Novartis to Spin-Off Sandoz on or about October 4, 2023

On August 18, 2023, Novartis AG (NOVN SW, NYSE: NVS) announced the company had filed a shareholder information brochure in relation to a proposed spin-off of its generic drug business, Sandoz. NOVN will hold an Extraordinary General Meeting (EGM) on September 15, 2023, at which time investors will vote to approve the posited spin-off. If completed, the separation would be accomplished via a dividend in kind whereby NOVN shareholders of record would receive one share of Sandoz for every five shares of NOVN. The Sandoz spin-off is planned to occur on or around October 4, 2023, with a primary listing on the SIX Swiss Exchange, and an American Depositary Receipt (ADR) program in the U.S.

In 2022, NOVN generated $50.5 billion in revenue and $16.7 billion in core operating income, as compared to $51.6 billion and $16.6 billion in the prior year. As the company currently stands, NOVN reports under two segments: Innovative Medicines, which contributed $41.3 billion in revenue in 2022, and Sandoz, which registered sales of $9.2 billion in 2022.

Innovative Medicines focuses on development and marketing of novel medicines and includes treatments for cardiovascular, immunology, neuroscience, solid tumors, and hematology. Well known products include Cosentyx (marketed for psoriasis) and Entresto (chronic heart failure). Year-over-year Innovative Medicines revenue declined by 2% in 2022 as significant growth from cardiovascular products, in particular 31% growth in revenue from Entresto, was offset by generic competition for the segments more established brands (Afinito/Votubia and Gilenya). Through 1H 2023 segment revenue increased by 5% on key product strength (Entresto, Kesimpta, Pluvicto, and Kisqali), which was partly offset by generic competition. Generic competition lowered revenue grew by 5 percentage points, while pricing added an additional 3 percentage point headwind. Core operating margins widened to 36.9% in 1H 2023 versus 36.2% in 1H 2022.

Sandoz controls NOVN’s portfolio of generic pharmaceuticals and biosimilars. Sandoz revenue decreased by 4% in 2022 and operating income declined by 8% as higher investments to generate sales and inflationary costs reduced margins to 20.6% versus 21.4% in the prior year. Through 1H 2023 sales increased 4%, largely on strength in Europe on products regionally launched within the prior 12 months, which was partially offset by pricing. Sandoz 1H 2023 core operating profit declined by 2% as margins were 19.6% versus 21.2% in 1H 2022.

The separations of generics from “Innovative Medicines” follows an industry trend where pharmaceutical manufacturers separate out the lower margin and in general revenue declining generics businesses from the higher margin, higher growth potential, yet involving higher R&D expense, proprietary development businesses. Following the separation, the parent company will optically have an improved growth and margin profile, while the spin company’s dedicated capital structure will allow it to pursue attractive off-patent opportunities and return capital to shareholders.

In conjunction with NOVN’s 1H 2023 results, management updated its full year 2023 guidance to include Innovative Medicines sales growth of high single digit, and core operating income increase of low single digit to mid-teens (includes corporate expenses and excludes Sandoz contribution). Sandoz sales are expected to increase by mid-single digits, and core operating income to decline in the low double-digit range based on standalone company costs and continued inflationary pressures.

Notably, in terms of rationale, specialty pharmaceutical companies trade at a premium to generic manufacturers. NOVN currently trades at 11.6x forward EBITDA, which is roughly in line with peers such as Pfizer Inc. (NYSE: PFE) and Merck & Co. Inc. (NYSE: MRK), while generic manufacturers such as Teva Pharmaceutical Industries Ltd. (NYSE: TEVA) trade at closer to 7.0x forward EBITDA. As such following the separation it should be expected that the parent company would not see a large degree of multiple expansion, while the generics company would likely experience multiple contraction top approximate peers.

