For those that don’t know, can you give everyone a background on how you got into investing? What led you to spin-offs?
I am Boston born and raised, growing up I always loved investing. I was always one of those kids that was in the investment club in high-school and college. I was lucky, my parents were both in the business. My dad was a large-cap value portfolio manager. My mom was a bond analyst.
I pestered them non-stop with questions. I found myself very interested in investing. It was awesome to have them as a resource.
After I graduated from college, I got a job in the equity research group at Eaton Vance (Equity Research Associate). It was a great place to start my career. I was able to work with a bunch of different senior analysts. MBA types with 15+ years experience. With their CFAs.
I got to cover healthcare. I looked at some financials. I looked at software, internet. Really got to learn the business that way. Eaton Vance encouraged everyone to do their CFAs. Which was helpful.
After six years at Eaton Vance, I wanted to switch it up a little bit. Eaton was a great place to start my career, but, some secular headwinds were becoming apparent — in terms of competition from passive managers, and the index funds of the world. Eaton Vance was largely focused on large cap. So there just wasn’t as much upward mobility in terms of career.
So I started exploring other options. I ended up switching and joining Citi Private Bank. Switching gears a little bit. Focused more on private equity research. My time at Citi was awesome. One of the best parts was that I learned something new. My learning curve took off. Learned the PE industry. It was more top-down research. We researched interesting themes, and tried to find best PE manager to execute on those themes.
So that was a great experience as well. I learned a ton there and enjoyed my time there. But I really missed focusing on making individual investment decisions, and doing the fundamental public analysis work. That is kinda how I got into starting my blog. Which ended up turning into my business. Which is focused on spin-offs.
Take me through the process from moving to Citi and going on your own?
Have you read Tim Ferriss’ 4-Hour Work Week?
Yes, I loved it.
I was a wantrepreneur for a long time. Never took the plunge. But reading that book really opened my eyes that there’s a whole world of people out there that are starting their own small, micro businesses. A person of one, all you need is your internet and a computer. You can basically start a business.
That was kinda inspirational. When I started my blog I always kinda hoped it would turn into a business. The idea was that I would start the blog anonymously. I would publish my spin-off ideas. It would serve two purposes:
1. It would get my name out there.
2. It would help me document my investment process.
In a weird way it holds you accountable. You don’t want to sound like an idiot. Maybe it’s a little deeper than if I wasn’t publishing online. So that’s the reason I got started. I was hoping that maybe I could turn it into a business. And I wanted to document my process and get better at that.
And I couldn’t agree more with you. It was so valuable to publish your thesis online. You meet so many interesting people who are investing in the same names, or looking at the same names. You get to talk to Portfolio Managers that have no reason to talk to you if you hadn’t published something they were interested in.
It not only made me a much better investor. But it basically built my business — and enabled me to meet a lot of people, like you. We wouldn’t have met if it weren’t for the internet.
Why spin-offs in particular?
One thing that I’ve always gravitated towards is inefficient markets. Basically, not mega-large cap stocks. My dad was a PM at a large cap value fund. I’ve had a lot of conversations with him. And at first, when he came out of business school and investing, he was like, “okay, value investing’s the way to go”. But then there became value benchmarks that you had to compete against.
Then everyone else figured out value investing generally works over the long-term. If you’re trying to do that in mega-cap stocks, it’s really hard to do it in a really diversified portfolio. It’s just hard. There are hundreds of analysts that are PhDs and MBA that are looking at these things.
In his experience, he had periods where he did really well and really poorly. One takeaway was trying to find an inefficient market. I saw that at Eaton Vance. We had a large-cap value fund that was 30-40B AUM. It had a great track record, but its hard to maintain that because everyone is gunning for you. Everyone’s looking at those stocks. Especially when you get up in size.
I’ve always gravitated towards smaller, more inefficient markets. Similar to a lot of people, I read You Can Be A Stock Market Genius, by Joel Greenblatt. That whole book was amazing. I’ve read it many times. The chapter on spin-offs was just, really eye-opening. Super interesting. And so when I read that shortly after college, that got me interested in investing in spin-offs.
