Call it de-conglomeration. Several large U.S. companies have goosed their shares in recent weeks by announcing split-ups or spinoffs that will create new public companies from their existing businesses.
For investors, that opens up the possibility of cashing in on the value that was previously hidden inside these vast corporations.
There are plenty of possibilities to choose from. Fortune Brands Inc., ITT Corp. and Marathon Oil Corp. have all announced they will split into pieces, and Motorola Inc. successfully cleaved itself earlier this month.
Each split was prompted by different factors. In the case of Fortune Brands, the driving motivation was the enterprise's odd agglomeration of businesses, spanning liquor, golf balls and plumbing fixtures. With ITT, the problem wasn't so much its disparate businesses as the valuations that the market was putting on them.
"By and large, these [situations] are not going to be common," says Frederick Lane, the vice-chairman of investment banking at Raymond James.
Mr. Lane says that in a rising market, companies will look at business segments they've built gradually, through small acquisitions and organic growth, and realize there are pieces that may have greater value when broken out for shareholders. The push to divest is especially acute when one business is out of favour, and another is particularly popular with investors.
Case In Point: ITT
ITT is a perfect illustration of that. The company garners roughly 50 per cent of its revenue from its defence industry business, about one-third from a water treatment products division and about one-sixth from a variety of other industrial operations.
As the 10th anniversary of Sept. 11 approaches and the U.S. fiscal picture darkens, the expectation of reduced military spending is causing defence stocks to lag the market. At the same time, the realization of the growing demand for water and its limited supply is making the water treatment business popular among investors.
The benefits of the latter to ITT are being hidden by the problems with the former. Analyst Ajay Kejriwal of FBR Capital Markets Inc. says stocks of companies in the "fluid technology" business are trading at a multiple of nearly 20 times 2010 earnings, while defence stocks are trading around 10 times. The result for ITT, Mr. Kejriwal says, is a share price that trades at a P/E discount of about 21 per cent to its multi-industry peers.
Assigning each line of business an appropriate multiple, Mr. Kejriwal arrives at a fair value of about $65 (U.S.) for ITT's shares – a considerable premium above Tuesday's close of $58.87.
"In ITT's case, the operating performance of the company was not the cause of its undervaluation," says Nicholas Heymann, an analyst with Sterne Agee & Leach Inc. It was "a rapid decline in the market's valuation of defence companies just as defence was becoming a disproportionately larger portion of ITT's business portfolio." Mr. Heymann has a "buy" rating and a $70 price target, but believes the company could fetch as much as $78 based on 2011 earnings.
The Possibility of Gains
ITT's stock price jumped 16.5 per cent on the day it announced its split-up. If you're a believer in the efficient market hypothesis – as is J. Ari Pandes, an assistant professor of finance at the Haskayne School of Business at the University of Calgary – those returns represented all the gains to be had. "In a truly efficient market, the wealth effects to shareholders should be impounded on the announcement day."
Yet Dr. Pandes acknowledges – and Mr. Lane of Raymond James emphasizes – the possibility of gains from new-investor demand. A clean-tech, environmental or socially responsible investing fund may have wanted to own shares in ITT's water business, but have been unable to because it was a minority contributor to a defence-driven company.
With the spinoff, though, ITT's water business becomes a pure play – opening up the possibility of gains as new buyers of the shares come on-line. "The growth of sector funds and of similar ETFs creates a driver for conglomerates to unlock value by making available a major business unit to these institutional investors running these sector funds or exchange-traded funds," Mr. Lane said. "I think the structural shift to specialized funds and its role in creating demand for spinoffs are critical nuances ignored by most observers."
In Fortune Brands' case, gains may come not from buyers of the stocks, but buyers of the company's businesses.
Fortune Brands, which traces its history back to the 19th-century American Tobacco Co., has combined liquor, door locks, Titleist golf balls and other businesses for more than 35 years. Yet it has also been on a long-term disaggregation campaign, spinning off its tobacco holdings a dozen years ago and also shedding office products and life insurance divisions.
Analyst Kevin Dreyer of Gabelli & Co. believes Fortune's spirits businesses – especially its bourbon and tequila brands – are the company's "crown jewel," and he expects significant interest in the unit, which pulls in $2.8-billion in annual revenue, from strategic acquirers such as Diageo, Pernod Ricard and Bacardi after the separation.
It has been Fortune Brands' Home and Security division, which sells Moen faucets, Master-Lock padlocks and Kitchen Craft cabinets, that has been the millstone around the company's neck. At $4.7-billion in sales, the division represents more than half the company's revenue, but the housing downturn has seen its earnings before interest, taxes, depreciation and amortization decline to $270-million in 2009 from $856-million in 2006.
Mr. Dreyer believes the company's $1.2-billion golf business will be sold off intact, leaving the home and security business as the sole spinoff. Valuing each division at what it would fetch as a private business, and deducting net debt, he arrives at a value of $79 a share in 2012.
"With shares currently trading at a 22 per cent discount, and the catalyst of a business separation unfolding in the back half of 2011, we recommend buying [Fortune Brands] shares," he said.
Fortune Brands Inc. says it will spin off its home and security division and sell or spin off its golf products division "in the next several months," leaving it to focus on its liquor business. Other companies are also splitting into pieces:
ITT Corp. said Jan. 12 it would, "before the end of the year," spin off its water-related businesses and its defence segment as standalone companies, leaving its industrial businesses.
Marathon Oil Corp. said Jan. 13 it will spin off its "downstream" business of refineries and gas stations as Marathon Petroleum Corp. and keep its exploration business, effective June 30.
Motorola Inc. split its government and large-customer technology business and its consumer cellphone and cable-box businesses into Motorola Solutions Inc. and Motorola Mobility Holdings Inc., respectively, Jan. 4.