On October 27, 2009, Vishay Intertechnology, Inc. (NYSE: VSH) announced plans to spin off its precision measurement and foil resistor businesses into an independent, publicly traded company named Vishay Precision Group through a tax-free distribution of shares to shareholders of record as of June 25, 2010. On July 6, 2010, the targeted distribution date, Vishay Intertechnology, Inc. stockholders will receive 1 share of Vishay Precision Group common stock for every 14 shares of VSH common stock held. Vishay Precision Group began trading in the when-issued market on June 23, 2010, at an initial price of $12.50 per share, and regular-way trading is scheduled to commence on July 7, 2010, under the symbol ‘VPG’ on the New York Stock Exchange.

At the time of this publication, Vishay Precision Group (‘Vishay’) was trading in the when-issued market for $12 per share, for a market capitalization of $160 million, which is somewhat over 10% of parent Vishay Intertechnology’s market value. This valuation appears very compelling considering the company’s average free cash flow over the last three years of nearly $20 million per year. The company has stated that it plans to significantly increase research and development and capital expenditures going forward, but even when taking these items into account, Vishay appears to be trading at a free cash flow yield of over 9%. It should be noted that this estimate does not factor in any growth that may be derived from the planned increases in research and development and capital expenditures and, as such, appears to be conservative. Therefore, on the basis of the company’s cash-generating potential, shares of Vishay are recommended for purchase with a fair value estimate of $17 per share, which represents a free cash flow yield of 9% based on 2010 projected free cash flow of $14.7 million.

Vishay will also have a very strong balance sheet, with estimated shareholders’ equity of nearly $164 million and net current assets of $132 million. The company’s net cash position amounts to approximately $58 million, which represents more than one-third of Vishay’s current market capitalization and implies a free cash flow yield of 14.5% based on the company’s enterprise value. Stated differently, Vishay could use cash on hand and seven years of free cash flow to repurchase all of its equity at current prices, while simultaneously making full investments in capital expenditures and research and development to drive future growth. Of further interest are the company’s $28 million in net operating loss carryforwards, the majority of which are likely to be of future benefit to the company.

Vishay’s strategy in recent years has been to pursue the vertical integration of its measurements (load cell modules) business, which is in contrast to the horizontal strategy of the parent company, which is focused on the sale of discrete semiconductors and passive components. The two companies do not share common technologies or manufacturing facilities, nor do they utilize a common sales force. Further, the longer lead times associated with the research and development of Vishay were not in line with the time horizons often targeted within the parent company. Due to these factors, management of Vishay had suggested the spin-off to the parent company, Vishay Intertechnology, in 2009. Interestingly, Ziv Shoshani, nephew of founder Dr. Felix Zanderman (who is expected to control approximately 45% of Vishay’s voting rights, on par with his current interest in the parent company), will become the CEO of Vishay. Mr. Shoshani was Vishay Intertechnology’s COO from January 2007 to November 2009, and since then an Executive Vice President with various areas of responsibility, including Executive Vice President of the Measurements Group Division and Foil Resistors Division.

One could argue that there are reasons to be skeptical of Vishay’s strategy going forward, as the company intends to shift its focus toward its Weighing Modules and Control Systems segment. Although this segment represents an area of growth for the company, it offers significantly lower margins and returns relative to the Foil Technology Products segment, and will likely require a higher level of capital expenditures. However, unless the company’s existing Foil Technology Products business suffers significantly (arguably unlikely, especially considering that these products are used in Weighing Modules and Control Systems products), the absolute level of cash that can be generated by Vishay is too significant to be ignored and warrants an investment in VPG shares.

On December 7, 2009, McDermott International, Inc. (NYSE: MDR) announced plans to separate its operating subsidiaries through a tax-free spin-off to existing shareholders. The Power Generation Systems and Government Operations segments will be spun off into The Babcock & Wilcox Company, which is expected to trade on the New York Stock Exchange under the ticker ‘BWC,’ while McDermott will be renamed J. Ray McDermott, S.A. and retain the ticker symbol ‘MDR’ on the New York Stock Exchange. The transaction is expected to occur during the third quarter of 2010. A valuation based on comparable multiples returns fair value estimates, at the time of the separation, of $13 per share for J. Ray McDermott (‘J. Ray’) and $12 per share for The Babcock & Wilcox Company (‘Babcock’), for a sum-of-the-parts valuation of $25 for McDermott International. Nevertheless, both entities offer compelling long-term investment theses that warrant purchase at prices as high as the estimates given here.

