoffs. Goldman Sachs was quoted finding that spinoffs outperform the S&P 500 by six percent in the first two years. This alpha can be extracted because the new company is no longer directly associated with the parent. In the article, I found the Energizer Holdings (NYSE:ENR) and Edgewell Personal Care (NYSE:EPC) spinoff to be the another attractive investment given its brand name and product durability. Gamco Investors (GBL), founded by the famous value investor Mario Gabelli, owns ~2% of ENR as of December 31, 2015.
If you are uncomfortable about spinoff investing, I would advise you to look at some past deals. For example, Kraft Foods Group (KRFT) has more than doubled since it spun off from Ackman's beloved, Mondelez International (NASDAQ:MDLZ), in 2012. We know Kraft as the cheese manufacturer with tremendous earnings power and strong cash flows, hence the acquisition from H.J. Heinz, which was backed by Warren Buffett and 3G Capital.
Summary
If you are looking for ways to add alpha to your portfolio, spinoffs are a great way to discover value. Quorum Health is an attractive spinoff stock to begin tracking. The recent price divergence between QHC and CYH may have presented a short-term opportunity for investors. Even though the healthcare industry continues to face challenges, investors can find new creative ways to enter the market. Given the recent consolidation of healthcare companies, I would suspect more spinoffs to take place over the next several years.
