A Definitive Spinoff Checklist towards 1500% IRR

The Marriott Corporation

Instead of asking the question, "Where can I find great companies?" a better question might be, "Where can I find mispricings in the market?"

So what are possible causes for the market to misprice a stock?

• Short-term troubles, the market prices as permanent ones

• On the surface, the company looks bad (using a screener) but inside the statements, there is a great business hidden inside, waiting to reveal itself

• Special situations like mergers or spin-offs where it becomes more difficult to value the company and other factors come into play

I am a big believer in precisely knowing what you are looking for.

• What does a good net-net look like?

• What does a good turnaround look like?

• What does a quality company even mean? (you can find our way of looking at quality in the post below)

A ranking system to beat the market

Today, we’ll take a look at: “What does a good spin-off look like?”

There are hundreds of spin-offs done worldwide each year. Imagine you would only focus on these, how would go about selecting the ones you think give you the biggest edge?

Joel Greenblatt, the Spinoff master, and value investor extraordinaire comes to the rescue. In his book “You can be a stock market genius”, he discusses the case study of The Marriot Corporation and their spinoff in 1993. Let’s go through this case study in more detail and see if we can use it to create a checklist.

Have you ever invested in spinoffs?

The Marriott

I believe Marriott does not need an introduction.

Its basic business model is, to develop land, build hotels, and sell the hotels under the condition of keeping the service management contract for up to 50 years. This allows them to roll off the assets. Developing and building the hotels was financed by debt (mostly senior notes and some in classic mortgage debt). This lodging management part of the business generated about half of the revenues. The other half came from contract services (food services, facilities management, airport and highway concessions,...). Since two-thirds of operations profits were generated from lodging and hotels, The Marriott was considered a hotel company.

In 1992, it owned, managed or franchised 746 hotels. (Marriott International owns or manages 9000 locations today). Marriott Corp had grown its revenues and profits steadily up until 1989. The US recession in 1990 hit the company. The company had considerable debt and the credit raters had downgraded that debt ⬇️

From the Journal of Economics by Robert Parrino

The plan

The 2 stock certificates (from the company website)

The lodging management, food services, and other parts were spun off into a new entity called Marriott International. The parent would be renamed Host Marriott. Host would retain ownership of the hotels and other properties. The Marriott family would continue to oversee the business.

The value creation would come from:

• Because of the improved financial strength, Marriott International would be able to seize more growth opportunities (better debt structure)

• A better assessment of the true value of the firm after the spinoff (a classic)

• It allowed investors to choose between a growth company and a long-term stable cash-generating one

Created by author - spin-off structure

What did the “before and after” look like?

Let’s take a look at the pro forma statements that Marriott published before the spin-off:

• Assets: Most hard assets were transferred to the host

• Liabilities: The spin-off was now charged with the long-term debt

• Marriott International would be the better company with high sales and net profits

Source: Spinoffs and Wealth Transfers by Robert Parrino from the Journal of Financial Economics 1997 (43).

Why did Joel think he had an edge?

In his book, his reasoning is as follows:

• Nobody will want the debt-laden Host Marriott, its toxic waste

• Institutions that own Marriott will want to get rid of it. There will be forced selling

• This toxic waste is led by someone who has a proven track record with these kinds of setups

• The CEO of HOST will have skin in the game

• Marriott International, the good company, will provide a credit line to offer sufficient liquidity to this host

The result

Marriott International and Host Marriott are still traded to this day. Let’s first take a look at the toxic waste.

Host Marriott is now called Host Hotel & Resorts (Ticker: HOST). As we’ve seen, this was the continuation of the Old Marriot Corporation.

After the spinoff, for each share of the old Marriott Corp, an investor now had:

• 1 share of Host Marriott

• 1 share of Marriott International

Since most were only interested in Marriott International, there was a massive sell-off ⬇️

from finchat.io

Now in Greenblatt’s book, he says it almost tripled in the next 4 months. Based on the data from finchat.io, I see an increase in price from 6-7 to about 14 USD in 3 months. That’s an IRR of 1500%.

Not bad.

Now let’s say you had held on:

price for Host Marriott since 1994

A wild roller-coaster ride!

So what about the good company: Marriott International (Ticker: MAR)?

Let’s see what happened immediately afterward:

Source: statmuse.com

The stock was up at the end of the year, but as might be expected, no sudden price movements as this is the part of the business people want to own.

But since this is the good part, what would have happened if you had held ