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.

On June 17, 2013, Ashford Hospitality Trust Inc. (NYSE: AHT), a hotel-focused real estate investment trust (REIT), announced that its Board had approved a plan to spin off 80% of its ownership in an eight-property portfolio in the form of a taxable special dividend to shareholders. The spin company, to be named Ashford Hospitality Prime Inc., is expected to trade on the NYSE under the symbol ‘AHP’. Ashford Trust ( ‘Trust’) will retain 20% ownership. Ashford Prime (‘Prime’) includes the premier hotels in AHT’s portfolio, generating RevPAR (revenue per available room) of about $140 in 2012. The spin entity will also enter into option agreements with Ashford Hospitality to acquire two additional upscale properties. Ashford Prime will be externally advised by Ashford Hospitality Advisors LLC, which is a subsidiary of AHT. Following the separation, AHT’s portfolio will consist of 114 hotels with 2012 RevPAR of approximately $95. The spin-off is scheduled to be completed by late 3Q 2013, and still requires an effectiveness declaration by the SEC.

The ultimate success of the spin-off transaction hinges largely on investors’ willingness to award Ashford Prime a higher valuation as a separate entity than within Ashford Trust. The discount valuation that Trust is currently awarded could be attributed to the higher-than-industry-average debt levels the company carries. Upon separation, Prime’s portfolio will compare more favorably with upscale hotel REITS in terms of RevPAR; however, it will still carry a debt level in excess of peers. While it can be argued that Prime deserves a higher multiple than Trust currently receives, the more interesting debate centers on whether Prime deserves a full comp multiple. Given that reduction in leverage is likely a multiyear process, a discounted valuation for Prime may persist following the spin-off. However, any multiple expansion will lower the cost of capital, allowing for accretive transactions to be made using higher than historical levels of equity.

Trust’s post-spin portfolio will not differ much from the current overall portfolio, aside from the loss of Prime’s earnings. Thus, it could be expected that Trust’s valuation would not shift materially following the transaction.

A pre-spin fair value estimate of $14.31 is derived for AHT, consisting of $4.44 per share of Prime and $9.87 per share of Trust. The post-spin fair value estimate derived for Prime is $3.55 per share due to differing share counts arising from AHT’s retention of 20% ownership in Prime. Post-spin Trust’s fair value estimate is $10.76, taking into account the 20% ownership in Prime. Given the approximate 23% upside from the current AHT share price, the shares are recommended for purchase prior to the transaction.”

On March 6, 2013, Time Warner Inc. (NYSE: TWX) announced plans to spin off its publishing subsidiary, Time Inc., into a separately traded independent company, leaving behind Time Warner’s television networks and film-related businesses. The spin-off entity publishes 21 magazines in the US, including People, Sports Illustrated, InStyle, and Time, and over 70 magazines internationally. The tax-free distribution of shares to TWX shareholders is subject to an effective declaration by the SEC of the company’s Form 10 (which has yet to be filed), receipt of a private letter ruling from the IRS, and final approval by the Board. The transaction has been pushed back from late 2013 until early 2014 to give recently named CEO Joseph A. Ripp more time to prepare a strategy for the standalone business.

The spin-off will allow TWX to focus on the more profitable film and television businesses, while separating the lagging, low-margin publishing segment. The remaining businesses will include television programmer Turner Broadcasting System Inc., which operates networks such as TNT, TBS, and CNN, among others; Home Box Office Inc.; and filmed entertainment through Warner Brothers Entertainment.

Time Inc.’s revenue declined 6.5% in 2012, while operating income decreased 25%. The trends in Time Inc.’s business are not surprising, given the secular decline in the publishing industry, which has seen migration of advertising dollars to other media. It could be argued that the publishing business may be a drag on Time Warner’s valuation, as television and film peers trade at higher multiples than the publishing group. Consequently, the separation could be seen as a way for TWX to lower its cost of capital.

The only true US publicly traded magazine publishers remaining are Meredith Corp. (NYSE: MDP) and Martha Stewart Living Omnimedia Inc. (NYSE: MSO), and Martha Stewart was not profitable in 2012 and is not projected to return to profitability in 2013. MDP reportedly discussed a potential purchase of TWX’s publishing segment prior to the spin-off decision. MDP is not necessarily an ideal comparable given its arguably more Midwestern, older readership, which has not fallen off as dramatically as circulation for other magazine publishers in recent years. Revenue has been closer to flat with only moderate declines in margin, particularly given MDP’s willingness to pursue strategic acquisitions with readerships similar to those of its core magazines. As a standalone Time Inc. may be better situated to pursue similar strategic acquisitions that were not considered good uses of cash when it was under the parent umbrella. Assuming a 10% free cash flow yield for Time Inc., a fair value of about $3.75 per share can be reached.