The reason why spin-offs are so interesting is they’ve historically out-performed the market by 200bps to 1000bps per year, going back a long way. Spin-offs don’t always outperform, and in the past year its been a tough year for them. But in general, I still think it’s a very interesting place to be. Especially the smaller spin-offs. The work that I’ve done shows that a lot of times, you’ll see the asymmetric returns to those smaller companies. They tend to be higher risk, but you can also see the situations where the stock goes up 1,2,3x. Those are the ideas that I’m a little more drawn to.
it’s really the inefficiency. It’s finding something that not everybody is looking at. As you know, spin-offs are distributed to parent-company shareholders. If you own a stock, for instance HON, you were distributed the spin-offs of GTX and REZI (Richard is not a shareholder in either company). You didn’t make a decision to buy that name. And often times that results in forced selling pressure. Because the investors that bought the parent company to begin with, bought it because it was a large cap company. They didn’t want exposure to these smaller spin-off type companies.
And so you often see indiscriminate selling and a situation where you can be a more informed buyer than a seller. I’m always looking for situations like that. It doesn’t have to be spin-offs. I also cover other special situations. Anything where its unique — not plain vanilla idea where there’s an asymmetric opportunity.
What is your ideal spin-off?
One thing that I’ve noticed anecdotally is that when you bring in an outside management team, you tend to have a large guidance miss. This is what happened with REZI and FTDR.
What I like to see when I’m looking at the spin-off is a company insider that is going to be the CEO or CFO of the new entity. And the reason why I look for that is because one of the big reasons why spin-offs should out-perform is that they’ve been held back by the parent company. They have to beg and scrape to ask for any investment in their business. They’re a tiny subsidiary more often than not. So there’s not much attention paid to the division. Employees and management have little autonomy. Speed of decision-making is held back.
What I’ve noticed is that when you have a spin-off where its a management team that’s more familiar with the business, they know exactly where the low-hanging fruit is. They finally have the opportunity to do something about it without needing four layers of approval.
An example of that is KTB. That’s a spin-off of VF Corp. That’s an example where the continuity of the management team is amazing. Everyone on that team was at VF before. If you listen to their last earnings call, and listen on the detail they go into. It’s pretty amazing.
That’s one thing I look for. In terms of other things I look for … I’m looking for a business that I can understand. For instance, Cyclerion (CYCN) is a recent spin-off that’s done poorly. It was a spin-off of Ironwood Pharma (IRWD). It could have been a home run. It’s based on a drug that will or will not get approved based on data that I have no edge forecasting.
Situations like that I try to avoid.
I’m looking for a company I can understand, that at the end of the day I can answer the question: Would I want to own this business at the right price?
There’s a lot of companies you wouldn’t have high conviction in owning around the business and valuation. But if it came to an attractive valuation, would I want to own this?
I’m not overly scared of debt. But one thing that I do look for is the interest rate. Bondholders are more focused on the downside than us equity holders. If the interest rate the company’s paying is over 10%, that’s a red flag. My return on equity better be very high because you could buy the debt and get 10% with more protection.
Ideally, you’re looking for a business with secular tailwinds, low capital intensity, that aren’t cyclical. Oftentimes that’s not the case with spin-offs. If a spin-off were to have all those attributes, that would be the ideal setup.
Do you think this space could get over-crowded?
Totally. I think it totally can. I think there’s been a lot more people who have come in and focused on spin-offs. This is somewhat cyclical. In the last year spin-offs have underperformed the market. I think there’s certain waves where value stocks tend to do well, and growth stocks tend to do well. Then spin-off stocks will do well.
I do think there’s more competition in the spin-off world. From the work that I’ve done, on a median basis, spin-offs don’t outperform that much. But if you’re on an average basis they do, because a lot of the smaller companies are the outliers. And they generate these crazy outperformances that pull the average up. And so what I tend to focus on is the smaller cap companies.
Even more micro-cap companies. One company that I liked was a $300M market cap company. Even though there’s a lot of special sit funds, there’s a lot that can’t go below $300M. It’s definitely gotten more competitive. I think micro-caps in spin-offs represent a big opportunity. And the inherent nature of spin-offs make them something you want to follow. Even if they don’t outperform, there could be crazy forced selling after the spin. But I think it’d be foolish to not keep an eye on spin-offs.
I will give the caveat that all spin-offs do not out perform. You want to own the business at the right price.
Also, spin-offs publish Form 10. It gives all the background, pro-forma financials, trends over the past three years. You can get a sense of the trends, capital intensiveness, secular tailwinds or headwinds. Then if you know the business and understand its worth, you can tell when the selling is forced selling from indexing.
The best way to do it is to dollar-cost-averaging … start buying a little bit at a time.
If you had to go to one place on the Form 10, where would you go? And how important are management incentives?
