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Spin-Off Spotting


Investing in corporate spin-offs is a time-proven strategy for beating the market, and 2007 will offer up a lot of opportunities to buy what many big corporations no longer want. Among the higher-profile deals will be Tyco International's (TYC) plans to set up its electronics and health-care businesses as freestanding units and Morgan Stanley's (MS) long-expected divestiture of the Discover credit-card unit.

Just how good have spin-off returns been? A recent Lehman Brothers (LEH) study found that from 1990 to 2005, spin-offs beat the Standard & Poor's 500-stock index by 18% on average in their first two years of independence. Most recently, an index of spun-off companies compiled by

Clear Asset Management in New York beat the S&P 500 by almost 11 percentage points a year over the past five years.

Not every spin-off is a winner, and investors need to examine the deals with care. One clue to the fate of a newly freed unit is to look in the executive suite. Are the current executives staying or jumping ship? "Management has access to superior information," says William Mitchell, who writes the monthly newsletter Spinoff and Reorg Profiles. So if the CEO goes with the new business, "it's a signal the business is particularly attractive," says Mitchell.

Another key is the method chosen for the spin-off. Many split-ups are accomplished by the parent company simply distributing ownership of an unwanted unit to shareholders. That usually means no road show or other promotions that can pump a lot of hype into a spin-off's shares. Two of the worst-performing spin-offs of recent years, AT&T Wireless (T) and Lucent Technologies (ALU)' Agere Systems (AGR), were accompanied by much ballyhooed initial public offerings.

Timing your purchases is also critical. Buying shares of parent companies in anticipation of the spin-offs isn't the best approach. Spin-off shares often trade down in the weeks and months after they hit the market. That's because index funds that hold the parent companies unload the spun-off shares, which are not in any underlying index.

Many companies also cast off units to free themselves of looming lawsuits, patent fights, or punishing debt. "There are many reasons why companies are getting spun off, and they're not all good," warns Andrew Corn, CEO of Clear Asset Management, a New York hedge fund manager.

Most of this year's spin-offs have yet to release plans detailing how much debt and other liabilities they'll carry or which executives will run the new companies. But there's plenty of time to scrutinize the spin-offs once they start trading, as you wait for the initial selling to subside over two to three months, says John Keeley, manager of the Keeley Small Cap Value Fund. "I take a few months to go through all the SEC filings," Keeley says. "Then I sit back and wait for it to happen."

The most talked-about spin-off this year is Tyco International's plan to split into three parts. The health-care and electronics divisions will become separate companies, and the remainder of Tyco will focus on fire and industrial equipment and security through its ADT Security Systems unit. Some of Tyco's $10 billion debt load will be distributed to the spin-offs, although the exact amounts aren't yet known.

The electronics unit is the "most intriguing," says Andy Ramer, an analyst with the FMI Large Cap Fund. Margins hurt by surging copper prices over the past three years ought to improve, and the company is pushing into the faster-growing consumer-electronics market, Ramer says. The health division, being renamed Covidien, intrigues Mitchell. "It's an easy-to-understand unit of a hard-to-understand conglomerate," he says. He expects a lot of short-term selling of Covidien shares because it won't be included in any index to start.

American Standard (ASD), another giant looking to slim down, is dumping its Wabco unit to concentrate on the Trane air-conditioning business. Wabco, which makes electrical and safety systems for trucks and buses, will be debt-free and should earn the equivalent of about $1.20 a share in 2007, making it worth $23 a share, according to analysts at Prudential Equity Group. The deal is expected in September.

Temple-Inland decided to restructure with a little prompting from activist shareholder Carl Icahn, who bought up almost 7% of the manufacturing and real estate company. The result is another case of a spin-off in an out-of-favor industry, a situation that often yields great bargains for long-term investors, fund manager Keeley says. Temple-Inland will give its shareholders ownership of Guaranty Financial Services, a bank that specializes in mortgage lending, and Forestar Real Estate Group, which owns 236,000 acres of developable land, mostly around Atlanta, and another 100,000 acres of timberlands. Temple-Inland hasn't disclosed full details of its plan, such as how much debt each unit will end up with, but analysts at Lehman Brothers say the bank, which earned $222 million in 2006, is worth about $2.7 billion. Lehman values Forestar, which earned $62million, at about $800 million.

In a deal that may upstage Tyco, Morgan Stanley officials have said they plan to spin off Discover Financial Services, the fourth-largest credit-card network, in the third quarter. The deal is planned as a tax-free distribution to current Morgan shareholders. With net income of about $1 billion last year and comparable companies like MasterCard doing well, a freestanding Discover should be worth $13 billion to $15 billion, three analysts at Deutsche Bank (DB) wrote earlier this month.

None of the spin-offs mentioned have a firm timetable, so if you're interested, keep on top of the news. Once the spin-offs start trading, it's time to start bargain-hunting.

By Aaron Pressman


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