Following the separation, the parent is likely to be compared to other cable television network operators, such as recent spin-off AMC Networks Inc. (NASDAQ: AMCX), Scripps Networks Inc. (NYSE: SNI), and Discovery Communications Inc. (NASDAQ: DISCA), which currently trade at an average of 11.5x forward EBITDA, or diversified media companies trading at around 10.5x. Applying an 11x multiple to post-spin TWX’s remaining operations would result in a fair value of $66 per share. It would seem that if investors purchase TWX prior to the separation, they would receive shares in the spin-off entity for free. As a result, the stock appears interesting. In addition, management could aggressively buy back shares following the share distribution depending on how much debt is placed with the spin-off entity. TWX has repurchased 32 million shares totaling $1.8 billion, of a $4 billion buyback program, through August 2013. For instance, if $1.5 billion in debt is placed with Time Inc. and TWX repurchases an equivalent amount of shares post-spin, the fair value rises about 5% to $69. One note of caution: multiples have expanded considerably for media companies over the last three years. Earnings could grow into these multiples. But if multiples returned to the norm, TWX would likely outperform the group while possibly still seeing price retraction.

Pharmstandard (PHST) is a Russian Pharmaceutical company, created in 2003 when a consortium of Russian investors acquired the Russian operations of ICN Pharmaceuticals. While the company has demonstrated remarkable growth in the past decade and has managed to compete directly with Big Pharma in the Russian market, it suffers from similar corporate governance issues to other Russian companies, which result in very poor treatment of minority shareholders. While the concept of an owner-operated company appears very appealing, as it relates to alignment of insider interests with those of outside shareholders—and Pharmstandard’s Chairman Victor Kharitonin is one of the owners of Augment Investments, PHST’s largest shareholder, with 54% of shares—that has not been the reality with this company. On July 5th, when the company announced its intention to spin off the OTC branded pharmaceutical segment, it offered to purchase the shares of objecting investors at a significant discount to its stock price (as of that date). More specifically, the offered price of RUR 2,180 was 2% below the current stock price on the MICEX and 16% below the equivalent GDR price.
The second red flag was the acquisition of Bever Pharmaceutical Pte, for USD 590 million, announced on the same date. That company is controlled, through Bristley Enterprises Limited (Bristley), by Pharmstandard’s Director Alexander Shuster. It was incorporated in May, and its only asset is a contract to purchase API’s[1] for two of PHST’s drugs at very low prices.

Given the numerous governance issues and history of value destruction, such as the questionable acquisition of Bever Pharmaceutical, shares and GDRs of Pharmstandard are not recommended for purchase, regardless of their price. The same applies for both OTCPharm and Pharmstandard post spin-off. Projecting OTCPharm’s and Pharmstandard’s profitability as standalone companies is also practically impossible, given the lack of information regarding the prices at which the former will purchase drugs from the latter. Thus, the figures included in this report are presented with a warning label. Investors still interested in such a company could purchase post spin-off Pharmstandard shares at a price below RUR 1,000, on the basis of expansion of prescription (Rx) drugs and substances, stable and low risk earnings from Third Party Products (TPP) and increasing healthcare spending by both individuals—as their standard of living increases—and the government —as it tries to expand and modernize its healthcare system. As far as OTCPharm is concerned, an appropriate entry point would be RUR 400 per share, due to the high margins of branded pharmaceuticals, as well as the material probability of a sale which can reward shareholders with a decent premium. However, it should not be forgotten that OTCPharm shares will be available for purchase a few months after the spin-off materializes, as until the first half of 2014 the shares will be unlisted. Additionally, they will be traded, at least initially, only in Russia. The aforementioned problems, along with an expected small market capitalization and high insider ownership, may lead to a liquidity discount being applied at the shares. Shares of Pharmstandard prior to the spin-off could be bought at a price below RUR 1,359 per share, in which case investors would be advised to tender their shares at the price of RUR 2,180. While the likelihood of selling all one’s holdings is slim, even a sale of 25% of one’s stake will lead to a significant return, compensating for the additional risk. In fact, such a strategy would result in a 60% gain (by purchasing the stock at RUR 1,359 and selling it at RUR 2,180) for a quarter of one’s holding, allowing for a 20% downside protection for the rest (shares would have to drop below RUR 1,085 in order for the all-in performance to turn negative).

