The Best Way to Profit From Stock Spin-Offs

When Forest Oil (NYSE: FST) announced in late 2010 that it would spin off its Canadian energy fields in a new company called Lone Pine Resources (NYSE: LPR), investors shrugged.

But investors who bought the parent of the spin-off when the deal was completed on Oct. 3, 2011, are glad to have waited. Since then, shares of Forest Oil have moved up from $9 to a recent $14. (Shares dropped from $15 to $9 in early October when the spin-off took effect, pushing shares up to an equivalent of $20 when the value of the spin-off is included).

#-ad_banner-#The key catalyst: Forest’s remaining business has become much easier for investors to assess.

Perhaps the main takeaway is that you should hold off buying a company when it announces a plan to spin off a division. Instead, you should pounce when the deal is done. Not only has Forest Oil rebounded more than 50% after the event took place, but Lone Pine Resources us up more than 20% since early October as well.

Just one day after that deal was done, on Oct. 4, 2011, Fortune Brands, a diversified conglomerate, cleaned up its act by spinning out its liquor business, now known as Beam Inc. (Nasdaq: BEAM). The remaining business, known as Fortune Brands Home & Security (Nasdaq: FBHS), became more of a pure play on the company’s security and home construction businesses. Since then, shares of Fortune Brands are up 57%, while Beam is up 26%.

Look for more of these spin-offs to come.

Investment bankers, hurting for fresh ideas these days, are likely knocking on the door of any major corporation that will listen to their sales pitch. Breaking up into two or more pieces can be profitable for shareholders if the company is suffering from a “conglomerate discount.” This term refers to a company’s relatively low valuation because investors have a hard time assigning a price-to-earnings (P/E) multiple on a group of different businesses with varying growth rates.

As an example, recent media reports suggested that Cisco Systems (Nasdaq: CSCO) wanted to unload its cable-TV set-top box business, because the unit carried lower margins and smaller growth rates than Cisco’s other businesses. In theory, Cisco would garner a higher P/E ratio if it was a faster-growing company with a higher margin profile. Cisco has since refuted the chatter, so this may be an event that takes place down the road — if at all.

Here are some other stocks that could arguably benefit by unlocking value in their subsidiaries.

Big pharma or nimble biotech?
Amgen (Nasdaq; AMGN), Biogen IDEC (Nasdaq: BIIB) and Gilead Sciences (Nasdaq: GILD) all have a real conundrum on their hands. They are currently profiting from a range of blockbuster drugs that generate strong sales now, but those on-the-market drugs are unlikely to grow much in the future. As a result, their P/E ratios have steadily compressed over the years. Gilead and Amgen, for example, trade for around 10 times projected 2012 profits. That’s a multiple usually reserved for major drug stocks like Merck (NYSE: MRK) and Pfizer (NYSE: PFE) that have shown almost zero organic growth in recent years.

But these relatively younger biotechs are also sitting on an extensive pipeline of new drugs. To get credit for that pipeline, it may be wise to create a tracking stock or an outright spin-off for this developing part of the business. The parent companies, with mature drugs, could carry a decent debt load and minimal cash because they already have strong cash flow. The spin-offs could be loaded up with cash to fund drug development, a move that would also allow investors to better track the value of these pipelines.

Where’s the synergy?

Johnson Controls (NYSE: JCI) is a fine example of a conglomerate in need of a divorce. The company has an impressive array of products targeting the auto-parts industry. Its heavy investments in new battery technologies also hold a great deal of promise. Meanwhile, Johnson Controls is also a major player in the movement toward greater building efficiency, with leading market share in heating, cooling and refrigeration systems.

Management must focus its energies on a lot of moving parts, utilizing an army of middle managers to help monitor and develop all of the company’s sales and manufacturing efforts. In a rebounding economy, Johnson Controls may remain saddled with the conglomerate discount and not see much movement in the stock. Management would be wise to mimic the value-unlocking moves that Forest Oil, Fortune Brands and others have recently made.

Risks to Consider: Shares can often languish when a spin-off is first announced. They typically post better gains after the spin-off is completed.

Action to Take –> The level of spin-off activity has sharply rebounded. In the fourth quarter of 2011 alone, eight companies announced spin-off plans that were valued at least $100 million. If you see a spin-off announcement and then shares drift lower, this likely creates a solid time to step in, before the post spin-off rebound takes place.

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