The Trader                  

By VITO J. RACANELLI | SATURDAY, DECEMBER 1, 2012

SPINOFF DEALS HAVE BEEN HOT this year. Mergers and acquisitions have not, though Corporate America is awash with cash.

In 2012, there have been 58 spinoffs announced so far, and 30 of them have been completed, according to Joe Cornell, head of Spin-Off Advisors and a longtime veteran of the field. The 2012 spinoffs completed to date are valued at about $105 billion, higher than last year's 25 spinoffs valued at $94 billion. With the possible completion by Dec. 31 of five or 10 more of this year's announced spinoffs, the 2012 final value should be significantly higher than 2011's.

If the Abbot Laboratories (ticker: ABT) spinoff of AbbVie—which begins trading on a when-issued basis this month but isn't officially completed until Jan. 1—were included, then the 2012 spinoff value would soar to $170 billion, Cornell points out. Other big spinoffs this year included Kraft Food Groups (KFRT), out of Mondelez International (MDLZ), and Post Holdings (POST), a maker of brand-label cereals spun out from Ralcorp Holdings (RAH), a private-label foods maker.

The Ralcorp split up, effected last February, is interesting for a couple of reasons. First, last Tuesday ConAgra (CAG) agreed to buy Ralcorp for $4.95 billion, or $90 a share. In these pages one year ago, when the pre-spin Ralcorp traded at $79, we suggested Ralcorp's July 2011 decision to split off Post would result in two smaller companies, each potentially attractive to bigger players in their sectors.

The rationale behind spinoffs is straightforward. Typically, they are done when one or more of a company's disparate divisions don't fit with the others, and the combined market value doesn't fully reflect the value of the various businesses. It's a tax-efficient way of giving shareholders separate shares of the new company, often a pure-play stock.

The hope is that the total value of the two will be higher than the value of the pre-split company. These moves often create investments that are easier for analysts and investors to understand and that can also be attractive acquisition targets. For a pre-spinoff Ralcorp holder, the gain is $11 a share from the ConAgra offer and about $17 worth of Post Holdings shares, a 35% return from one year ago.

That's the classic spinoff motivation. But as Cornell notes, what's driving the activity higher lately is intensifying agitation by a number of big institutional shareholders—such as Pershing Square Holdings and JANA Partners—for such moves. Institutions are buying stocks and then leaning on management to create value, he says, particularly where there's an argument that the sum of the parts is greater than the whole.

Only the latest example, he notes, is the pressure from Relational Investors and California State Teachers' Retirement System, to urge bearings maker Timken (TKR) to spin off its steel unit.

Studies show that spinoffs often outperform the market over a two-to-three-year period, Cornell says. As of Thursday, the Bloomberg U.S. Spun-off Companies Index of 20 spinoffs with a total market value of at least $1 billion is up about 42% year to date. Stocks are in the market-weighted index for three years after their spinoff dates and the return noted above is for the entire portfolio, not an average return.

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By Lindsey Rupp and Tara Lachapelle | Dec. 4, 2012 (Bloomberg)

Timken Co., the bearings maker that trades at the lowest earnings multiple among its peers, is costing shareholders the chance to recoup $1.3 billion in market value lost this year by not spinning off its steel unit.

Ralph Whitworth’s Relational Investors LLC, known for pushing for changes and board seats at companies from Hewlett- Packard Co. to Illinois Tool Works Inc., announced a 5.7 percent stake last week and said Timken’s value would jump to $64.98 a share by separating the bearings and steel units. The plan was revealed after the Canton, Ohio-based company, which closed yesterday at $45.12, fell 28 percent from its April high.

While Timken last week rejected a breakup and said keeping the units combined provides technology and profit benefits, BB&T Corp. said it’s “uncontroversial” that the company is worth more in pieces after past attempts to eliminate the discount from the steel business have failed. The $4.3 billion company would be valued 33 percent more if split, according to the average of four analysts’ estimates compiled by Bloomberg.

Timken’s price-earnings ratio of 8.6 is cheaper than every global competitor, with its valuation about 45 percent less than the median, the data show.

Timken “doesn’t get a proper valuation,” Samuel Eisner, a New York-based analyst with William Blair & Co., said in a telephone interview, adding that a breakup may not be imminent because of the relatively high ownership among members of the founding family and the company pension. “If you did have a chance to spin it off, you might be able to revalue that business at a higher multiple,” he said, referring to the steel operations.

Chassis, Engines

The company, founded in 1899 by Henry Timken, produces anti-friction bearings and power-transmission components, in addition to running the business Relational wants jettisoned, which produces alloy steel used in vehicle chassis and engines as well as steel forging bars and seamless tubes for oil and gas drill bits. The company runs 58 manufacturing facilities and has operations in 30 countries and territories, according to Timken’s annual report from February.

“We have significant technology, cost and revenue synergies between our bearing and steel businesses as well as diversification benefits in continuing to operate under our current structure,” Timken Chief Executive Officer James Griffith said in a Nov. 28 statement. “These synergies and benefits, coupled with a potential reduction in financial flexibility, among other factors, led the board to conclude that the separation of the businesses at this time would not be in the best interests of Timken shareholders.”

‘Suboptimal Structure'

Pat Carlson, a spokeswoman for Timken, declined to comment further.

