spinoffs (2)–the ugly duckling

Yesterday, I wrote about the stock market value that can be created by separating multi-line companies into their components.

Today, the real world counterpart in value creation–the ugly duckling.

the ugly duckling…

Many times the top managers of company ABC come mostly or entirely from A and B.  As a result, they typically don’t understand C.  In many cases, they don’t care to put in the effort to figure out how C works, especially if C is significantly smaller than A or B.

Because of the perception that C “doesn’t fit” in ABC, it may be starved of the capital it needs to expand.  Because it’s small it may be perceived as not worth the trouble or to be incapable of moving the profit needle significantly no matter what it does.  No matter what its standalone prospects, it may be run simply to generate cash for the rest of the company.

Management of C will likely be poorly paid by industry standards, because of this perception.  A significant portion of that compensation will through stock options.  Since C isn’t publicly traded, those options are doubtless on ABC stock. There’s very little the management of C can do to influence their value.  More than that, if ABC is a mature firm these options may only accrue value slowly.

…can become a swan

If C is spun off, however, the hands of the management of C become untied as it gains control of an independent enterprise.  Freed of the shackles of an unimaginative ABC corporate mindset, it can raise and use new capital to expand.  It can change its corporate structure and focus.  It can experiment.

Management will participate directly in the success of C both through higher salaries and by holding options on C’s stock.  So it will probably be a lot more highly motivated to grow.

the Coach spinoff from Sara Lee

The spinoff of Coach(COH) by Sara Lee in 2000 in an offering that valued all of COH, now a $10 billion  company, at $140 million is a prime example.  At the time, Sara Lee said it wanted to spend its time managing larger brands like Sara Lee baked goods, Ball Park franks, Hanes underwear and Kiwi shoe polish.

The Sara Lee statement is telling.  The businesses whose prospects it understood, and valued most highly, were low-priced, slow-growth, commodity-like consumer goods sold predominantly in retail outlets, like supermarkets, that Sara Lee did not control or run.  Even before its amazing post-spinoff transformation, COH owned its own retail outlets and sold predominantly to women in families with income of $100,000.  Not Sara Lee-like at all!  COD’s biggest issue was that, because it had a very narrow range of leather products, customers only bought something new when the old one wore out, that is, every seven or eight years.

Sara Lee (SLE) no longer exists.  It split itself in two, changed names and had both parts bought out within the past few years.  That total buyout price was about $17 billion.

The earliest market capitalization figure for SLE that I can find is $14 billion at yearend 2002.  By that time, COH, which went public in late 2000 had quadrupled in price and had a market cap of just over $500 million.


spinoffs …do they create value?

My daughter asked me this the other day.

My answer is:  most times, yes.

I’m going to elaborate in today’s post, and in the next two days’ as well.

Let’s get started–

what it is

spinoff  is when a company with multiple lines of business, say ABC, separates one line, say, C, and divests it.

lots of variations

There are two main separation techniques:

a)  sale to another company, or

b)  distribution to existing shareholders, who then own shares of now-AB + shares of C.

In the normal way Wall Street works, there are lots of varieties of both sale and distribution–a portion of the shares of C, all the shares of C, or a portion now followed by the rest later.  In perhaps the most complicated case, a partial distribution cum IPO can be followed by a sale of the remainder into the open market.  This means the proceeds of the follow-on sale go to the corporate coffers of AB.

adding value

This can happen in a number of ways.  The one I’ll write about today is for publicly traded companies only.  It’s the portfolio effect.

It’s the idea that any publicly traded multi-line company is like a portfolio of mono-line firms in the eyes of a professional equity portfolio manager who might be thinking of buying shares for his clients.

A PM may be looking to establish a position in industry A.  Maybe he thinks that low oil prices will be with us for longer than most people think and that he should add to his holdings in petrochemical companies because of this.  He’s interested in pure petrochemicals plays.  At the same time, he does not want exposure to oil and gas exploration and production.  So a hydrocarbon conglomerate like any of the large integrated oil companies–which have both exploration and chemicals–raises conflicting emotions.