Metso will demerge its Pulp, Paper & Power division into a company known as Valmet by the end of 2013. Valmet operates in relatively weak markets that can marginally grow over the next few years. As a mitigant to these challenges, Valmet will start with a pro forma net debt of EUR 13 million and approximately EUR 130 million in additional liquidity, should it be required. Additionally, it is a market leader in most of the sectors it operates in, such as paper, pulp and biomass equipment and services. It is expected to trade at approximately EUR 9 per share, which is our low case valuation. While the mid case implies a share price of EUR 10.15, a mere 12.5% upside does not compensate investors for the risk of the company. Rather, one should seek higher return, that can be achieve by purchasing the stock at approximately EUR 8 per share. Given that Valmet will be a much smaller company, a selloff after the spin-off is possible and can provide investors with an attractive entry point.

A post spin-off Metso will focus on Mining & Construction and Automation. While mining is expected to suffer from a drop in mining capital expenditures, Metso has significantly developed its services business, which currently accounts for approximately half of its revenues in both Mining & Construction and Automation. Given that the services business is dependent on installed capacity rather than new capex, it is expected to remain pretty stable during periods of economic downturn. The Automation division also looks promising, as clients can invest to both increase efficiency and decrease expenditures. Additionally, Metso has very healthy margins, with both EBITDA and net income margins being fairly stable. Net income margins for the past three years have been approximately 6.5%. A low case valuation for Metso post spin-off is EUR 25.4, with a mid case being EUR 30.9 and a high case EUR 33.0. Shares of a post spin-off Metso would be recommended for purchase at a price close to the low end valuation—approximately EUR 25-26. Long-term investors, who could also benefit from the next big round of mining capex—which is, of course, a few years away—could purchase the stock at even higher levels. However, based on Metso’s current stock price, it is possible that Metso could trade at an even lower price, close to EUR 23-24, after the demerger.

Last but not least, and given that even a low case sum-of-the-parts valuation is 20% higher than Metso’s current price, shares of Metso are recommended for purchase before the spin-off. The SOTP valuation implies limited downside, while it is very probable that the two separate companies would command higher multiples than the company’s current 13 times estimated earnings. Additionally, Cevian Capital, Metso’s largest shareholder, is a long-term investor which has been with the company since 2005 and, if history is any indication, will hold onto its shares, an action that could reduce the effect of any selloff and provide fewer entry points after the demerger.

Spin-offs as an asset class have historically provided returns exceeding those of the broader market. In this white paper, evidence will be presented that over a ten-year time period, spin-off stocks have, on average, provided a degree of alpha that investors may find hard to consistently replicate via other asset classes through market cycles. Further, it will be shown that the parent company in spin-off transactions also provides excess returns above a benchmark, although to a lesser degree. While as a whole the statements above hold true over the period studied for this paper, it will be noted that returns vary widely among transactions, with instances of left- and right-tail events exceeding normalized return scenarios.

It is shown in this study that spin companies on average underperform the benchmark through the first month of regular-way trading, providing a limited window whereby investors may capture additional returns through market timing. Reasons for the underperformance can vary, but in general it can be stated that the shareholder base will enter a period of transition for various reasons, including market size and sector exposures.

Investors’ ability to avoid severe underperformers (including bankruptcies), capitalize on forced selling to create a margin of safety in purchases, and identify cyclical versus secular industry trends may allow excess returns to be captured above the average returns shown in this study.

On December 1, 2011, Alexander & Baldwin, Inc. (NYSE: ALEX) announced that its Board of Directors had approved separating into two independent, publicly traded companies. Prior to the separation, Alexander & Baldwin shareholders will vote on the creation of a holding company, Alexander & Baldwin Holding Inc., in which all assets currently part of ALEX will be merged. The formation of the holding company is to facilitate the transfer of real estate assets in an efficient manner, as well as to enable the ocean transportation company to maintain its Jones Act protection. The holding company will operate under maritime restrictions limiting ownership of shares by non-US citizens to less than 22%.