If you read Greenblatt’s book, he thinks incentives are the most important thing. You do see these days, more often than not, you can go to the executive compensation section of the Form 10. And you can usually find how many shares are reserved for executive compensation and incentive compensation.
I’d say, if it’s a small company, you could have 10-15% of shares outstanding reserved for incentive compensation. That’s obviously a huge incentive for management to not only not pump up the stock price, but eventually create real value — because they’ll become rich if they do.
When you see the larger spin-offs, usually 5% of shares will be reserved. Or even maybe less. It’ll add up to a real dollar amount, though. $100M of dollars of stock.
In terms of the Form 10 … I usually scan the financials. I want to figure out basic questions:
1. Is revenue growing? Is it declining?
2. Is this business capital-intensive? What’s the return on capital?
I use the Greenblatt method: Add up net PP&E and divide by net working capital. And then your numerator is your EBIT.
Often I’ll search for the world “valuation”. For one reason or another, there’s a minority sale. And for one reason or another they valued that business during the minority sale. This let you glean into what outside investors thought the business was worth. Other than that, I’d say don’t get overwhelmed with the Form 10. Just read through it. As you’re reading, write down questions as they come up.
Some of those questions will get answered as you continue to read. If I don’t answer those questions, I’ll set up a call with management or IR to walk me through those questions.
Don’t get intimidated by them. They’re dense documents. A lot of it is fluff.
Get a sense of the financials, read managements explanation of trends and get a general feel for the business. See how many shares are reserved for shareholder compensation. It’s an iterative process.
Do you look at international spin-offs?
I focus right now on US spin-offs. But I’m hoping that as I build out my team, I focus on international spin-offs. The opportunity is the same, and probably fewer people cover international spin-offs.
How do you primarily source spin-off ideas?
I have a bunch of Google Alerts, probably eight. Once a week, there’s a Bloomberg that I have access to and I’ll search for recently announced spin-offs. If there’s anything that I have missed, usually people shoot me ideas. It’s primarily news alerts. You can go to an SEC site that has all the Form 10s that have been published.
How much of your idea generation comes from social outlets?
First of all, I know you’d agree — Twitter has been awesome. Not just for ideas, but for searching what’s going on with a stock. Also, when I’m ramping up on a stock, you can search for who else is interested in the stock and if they’ve published anything.
I don’t know if I’ve gotten any ideas that I’ve sourced from social networks. But it’s enhanced my research process and my ability to find information quickly on things that I’m interested in.
I’d say my subscribers send me ideas — not all the time — but my most recent idea was one that a subscriber shared with me. There are a lot of ideas we’ll share back and forth — special situations. But my latest recommendation, I’m a shareholder (Recro Pharma).
The idea was that they’re spinning off their drug development business. What was going to be left behind was their CDMO business. Basically its an excellent business, 50% EBITDA margins. It’s on pace to grow revenue 30%. They’ve beaten expectations the past two quarters. There’s been crazy consolidation in the space.
In the Form 10, REPH lists 6 CDMO peers, and 4 of them have been acquired. I just dug into that one and I was like “this looks super compelling”. That was a recommendation, the remaining company. But I couldn’t agree more in terms of Twitter’s usefulness. And then just interacting with other people who are looking at the same ideas.
What other ideas are you currently looking at? What ideas are you most excited about?
Two that I’ve mentioned:
1. Recro Pharma (REPH)
I think the thesis there is it’s a great business, sticky business. The manufacturing of the drug is written into the label of the drug. So to change the manufacturing, the drug company would have to refile the label with the FDA. There’s a lot of growth.
The one thing to be aware of, they’re very concentrated. 80% of their revenue came from Novartis or Teva. They are diversifying a lot. It’s just a small company.
It’s just a great business — not very capital-intensive. It’s a defensive business. People are still going to take their medicine in a recession.
It’s rare to find a business that’s growing quickly, there’s a secular trend where pharma companies are outsourcing to third-parties. There’s margin expansion. And it’s trading at 13x this years EBITDA, and maybe 9x next years EBITDA.
2. Kontoor Brands (KTB)
That was an ideal spin-off. I wanted to own it at the right price. Did my work, think it’s worth about $40. It started selling off like crazy. First month it sold off, bottomed close to $25. I think I recommended it at $29.40. I was early, but I was able to buy more as it continued to fall. And then the cool thing is, if you read the Form 10, they were going to pay a $2.40 dividend. So that’s a 9% dividend yield at the bottom.