Based on 1H 2023 results, and managements guidance, we forecast that as standalone companies, Sandoz and Novartis (ex-Sandoz) will generate $1.9 billion and $17.7 billion in respective EBITDA during 2023. Valuing Sandoz at 7.0x and Novartis at 12.0x, implies post-separation enterprise values of $13.1 billion and $212.7 billion. Incorporating current net debt and diluted shares outstanding, as well as the current USD/CHF exchange rate, we preliminarily assign a pre-spin fair value estimate of CHF 92.00 per share to NOVN SW.

On June 21, 2022, Kellogg Co. (NYSE: K) announced that its Board of Directors approved a plan to separate the company into three standalone, publicly traded companies. The separation, which was posited to be completed via tax-free spin-offs, would have resulted in shareholders of record owning interests in, as referenced at the time of the announcement, “Global Snacking Co.,” “North America Cereal Co.,” and “Plant Co.” In February 2023, in conjunction with the company’s 2022 year-end results, K announced that it now plans to retain its plant-based business while spinning off just its North America cereal business. In terms of timing, management is currently targeting the spin-off to be completed by year-end 2023, subject to customary closing conditions including the final approval from the Board of Directors, an effectiveness declaration of the company’s Form 10 filing by the SEC, and receipt of a private letter ruling from the IRS in respect to the tax-free nature of the transaction, amongst others.

The spin company will control the North American Cereal business, adopt the corporate moniker WK Kellogg Co. and intends to trade on the NYSE under the symbol “KLG.” The parent company, a global snack-focused business, will change its name to Kellanova following the separation and continue to trade on the NYSE under the ticker “K.”

Management’s stated rationale for the separation largely hinges on the idea that it believes that Kellanova’s growth and margin profile has been obfuscated withing the current conglomerate structure. Following the separation, Kellanova’s superior revenue growth and margins, relative to WK Kellogg’s, will be more apparent to investors, while WK Kellogg’s dedicated sales force and management, combined with its independent balance sheet, will allow management to make investments in its supply chain to expand margins.

In theory, upon the separation, the snacks-focused growth company with higher margins should be re-rated to a higher valuation multiple while the cereal company will likely be re-rated lower. Interestingly, with K currently trading at 11.0x 2024 estimates, it approximates that of WK Kellog peers. However, given the spin company’s margin profile and goal of “stabilized” sales, the shares will trade at a discount to the group.

On a pre-spin, sum-of-the-parts basis, we fairly value shares of Kellogg Co. at $73 per share, consisting of $3.50 per share in value from WK Kellog and approximately $70 per share in value from Kellanova. With shares trading at 11.0x the current 2024 consensus EBITDA estimate, current negative volume trends across the business, and the impending separation, combined with the implied upside to our fair value estimate, we view it as prudent to rate shares of K at NEUTRAL ahead of the expected 4Q spin-off of WK Kellogg.

While we do not see a pre-spin opportunity, we do anticipate the potential for post-separation investment opportunities, depending on the ultimate initial trading range of Kellanova and WK Kellogg. Of primary interest would be if WK Kellogg experiences an initial sell-off of shares due to investors exiting the spin company ownership position in favor of maintaining a position in the more growth oriented, geographically diversified snacks company, which should pressure shares of WK Kellogg in initial trading. Additionally, given the relative estimated market capitalizations of the post-spin company’s it should be expected that WK Kellogg will not be included in the S&P 500 (K is currently a constituent and we would expect Kellanova to remain in the index), which would also create indiscriminate/forced selling by indexed investors. If shares of WK Kellogg trade at a significant discount, investors may see an opportunity to invest in a “classic spin-off” where an “unloved” and underinvested entity is able to significantly improve operations and offer significant out sized returns over the longer term. Given a separate management, focused sales force, and an independent balance sheet, if management were to successfully widen margins to approximate that of peers and delever following the investment phase, WK Kellogg could show significant earnings growth potential in the out years.