McDermott International (‘McDermott’) is pursuing the spin-off of Babcock partly to free Babcock of potential regulatory constraints that could impact its business with the US Government. This stems from recent rule changes to the US Federal Acquisition Regulation (‘FAR’) that may prevent ‘inverted’ companies (companies that are headquartered and have significant operations in the US, but are incorporated outside the United States for tax purposes) and their subsidiaries from seeking contracts with the US Government. As an ‘inverted’ company, McDermott, which is incorporated in Panama, may jeopardize Babcock’s ability to pursue contracts with the US Government. Once the spin-off is complete, The Babcock & Wilcox Company, incorporated in Delaware, will be free to pursue these opportunities.

Babcock operates two business segments: a Government Operations segment, which has exhibited a significant degree of stability and growth in recent years, and a Power Generation Systems segment, which has been negatively affected by the recent recession’s impact on its clients’ capital expenditure budgets. Because of this weakness, Babcock’s current valuation (as part of McDermott) appears to be based upon earnings estimates that are still at cyclical lows and valuation multiples that are below historical averages (fair value reflects an EV/EBITDA multiple of 6x versus the historical average of 11.1x). Capital expenditures are starting to rebound, however, and could start to drive revenue growth for the Power Generation Systems segment, with future growth being propelled by ongoing increases in energy demand. Further, the Government Operations segment is likely to maintain its recent strength, as this business is, to a degree, contracted, and Babcock is uniquely positioned to service these contracts. Lastly, Babcock is positioned to become an interesting nuclear energy play, should nuclear become a more significant domestic energy source. The company generates one of the highest returns on equity in its industry and will be well capitalized, with an expected net cash position of just under $380 million, making Babcock a compelling investment at the appropriate price.

Babcock’s pro forma return on equity for 2009 was a compelling 34%, implying that future opportunities for the company to put capital to work should result in strong future earnings growth. These opportunities for investment will likely present themselves, driven by the capital equipment replacement cycles of its customers and modest secular growth in energy demand, with further potential growth to be captured should the US embrace the company’s nuclear technologies, currently in development. Without considering this growth potential, however, and only using the company’s recent normalized results, the fair value estimate for Babcock represents an attractive 6.25% free cash flow yield.

The investment thesis for J. Ray is comparable to that of Babcock, in that its business has experienced some recent weakness due to declines in capital expenditures by its customers. Further, current valuation (as part of McDermott) appears to be based on these lower earnings and below-average multiples (fair value reflects an EV/EBITDA multiple of 6.1x versus the historical average of 9.9x). As with Babcock, however, revenues have started to rebound, and there appears to be a long-term growth opportunity, as capital expenditures will be driven by increases in global energy demand. This revenue is likely to generate significant earnings growth, as J. Ray earns one of the highest returns on equity in its industry. Lastly, J. Ray will also be well capitalized, with an expected net cash position of nearly $570 million, leaving the company well positioned to thrive as an independent entity.

J. Ray’s pro forma return on equity for 2009, while not quite as impressive as Babcock’s, was still compelling at 19%. Again, the company should translate these returns into long-term earnings growth as it capitalizes on the secular trends in global energy demand and its unique position as one of the few global engineering and construction firms operating in energy sector. Further, as with Babcock, the fair value estimate for J. Ray represents a 6.25% free cash flow yield, based only on recent normalized results.

McDermott currently trades at $23- $24 per share, which, based on our sum-of-the-parts valuation of $25 per share, implies that there is not significant latent value to be unlocked in this spin-off. However, both entities are uniquely positioned to capture the long-term growth opportunities in their respective industries, and both, as well-managed, efficient companies, are likely to translate these opportunities into increased shareholder value. That Babcock and J. Ray, as independent entities, will likely be valued based on depressed earnings and historically low multiples is not an unusual dynamic in today’s market. Therefore, investors should be mindful of the price to be paid for these businesses, as other, cheaper, opportunities may be available. Nevertheless, we believe both Babcock and J. Ray are compelling investments and should be purchased at prices up to $12 and $13 per share, respectively.

