Aristotle Did Not Anticipate Spinoffs

During both my college and post-graduate education, the wisdom of Aristotle was impressed upon me by instructors in multiple and varied settings. “Venerated” would be an understatement of Aristotle’s status within the pantheon of great thinkers. One of Aristotle’s frequently quoted insights is: ““The whole is greater than the sum of its parts.”

Aristotle’s premise is one of the main philosophical elements of the term “synergy” (from the Greek words synergia and synergos – “working together”) which is defined in en.wikepedia.org as “the interaction of multiple elements in a system to produce an effect different from or greater than the sum of their individual effects. For their part, the Germans founded “Gestalt Theory” along the primary principles of synergy and Aristotle’s premise.

The timelessness of this philosophical principle has been established through thousands of years of its popularity and widespread application. However, as is often the case in business and economics – this Aristotelian premise is not without significant exceptions. The twentieth century witnessed a period during which corporate conglomerates were “the hot thing” (such as the era starting in the late 1950’s and extending into and beyond the 1990’s, during which Litton, Ling-Temco-Vought (LTV), and Textron modeled how to build one). However, during the past fifteen to twenty years, increased attention has been dedicated to “corporate focus” and “unlocking shareholder value” – which in many cases has led to instances of corporate divestiture. Those divestitures (usually resulting in improved stock market performance) are just one demonstration of the limits of the applicability of Aristotle’s premise. Within the totality of corporate restructuring, there is a subset that has produced demonstrably outstanding results for shareholders – the corporate “spinoff”, often referred to as “demerger”. Within a long list of formal, documented studies of the impact of “spinoffs”, a 1998 working paper from Pennsylvania State University stands out. That study examined eighty-three equity carve-outs completed between 1981 and 1990. The results revealed that, during the first three years after the spinoff, the carved-out companies had significantly higher revenue and asset growth, higher earnings, and higher capital spending than the industry average. Summarizing the impact of demerger on the stock price of the “parent” and “spinoff” companies, data shows that (on average) during the first three years following a demerger, parent companies outperformed the S&P 500 by 6% while spinoff companies outperformed the S&P by 10%.

Contrasting these clear and compelling results with Aristotle’s infamous tenet, one could say: “Sorry, Aristotle, sometimes the sum of the parts are greater than the whole!” As we can see in the following graph, spinoffs reached a peak at the end of the prior millennium (annual rate of 66), settled back to an average of half that rate during the following seven years (32.5), and then faded to an average of 24 each year through 2011. However, during 2012, 34 spinoffs took place, and the increasing pace of spinoffs continues this year:

The reasons for the desirability and success of well-executed spinoffs are not hard to identify, especially in this age when terms like “core focus”, “shareholder value”, “competitive advantage”, etc. have become so important. Some key elements of spinoff success include the following:

1)    Post spinoff, it is easier for investors and analysts to recognize underlying value;

2)    It becomes easier for the spinoff, with greater control over resources and much tighter focus, to pursue compelling opportunities;

3)    Increased freedom for both spinoff and parent to streamline production, reduce overhead, and seek new products or investments;

4)    More direct accountability for corporate executives (especially within the spinoff) and increased incentives for performance (stock options, performance metrics);

5)    Often eliminates competitive disadvantages;

6)    Increased access to capital.

An overriding dynamic within the corporate operation of both the parent and the spinoff is tighter focus by the executive team upon the identify, vision, mission, and core objectives of their “transformed” company.

The next question I would ask if I were you, the reader, is: “This sounds interesting. Give me a good example of how I can actually apply all of this good information in my investing and trading!”

CST BRANDS SPINOFF FROM VALERO ENERGY

Thank you for asking! In fact, there are a few interesting spinoff stories currently at hand. For example, Valero Energy (VLO) demerged 80% of CST Brands (CST) on May 1. Valero shareholders received one share of CST for each nine shares they held of VLO. Demonstrating its own belief in CST’s future, VLO has retained 20% of the CST shares outstanding.

CHART: The chart above contrasts the price of VLO with that of the S&P 500 Index over the past two years. (All charts are constructed by T. Petty via www.yahoofinance.com )

Yahoo Finance identifies VLO’s competitors as BP plc (BP), Chevron (CVX), Exxon Mobil (XOM), and  Royal Dutch Shell (RDS).  The “Industry” average P/E ratio for that group is 11.6, while VLO and BP have a P/E of under 7 and the P/E ratio of CVX and XOM is about 9.3. Contrast that industry classification with the one identified with CST – which is broadly categorized as a convenience store and gas pump retail business. This industry is more difficult to value because several major participants are privately held (7-Eleven, Quik Trip Corporation, and Kwik Trip Inc,). However, Casey’s General Stores (CASY) has a P/E of 20.62 and the most direct competitor of CST (Susser Holdings: SUSS) has a 25 P/E. The sharp contrast in industry valuations seen above (the difference between a 6 P/E and a 25 P/E) offers one of the clearest possible indicators of how this demerger “unlocks shareholder value”.

CHART: above is the 2 year price action of Susser Holdings (SUSS)                                      

The CST Brands website offers an inviting description of its business – it operates “Corner Stores” (selling gas and a plethora of food, drink, and convenience items) in nine U.S. states (primarily Texas) and six provinces in Eastern Canada. Here is a table of existing stores and projected store growth:

 

U.S.