On November 3, 2022, before the market open, Lithium Americas Corp. (NYSE: LAC) announced that it intends to spin off its North American mining operations into a separate, stand-alone publicly traded company. The separation, if completed, will be accomplished by a pro-rata distribution of shares in Lithium Americas (NewCo) to shareholders of LAC, while the parent company will be referred to as Lithium Argentina. Lithium Argentina will control the Cauchari-Olaroz project, as well as the Pastos Grandes basin development operations. NewCo will consist of the 100% ownership of the Thacker Pass project. The spin-off will be subject to customary closing conditions, is expected to be “tax-deferred” to U.S. shareholders and is currently targeted for completion by October 15, 2023, but in any event, no later than December 31, 2023.

Lithium Americas Corp. (NYSE: LAC), is a pre-production lithium miner that develops (and will eventually operate) lithium projects in two main geographic regions, namely Argentina and the U.S. Founded in 2007 by Raymond Edward Flood Jr., and currently headquartered in Vancouver, British Columbia, Canada. LAC conducted an initial public offering in 2010, raising $5 million. The company is currently pre-revenue and is in various stages of permitting, construction, and ramp up of production on its major projects, which include Cauchari-Olaroz in Argentina, and Thacker Pass, located in Humboldt County, Nevada. Notably, the company acquired its U.S.-based assets (i.e., Thacker Pass) in 2016 through a merger with Western Lithium. LAC also controls the Pastos Grandes Project mine operations, which are also located in Argentina, which were acquired in 2022, as well as the 2023 acquisition of the Sal de la Puna Project.

We base our fair value estimates on management’s disclosed DCF and NAV values. Given the large reserve values, projected supply demand imbalance, and current pricing of lithium, it is difficult to argue that future cash flows will not exceed the current market capitalization/enterprise value. However, given the long-time frame in which the mines will produce lithium, currently modeled at 40 years, and the differences in initial production of battery-grade lithium from the two disparate sites, investors must consider the time-value of money in considering an investment. In that context, LAC’s spin transaction in and of itself is likely not a significant value-creating event, in contrast to most spin-offs that fall into our coverage universe. Instead, the separation highlights the near-term production ramp up in the Argentinian assets versus the long road ahead for the American asset. In that respect, investors looking to capitalize on the increasing demand for lithium and the structural supply and demand imbalance, would likely favor investment in Lithium Argentina, while investors with a longer investment time horizon may take a closer look at post-spin Lithium Americas.

In the short-term, we would expect the share price of LAC to be highly speculative, particularly in relation to post-spin Lithium Americas (NewCo), with shares reacting to news and litigation flow prior to the eventual production of battery-grade lithium. For Lithium Argentina, we would expect much less speculation in shares given the near-term production ramp up, and therefore expect shares to trade more dependently on production and pricing of lithium.

Given the above noted differing characteristics of the two post-spin companies, most starkly illustrated by the significantly longer time frame until production ramps up at the U.S.-based asset, we view it as appropriate to value shares using a higher discount rate versus the Argentinian assets. Thus, we value shares of Lithium Americas (NewCo) at 12% and Lithium Argentina at 10%. Based on management’s post-spin capitalizations, we assign a post-spin fair value estimate of $19 per share to New Lithium Americas Corp, and $4 per share to Lithium Argentina (see Exhibit 13). On a pre-spin, sum-of-the-parts basis, we fairly value shares of LAC at $23 per share. While presenting ~20% upside to our fair value, we rate shares at NEUTRAL, based on the above noted factors related to the time horizon to capture the upside potential in shares and our opinion that the spin transaction is not necessarily the catalyst to immediately realizing that value. In that context, investors with a longer investment time horizon may wish to consider ownings shares of LAC.