On July 1, 2008, The E.W. Scripps Company (NYSE: SSP) completed the spin-off of Scripps Networks Interactive Inc. (NYSE: SNI), its cable television network. The Spin-Off Report published a comprehensive report on the spin-off on June 4, 2008, recommending the purchase of SSP shares ahead of the transaction. Following their initial listing period, shares of SNI retreated in 2008-2009, along with the overall market, and are since up approximately 5% from the levels seen in their initial trading period. SNI shares have outperformed the S&P 500 by approximately 15% during this period (not adjusted for dividends), however, Scripps Network Interactive (‘Scripps’) has grown considerably during this period, and the recent acquisition of the Travel Channel and plans for international expansion, among other initiatives, position the company for significant growth going forward. It does not appear that the market has fully appreciated Scripps’ growth potential, and for this reason, SNI shares appear to be undervalued. Therefore, we recommend shares of Scripps for purchase.

One of the clearest indications that the market has yet to appreciate Scripps’ growth potential is found in current consensus earnings estimates. These estimates call for earnings per share of $2.06 in 2010 and $2.37 in 2011, for an increase of $0.31 – a number that will arguably be achieved almost entirely by the elimination of unusual expenses in 2010, which could be as high as $0.29. In this context, it is fair to question the extent to which the market understands the company’s growth prospects.

Scripps earns the highest return on equity among its peers and, with a minimal dividend, retains a significant portion of earnings with which to fund its growth initiatives, which appear to be plentiful. Aside from the recent acquisition of the Travel Channel and the international expansion, the company plans to rebrand its Fine Living Network into the Cooking Channel. Further, a cyclical rebound in advertising spending, which appears to be taking hold as the economy improves, as well as growth in affiliate fees (derived both from negotiated rate increases and ongoing, contracted escalations) should also contribute to the company’s profitability. In total, we see the potential for Scripps to earn approximately $3.60 per share by 2013-2014, a nearly 80% increase over currently projected 2010 earnings in a period of three to four years.

At current earnings multiples (22x 2010 earnings), which are slightly below those of its closest competitor, Discovery Communications (NASDAQ: DISCA), projected earnings growth would equate to 15%-25% compounded annual share price appreciation over this three- to four-year time frame. Scripps’ future valuation multiples are uncertain, however, and will largely be based on the company’s growth prospects at that time. Although the company, with its relatively modest channel offerings, could continue to realize strong earnings expansion, a more conservative approach may be to value these future earnings at multiples equal to those of Scripps’ more mature peers. Still, even at a price-to-earnings multiple of 18x, these earnings projections amount to 8%-15% compounded annual share price appreciation.

On October 27, 2009, Pharmaceutical Product Development, Inc. (NASDAQ: PPDI) announced that its Board of Directors had authorized a plan to spin off the company’s compound partnering business, known as its discovery sciences division, from its core contract research organization (‘CRO’) business. The spin-off, to be named Furiex Pharmaceuticals, Inc., will be listed on the Nasdaq Global Market under the symbol ‘FURX’. The transaction will be enacted via a tax-free distribution to existing shareholders of Pharmaceutical Product Development (‘PPD, Inc.’), which is scheduled for the first half of 2010. A distribution ratio has not yet been set, but in this report we have assumed a ratio of one share of Furiex for every ten shares of PPDI.

The spin-off will likely be a transformative transaction for PPD, Inc., as Furiex is currently a significant drag on consolidated earnings. We believe PPD, Inc., excluding Furiex, has a fair value of $26 per share based on 2011 earnings estimates and, therefore, is currently undervalued as a consolidated company. We recommend shares of the parent company for purchase, either pre- or post-spin off, based on the thesis that the market has yet to appreciate the likely increase in earnings that will be realized once Furiex is spun out as an independent entity. PPD, Inc. is currently trading at multiples comparable to its peer group based on 2010 estimates – estimates that, for PPD, Inc., include expected losses from Furiex for the first half of 2010 as well as increased expenses related to the integration of recent acquisitions, which are not likely to recur in 2011. However, PPD, Inc.’s estimated earnings growth in 2011 is approximately twice that of its peers, an expectation that is both realistic and, arguably, not reflected in the company’s current share price.

Our investment thesis for PPD, Inc. is not based on any value being derived from Furiex, although this spin-off will have some value. Furiex will be considerably more speculative than the parent company, as it will have minimal revenues and is expected to post significant operating losses as it develops the drugs currently in its pipeline. The company will collect royalties on sales of a drug that has recently received marketing approval in ten countries outside the US, but visibility into the magnitude and timing of this revenue stream is minimal. Furiex will be capitalized with $100 million in cash and no debt, which should fund research and development for close to two years, by which time Furiex will have had to either collect additional milestone payments, grow its revenue base enough to support the ongoing development of its drug pipeline, or raise additional capital.

