Investing: When A `Carve Out' Is A Good Deal

Taking a page from a popular playbook, Barnes & Noble recently unveiled plans to sell a minority stake in its online operations via an initial public offering. For the nation's largest bookseller, there's an allure to this special type of deal, which is known on Wall Street as a partial spin-off, or "carve-out." Hoping to exploit the fancy prices the market is still awarding Internet companies despite equities' recent decline, Barnes & Noble can expect to collect $100 million or more from outside investors hungry to get in on But by spinning off only a part of, the parent will still be able to maintain firm control over its growing unit.

RICH OFFSPRING. Similar thinking lies behind lots of recent deals, including CBS's pending carve-out of its radio and outdoor-advertising properties (table). In a variation on the theme, General Motors is readying what may prove the biggest such deal yet, a two-step spin-off of parts maker Delphi Automotive Systems. In the first step, expected early next year, GM would sell a minority stake in Delphi via an IPO, spinning off the balance to the auto giant's shareholders later in the year. That would mimic AT&T's wildly successful 1996 spin-off of Lucent Technologies. The first step helps the parent raise capital while also allowing the market to set the unit's value before the balance is given over to shareholders, usually some months later.

If you're thinking of buying carve-out shares--whether you already own stock in the parent or not--you've got some homework to do. Carve-outs have complications that don't exist in conventional spin-offs, in which a company simply distributes to shareholders stock in one of its businesses. A carve-out is a special kind of spin-off in which a parent company, instead of handing out shares in a subsidiary directly to current stockholders, sells a partial interest in an IPO. The parent benefits by getting cash from the IPO. Sometimes, too, the parent will follow the initial carve-out with a spin-off of its remaining stake in the subsidiary directly to the parent's stockholders. Many times, that gives shareholders stock in two companies worth more than the parent's stock beforehand. And the offspring's stock may outperform the parent's. Witness Lucent's vault to more than $108 a share, from $13.50 each, in two years, while AT&T's shares haven't even doubled.

But sometimes, the parent itself becomes more valuable. Take Barnes & Noble, which hopes its online unit will command a market multiple akin to the more than 10 times estimated 1998 revenue that online leader's $4.4 billion market value suggests. Apply that same multiple to Barnes & Noble's Internet operation, and it would fetch a market value of at least $500 million. That's more than one-quarter of the parent's total capitalization, even though it contributes less than 2% of total sales. Look at the numbers, and you can see how the market's appreciation of Internet operations has become grossly inflated. Knowing that, it's hard to miss the point that owning the parent would be a better bet than buying the carved-out shares.

SEEKING CLARITY. Researchers on Wall Street and in academia think it's a good idea to examine carve-outs this way. "It brings clarity to how people are valuing different parts of a business," says Joseph Cornell, director of equity research at High Yield Analytics.

RJR Nabisco may present just such an opportunity. It has two publicly traded shares--those of the parent RJR Nabisco and of snack maker Nabisco, 20% of which is owned by the public. Cornell, author of Spin-off to Pay-off (McGraw-Hill, $50), notes that shares in the parent have been trading around $22, while Nabisco stock is around $33. True, RJR has been dragged down by fears it will face huge tobacco liabilities. But at current prices, the market is awarding the cookie unit alone a value equivalent to the market value of the entire tobacco and cookie company. In other words, at $22 a share you could buy RJR Nabisco and essentially pay nothing for the tobacco unit. "Sometimes," Cornell says, "the market doesn't get it."

In these cases, investors seem to be overvaluing the carved-out stocks while overlooking values inherent in the parents. But sometimes investors fail to recognize the value in carve-outs. A trio of professors--Heather Hulburt of West Virginia University and James Miles and J. Randall Woolridge of Pennsylvania State University--found both carved-out units and the parent companies' shares returned more on average than industry rivals' shares. They think investors may be slow to catch on to the improved efficiencies and fresh capital investments that bolster carve-outs' underlying businesses and pay off in higher profits over time.

In a recent paper, the professors describe how they examined 83 carve-out deals from 1981 to 1990. They found that those companies, on average, saw faster growth in sales, operating income, capital expenditures, and assets than their industry rivals, producing higher returns on assets and sales. "Managers have stronger incentives to pursue shareholder value," says Penn State's Miles, who notes that 80% of the carve-outs in the study awarded stock options to executives, an incentive they may not have had as managers in a conglomerate.

Just the same, experts think it's usually harder to outperform the market by snapping up carve-out shares quickly than with stock in a straight spin-off. After a spin-off, many investors dump the new shares without much thought. What's more, institutional investors who are tracking an index or hewing to some other rule may be required to sell. That creates temporary weakness in the price of the spin-off stock--an opportunity for buyers.

In contrast, carve-out shares enter the market in an IPO, and the investment bankers who talk them up among institutions usually succeed in boosting their value--limiting the chance the market will underprice them. Investors in carve-outs also run a risk the parent's liabilities might eventually infect the subsidiary. Tobacco litigants, Cornell notes, would love to secure a claim to the cash flow from Nabisco's sales of Oreos and other snacks.

There's the worry, too, that the parent company will deal itself a better hand in any transactions with its carved-out subsidiary. In August, Cincinnati Bell carved out its billing and customer service unit, Convergys, and sold 10% to the public with plans to spin off the remainder in a few months. Meantime, it is busily divvying assets, liabilities, and management talent. While no one has suggested any ill decision-making, Cincinnati Bell CEO John LaMacchia notes that the process requires a lot of judgment calls. "You try to be as fair as possible," he says. "But you can't just close your eyes and cut the baby in half."

For investors, timing also is crucial. Cornell suggests waiting a bit after a carve-out to allow the effect of the underwriters' salesmanship to wear off. Cookie maker Keebler, 16% of which was sold to the public at $24 a share last January, initially ran up almost to $32. But by July it had sunk back nearly to $24. Recently, however, the shares have been on the upswing even in the recent market plunge, as Keebler has unveiled acquisition plans, not to mention big jumps in sales and earnings. "These things fall through the cracks," Cornell notes. Then they're ready to be caught.

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