Relational and California State Teachers’ Retirement System announced their purchase of Timken shares in a Nov. 28 filing, with the latter revealing a 0.4 percent stake. Calstrs, as the second-biggest U.S. pension is known, submitted a proposal to be voted on at the next annual meeting that recommends hiring an investment bank to spin off the steel business into a separate publicly traded entity.

“There are a range of discounts out there that we’ve seen from analysts, indicating values from $55 to $65-plus per share,” Whitworth said during a phone interview yesterday.

“This discount will persist through all cycles and conditions due to the incongruous nature of these two businesses,” he said. “Waiting is not the answer. The costs to shareholders of a suboptimal structure compound over time.”

Relational’s Record

Ricardo Duran, a spokesman for Sacramento, California-based Calstrs, declined to comment beyond last week’s filing.

Relational, based in San Diego, has proven to be a catalyst for change in the past. Illinois Tool Works agreed in August to sell a majority stake in its decorative surfaces division to Clayton, Dubilier & Rice LLC, following pressure from Relational to reduce the number of business units. In November 2011, HP said it would add Whitworth to its board to help shore up investor confidence shaken by strategy shifts and lower sales forecasts.

After retreating from an all-time high of $57.72 in April, when the shares had a market capitalization of $5.6 billion, Timken yesterday had the lowest price-earnings ratio among the

12 companies it describes as its peers in the steel industry and the bearings and power-transmission group. Its 8.6 multiple to earnings compares with 16.6 at Carpenter Technology Corp., 14.8 at SKF AB and 22 at Nucor Corp., data compiled by Bloomberg show. The group median is 15.7.

‘Negligible’ Benefit

In an August presentation to Timken management, Relational described Timken’s lower valuation as “significant, reflecting the market’s clear preference for pure-play bearings or steel alternatives,” according to the document, filed with the Securities and Exchange Commission on Nov. 28. Relational said the value created by keeping the businesses together are “negligible when compared to the market discount.”

“We agree that the market is unlikely to properly reward either the steel or the bearing business for the secular improvements they have made as long as these businesses remain combined,” Stephen Volkmann, a New York-based analyst at Jefferies Group Inc., wrote in a Nov. 29 report.

Volkmann estimates that Timken’s parts would be valued at a total of $55 a share if the company were split, and William Blair’s Eisner has the same projection. BB&T’s Holden Lewis forecast $61 to $62 a share in a Nov. 29 note. SunTrust Banks Inc.’s James Kawai said $69 in a report issued Nov. 14, two weeks before Relational made its proposal public. Those estimates indicate an increase in Timken’s market value of $1.4 billion, on average.

More Volatile

While Timken would be worth more if broken up, “the presence of the more volatile specialty steel business suggests a material 20 percent-type conglomerate discount will likely persist,” Kawai wrote.

Timken’s stock price is depressed because of the seasonality of its business and because investors aren’t giving its ability to generate cash enough credit, said Tim Kang, an analyst for Olstein Capital Management LP, which oversees $555 million including Timken shares.

Timken produced $359 million in free cash flow, or cash from operations after deducting capital expenses, in the last 12 months, data compiled by Bloomberg show. The shares traded for

12.2 times that amount yesterday, lower than the 16.5 median among peers, the data show.

While Kang agrees with Relational that Timken would be valued at about $65 a share if split, he said the stock may climb to that level on its own in the next year or two.

Price Forecasts

“Breakups sometimes act as catalysts to unlocking that value,” Kang said in a phone interview from Purchase, New York.

“We don’t necessarily believe Timken has to break up to realize value,” he said. However, “we would not be against a breakup if the company were for doing it.”

Analysts don’t see the shares getting to the mid-$60s in the next year. The average 12-month price forecast is $49.78, according to data compiled by Bloomberg, only 10 percent more than yesterday’s closing level.

Today, Timken shares fell 0.8 percent to $44.78 at 10:41 a.m. in New York.

The difference of opinions on a breakup stems from whether investors are seeking an immediate gain or are patient enough to wait, said Stanley Elliott, a Richmond, Virginia-based analyst for Stifel Financial Corp. A longer-term approach can be riskier, he said.

Insider Ownership

Both Relational and Timken “make valid points,” Elliott said in a phone interview. “Splitting up the company would be a way to unlock the value more near term. The longer-term view would be seeing that the changes that they made to the business and investments that they’re making are allowed to be realized,” he said. “There would be some execution timing, probably a little more risk involved.”

Insider ownership may impede a spinoff, William Blair’s Eisner said. Members of the founding family, including Chairman Ward J. Timken Jr., have sole or shared voting power covering

10.3 percent of the company’s shares, according to a March filing. Participants in the Timken savings and investment pension plan have 5.4 percent.

Businesses spun off from larger U.S. companies are beating the rest of the stock market this year. The Bloomberg U.S. Spin- Off Index of 20 stocks has surged 41 percent in 2012, versus a

12 percent gain in the Standard & Poor’s 500 Index.

Spinoff Success

The index includes such companies as ADT Corp., the residential security business that was once part of Tyco International Ltd., and Kraft Foods Group Inc. after its grocery unit was separated from the snack foods division, now known as Mondelez International Inc.

“Historically, spinoffs have worked out well,” Joe Cornell, founding principal of Spin-Off Advisors LLC in Chicago, said in a phone interview. “The common thread that runs through all of this is, if you boil it down, the management focus. They go from being unwieldy conglomerates with different businesses competing for capital and management’s attention, to being more focused entities. Often that translates into better financial performance that should work its way into the stock.”