Following the merger into the holding company, the real estate and agribusiness assets will be separated into a new entity, which will retain the Alexander & Baldwin name and ticker symbol, while the holding company’s name will then be changed to Matson Inc. A decision on a ticker symbol is still pending. The shareholder vote on the merger is scheduled for mid-May 2012. If it takes place, the separation may occur as early as July 1, 2012. Completion of the transaction will require receipt of a favorable IRS ruling and tax opinion, effective declaration of ALEX’s Form 10 by the SEC, and final approval by the Board of Directors. Current ALEX CEO Stanley M. Kuriyama will serve as chairman and CEO of the new Alexander & Baldwin, while Matson’s current president, Matt Cox, will serve as Matson’s president and CEO upon separation. ALEX’s chairman Walter Dods will hold the same title at Matson and will retain a Board seat with the new Alexander & Baldwin.

Matson’s operations include 17 Jones Act vessels and 47,000 company-owned containers and container equipment, along with dedicated terminal facilities and a top US logistics company, among other businesses. Matson serves routes between US West Coast ports, Hawaii, Guam, and China. ALEX will focus on property development and management, which currently includes 88,000 acres of land, primarily in Hawaii, and 7.9 million square feet of commercial properties in Hawaii and on the US mainland. Additionally, ALEX’s agribusiness consists of 36,000 acres of productive agricultural land.

The separation should more clearly define the new businesses and attract a more focused shareholder base than is possible with the current corporate structure. On a sum-of-the-parts basis, one may value ALEX pre-spin at $57 per share, offering modest upside to investors. The stock appears interesting ahead of the separation transaction, but perhaps, the best opportunity for investors will emerge following the spin-off. In particular, there would appear to be significant potential for investor mispricing of either or both equities give the niche positions both entities fill in their respective industries.

Given that Matson is protected by the Jones Act, its revenue and operating profit have remained far healthier than the overall global containerized shipping industry. If Matson’s shares come under pressure post spin due to its perceived position in the competitive global shipping industry, that may provide an attractive entry point for investors, particularly if the Hawaiian economy continues to strengthen and the expected relocation of the US military base on Okinawa to Guam moves forward. The stock may appear attractive priced below a fair value of $19 per share following the transaction.

Investors may also be presented with an opportunity to purchase new Alexander & Baldwin (‘New A&B’) post transaction at an attractive price, as it is unlikely the stock will generate significant analyst coverage. A valuation is complicated by its sugar production business. Moreover, management has expressed no interest in transforming New A&B into a REIT, unlike most of its peers in the real estate developing and leasing industry. Also notable is the significant valuation divide between real estate entities included or excluded from exchange traded funds (ETFs), as shown in the attached tables. Stocks in the second attached table that are included in only a handful of ETFs have nearly twice the dividend yield as stocks in the first attached table and trade at nearly a 50% discount on a price/book basis. At least in the initial trading, ETFs are more likely to exclude New A&B given its sugar production operations and other complications. This could provide a compelling opportunity for investors if the stock initially trades a price below a fair value estimate of $38 per share.

On January 7, 2013, Newcastle Investment Corporation (NYSE: NCT) announced plans to spin off its residential assets into a separately traded real estate investment trust (REIT), New Residential Investment Corporation, leaving behind investments in commercial properties. The spin-off was revealed in conjunction with the announced investment of up to $340 million in excess Mortgage Servicing Rights (MSRs). Funding for the acquisition came from a 57.5 million share offering completed in January at a price of $9.35 per share. The spin-off is expected in March 2013, pending final Board approval and an effectiveness declaration by the SEC. New Residential is applying to list on the NYSE under the ticker ‘NRZ.’ The distribution of NRZ shares will be conducted as a pro rata taxable dividend to NCT shareholders. In February 2013, NCT sold an additional 23 million shares (including 3 million share overallotment) at $10.34 per share.

The separation would appear to be an effort to unlock value in NCT, which traded at an average dividend yield of about 12% in the 12 months prior to the spin-off announcement. Since plans for the transaction were revealed, the stock is up 18% (as of February 22), compared to a 2% rise for the S&P 500 and the Dow Jones All REIT Total Return Index.

Since the housing crisis, many mortgage REITs have sought ways to reposition their portfolios. Over the last two years, NCT has been purchasing excess MSRs, while Basel III Accord regulations, to be implemented shortly, may push larger banks out of this market. The excess MSRs will make up the largest portion of the spin-off entity’s assets, followed by remaining non-agency residential mortgage-backed securities (RMBS). Meanwhile, the parent has been de-risking the portfolio by reducing leverage and de-consolidating and selling securities to generate cash flow, while buying back debt at a discount. In 2012, NCT also purchased senior living properties. As one potential growth strategy, the parent may seek to transform itself into a property REIT following the separation.