Furiex is difficult to value without visibility into its upcoming revenue stream. However, when one considers the company’s expected cash burn rate of approximately $50 million per year, it is reasonable to assume that a valuation representing a discount to its cash balance is likely until the market has greater clarity on its revenue prospects. We believe the market should have additional visibility into the company’s revenue expectations within one year from spin off, at which point Furiex will likely have $50 million in cash and potentially will have collected additional milestone payments. This cash balance sets a reasonable valuation floor when considering an investment in Furiex, in our opinion, and is the basis for our $50 million fair value estimate for Furiex. Based on our assumed exchange ratio of one share of Furiex for every ten shares of PPD, Inc., we arrive at a $5 per share fair value estimate. However, given that PPD, Inc. is spinning off this entity due, in part, to earnings dilution concerns, we do not expect Furiex to be a compelling investment opportunity in the near term.

On January 15, 2008, the Board of Directors of First American Corporation (NYSE: FAF) authorized a plan to spin off the company’s financial services business (‘FinCo’) from its information solutions business (‘InfoCo’), via a tax-free distribution to existing shareholders of First American Corporation. However, in July 2008, the company delayed the spin-off, citing the uncertainties in the real estate and mortgage credit markets that existed at the time. On December 14, 2009, the company filed a Form 10 with the SEC, with a view to completing the spin-off by April 1, 2010. A distribution ratio has not yet been set. It is expected that FinCo will adopt First American Corporation’s stock symbol, ‘FAF,’ on the New York Stock Exchange following the separation, while InfoCo’s stock symbol has yet to be determined. We believe the spin-off could unlock significant value within First American Corp. and, therefore, we recommend for purchase shares of FAF before the separation is completed.

The valuation discrepancy within First American appears stem from the inefficient valuation of the company’s information services segment. This business, which has proven to be relatively resilient throughout the recent economic downturn and earns significantly higher margins than the title insurance business, is trading at title insurance multiples. As a consolidated company, First American currently trades at approximately 0.52x consensus 2010 revenue estimates and 0.8x current book value, which is comparable to its closest competitor in the title insurance industry Fidelity National Financial (NYSE: FNF), which currently trades 0.66x consensus 2010 revenue estimates and just under 1.0x current book value. These valuations for First American, however, arguably ignore the fact that approximately 60% of the company’s current consolidated operating income is derived from information services, and that companies with comparable business models to that of InfoCo trade at meaningfully higher multiples of EBITDA and free cash flow.

First American has recently undertaken a number of transactions for the various equity stakes in its businesses that comprise InfoCo. First, the company tendered for the outstanding shares of its First Advantage business, which had been public, in order to enact the spin-off. Further, First American has entered into two agreements with Experian plc (LSE: EXPN), which owns 20% of the joint venture which comprises essentially all of the remaining business with InfoCo. These transactions imply an equity valuation for InfoCo today, which includes two businesses that will be transferred to FinCo in the spin-off, of approximately $2.9 billion.

It would be understandable for investors to view these transaction valuations with a degree of skepticism, as they may reflect premiums paid for these businesses in order for First American to proceed with its spin-off. However, valuations on both a free cash flow and EV/EBITDA basis confirm a fair value for InfoCo of $2.9 billion, although this may be conservative, as it implies slightly below-average multiples relative to its peers. This is approximately equal to the current market capitalization of the consolidated company, in which case investors are receiving the value of the FinCo spin-off for free.

Certainly, FinCo’s performance has been negatively affected by the recent turmoil in the real estate market. The company has managed to return to profitability, however, by managing expenses while benefiting from a slight rebound in business activity. Going forward, when one considers FinCo’s 27% market share and its position as the second largest title insurer in the US, combined with the significant barriers to entry in creating a title plant (the vast, detailed database of property-specific ownership and transaction history), it can be argued that FinCo has significant value. Moreover, if one simply values FinCo using comparable multiples based on its profitability in the current environment, this segment has an equity value of approximately $1.9 billion, for a fair value of nearly $2.2 billion when including the $250 million stake the company will hold in InfoCo. There also appears to be significant opportunity for FinCo to enhance its value going forward should it reach its goal of bringing operating margins in line with its peers.

