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Secret Hiding Places: Restructuring Opportunities

- By Robert Abbott

Big changes sometimes can turn a mediocre company into a good one; that's the second theme of chapter five in Joel Greenblatt (Trades, Portfolio)'s "You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits."

Put emphasis on the word "big" above. That's the key to finding profitable corporate restructurings: "This means the sale or shuttering of an entire division. Not just any division, either. We're talking a big division, at least big in relation to the size of the entire company."

This matters because the sale of big portions of a company can bring out hidden value. The example Greenblatt used was of a conglomerate earning $2 per share and trading at 13 times earnings ($26). The company has three divisions; two of them are profitable and earn $3 per share between them, while the third produces a $1 loss.

Selling the division losing money would immediately boost the bottom line to $3 from $2. If the stock continued to trade around $26, its price-earnings ratio would drop from 13 to less than 9.

At the same time, the company would become more focused, allowing management to concentrate on new opportunities rather than propping up the losing division. In effect, it is the opposite of a spinoff.

Greenblatt listed two ways in which investors can profit from corporate restructurings:

  1. After a major restructuring has been announced. It may take some time before the broader market appreciates what has happened. Theoretically, at least, the price will be relatively low soon after the transaction and then pick up steam later.
  2. Before an announcement has been made. In this case, it is a matter of putting your money into a company that is "ripe for restructuring." The author said he does not go looking for these situations.

In one of the two case studies, Greenblatt gave credit to his wife for finding a unique new kids' store and to Peter Lynch for helping him appreciate what she had found. The company was Greenman Brothers (now defunct), which had operated a distribution business for toys, houseware and stationery products. It was serving 7,000 retail stores, but it was only marginally profitable.

Greenblatt's wife had discovered the company's newest venture, Noodle Kidoodle toy stores. After visiting the stores himself, he agreed with his wife that the chain had great potential. In addition, while the company traded around $5, it had a book value of more than $8 per share. Thus, he concluded that the sleepy distribution business was masking an impressive new retailing idea -- Noodle Kidoodle.

In 1995, Greenman announced its trial of the toy chain had been successful and it would expand it. In May of the same year, it also announced it might sell its distribution business and use the freed-up capital in the retail stores.

Apparently, the author wasn't the only one watching this special situation; within two months the share price had roughly doubled to $11 and within four months had reached $14; Greenblatt sold his stock for between $10 and $11, roughly doubling his capital. As for the chain itself, it was acquired in 2000 by another retailer, Zany Brainy, which went under in 2001.

He acknowledged that he succeeded in part because of luck, but there were three aspects of the situation that made it attractive:

  1. A limited downside (stock price compared to book value).
  2. A business around which the restructuring took place: Noodle Kidoodle.
  3. A catalyst, finding a "hot new concept."

As for people not in his position, Greenblatt wrote, "I don't think this would be a fruitful exercise for most investors."

That was a case in which he took a position in a company before the restructuring was announced. In the second case, General Dynamics (GD), it involved an entry well after the announcement and when the stock price had already nearly tripled.

The situation came about when General Dynamics announced it would buy back 13 million of its own shares -- a dramatic move given that this would bring in almost a third of its outstanding shares. It involved a "Dutch auction tender" in which shareholders could tender their shares back to the company for a price between $63.375 and $75. Once the tenders were received, the company would set a price that would bring in 13 million shares.

In the early stages of this restructuring, senior management had received stock incentives set at $25 per share. After the Dutch auction tender had been announced, the price of shares had advanced to $71. While studying the tender documents, Greenblatt was impressed to see that these managers were not selling back their shares, even after they had already nearly tripled -- they wanted to stay invested. He read this as meaning insiders thought the stock was still undervalued.

All of this was taking place in 1992, soon after the collapse of the Soviet Union and a slowdown in military spending. In response, General Dynamics' leaders decided to sell off all non-core assets and restructure those that were left. At the time Greenblatt became involved, the company had already sold off two subsidiaries for $1.25 billion and more were coming. The proceeds of these sales would be distributed to its shareholders.

Bottom line, the company had more than a billion dollars to return to shareholders or reinvest in its core businesses. And, Greenblatt calculated that General Dynamics was selling at a 40% discount to other defense contractors.

As it turned out, the company bought back 13 million shares in July 1992 at a price of $72.25 each, reducing its float considerably. Two weeks later, Warren Buffett (Trades, Portfolio) announced Berkshire Hathaway was buying 4 million shares, for a further 15% reduction in the float.

By the end of 1993, the company had delivered dividends worth more than $50 per share, and the share price had risen to more than $90 per share. That's a total of $140, and according to Greenblatt, a double in less than the 18 months since the tender offer had been made public.

He summarized his thoughts about restructuring this way:

  • Corporate restructurings can uncover great values.
  • In restructurings, look for limited downside, an attractive business at the core and well-incentivized executives.
  • Is there a catalyst which will push events forward?

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

Read more here:

Secret Hiding Places: Like Running in the House With Scissors

Secret Hiding Places: Two Case Studies

Secret Hiding Places: How to Assess Spinoffs

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This article first appeared on GuruFocus.