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Thursday, July 26, 2012 - 13:00
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Thursday, July 26, 2012 - 13:00

It's Time to Buy this Spinoff Stock

Thursday, July 26, 2012 - 1:00pm

Some companies act within so many different business segments, that it's difficult for the market to assess what the company is really about.

This is especially true when the businesses don't really fit together and management is unable to focus on all product lines. Struggling to grow, many decide to break one or more of their businesses off into a separate company. As new entities, they can grow market share and improve their balance without the diversion from a parent company. And this is when shareholders can greatly benefit.

Take the Altria (NYSE: MO)/Kraft (Nasdaq: KFT) spinoff for example. Before the spinoff of the food processor from the tobacco company in 2007, Altria's shares had outperformed the S&P 500 Index by about 3% each of the previous five years. Since the spinoff, shareholders in Kraft have enjoyed a 7% annualized outperformance, while Altria shares have beaten the broader market by an average of almost 13% per year.

Other spinoffs are made to separate lines of business with significantly different growth rates and financial needs. The mature business often has large amounts of free cash flow that's appropriately used to increase dividends or buy back stock, while still-growing businesses may have trouble obtaining financing because of the high debt amount that's usually from the mature business.

A 2004 Purdue University study showed that spinoff companies outperformed their industry benchmarks by more than 20% during the first three years after their split. Parent companies have also been shown to outperform by roughly 6% after spinning off their other business. This is why I pay close attention anytime management says it is going to break up a company.

News Corp. (Nasdaq: NWSA) announced in June that it would separate its operations into two -- a publisher, and a media and entertainment company . Shareholders have been waiting for this for a long time and the spinoff could result in some big gains, even after a 13% surge in the stock since the announcement.

News Corp. is a media conglomerate owning controlling interests in The Wall Street Journal, The New York Post, Sky Italia, BSkyB and the Fox networks. As the company has grown from a small publisher of Australian newspapers over the years, the idea was that the different media and publishing assets could be leveraged together for revenue and cost synergies. The strategy has worked and shares have increased about 9% on an annualized basis during the past 10 years, but margins at the company are not as high as peers within the two separate industries. Management has done well with the $36 billion behemoth but may not be doing as well as they could with a smaller footprint.

The company's operating margin of 15% is about average for publishers, but much lower than other networks while return on equity of 13% is also lower than peers in the two separate segments. The Fox network drew 4.3 million viewers in the key 18-49-year-old demographic during primetime broadcasting in the first quarter, more than any other network. The fact that the No. 1 network in terms viewers cannot bring operating margin up to industry standards, tells me that the company is too large and complicated to manage.

Separating the publishing segment would allow management to increase dividends or share repurchases from strong free cash flow. Segregating the media and entertainment segment would mean less sensitivity to exchange rate shifts and lowered risk. Both individual companies would be relatively large. Income in the last four quarters was $8.6 billion for publishing and $25.7 billion for media, so each would still have scale advantages over competitors.

Effectively, investors are getting one dividend stock and one growth stock from the proposed split.

Short-term gains in a strong market

While the spinoff may take as long as a year and share price gains from a more effectively managed company may take longer, there is also a short-term reason to buy this stock.

The company is set to launch MundoFox in August, a Spanish-language channel for the fastest growing demographic in the United States. Univision currently holds about 73% of the market share and drew a larger audience than NBC on four of every five nights during the first quarter of the year. Primetime audiences of English-language broadcasters have declined 4% in the last quarter while the Spanish-language broadcasting audience grew by 3%.

News Corp. is well positioned to compete against Univision and should be able to take market share by offering advertisers bundled services across its network of strong brands. The station has already signed Toyota, T-Mobile, and L'Oreal as major advertisers. Univision has a significant amount of debt, more than total assets, and will likely be at a disadvantage against News Corp. in any pricing competition for advertising rates.

Risks to Consider: Shares of News Corp. have already come up more than 13% since the June decision to split. Some give back may happen as investors realize that the split will take up to a year to finalize. The MundoFox venture should show immediate support in the first few quarters and investors should look to longer term for gains from the split.

Action to Take -->
The split should be completed within the next 12 months and investors should plan on holding shares for at least a year or two afterwards to give management time to unlock value in each segment. Dividend yield should increase closer to the 2% industry average for the publishing segment so investors will be paid while they wait for share price appreciation. The media segment looks to win big from higher margins and growth as it moves to compete for latino viewers in the United States.

Joseph Hogue does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.