Based on our analysis, the fair value of First American is an estimated $5.1 billion based on the sum of its parts. Given this, we believe the spin-off of FinCo will be a catalyst that unlocks significant value for the company, and, therefore, we would advise investors to purchase shares of First American before the distribution of FinCo shares. It would also appear likely that, once the spin-off is complete, investors will have the opportunity to purchase either FinCo or InfoCo at a significant discount to our fair value estimates, which are $23 per share and $28 per share, respectively. We would advise an investment in either entity at the appropriate discount to these fair value estimates.

H&R Block, Inc. (NYSE: HRB) is best known for its tax preparation services business, which has proven to be a stable operating segment with significant free cash flow characteristics. Revenue from this segment, which accounts for approximately 75% of consolidated revenues, grew at a mid- to high-single-digit rate in fiscal years 2007 and 2008. In fiscal year 2009, however, the economic recession, which resulted in one of the weakest employment landscapes in recent memory, had a slight negative impact on the number of prepared tax filings. Despite this, H&R Block was able to offset any impact this might have had on revenues by charging slightly higher fees. If one were to ascribe a 14x multiple to the estimate 2010 free cash flow of the Tax Services segment alone, one would find that this segment is worth as much as the entire consolidated company. Investors who purchase shares of H&R Block on this basis can be considered to be investing in the Tax Services business at a 7% free cash flow yield, which provides a significant degree of stability and the potential for growth, while receiving a free option on the company’s Business Services segment, RSM McGladrey, and its retail banking operation, H&R Block Bank. Given these considerations, shares of H&R Block are recommended for purchase.

H&R Block Bank’s exposure to residential mortgages may explain why the free cash flow generating potential of the Tax Services business appears to be undervalued. The banking operation is interesting, however, in that it is significantly overcapitalized, with capital ratios two to three times higher than those required to be considered “”well capitalized.”” Given this, the banking operation has latent earnings potential, in that its current capital base would allow it to approximately double its risk-based assets, presumably at a positive net interest margin. This incremental earnings potential, combined with the opportunity for retail banks to realize multiple expansion to levels resembling historical averages, implies that investors are receiving for free a valuable option.

H&R Block’s Business Services segment, which operates as RSM McGladrey and provides such services as business consulting and tax, capital markets, and retirement plan services, has posted stable earnings growth in recent periods. This segment also exhibits strong free cash flow characteristics that make it valuable in its own right. Although the segment saw revenues decline during the last fiscal year as a result of the weak economy, aggressive cost-cutting measures led to a 10% increase in pretax earnings. There had been risks related to this segment, which may have been weighing on H&R Block’s share price: namely, the uncertainty related to the fact that McGladrey & Pullen has chosen to terminate the agreement under which it provides attest services to RSM McGladrey and shares in RSM’s costs. This agreement has been renegotiated, however, and the new relationship between these two firms is not expected to significantly alter H&R Block’s earnings going forward. Again, it would appear that investors are purchasing this segment at a discount.

There are no assurances that H&R Block will pursue a strategy that maximizes the earnings potential of its banking operation. Indeed, to do so might require that H&R Block divest this business via a sale or tax-free spin-off, while retaining agreements that call for H&R Block Bank to continue to provide certain services to clients of the Tax Services segment. Although such a development could take some time to transpire, there is an opportunity for the banking operations to experience significant multiple expansion within the consolidated company, and we reiterate that investors appear to have little downside should H&R Block continue to operate the bank as part of the consolidated company.

On September 27, 2013, Newcastle Investment Corp. (NYSE: NCT), a commercial mortgage and senior housing REIT, announced its intention to spin off its media assets through a taxable distribution of shares to NCT shareholders in early 2014. The entity intends to apply for listing on the NYSE under the ticker ‘NEWM’. The spin-off will comprise the Dow Jones Local Media Group assets acquired from News Corp. (NASDAQ: NWSA) for $87 million earlier in September, as well as GateHouse Media group assets. Also on September 27, Gatehouse entered a pre-packaged bankruptcy sponsored by Newcastle, which owns 52% of the approximately $1.2 billion of Gatehouse debt. The restructuring will convert the debt to equity in the new entity. The spin-off still requires an effectiveness declaration by the SEC, as well as final Board and bankruptcy court approval. The spin-off entity includes 404 community publications, 350 related websites, 313 mobile sites, and six yellow-page directories, reaching about 10 million people each week. Publications include local community papers and “”free”” shoppers. Advertising revenue continues to decline, but circulation revenue has begun to stabilize.