On July 12, 2023, after the market close, Lions Gate Entertainment (NYSE: LGF/A, LGF/B) issued a press release announcing that the company filed a public Form 10 registration statement with the SEC to conduct a tax-free spin-off of its Motion Picture and Television Production business segments, collectively referred to as LGF’s Studio Business. The transaction, which is targeted to be completed by the end of September 2023, is subject to customary closing conditions, including an effectiveness declaration of a Form 10 filing with the SEC and final approval from the company’s Board of Directors, amongst others. Following the separation, the parent company will control the Starz cable television station operations. Post separation, the spin company will adopt the corporate moniker Lions Gate Entertainment Corp. (“New Lionsgate”) and the parent company will change its corporate name to Starz Entertainment Corp. (“New Starz”). As of this writing, share distribution ratios and post-spin capital structures have yet to be finalized. LGF’s current CEO Jon Feltheimer, CFO James W. Barge, and COO Brian Goldsmith will all remain with the Studio business following the spin.

In terms of rationale, the undoing of the ill-timed/miscalculated acquisition of Starz appears to be the main motive. The increased prevalence of cord-cutting, whether a true industry phenomenon or just a STARZ-specific issue, is pressuring the company to invest in original content, which competes for investment with the studio business, especially when considering that cash flow is largely generated from the Lions Gate film library and the Starz international operations continue to operate at a loss. Following the LIONSGATE+ write-downs, it would appear that the value of Starz will be far below the 2016 purchase price, and the Studio business will likely look more attractive to investors and potential acquirers as a standalone company. In reference to the potential acquisition of the Studio business, which may make sense for another production company to add scale, it should be noted that there may be near term impediments to a potential acquisition of the spin company in order to maintain the tax status of the spin-off. Those restrictions may not apply to the parent company, however. Notably the separation creates a pure-play content company (New Lionsgate) and a pure-play premium subscriber platform (New Starz), a reverse from the Starz acquisition rationale, which at least in part was driven by increasing diversification of revenue away from heavy reliance on blockbuster theatrical releases.

In the context of better positioning the post-spin companies to create shareholder value, it is worthy to consider that it was reported by Reuters in 2017 that toy and game manufacturer Hasboro Inc. (NASDAQ: HAS) attempted to purchase LGF for a reported minimum of $40 per share. At the time of the reports LGF shares traded at slightly above $29 per share. Further, at the close of the STARZ acquisition on December 8, 2016, shares of LGF traded at $26.06.

On a pre-spin basis, we assign a fair value estimate of $8 per share to pre-spin LGF, consisting of $7 per share in value from New Lionsgate and $1 per share in value from New Starz, and assign a NEUTRAL rating. While it appears that you would be getting the Starz business for virtually free by our valuation exercises, we refrain from recommending shares as continued headwinds at Starz and the inherent lumpiness of the film industry, combined with the current writers (and actors) strike inserts increased risk to our fair value estimate while not providing for a large enough margin of safety to be comfortable with a more positive recommendation. Post-spin, although inherently somewhat erratic, we would favor the Studio business over Starz given the large library of content controlled, which should provide some degree of top line stability, and the potential for acquisitive suitors over the long term provide a more attractive investment opportunity than the Starz business, in our view.

On September 15, 2022, after the market close, NCR Corp. (NYSE: NCR) announced plans to separate its digital commerce and ATM businesses into a separate, publicly traded companies. The separation is targeted to be completed in early 4Q 2023 and is subject to customary closing conditions, such as final Board approval, an effectiveness declaration of the company’s Form 10 filing by the SEC, and an opinion on the tax-free status of the separation. In conjunction with the spin announcement, management stated that throughout the review process, the company received “material interest in a whole company sale,” as well as interest in various individual segments.

As of today, the company operates under five segments: Retail (29% of revenue in 2022), Hospitality (12%), Digital Banking (7%), Payments and Network (16%), and Self-Service Banking (33%). In recent years, the company has particularly focused on shifting sales offerings from hardware sales and onetime perpetual software license offerings to multiyear subscription-based revenue streams, positioning the company as a Software-as-a-Service (“SaaS”) provider to financial, retail, and hospitality companies.