Based on book values, projected internal rates of return (IRR), and target dividends, one may reach fair values of $6.52 per share for New Residential and $4.69 per share for the parent following the separation. One may choose to question the ability of management to achieve the 14% targeted IRR for each business following the separation. However, one may take comfort in the current yield, and the potential for higher dividends and multiple expansion through additional excess MSR and senior living acquisitions. Based on the current 8.3% yield and 5% upside to the fair value sum-of-the-parts estimate of $11.21 per share, NCT is recommended for purchase.

On July 31, 2012, Valero Energy Corp. (NYSE: VLO) announced that its Board had approved efforts to pursue the separation of its retail segment through a tax-efficient spin-off of the operations. The spin company will be named Corner Store Holdings Inc., and VLO will distribute 80% of the spin-off entity to shareholders on a pro rata basis. Corner Store intends to apply for a listing on the NYSE under the ticker ‘CST.’ Management expects a transaction to be completed in late 1Q or early 2Q 2013. The transaction requires an IRS private letter ruling, effectiveness declaration by the SEC, and final Board approval.

Valero has daily throughput of more than 2.8 million barrels per day combined (including 2.3 million barrels of crude oil capacity) at its 15 refineries located in the US, UK, and Canada. It also operates 10 ethanol plants with annual capacity of 1.1 billion gallons. The retail segment consists of 1,876 gas stations and convenience stores in the US and Canada. More than half the US stations are in Texas, with the remainder in California and additional western and southwestern states. The Canadian operations are primarily in the province of Quebec, with additional stations in Ontario, the Maritimes, and Newfoundland. The US retail stores are joint filling stations and convenience stores, some of which also offer car washes, video and game rentals, as well as ATM access. Of the 1,027 US locations, 828 are owned and 199 are operated under long-term lease. In Canada, there are 256 filling stations with joint convenience stores that are owned or operated under long term lease, 514 retail sites where Corner Store holds title to the motor fuel, but the convenience stores are operated by third parties and 79 cardlocks, owned and operated in remote areas by Corner Store, where pumps are unlocked by membership card and there are no adjoining convenience stores.

Convenience store operators have traded at higher multiples than refiners in recent years. The spin-off would appear to be an effort to unlock value, as, despite its sizable retail operations, VLO trades at a modest discount to other US refiners. VLO has also signaled that, following the separation, it plans to conduct an IPO for its midstream assets into a master limited partnership (MLP), which should likewise trade at a higher multiple than the remaining refining operations. Given the two expected transactions, shares of VLO post spin would seem positioned to outperform those of refiners over the next twelve months. Smaller refiner and fertilizer producer CVR Energy (NYSE: CVI), controlled by investor Carl Icahn, expects to raise more than $500 million in January 2013 through an offering of units in an MLP, CVR Refining LP (NYSE: CVRR), which includes its refining assets. CVI will control more than 86% of the units following the offering, including the general partner interest.

Given improving crack spreads, refining stocks have outperformed the S&P 500 over the last year (a group of four large US refiners, including VLO, is up an average 81% for the one-year period through mid-January 2012, compared to a 14% rise for the S&P 500 over the same period). However, rising refined product inventories could put the group at risk for underperformance in 2013. Recent M&A transactions in the refining space place a value of about $30 per share on VLO’s refining business. As a result, on a sum-of-the-parts basis, a fair value of about $37.50 per share for VLO can be reached.

A pullback in the current price of VLO could present an attractive entry point prior to the spin, although the current share price would appear to offer only limited upside ahead of the transaction. Greater availability of crude oil to refineries in the Gulf Coast (where VLO has the strongest presence), resulting from increased capacity from the Seaway pipeline and the southern leg of the Keystone pipeline (both running from Oklahoma to the Gulf), could improve refining spreads, bringing them closer to what is currently captured by Midwest plants. Progress on those fronts could be a catalyst for VLO shares. At minimum, a pair trade involving VLO and one of a group of other US refiners might be the best way for investors to benefit from the forthcoming transactions while minimizing the risk from a pullback in refining stocks. If the stock trades below $34 per share prior to the spin-off transaction, CST could be treated as a free dividend. Following the transaction, VLO could be valued at about $34.50 per share (including its remaining 20% stake in CST), and CST could be valued at $3.70 per share. VLO intends to dispose of its remaining CST shares within five years of the distribution. – The Spin-Off Report