Non-NCT bondholders of GateHouse can receive cash at 40% of debt face value or equity in the new entity. Please see the attached report for a full explanation of the transaction options. The Spin-Off Report valuations for both NCT and NEWM assume that 100% of bondholders, other than NCT, opt for the cash-out. Under this scenario, a valuation of $5.13 per share for post-spin NCT can be reached when considering that the mortgage REIT continues to make progress in its conversion to a property REIT. An investment in NCT pre- or post-spin should be based on confidence in management’s ability to generate proceeds from the CDOs and purchase senior housing at attractive prices. Longer term, if management achieves its goals and can reach 20% or higher investment returns on senior housing, one could reach a valuation of $7.54 per share for NCT. Separately, a fair value of $1.21 per share is reached for NEWM. This results in a pre-spin sum-of-the-parts value for NCT of $6.34.

Given the approximate 8% upside to the current share price, plus current 6.8% dividend yield, NCT appears interesting. However, one might expect significant selling pressure on NEWM in initial trading. NEWM is unlikely to attract sell-side analyst interest, and one might suppose that NCT shareholders do not own the stock for the media assets, particularly given that NCT is a REIT. In fact, certain investors may be forced to sell the stock immediately following separation. One might expect sellers to far outnumber buyers in early trading, given general sentiment regarding the newspaper industry. This may create a compelling buying opportunity for NEWM and it is worth watching. Selling pressure may be less severe if a greater number of bondholders opt for equity over the cash-out. One might suppose that if those holders opt for equity, they would be willing to maintain positions for a period of time.

On April 25, 2013, Theravance Inc. (NASDAQ: THRX) announced plans to separate into two independent, publicly traded companies through a spin-off of its early-stage drug development business to shareholders, while retaining the royalty rights to its respiratory drug partnership with GlaxoSmithKline plc (LSE: GSK; NYSE: GSK). The spin entity, to be known as Theravance Biopharma, will be capitalized with $300 million at the time of the transaction, which is expected to fund operations for two to three years. The transaction is scheduled to be completed in late 2013 or early 2014. Rick E. Winningham, the current Chairman and CEO of THRX, will assume the CEO position at both companies. The separation still requires an effectiveness declaration from the SEC, and any other standard regulatory approvals.

New Theravance will control late-stage respiratory program partnerships with GlaxoSmithKline plc (NYSE:GSK). New Theravance’s assets will comprise therapies for COPD (chronic obstructive pulmonary disease) and asthma, such as BREO ELLIPTA (known as RELVAR ELLIPTA outside the US) and ANORO ELLIPTA. The parent will assume all of THRX’s net operating losses (NOLs), as well as milestone payments due to GSK at the time of commercialization and all convertible notes, and is expected to return capital to shareholders through dividends, if and when the respiratory therapies are formally marketed. New Theravance will be minimally staffed, as R&D and commercialization expenses are being handled by its partner, GSK. Most Theravance employees will remain with the spin entity at its current headquarters in San Francisco, CA.

Given that New Theravance’s partnerships with GSK are about to be commercialized, the company will essentially turn into a royalty collection vehicle. The rationale behind the spin-off is likely rooted in the fact that royalty based companies can trade at high valuations. However, in its current corporate structure, profitability from those royalty payments would be diminished by the corporate overhead and R&D expenses associated with the early-stage drug development programs. Spinning off Theravance Biopharma might result in a reduced cost of capital for New Theravance and allow for a return of capital to shareholders via dividends and or share repurchases.

Theravance Biopharma will focus on early-stage, small-molecule drug development. The transaction will separate the riskier drug discovery business, with its longer development timeline, from the more commercially viable operations that will remain with New Theravance. Early-stage biopharmaceutical companies typically have de minimis revenue and generate operating losses, and thus trade on the basis of cash or book value. Recent spin-offs of early stage development companies have seen trading in early months approximating cash or book values before experiencing multiple expansion for various reasons, including positive research results. It could be expected that upon distribution, Theravance Biopharma would trade at a market cap of $300 million, or $2.71 per share, with upside to approximately $4 per share depending on the success of drug development. Investors with a sufficient risk tolerance for early stage drug development companies may look for shares trading at or below the cash level of $2.71 per share. Trading at this level might provide a sufficient margin of safety for new purchases of the shares, since downside risk could be limited to the company’s current cash burn rate, which is expected to approximate three years. Optionality exists on positive research results.