Since prior to a strategic review announcement in early 2022, NCR has been a constant target of speculation as to whether it would be acquired in whole or part, with commonality in potential suitors throughout the years. The company has worked to transform itself from a hardware manufacturer with a perpetual sales license model into more of a SaaS company that also supplies hardware, in particular in relation to Retail, Hospitality, Digital Banking, and Self-Service Banking. While management is often queried on the subject during earnings conference calls and in person, their responses are measured, as required. The latest buyout speculation surrounds the potential sale of the Digital Banking business ahead of the planned spin-off.

In terms of rationale, management believes that the current structure obfuscates the underlying business characteristics of both businesses, with a particular impact on the ATM operations. Historically investors have looked at the ATM business as a steady state operation that will likely face structural headwinds in an increasingly cashless world. It should be noted that while cashless transactions continue to increase, cash in circulation is also increasing, benefiting from global wealth creation in international markets. As a standalone entity, the shift to the ATMaaS model’s financial benefits will be more clearly articulated. On the parent company side, the transition to a SaaS-based model should also increase and provide a growing, recurring revenue base over time that capitalizes on increased use of technology-enabled solutions across the retail and hospitality division, with the digital banking operations providing upside optionality in the event that management enters into a sale of the division, as has been speculated in the financial press. (Notably if the Digital Banking business remains within the parent company, the high margin and growing revenue would also benefit furthering of the Retail and Hospitality R&D spend in support of future growth.)

On a pre-spin basis, we fairly value shares of NCR at $32 per share, consisting of approximately $11 per share in value from ATMCo. and $21 per share from the parent company. At this level, we are valuing shares at 7.6x our consolidated EBITDA estimate, which on the whole appears attractive when compared to SaaS companies, as well as considering the healthy cash flow from ATMCo., and opportunities for revenue acceleration at both post-spin companies if management can successfully implement customer shifts to the ATMaaS and SaaS platforms. Given the favorable business trends, combined with the implied upside to our fair value estimate, we rate shares of pre-spin NCR at BUY. Post-spin, despite managements conjecture that investors appear interested in the ATMCo.’s cash flow characteristics, we would posit that NCR shareholders may rotate out of ATMCo. given the view that the ATM business is a legacy business that lacks growth, in favor of the parent company, which may initially pressure the new company’s share price.

Tiptree Inc. (NASDAQ: TIPT) operates two business segments: (1) Insurance, which is a group of specialty insurance companies operating as Fortegra (89.5% of sales and ~90% of adj. net income in 2022) that focuses on underwriting niche commercial and personal property & casualty insurance as well as offering capital-light, unregulated, fee-generating warranty solutions in the U.S. and Europe; and (2) Tiptree Capital, which seeks to acquire quality small & middle market businesses outside the insurance sector. Since its founding in 2007, TIPT has invested in ~20 companies with realized internal rates of return (IRRs) nearing 25% although its primary current investments are in cash & short-dated U.S. treasuries along with the mortgage originations and senior housing sectors.  

By our calculation, TIPT, at ~7.5x 2024E adj. net income, trades at a meaningful discount to the sum value of its parts, particularly its majority ownership in Fortegra, which has posted 20%-plus compound annual growth in sales and net income since 2017 but seemingly trades at a significant discount to the valuations awarded specialty insurance peers in both the public and private markets.  In that context, following a scuttled attempt at an initial public offering (IPO) in April 2021, Fortegra secured a minority investment from Warburg Pincus in October 2021, which, at the time, appraised the business at a post-money valuation of ~$725 million (or ~13.5x trailing 12-month net income). Moreover, recent indications suggest that management, who collectively owns 31.5% of TIPT, is likely to revisit its strategic options for Fortegra (including an IPO, spin-off or sale) as its robust growth profile persists and new issue market conditions improve, which we think would unlock substantial value for shareholders.  (Conversely, TIPT could monetize the investments held at Tiptree Capital.)  

