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.


Coach’s new Hong Kong Depository Receipts

Hong Kong Depository Receipts (HDRs)

I didn’t know until I was reading the Wall Street Journal this morning that Hong Kong had depository receipts (DRs).  But COH just issued one.

Sure enough, checking with the Hong Kong Stock Exchange website, HDRs have been permitted in that market since mid-2008.  Not many takers so far, however.  The HKSE lists Vale, the Brazilian iron ore company, with two HDRs; SBI, a Japanese internet-based financial, has one.  And now there’s COH (6388 is the Hong Kong ticker symbol).

what they are

The basic idea behind a DR is to provide a simple way for a domestic investor to buy a foreign stock without having to set up a brokerage account in the foreign country or to deal with foreign exchange, either in buying and selling or in receiving dividends.

The buyer doesn’t actually get a share of stock, however.  Instead, he gets an IOU (the receipt) from some financial entity, usually a bank, that holds the real shares in a depository account.  The bank handles all the necessary administrative details, like foreign exchange and the sometimes messy business of meeting the foreign country’s securities and tax regulations.


The company whose stock underlies the DR may use the DR issuance to raise capital in a new market, where investors may well pay a higher multiple for shares than would be possible in the home market.  In the biggest DR market, the US, I’ve found this often the case–and regard it as a bad sign.  In my experience, seeing a mature company launch an ADR means it has lost its allure for more knowledgeable home market investors.  (Another important factor in ADR issuance in particular is that it circumvents the more stringent disclosure and reporting requirements that the SEC has for US-based companies.)

In the COH case, however, the firm has not created 6388 to raise new funds–after all, operations are generating $1 billion in annual net cash.  It has created a DR to raise its public profile in Greater China.

their Achilles heel

The bane of DRs, in my opinion, is low trading volume and potentially Grand Canyon-wide bid-asked spreads.  I’ve found the problem especially acute in cases, like this one, where the operating hours of the home and DR exchanges don’t overlap.  According to the HKSE website, trading in 6388 over the past five days has only totaled about US$11,000.  The bid-asked spread shown is about 2% (my experience in the US is that the spread for a stock like this could be more like 10%).  December is usually a dreary month for investors, so January will probably give a better read on volume.

worth watching

Nevertheless, COH has probably gotten more publicity in China through the HDR listing than it would have been able to buy with the money it spent to create its HDR.  The phenomenon itself it worth watching, as well.   Two reasons:

–we may ultimately reach a tipping point where having a HDR acquires a cachet that exerts a positive influence on the home market security price, and

–pioneers like COH may have a leg up on obtaining an eventual listing on a mainland exchange.

Coach is starting off fiscal 2011 with a bang

COH reported earnings results for the first fiscal quarter of 2011 (the company’s fiscal year ends in June) before the market opened in New York yesterday morning.  The news was strong enough to push the stock up by about 12% that day.

the results

Sales for the quarter were $912 million, up 20% year on year.  Earnings per share were $.63, up 43% vs. the comparable period in fiscal 2010.  This was far ahead of the analysts’ consensus for the quarter, which was $.55.  Wall Street expects the company to earn about $2.75 for the full fiscal year, although I would imagine that number is even now being revised up.

Two “unusual” factors helped performance a bit.  The weak US currency turned sales in Japan from a 3% gain in ¥ ( impressive itself, in a market that’s shrinking) to a 14% increase in $.  Also, US department stores are restocking in anticipation of a better holiday season, so their orders were very strong.  Still, the COH figures were very good.

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