He is willing to pay a full price for the chemicals   …but you have to compensate him for being forced to take the exploration business he doesn’t want..

At the same time, there may be PMs with the opposite view.  They’re willing to pay up for the exploration but don’t want the chemicals at all.

Both PMs are stuck with stuff they actively don’t want if they buy the conglomerate.  So, in theory–and most often in practice–the stock market value of the business AB is less than if both A and B traded separately.

One might argue that there’s some hedging value to having both a part that benefits from higher hydrocarbon prices and one that benefits from lower.  Maybe, although it’s not my cup of tea.

Even so, there are plenty of companies with completely unconnected lines.  Take Swire Pacific in Hong Kong.  The modern iteration of one of the old British opium companies, it consists basically of property and an airline, Cathay Pacific.  When it announced years ago it was spinning off a portion of the airline– creating a pure play transportation stock + a purer property play, the stock went up by 40% in anticipation of the portfolio effect.  Airline buyers would no longer be stuck with office buildings; property buyers would no longer be stuck with an airline.


More tomorrow.



What Amazon (AMZN) said about its web services Thursday night

AMZN shares rose by 15% last Friday, after the company gave its first income statement details about Amazon Web Services (AWS), its cloud business.  In its quarterly reporting from now on, AMZN will break out three business segments:  US sales, International Sales and AWS.

IN the late Thursday earnings release, Jeff Bezos said that AWS is growing fast and “in fact, it’s accelerating.”

the data

operating income

–during calendar 2013, AWS had segment operating income of $673 million, according to the GAAP accounting rules used in financial accounting.  That was 35.3% of AMZN’s total segment income.

—for 2014, AMS had segment operating income of $660 million, or 36.5% of the total

–in 1Q15, AMS had segment income of $265 million, 37.5% of the corporate total

cash flow

–on GAAP principles, AWS had cash flow of $2.4 billion last year.

capital spending

–AWS represents over a third of AMZN’s plant and equipment of $17 billion.  With $4.3 billion in plant additions in 2014, AWS was almost half the company’s total capital spending.  Of the $4.3 billion in new plant, $3 billion was acquired using capital leases–meaning a kind of financing which looks like a loan but which allows AWS to buy the stuff cheaply at the end of the lease.

plant life

–if we divide last year’s depreciation into the average of 2013 and 2014 plant, we get an average plant life of 4 1/2 years.

–return on capital

–last year AWS earned $660 million, using capital of $4.6 billion, meaning a return of 14%.

what to make of this

It’s hard to make a lot out of two years’ data, especially in such a fast-moving and capital-intensive business as AWS’s.

The GAAP numbers look good. Nevertheless, AWS is cash-flow negative, which isn’t troubling if we’re certain that the company will continue to earn a significant return on the capital it is pouring into AWS.  Also, although there’s no way to tell for sure, it seems to me likely that on its IRS books, AWS is losing money.  How so?   …tax breaks for technology investment, including depreciation that’s heavily front-loaded (vs. spread out evenly over the assumed life of the equipment, as GAAP calls for).

Certainly, if Wall Street’s view has been that AWS is bleeding red GAAP ink, the reality is hugely better.  As time goes on, we’ll be better able to judge how insatiable AWS’s need for capital is–or whether, as one would hope, AWS will turn cash flow positive .  My guess is that before then, AWS will be more than half AMZN’s profits, as well.  So holders will have to figure out whether or not it’s an uptick to hold shares in an internet infrastructure business that happens to retail stuff online, too.



3Q15 earnings for Microsoft (MSFT)

the report

After the closing bell last Thursday, MSFT reported earnings for its third fiscal quarter (its fiscal year ends in June).  The company had revenue of $21.7 billion for the March period and earnings per share of $.62.  This compares with Wall Street consensus estimates of $.51/share.