Following the transaction, New Theravance will effectively be a royalty collection business with opportunities to return capital to shareholders. Given that the COPD products have just recently begun to receive regulatory approval, initial royalty streams will support only a minimal dividend. Instead, investors with a more long-term outlook could see potentially significant market share gains for New Theravance’s drug portfolio. Based on a discounted royalty stream from consensus sales estimates, a fair value of $41 can be derived for New Theravance. However, following bids by at least two companies for the royalty stream business of Elan, a similar royalty collection company, the potential exists for a premium to be paid up to $49 per share in a takeout scenario. In support for an increased premium it can be noted that New Theravance will have $1.2 billion in NOLs, which may be of significant value to potential suitors and is not included in the $41 fair value estimate.

Given that the current THRX share price approximates the discounted royalty stream of $41, investors may wish to purchase shares ahead of the transaction, as it appears one would receive the spin-off for free. Investors could then treat the Biopharma distribution as a dividend, selling the spin company upon receipt, to obtain an approximate 7.3%-10.5% return.

On November 15, 2012, Penn National Gaming (NASDAQ: PENN) announced its intention to separate its real property assets into a publicly traded real estate investment trust (REIT) through a tax-free spin-off to shareholders. The spin-off entity will become Gaming & Leisure Properties Inc. and intends to list on the NASDAQ under the symbol ‘GLPI’. PENN has already received a private letter ruling from the IRS in regard to the transaction. The separation is anticipated to be completed in 4Q 2013 and still requires additional gaming regulatory approvals and final Board approval. Subsequent to the spin, GLPI will declare a special dividend to purge earnings and profits associated with the assets in order to qualify as a REIT, for which the company plans to elect REIT status on January 1, 2014.

Upon separation, Gaming & Leisure Properties will own 19 gaming properties. It will lease 17 of those properties back to PENN. Aside from the remaining two properties, which will be operated by GLPI subsidiaries, Gaming & Leisure Partners’ REIT structure will be little more than a mechanism to collect rent. Structuring the initial master lease as triple-net places minimal capital requirements on GLPI, as the lessee is responsible for maintenance capital expenditures. Under such a reduced-risk structure, REITs operating under triple-net lease terms tend to be rewarded with an increased valuation versus other forms of REITs. One may expect that GLPI will trade at an initial discount to peers given the risks associated with the discretionary nature of gaming and perceived single-tenant risk. Opportunities to diversify the asset base away from PENN as the only tenant and into what may be perceived as less volatile client businesses could lessen any discount. The acquisition and subsequent leasing out of additional properties would result in upside to the fair value, in our view.

Post spin, Penn National Gaming will primarily be a regional gaming operator. The company will enter into a master lease agreement with Gaming & Leisure Properties Inc. on 17 of the 19 separated properties. Recent trends in regional gaming show increases in total consumer spending; however, the lion’s share of the gains is being captured by new properties, resulting in cannibalization of existing gaming properties’ customers and sales. With rent set to approximate half of PENN’s pro forma 2013 EBITDA before rent expense (EBITDAR), it may be considered the riskier of the two securities, with PENN shares likely to be volatile upon separation. However, the risk/reward scenario, especially for those with a longer investment time horizon, would appear to be in investors’ favor. Since PENN would be the only client of GLPI, if revenue were to fall to levels where rent could not be made, it is likely that GLPI would amend lease terms, as it is unlikely to wish to take back operational control. Alternatively, a rebound in regional gaming would provide significant earnings growth potential for PENN.

It could be expected that the operating company PENN’s loss of earnings power will be offset by multiple expansion at GLPI (i.e., the capitalization of that rental expense, as rental income, in the public market). Investors’ desire for yield may draw interest to GLPI, as the shares may initially be priced with an above-average yield. Further, eventual inclusion in REIT-focused ETFs may provide more liquidity for GLPI and attract additional investors.

For the pre-spin Penn National Gaming, a sum-of-the-parts valuation of $55 per share can be derived, consisting of approximately $37 worth of GLPI, $14 of post-spin PENN, and $3 received from the E&P purge. Given limited share price appreciation potential prior to the transaction, shares of PENN are not recommended for purchase.