Revenue only fell 10% in the GFC. The dividend yield is still 6%. Just listen to the call, there are tons of low hanging fruit. It just goes to show that the brands, Wrangler and Lee, weren’t as high growth as Timberlands or Vans or North Face.
The sense you get from KTB, VF was harvesting the cash flow the business generated, and not reinvested in the business. And that’s changing. Management’s super smart. All VF veterans. Really well-regarded corporate culture. They’ve identified a lot of ways to grow revenue, with really simple things.
Lee Brand is a pretty big brand in China. It’s one of the leading lifestyle brands in China. But Wrangler hasn’t launched yet in China. Wrangler and Lee were managed separately when they were a part of VF. They didn’t take the time to launch Wrangler in China. So that seems like a super easy thing to accelerate growth.
They’re underindexed internationally. They’re only 26% and peers are closer to 46%. They’re also expanding into other accessories and other products. Using the Wrangler and Lee brand, but not necessarily in jeans. But in T-shirts. Some jean companies sell 500 t-shirts for every 1 pair of jeans. Wrangler sells 1 t-shirt for every 5 pairs of jeans. So there’s a big opportunity there that doesn’t take rocket science to roll out more t-shirts, or expand distributions there, or launch in China.
My price target was originally $40 — which was kinda conservative. I think it’s now worth closer to $50. Pretty decent upside. It’s trading around $38 now. You get a 6% yield. Even though it’s run a bit, it’s still pretty compelling.
I am a shareholder.
3. Madison Square Garden (MSG)
I am a shareholder of this one too … full disclosure.
The thesis has always been that the individual pieces are worth more than the sum of the parts. Well, the spin-off has been announced. When the spin-off was announced two summers ago, the stock rallied 30%. It almost peaked at 330. If you look today its at 273.
Basically the spin-off is a quarter away. You can do dumb math and figure out that the value of the Rangers and the Knicks, and the cash on the balance sheet is worth more than the Enterprise Value of the company.
It looks ridiculously cheap that’s less than a month away. The other interesting dynamic is there’s been a lot of speculation that PE is interested in buying the sports companies. SilverLake already owns 10% MSG. There’s a lot of interest in sports franchises from institutional investors.
The original spin-off was structured so the sports business would spin-off. That was changed. They’re now spinning off their entertainment business which includes cash a billion, MSG arena, as well as its entertainment business. My understanding is that because it’s a tax-free business, and because MSG owns the Rangers and the Knicks franchises for so long, that whole company could get acquired without any sort of tax liability.
A big knock on the SOTP valuation was that Dolan would have to pay a big tax fee if they sold off the sports. My understanding is that there wouldn’t be a tax liability. For that reason, you should see the discount close significantly. Even if it stays open, Dolan has admitted that if the stock is trading at a big discount to its clear value, I have a fiduciary obligation to close that gap. He also owns 20% of the common stock outstanding.
I think that one’s interesting. There’s been a lot published. But it feels like an idea hiding in plain sight. It’s finally here, but it’s still trading at a big discount.
I just love the sports franchise businesses. You’re probably aware of this, the cable companies, and some of the legacy media companies are in trouble. Nobody’s watching legacy, linear TV anymore. But if you’re an advertiser and you want to get in front of a large, engaged audience, you go to live sports or live news.
That’s why there’s such appeal for sports rights. And that’s why the value of these sports franchises continues to go up.
The other interesting aspect is the number of professional sports franchises is fairly fixed, but there’s more billionaires. Every once in a while you get a new team every 10 years. But there’s more billionaires to buy the assets, but the same number of assets. So you get the supply/demand imbalance.
The other thing is sports businesses tend to be recession proof. NBA and NHL revenue didn’t go down during the GFC.
If everyone is assuming it’s going to happen, is it still a great idea?
You got to think a level ahead. And that definitely could be the case. From my perspective, there’s been all this buzz around people interested in the sports business. Whether its SilverLake or other PE managers. Dolan’s getting nonstop hell for the Knicks being so bad for so long.
There’s clear valuation marks for how much the Rangers and the Knicks are worth, through Forbes. Forbes values the Knicks at $4B and the Rangers at $1.6B. So that’s $5.6B. Typically when you sell a sports franchise, it transacts at a 38% premium to the last Forbes valuation.
So those valuations are conservative. Even if you assume the Forbes valuation, the stock is so ridiculously cheap. I think that once it happens, and once this clean split happens, it’s going to be pretty hard to ignore how cheap the sports franchises are.