2010

2011

2012

2013 (Proj)

Beg of Year

991

994

998

1032

New to Industry Stores (NTIs)

10

8

11

15

Acquired

0

0

29

0

Closed/divested

(7)

(4)

(6)

End of period

994

998

1,032

1,047

Source: CST Brands filings

CANADA

2010

2011

2012

2013 (Proj)

Beg of Year

907

895

873

848

New to Industry Stores (NTIs)

24

19

16

8

Acquired

0

0

0

0

Closed/divested

(36)

(41)

(41)

End of period

895

873

848

856

Source: CST Brands filings

Two of the simplest and most easily grasped dimensions of CST’s growth plan are: 1) Upgrade its store base through the steady addition of “New to Industry” (NTI) retail locations, which offer a larger, more modern format that produces higher EBITDA , including (over a 3 year ramp up) an expected 60% increase in gross margin on merchandise and 55% hike in average fuel gross margin; 2) expansion and enhancement of its “Cardlock” truck fuel business in the U.S. and northern Quebec. For those who, like me, have not heard of “Cardlock” before, it is a tremendous “value added” service to truck fleet businesses – providing each fleet driver with a coded network access card that identifies these unique metrics related to her/him: identification of vehicle and driver, date, time, and location of gas purchase, type of fuel purchased, unit price and quantity of fuel, automated calculation of mpg. The access cards are restricted to fuel purchase (thereby further tailoring it for maximum value to truck corporations). Reports are transmitted monthly to participating trucking firms for easy import into corporate business systems for analysis and summary.

Sample (above) of existing CST store. (Source: CST Brands website)

Sample (above) of new, larger, more profitable CST store (NTI). (Source: CST Brands website)

An additional measure adopted by CST to ensure its future success is an upgraded compensation and employee incentive plan. The company has made strides in more closely approximating the compensation profile of its retail peer group (the female CEO has received a 42% compensation increase this year). Along with a newly enhanced stock option plan (with penalties for early departure) and an Omnibus Stock Incentive Plan (that will deliver awards in one-third increments over the next three years) – the board has “set the table” for retaining existing CST leadership and providing them with incentives to excel. An additional benefit of these plans is that it will result in a significant increase in employee ownership (“insider ownership” within VLO has, until now, stood at a relatively paltry .35% of total corporate shares).

With regard to the financial structure and vibrancy of CST Brands, analysts and experts categorize the convenience store/retail gasoline industry as one characterized by a leveraged financial structure. CST Brands will be no exception. CST Brands has incurred $1.05 billion in long-term debt as a structured element of its spinoff. That debt reflects the cash amount paid to Valero as “partial consideration” for spinning off its retail business. This obligation will result in an annual expense and debt amortization figure projected to total $42 million. Although it has indicated that it does not intend to draw upon it, CST Brands will have access to a revolving credit facility totaling $300 million. That should provide them with a very helpful “safety net” moving forward. Perhaps the most encouraging aspect of CST Brands’ financial structure is that, when compared with its primary industry competitor (Susser Holdings) it will boast a very strong interest coverage ratio – more than doubling the ratio reported for Susser. Therefore, within its industry group, CST should be equipped with the financial resources and flexibility to both service its debt and expand/enhance its retail locations.

Looking ahead to practical ways of assessing the value of CST Brands as a potential investment, Mr. James Osbiston (an Equity Analyst in London who has shared his extensive research with me) performed a detailed projection of potential share value for CST. Mr. Osbiston pieced together projected valuations predicated upon how a range of optimistic, neutral, and negative variables would likely impact the growth and financial condition of CST. Here is his summary table:

VALUATION ANALYSIS RELATIVE TO SCENARIO OPTIONS

Time Period following initial stock issue

NEGATIVE

NEUTRAL

POSITIVE

Six Months

$24.82

$29.33

$33.39

Twelve Months

$24.22

$30.05

$34.98

Eighteen Months

$23.66

$30.76

$36.57

Adapted from the analysis of James Osbiston, London 

A natural question for investors to ask would be: “What shall I watch for in assessing when or if I should invest?” The first consideration should be the likely impact of the fact that, prior to the actual spinoff, institutions and mutual funds held 86% of Valero’s outstanding shares. It is inevitable that many such institutions and funds will make adjustments in their holdings following the spinoff. In particular, CST will begin as a $2.15 billion business in the convenience store/retail gas industry. Those two criteria place CST in a considerably different set of stock classifications than parent VLO. Valero is included in the oil and energy indices, and qualifies for the S&P 500. CST does not qualify for either of those classifications. Therefore, all existing index and ETF holders whose investment mandate excludes CST will be required to divest its shares.

Such ownership adjustments by institutions and funds following a spinoff are normal and expected. On average, the complete adjustment process spans a period anywhere between two and four weeks. Therefore, during the first month following the May 1st issue date, CST shares could fall under selling pressure. Interestingly, although the “when issued” price was $28.60, the price at the close of trading on May 8th was $ 30.75 (after reaching an intraday high of $32.09).

CHART: above is the price action of CST and Susser Holdings during the past month. Note that full exchange trading of CST did not begin until May 1 (see volume bar changes).

For anyone intrigued enough by CST to consider purchase, there are a couple of obvious possibilities:

1)    Dollar cost average purchases in several lots over the course of the remainder of May, to attempt to optimize your average cost;

2)    Consider selling some put options at strike prices you are willing to purchase the shares for, thereby securing shares at a price lower than currently available. Note that CST options are (to say the least) thinly traded).

As with all investment choices, each investor must judiciously weigh whether or not an investment in CST Brands corresponds with her/his investment objectives and risk tolerance. Nothing the author has written above is intended (nor should it be construed to be) a recommendation to buy or sell any security. It is intended primarily as an educational tool.

Submitted by Thomas R. Petty, C.F.P.

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