On December 10, 2012, Ingersoll-Rand plc (NYSE: IR) announced its intention to spin off its commercial and residential security business into a standalone public company to be known as Allegion plc. The new entity, which will have annual revenue of about $2 billion, will comprise IR’s Security Technologies segment as well as a portion of its Residential Solutions segment. Allegion, which has applied to list under the ticker ‘ALLE’ on the NYSE, will sell electronic and mechanical security products, including brands such as Interflex, Kryptonite, and Falcon. The spin-off is still subject to regulatory approvals, including the effective declaration of the company’s Form 10 filing and the receipt of a ruling from the IRS regarding the tax-free status of the transaction. The spin-off is expected to be completed in late 2013. 

Activist investor Nelson Peltz had been advocating the corporate restructuring of IR for several months. In August 2012, Peltz presented several strategic alternatives, including a call for IR to split into three separate companies. Ultimately management chose to keep the heating, ventilation, and air conditioning (HVAC) business with the industrial machinery segment, which manufactures diverse products for a wide variety of end markets. 

Allegion has a higher operating margin and generated stronger free cash flow than the businesses that will remain with IR, although in recent years sales have been growing at a slower pace. The peer group trades at a higher multiple than more diverse industrial machinery providers, and as a result ALLE will likely lower its cost of capital. The security products industry remains fragmented, although Switzerland’s Assa Abloy (ASSAB SS) has made a series of acquisitions over the last decade. As a standalone entity, ALLE may be better positioned than it was as part of IR to play a leading role in the consolidation of the industry. Consolidation could lead to better pricing power in mature markets. Expansion in emerging markets and increased spending on new technologies may offer organic paths to growth. In June 2013, IR named David Petratis, a veteran of spin-offs, as CEO and Chairman of ALLE. Petratis became CEO of Quanex Building Products Corp. (NYSE: NX) in June 2008, two months after it was spun off to shareholders of Quanex Corp. The remaining parent simultaneously merged with Gerdau SA. 

Management is targeting a 3x leverage ratio for the spin-off entity, which would result in about a $1.3 billion cash distribution to the parent at the time of the transaction. IR has established a $2 billion share buyback program, which may be completed in early 2014. Through 2Q 2013, IR repurchased $480 million in equity, or about 9 million shares. The company expects to buy back a total of $900 million by the end of 2013. 

The remaining businesses, which are expected to generate annual revenue of $12 billion, could be compared to a group of large global industrial conglomerates. Alternatively, the HVAC business could eventually be separated. Following the separation, that business will generate about 60% of company profits. HVAC businesses trade at slightly higher multiples than their more diverse peers. These factors would tend to lend credence to Peltz’s call to split the company in three. HVAC cycles are driven primarily by new residential and commercial construction and new technologies, as well as by changing environmental regulations. 

ALLE’s growth and margin metrics are very close to those of the largest comparable, ASSAB. Applying current and historical ASSAB multiples, as well as ASSAB takeover multiples, to ALLE results in a fair value of about $42 per share for ALLE, assuming about a 3x leverage ratio and 1:3 share distribution. Meanwhile, for post-spin IR, applying a mix of industrial machinery and HVAC company historical and current multiples, as well as considering reasonable cash flow yields, results in a fair value per share of $51. On a sum-of-the-parts basis, a pre-spin fair value of $65 per share can be reached. This valuation offers limited upside prior to the spin. However, if IR utilizes the more than $1 billion cash distribution from ALLE to complete its $2 billion buyback in early 2014, the fair value of IR post-spin could rise about 6%. One may also note that recent industrial conglomerate spin-offs, including Exelis Inc. (NYSE: XLS) and Xylem Inc. (NYSE: XYL) from ITT Corp. (NYSE: ITT) in 2011 and ADT Corp. (NYSE: ADT) from Tyco International (NYSE: TYC) in 2012, have thus far not appeared to significantly unlock shareholder value, although the spin-off and merger of TYC’s flow-control business into Pentair Ltd. (NYSE: PNR) in a Reverse Morris Trust (RMT) transaction has benefited shareholders. Further unlocking of value remains possible, if management reconsiders an HVAC spin-off or other asset sales. Otherwise investors may prefer to await better entry points following the transaction.