I think another reason why this is interesting is because no-one’s interested in owning the entertainment business. Dolan’s gonna spend $2B building this sphere. Why would I want to own this stock now?
But what I’ve found, and KAR Services was a good example. They spun-off IAA, which was a business that does auctions. Primary customers are insurance companies. You wreck your car, insurance company insures the car. Instead of getting it fixed, they’ll write you a check for the pre-accident value of your car. Then they’ll auction off your car through IAA.
That business is an awesome business. Great business. People get into accidents in any market. 30% EBITDA margin business, revenue growing 8%. People are more distracted now driving — more and more accidents. You also have cars with so much tech. A larger percentage of cars that get into accidents are deemed total losses. It’s so expensive to fix them.
So you have all these secular tailwinds for IAA. And if you looked at that business ahead of time, even though its remaining business was an auction business for used cars. Even if you assumed the remaining business was worth 9x EBITDA and IAA was worth 13-14x EBITDA — it’s still a huge discount to Copart.
So that gives me confidence that people might not buy until the spin-off happens. I’m still confident in the upside, but you’re totally right. But even if I’m not right, the downside is pretty limited.
One of the cool things about investing in spin-offs, and I’m going on a tangent, is you get to invest in really eclectic ideas and assets. It’s cool where people who are getting into investing, or if you have kids, it’s a great way to teach someone that’s younger. If you buy a share of MSG entertainment, you can say you’re a part owner of the building or the team.
The other thing that’s so cool is that you’re a generalist by default as a spin-off investor. That’s also tough because you might not know something that a sector specialist doesn’t.
What is your valuation process?
In an ideal world, you have clean financials, you can do a DCF. You can look at publicly traded comps that are good comps for the business you’re looking at. And you can also look at similar transactions. With REPH, you can do all of those. That’s the ideal way that I want to value a company.
I’d say the biggest thing that I look for is relative value. When a spin-off is trading, I want to know what its peers are trading at, and trying to get a sense of whether or not this is a good comparable company. Whether the spin-off deserves to trade at a discount or not. That’s the metric I lean on most heavily, EV/EBITDA.
But if I can, transactions or DCFs.
There can be other situations, Nuvectra. Recommended it, went up a bunch, and then went bankrupt. When that spin-off came out, it had an approved medical device, and a pipeline, and was selling for $40M with $60M in cash on the balance sheet. With that one, I’m not going to do the DCF, but more a function of indiscriminate selling. Down 60% and below cash on the balance sheet with an approved product and heavy investment to build out the platform.
You have to be flexible. In an ideal scenario: DCF, comparable companies and transactions.
What’s been the most fulfilling thing since going from corporate world to owning your own business?
It’s been an amazing process. I’ve loved it. These are obvious things. But when you work at a big institution, everything you do or write has to be documented. Every decision has to be run up the tree. Everything checked by internal and external council, then compliance.
It gets tough to do work. You’re focused on jumping through hoops. It’s so freeing being able to make my own decisions super quickly, and implement them tomorrow.
If I have a new stock idea or a marketing idea, I can get it up and running. Or if I want to expand (like odd-lot share repurchases, etc.) I can change. I can make that decision. I can add that to my service without need committee approval.
I also have two small kids. I have a four-year old girl and a one-and-a-half year old boy. When I was working at Citi, I saw my girl on the weekends. I’d get home at 7-8 and she was asleep. You don’t realize you’re missing anything until my boy comes along and I see him several times a day. We get to hang out so much and I get to know him so much better.
It’s having the flexibility and control of your schedule.
What gets you exited when you wake up in the morning?
One nice thing about working for myself is that I have time for the gym. But in terms of work stuff, the thing that gets me super excited is when I have another idea that I think is really interesting. I want to complete my diligence on. I love those situations. It doesn’t happen every day, obviously, but it gets me fired up.
I also love when I do a ton of work on a spin-off and waiting for the indiscriminate selling to happen. That happened with KTB. It doesn’t happen all the time, but those are the really fun days.
https://macro-ops.com/wp-content/uploads/2019/12/aaron-burden-y02jEX_B0O0-unsplash_495x400.jpg400495Brandon Beylohttps://macro-ops.com/wp-content/uploads/2019/12/Macro-Ops-Logo.pngBrandon Beylo2019-12-14 11:07:532019-12-18 14:35:33Podcast Transcript: Interview with Richard Howe