Super spinoffs

On March 30, Altria Group will complete the spinoff of Kraft Foods. Altria shares have gained 48% since April 2005, double the S&P 500's return, when Chief Executive Louis Camilleri announced the possibility of separating Altria into several companies.

Charles Norton, manager of the Vice Fund in Dallas, Texas, believes that the spinoff will now allow Altria to unlock the true value of its core tobacco business. Norton sees Altria management focusing on international operations, which currently account for 45% of revenues.

Further, with Altria's $5 billion in cash and underleveraged balance sheet, Norton sees a hefty share buyback and a possible acquisition in the near future. With Altria currently trading at an almost 20% discount to the consumer staples sector and his sum-of-parts valuation, Norton sees shares easily appreciating by a similar percentage within the next 12 to 18 months

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Although Norton is less sanguine on Kraft's short-term prospects (and he's not alone), many analysts believe that Kraft management will be better able to tackle problems, such as stagnating growth, as an independent company.

Spinoffs usually occur when companies want to streamline operations or divest underperforming businesses. Sometimes such motivation comes from within, other times it results from the urging of shareholder activists. A recent example: Carl Ichan, who pressured Temple-Inland to spinoff two businesses and to divest its timberland operations.

In a pure spinoff, the parent company issues stock in a subsidiary (or business segment) to shareholders, forming an independent company. An advantage to prespinoff shareholders of the parent company is that such, in most cases, distributions are tax-free.

Spinoffs tend to be attractive long-term investments. Research from Lehman Brothers found that spinoffs from the top 1,500 U.S. stocks, by market value, beat the stock performance of the S&P 500 by an average of 18% from 1990 to 2005.

Why the success? For one, the newly formed company benefits from a greater focus on its core business. Management operating as a stand-alone company may find compensation tied directly to their performance, rather than having their pay based on the success or failure of a diversified parent company. Such breakups create greater attention and transparency for the independent company, making it easier for Wall Street analysts to cover and make forecasts.

With this in mind, we have searched for potential spinoff standouts that have not received the attention of Altria.

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One notable: Western Union, spun off from processing giant First Data in October 2006. Founded in 1851 as a telegraph company, Western Union is now the preeminent player in the money-transfer industry. Through a sprawling network of over 270,000 agent locations in 200 countries, Western Union controls 17% of the money-transfer market; that's over five times the share of MoneyGram International, the company's closest competitor.

Western Union management has seen sales grow at nearly 15% per annum since 2001, and it expects growth to remain robust as the company expands internationally, especially through Eastern Europe, China and India. The company is a cash cow, too. With net margins topping 30% and little long-term reinvestment needs, Western Union converts an impressive 20% of its sales into free cash flow (we define free cash flow as net income plus depreciation less capital expenditures).

Caveats? The U.S. immigration debate continues to cast doubts on the sustainability of the Western Union's growth. However, the concerns may be overblown. Morningstar equity analyst Brett Horn, for one, believes that the impact of any legislation would be limited, as "the economic pull of wealthier countries to immigrants is a well established trend."

Another issue: Running your own company is not cheap. Management expects to take on between $65 million and $75 million in additional costs a year, dampening margins in the short term.

Western Union, shares of which have gained 18% since closing on the first day of trading, trades hands at 17 times estimated earnings for 2008, compared with an aggregate multiple of 18 for the data processing industry.

All companies in the accompanying table are potential spinoff stars. Based on Thomson IBES consensus earnings estimates for fiscal 2008, all trade at a discount to their respective industries. Analysts expect all these companies to post long-term annualized earnings growth of at least 10%.

Those investors drawn to spinoffs, but not interested in picking individual winners, may want to consider the Claymore/Clear Spin Off ETF, which tracks a propriety index of 40 select spinoffs. The exchange-traded fund is off to a solid start: It has posted a 4% gain, versus a loss of 2% for the broader market, since it began trading in mid-December.

Spinoff Standouts

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