Based on management guidance & commentary as well as peer and M&A valuations, TIPT’s Insurance business, Fortegra, could be valued at ~$22 per share based on a 12.5x multiple of 2024E net income while Tiptree Capital could be valued at ~$3 per share based on a 0.5x multiple of book value (ex-NCI), yielding a base case sum of the parts value of $24.50 per share (with bull & bear cases of ~$29 and ~$20 per share, respectively).  Potential catalysts include the separation/monetization of assets, including Fortegra and/or the investments held at Tiptree Capital, accretive M&A, share repurchases, and/or better than expected growth and margins, particularly at Fortegra. Risks include management execution, competition, regulation, increased adverse claims/investment losses, cyberattacks/technology breaches, persistent inflation and/or a recession.

On December 6, 2022, BorgWarner Inc. (NYSE: BWA) announced its intention to spin off the company’s Fuel Systems and Aftermarket segments into an independent, standalone, publicly traded company. The transaction, which is expected to qualify as tax-free to U.S. investors, is to be completed on July 3, 2023, after the market close, subject to customary closing conditions, including an effectiveness declaration of a Form 10 filing with the SEC and final approval from the company’s Board of Directors, amongst others.

The spin company will adopt the corporate moniker PHINIA and is expected to trade on the NYSE under the ticker “PHIN.” BWA shareholders of record as of June 23, 2023 will receive one share of PHIN for every five shares of BorgWarner owned. When-issued trading is expected to begin on the third trading day prior to the distribution (June 28, 2023) and regular-way trading is expected to begin on the first trading day following the distribution (July 5, 2023).

The spin-off of PHINIA is a key step in attaining BWA’s electric vehicle parts sales goals. The company has said it is on target to achieve the $3.5 billion in all-electric sales, achieved via current booked revenue, targeted M&A, and the separation of PHINIA. Further the company is targeting $10-plus billion in eProducts, with eProducts sales achieving adjusted operating margins of approximately 7%, while maintaining double digit margins on “foundational products.” As of now, eProduct sales are expected to operate at a breakeven level by the end of 2023.

Shares of BWA currently trade at 5.4x the 2024 consensus EBITDA estimate and 8.4x the consensus EPS estimate and have averaged 5.1x EBITDA over the past five years. The company, as it is currently constructed, is largely considered a traditional auto parts supplier while it is still early in its transformation into an EV supplier. The separation of the fuel systems and aftermarket businesses amplifies the current EV focused pieces of the business, and as such should be rewarded with a higher multiple following the spin. Conversely, PHINIA’s business should be re-rated lower to account for its focus on combustion light vehicles and the aftermarkets business.

On a pre-spin, sum-of-the-parts basis, we fairly value shares of BorgWarner Inc. at $51 per share, consisting of approximately $44 per share in value from post-spin BWA and $7 per share in PHINIA. On a post-spin basis, we value shares of BWA at $44 per share and PHINIA at $33 per share to account for the one-for-five share distribution ratio. Given limited upside to our fair value estimate, we rate shares of pre-spin BWA at NEUTRAL. On a post-spin basis, we would favor the BWA remain co. businesses as the path to electrification provides for a greater growth story versus PHINIA, granted they achieve their profitability goal on the eProducts portfolio and successfully manage their M&A integrations. For PHINIA, we would be incrementally positive if shares traded at a significant discount to our fair value estimate, as we do see significant cash flow generation from its product portfolio over the coming years. However, would remain cautious as the company likely does not receive a valuation multiple above low single digits given its end market exposure.

On July 28, 2022, Laboratory Corporation of America Holdings (NYSE: LH) (“Labcorp”) announced that it plans to separate its clinical development business into a standalone, publicly traded company via a tax-free spin-off. The spin company will adopt the corporate moniker Fortrea Holdings Inc. and is expected to trade on the NASDAQ under the symbol “FTRE.” The separation is to be completed on June 30, 2023, to shareholders of record as of 5:00 p.m. EST on June 20, 2023. The completion of the spin-off is subject to customary closing conditions, such as final Board approval, an effectiveness declaration of the company’s Form 10 filing by the SEC, and “appropriate assurances” in regard to the tax-free status of the separation. Labcorp shareholders will receive one share of FTRE for every share of LH held as of the record date. When-issued trading is expected to begin on or around June 16, 2023, and regular-way trading is expected to begin July 3, 2023.

