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Secret Hiding Places: Two Case Studies

- By Robert Abbott

Could there be a great profit opportunity in a small company that specialized in automotive locks? In his book, "You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits," author Joel Greenblatt (Trades, Portfolio) thought there was --because it was a spinoff with the right characteristics. In chapter three, he revealed his thinking about several further examples.

Briggs & Stratton (BGG), which manufactured small, gas-powered engines, announced in May 1994 that it planned to spin off a division unrelated to its main business: the one that made automotive locks. That company, which was to become Strattec Security (STRT), made up less than 10% of its parent company's annual sales and earnings.

Briggs & Stratton had a market cap of about $1 billion at the time, so spinoff Strattec, at less than 10% of the parent company, would be valued at less than $100 million. That mattered because, as Greenblatt had explained earlier, that low share prices or low company valuations would force many institutional shareholders to dump their shares soon after the spinoff occurred.

He was also interested because of information in the SEC Form 10 that came out six months later, and then was amended two months on. It revealed the company was doing the spinoff for the right reason, to "provide incentive compensation to its key employees that is equity-based and tied to the value of [Strattec's] business operations and performance as a separately traded public company, not as an indistinguishable unit of Briggs."

The parent company had decided to highly incentivize the officers and employees of the soon-to-be new company, which augured well for future financial results. Greenblatt argued that the richer the executive compensation the better -- as long as it is in the form or stock options or restricted stock plans.

The third attractive element of the spinoff came from the Form 10, which indicated a strong competitive advantage, or economic moat. It was a dominant supplier of locks and keys to General Motors (GM) and Chrysler (FCA); also tucked away in the form was news that the company expected Ford (NYSE:F) to become a customer. What's more, Ford was expected to be the new company's second-largest customer by the end of fiscal 1996.

Several other factors were also considered:

  • Earnings for the most recent fiscal year were $1.18 per share.
  • Other companies among OEM suppliers to the auto industry had price-earnings ratios that ranged between 9 and 13 times earnings.
  • Based on a price-earnings ratio of 10, this would work out to a fair price of $11.80; Greenblatt was looking for an entry price of less than $7 per share.
  • Earnings for the most recent six-month period had risen by 10%.

As it turned out, the newly independent company closed at $11.50 on its first day of trading in February 1995 and remained around that level for several months. Greenblatt did not say what he paid when he entered (if he did), but by the end of that year it had risen to $18 per share, a gain of more than 50% in less than eight months.

Again, as in the case of the Marriott (MAR) hotels spinoff, there were three key indicators that the spinoff might be profitable:

  1. Because of the spinoff's diminutive size, many holders of the parent stock, including institutional investors, would sell immediately and push the price below its fair value.
  2. Insiders would stay with the company and had a significant stake in it.
  3. Some new opportunity would arise to increase the valuation.

And as we saw, those three indicators did foretell a profitable opportunity for investors.

The third case study was about the Home Shopping Network (HSNI), which was a hot stock in the 1980s. But by 1992, its star had faded. Greenblatt saw that it might have become a value stock. It had been named one of the best 10 stocks for the 1990s in a magazine article based on Benjamin Graham's value metrics: low price-earnings ratio, price-cash flow ratio and price-book ratio.

And, there was a potential spinoff in the making; it was making plans to spin off the broadcast properties it owned (within a subsidiary called Silver King Communications). Originally, the idea was that the broadcast properties would provide an in-house platform for the Home Shopping Network.

The reason for the spinoff plan? Analysts and investors could not figure out how to value the combined company. The Home Shopping Network was a retail type company, which would normally be valued on a multiple of its earnings per share, while Silver King, the broadcast subsidiary, would normally be valued on a multiple of its cash flow. By splitting the two companies, each was expected to enjoy a higher valuation.

The market, in the eyes of Greenblatt, was incorrectly assessing the combined entity and the two parts, and "The whole situation had opportunity written all over it."

One of the reasons for that optimism on Greenblatt's part came from suspicion the parent company might be cleaning itself up in hopes of getting a buyout offer. And, in fact, something similar was happening with merger talks involving its rival, the QVC Network (QVCD).

Silver King was spun off in January 1993 and over the following four months traded around $5 a share, "an enticing bargain" because it was at less than five time its cash flow, after interest and taxes. After the first four months the share price began moving between $10 and $20 dollars.

Two things influenced this change in pricing. First, post-spinoff selling eased off, presumably as institutional investors finished selling off their shares. And speculation arose that Silver King might become part of a fifth television network.

While Greenblatt did not share about incentives or benefits to insiders in this case study, we know that early selling of the spun-off company made it a bargain value stock for several months, and there was a surprise opportunity that arose because Silver King became its own master.

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

This article first appeared on GuruFocus.