Cloud-related businesses were very strong, Windows-related less weak than expected–although the coming launch of Windows 10 at mid-year is already keeping a lid on Windows performance, as potential buyers wait for the newer version.


MSFT shares opened Friday trading up by 5%+ from the Thursday close and tacked on another 5% or so be 4pm.


Yes, the quarter was good.  And management made it clear, even through its brand of jargon-laden corporate speak, that its move to the cloud can enable a radical expansion of its business, not simply a shifting of revenues from one pocket to another.

the Amazon influence

However, I think the unusually sharp rise in MSFT shares on Friday is more due to Amazon (AMZN) than to MSFT.

AMZN also reported after the close on Thursday.  For the first time, it broke out its Amazon Web Services as a separate business line.  Most Wall Street observers had apparently assumed that AWS, a cloud industry leader, made little or no profit for the company.  I’m not sure why they thought this.  The only thing I can come up with is that AMZN as a whole lost money for the first eight years of its existence as a public company–and analysts argued that AWS would be déjà vu all over again.

Turns out, though, that despite AMZN’s notoriously conservative accounting, the line of business breakout shows AWS making a ton of money.  AMZN shares opened Friday up by 12.5% from Thursday’s close, and drifted higher during the day.

It seems to me that MSFT rose mostly in sympathy with AMZN.

what to do about the stock

The move to the cloud has a bunch of pluses for MSFT:

–the company’s services can be used on many platforms–servers, PCs, smartphones, tablets

–it is launching new multimedia, multi-platform services

–it can provide truncated versions of sophisticated corporate services to small businesses and individuals

–the rental model for services will generate higher income than sales, and

–MSFT can reshape its image from being a PC-centric company of the past to being a cloud-based company of the future.


My sense is that Wall Street still views MSFT through PC glasses.  Change in perception represents substantial upside for the stock, in my view.  Still, the outsized upward move in the stock has got to tempt holders–myself included–to take some profits now, with the idea of replacing the stock being sold at lower prices.

NASDAQ at an all-time high …significance?

The NASDAQ Composite index closed yesterday at a level of 5056.06.  That’s an all-time high, surpassing the previous peak of 5048.62 achieved on March 10, 2000.  NASDAQ is the last of the three major US indices to close above the highs made during the last gasps of the internet bubble of 1999-2000.   A purist might say that the all-time intraday high of 5132 and change–also made on March 10, 2000–has not yet been broken through.  Although I’m somewhat of a stickler about these things, I think the closing figure is much more important in this case.  So I buy the idea that we’re at a new high, even though on an intraday basis we’re fifty-some points short.

Does this achievement have any significance?

In terms of fundamentals, no.

In terms of market psychology, yes, in three ways:

–it finally closes the book on the Internet Bubble, allowing technically minded investors to concentrate their attention on the future, rather than retaining this one tiny cautionary reminder of an ugly period in the past

–an old high acts as a psychological ceiling, particularly for chart-oriented investors.  The more time an individual stock or an index spends just below that level, trying to break through but having no success, the stronger and more impenetrable the ceiling becomes (in the NASDAQ case, we’ve been hovering below the old high for about two months).  Once a breakthrough occurs, and provided the stock/index can stay above the old high, the ceiling reverses its role to become a floor that lends support.  In addition, once the old high is crossed, there are no further barriers to advance for chartists to worry about–no more it-can’t-go-higher-than-this levels, just blue sky

–with 2000 out of the way, I think the relevant chart period to consider is from the highs in late 2007 until now.  Over this time frame, NASDAQ isn’t a laggard.  Quite the opposite.   It’s up by 80% from the old highs vs. +35% for the S&P 500.  NASDAQ is the healthy one, not the S&P.

No, the fundamentals haven’t changed.  And no, I’m not going to skew my portfolio further toward NASDAQ names.  Still, it wouldn’t be surprising to see the OTC index show relative strength over the next few months–provided we can stay above 5048–purely because technically driven buyers will become more favorably disposed toward it.