Today, Labcorp is a provider of diagnostic, drug development, and technology-enabled solutions to over 160 million patient encounters per year. Additionally, the company participates in research-based drug development processes via LH’s central laboratory, preclinical, and clinical development businesses. The company currently operates under two reporting segments: Labcorp Diagnostics (“Dx”) (62% of revenue) and Labcorp Drug Development (“DD”) (38% of revenue). Given Labcorp’s significant participation in diagnostics, the company benefited greatly from the COVID-19 pandemic. As the pandemic has shifted to an endemic, COVID-related revenues are expected to sharply decline in 2023, providing a drag on company revenue (in particular Dx revenue.)

In terms of rationale, management has been explicit in its view that the CRO (contract research organization) business was never given a proper valuation in the current consolidated structure and instead has traded either in line with, or at a discount to, comparable lab services peers. For comparison, LH currently trades at 8.9x the current 2024 consensus EBITDA estimate, while the best pure-play diagnostics peer trades at 10.0x and Fortrea peers trade, on average, at 12.4x.

In theory the spin company would experience multiple expansion that is closer to its new peer set. However, with margins lagging peers, and the execution risk of further operational improvement implementations, combined with what appears to be low management expectations on standalone corporate costs (versus historically allocated costs from LH), it is unclear if the new company will be awarded a full peer multiple, at least initially, and in fact may warrant a discount or only a slight premium to the low end of the peer set. Conversely, the parent company appears to be nearing the end of COVID-related revenue declines and margin reversion, and may in fact be trading at an implied discount to where shares ex-FTRE should be trading.

On a pre-spin, sum-of-the-parts basis we fairly value shares of Labcorp at $255 per share, consisting of $219 per share in value from post-spin LH and $35 per share in value from Fortrea. Given the strength in both company’s base businesses, the lessening impact of COVID-related revenue on the parent company, and margin improvement opportunities at Fortrea, combined with the implied upside from the current share price to our fair value estimate, we rate shares of LH at BUY ahead of the spin-off.

Importantly, on a pre-spin basis it should be noted that the true value to be unlocked from this transaction would be related to the re-rating of the parent company, given the relative size of earnings contributions and net debt-to-EBITDA levels between the two post-spin entities. Even if the spin company were to receive multiple expansion to equal that of peers, the pre-spin fair value estimate would increase by approximately $6, versus a one turn increase in the parent company’s multiple, which would increase the pre-spin fair value estimate by approximately $25 per share. On a post-spin basis, we would favor the parent company if it were to trade at a discount to our fair value estimate.

RCI Hospitality (NASDAQ: RICK) operates two primary business segments: (1) Nightclubs (~77% of consolidated sales and 87% of adj. EBITDA in September-ending F2022), which owns and operates 59 gentlemen’s clubs in 13 U.S. states; and (2) Bombshells (~22.5% of total revenue and ~13% of adj. EBITDA), which operates 13 military-themed, casual dining restaurants & bars. The “Other” segment (~0.5% of sales in F2022), is primarily comprised of RICK’s media division along with sales of the energy drink, Robust.  In our view, RICK, which, on a consolidated basis, targets compound annual free cash flow per share (FCF) growth of 10%-15% (at minimum), is, at ~8.0x F2025E EBITDA and a FCF yield of ~11.0%, undervalued relative to the sum value of its parts. On the fundamental front, in pursuit of its FCF goals, RICK intends to further consolidate the Nightclubs business, which enjoys structural barriers to entry and generates high margins with durable cash flows, at 3x-5x EBITDA (and cash-on-cash returns of at least 25%-33%), as well as organically expand its Bombshells sports bar concept, via both company-owned and franchised locations (again, targeting cash-on-cash returns of at least 25%-33%).

RICK will also repurchase shares when its FCF yield exceeds 10% (which, per management’s baseline assumptions, is currently estimated to be in the $72-$83 per share range). On the transactional front, we think RICK’s Bombshells concept presents optionality for an eventual spin-off or sale as it gains incremental scale toward ~$50 million of annual EBITDA. (In fact, management has anecdotally indicated that a financial sponsor offered ~14x, or ~$280 million, for Bombshells in mid-2021, but the company concluded the transaction was premature and offered inadequate value.)

Based on management guidance and commentary as well as peer and M&A valuations, RICK’s Nightclub and Bombshells businesses could be valued at ~$118 per share, and $25.50 per share, respectively. Accounting for corporate costs and projected net debt of ~$43.50 per share yields a base case sum-of-the-parts fair value of $100 per share (with bull and bear cases of ~$126 and ~$74 per share, respectively). Potential catalysts include a spin-off or sale, better than expected growth/margins/FCF, stock buybacks, and/or acquisitions. Potential risks include execution, regulatory changes, including on employment classifications, zoning and liquor licenses, cost inflation, changes in consumer behavior, insurance liability, a pandemic, and/or a recession.

On May 10, 2022, Aramark (NYSE: ARMK) announced that it plans to divest Aramark Uniform Services (AUS) into a separately traded public company. The separation is expected to be completed via a tax-free spin-off of shares in AUS to ARMK shareholders of record as of a yet-to-be disclosed record date. Management currently expects to complete the transaction by the end of F2023 (September year-end) and the transaction is subject to customary conditions, including final Board approval, as well as the receipt of a favorable tax status opinion from the IRS.

In conjunction with the spin-off, AUS will raise a yet-to-be determined amount of debt, which will be used to fund a one-time cash dividend to the parent (ARMK), which will use the proceeds to reduce its outstanding debt. At the time of the spin announcement, it was stated that both companies were expected to have targeted leverage ratios below 3.5x by F2025.

As it stands today, ARMK operates as a “leading global provider of food, facilities and uniform services to education, healthcare, business & industry, and sports, leisure & corrections clients.” Aramark’s main operations are in the United States and has exposure in an additional 18 international markets. The company manages several interrelated services, including food service, facilities support, including custodial, groundskeeping and transportation, amongst others, and uniform solutions including uniform laundering, as well as sales of uniforms and related products. In F2022, the company generated $16.3 billion in revenue and $1.3 billion in EBITDA.

Shares of Aramark currently trade at 10.2x the consensus 2024 EBITDA estimate. In theory, shares of the Uniform company, with wider margins than the parent, should experience a degree of multiple expansion as a standalone company. The larger question is what happens to the parent company’s trading multiple. On the surface, when compared to peers in terms of sales growth and margins, we view the FSS business as operating in between CPG LN and SW FP, which trade at 12.6x and 9.2x, respectively.  If the company is viewed in that perspective, it should not be expected to see a corresponding level of multiple contraction (relative to the SpinCo). In fact, over time, it appears reasonable that the company would also see multiple expansion as margins continue to improve. Anecdotally, shares of ARMK have traded, on average, at 9.9x and 9.7x forward EBITDA estimates over the past five and ten years, respectively.

On a pre-spin, sum-of-the-parts basis, we value shares of ARMK at $45 per share. In our view, ARMK is in the process of returning its segment margin profiles to closer approximate that of pre-pandemic levels, having already achieved that goal on a revenue basis. Through new client wins across FSS and Uniform, as well as successfully passing pricing through to counteract the inflationary environment, it appears the company is poised for above-historical earnings growth over the next several years (management has guided to 32% operating income growth in F2023). Absent a resurgence in inflation or a severe recession, we believe that shares of ARMK, trading at less than 10x 2024E EBITDA, appear attractive heading into the separation of the Uniforms business. As such, we rate shares of ARMK at BUY.