Investing in fragments of a company can sometimes pay off handsomely
Mario J. Gabelli
From the Print Edition:
The Sopranos, Mar/Apr 01
In past columns, we have shown that there are more ways to earn a return than just buying a stock. We have discussed absolute returns, relative returns, even returns from announced mergers and acquisitions (risk arbitrage). In this article, we zero in on another approach: investing in stubs, spin-offs and liquidations.
Stubs are created through the leveraged buyout process. As the name implies, leveraged buyouts (LBOs) are transactions in which the buyer uses debt to fund the acquisition of a company. Usually, the LBO group will buy all of the target company's publicly traded equity. However, occasionally it will leave a small portion (usually 10 to 15 percent of the float) in the public market to avoid having to book "goodwill" (purchase price in excess of book value), which eventually must be written off against earnings. Shares of this small portion of equity remaining in public hands are called stubs.
Because we analyze securities in much the same way as LBO specialists -- looking for undervalued assets and focusing on how much free cash flow a company generates -- many of our portfolio holdings have been targeted by LBO groups. We have our cake in the form of premiums paid by LBO groups to buy portfolio companies. Every now and then, we get to eat it too, by holding on to stubs that allow us to participate, along with the LBO group, in realizing a portfolio company's full upside potential. Our risk arbitrage operations -- buying deal stocks at a modest discount to the purchase price to earn respectable annualized returns when the deal closes -- also give us the opportunity to take advantage of fundamentally attractive stubs.
The Power of the Stub
Let me give you an example from the Gabelli files. On January 23, 1997, Amphenol, a leading electrical equipment manufacturer, announced that the prominent LBO group Kohlberg Kravis Roberts & Co. (KKR) was purchasing 90 percent of its equity for $26 per share in cash. The remaining 10 percent would remain in public hands -- a classic stub. We thought the deal price was a little skinny, valuing Amphenol at around 15 times earnings, when its competitors were trading at 17 to 18 times earnings in the market. Believing we might see a better bid from a competing suitor and/or KKR, we bought Amphenol stock at $25.50. At this price, we could earn a modest 6 percent annualized return on our investment even if no higher bid materialized. We also had the option of holding on to all or part of our Amphenol position via the stub. Either way, the downside risk was limited and the upside potential appeared attractive.
Other shareholders saw value in the stub, and approximately 9 million shares (about 20 percent of the publicly held equity) were not tendered for cash. The deal was then pro-rated, requiring the remaining shareholders to tender half their position for cash and retain half of their shares in the stub, which within one year was trading at $61 per share. We earned a 6 percent annualized return on the half of our position we were forced to tender and 139 percent on the half that remained in the stub. So, the one-year total return on our Amphenol investment was 72 percent. Behold the power of the stub.
Spin-Offs and Liquidations
A spin-off is when a company creates a separate publicly traded stock for one or several of its businesses. Stock of the company being spun off is distributed free of charge to shareholders of the parent company, which generally will retain a substantial position in its now publicly traded child.
Business are spun off for a variety of reasons. In many instances, the parent company wants to highlight the value of the businesses it is spinning off, believing the market will value the sum of a company's parts greater than it has valued the whole company. Prior to last year's technology stock massacre, many "old economy" companies spun off "new economy" businesses to bring out their value. These kinds of spin-offs tend to be priced rather too richly for value investors' tastes.
Companies will also spin off non-core businesses to clean up their images in the marketplace. This is often perceived as a convenient way to dispense of underperforming businesses, and these spin-offs are generally not treated particularly well in the market. However, independence from a parent that has failed to provide the capital or management focus to nourish these businesses can substantially improve their prospects within their industries and turn a bargain-priced investment into a big winner.