Will This Spinoff Put You on the Road to Riches?
Brendan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
There is an old saying by Aristotle that “The whole is greater than the sum of its parts.” Unfortunately, if an investor followed Aristotle’s advice he or she would have missed many opportunities where value is unlocked for shareholders by splitting smaller companies from a larger whole. Consider the outperformance of the Guggenheim Spin-Off ETF, which has greatly outpaced the S&P 500 over the course of this bull market.
Figure 1: Guggenheim Spin-Off ETF versus the S&P 500
When a small company is spun off from a larger one it creates opportunity for several reasons. First, the newly formed spin-off will typically start with a valuation reminiscent of its parent even though its prospects for growth may be brighter. Second, the smaller nimbler company will often be able to improve efficiency once it has been liberated from its larger parent. This combination of a low valuation and a catalyst for improved operating efficiency can yield impressive results.
Recently, the refiner Valero (NYSE: VLO) spun off CST Brands (NYSE: CST), divesting itself of its convenience store business. Because the refining business is highly capital intensive and enjoys low-margins (see table 1), the valuation of CST began at a low level relative to the earning power of the company. One key consideration when analyzing a spin-off is to consider whether the parent company has a depressed valuation relative to what should be fetched for the new spin-off company. Because refiners enjoy low valuations, the starting point for CST was depressed. At $28/share, CST's price/sales multiple was 0.16, roughly at par with Valero's price/sales multiple.
While the multiple has expanded, CST still looks cheap relative to the average valuation for its sub-sector. The average company in the food retailing sub-industry currently trades for 17.1x TTM earnings as compared to CST's valuation at 11.4x TTM earnings. Let's take a quick look at some comparable companies to see how CST stacks up.
Casey's General Stores (NASDAQ: CASY), operates primarily in the Midwestern states and owns 1,735 stores employing 14,500 workers. Casey's is a good example of the valuation that a well managed company can fetch and represents the high end of the valuation range that can be expected for CST. Furthermore, the average annual 5-year EPS growth of 11.6% shows how a boring convenience store operator can boost earnings through a combination of revenue growth, share repurchases and expanding margins.
Susser Holdings (NYSE: SUSS), is a family led business that owns 560 convenience stores across Texas, Oklahoma and New Mexico. The company has weaker margins and return on equity compared to Casey's, but still has a similar multiple in terms of trailing earnings and PEG ratio. Looking at the valuation of Susser convinces me that CST should trade for a higher multiple as even a fairly lack-luster convenience store operator currently sells for 22x TTM earnings.
The Pantry (NASDAQ: PTRY) is an example of an underachieving convenience store operator. Headquartered in Cary North Carolina, the company consists of a network of 1571 stores in the Southeastern United States. However, even with such a large network of stores, The Pantry has been unable to maintain profitability. The company is cheap in terms of price/sales and price/book, but is not a buy due to its inability to generate earnings or return on equity.
Table 1: CST Brands and Comparable Companies
CST's performance over the past several years gives upside relative to analyst’s expectations. From 2009 until present, revenue increased from $8.78 billion to $13.15 billion or nearly 50% over three years. However, analysts' expect flat revenue growth and declining profitability to $2.45 per share, in the coming twelve months.
Figure 3: Robust Revenue Growth for CST Brands
If CST is able to establish a growing trajectory in earnings, the market will likely respond by pricing in a multiple in line with peers. CST can accomplish this is by improving profitability through selling higher margin products. Casey's General Stores, for example, sold $1.185 billion dollars worth of gasoline in the first quarter of 2013 earning a 4.4% margin, but $330 million of grocery items and $137 million of prepared food and drinks, earning margins of 31.7% and 60.6% respectively. Casey has achieved industry leading margins by diversifying its revenue base beyond gasoline.
In comparison, CST sold $1.62 billion dollars worth of gasoline in the first quarter of 2013, but only $293 million dollars of other merchandise. While Casey's derives 28.2% of its revenue from higher margin items, CST receives only 15.3% from these items. Now that CST has been spun-off, management should be able to focus on improving margins through diversifying the company's revenue base beyond lower margin gasoline sales.
Table 2: CST Trending Toward Higher Earnings
It is expected that CST has an asymmetric risk/reward profile because earnings expectations are low and margins could improve significantly. If the company performs well, pricing in a comparable multiple with peers would cause one to expect a $60 twelve-month price target (22x $2.75/share forward earnings). While it will probably take longer for CST to achieve the average valuation in the sub-sector, this gap causes attractive returns to be quite probably, while a severe decline seems unlikely.
In the market it is often the case that the sum of two parts is greater than a whole. Stock spin-offs are worth reviewing because very reasonable valuations can be obtained for brands offering good growth. Furthermore, effective management can often improve a newly spun-off business' efficiency, providing a catalyst for higher prices. CST seems to have both attributes and this combination bodes well for investors in the company.
Brendan O'Boyle has no position in any stocks mentioned. The Motley Fool owns shares of CST Brands. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!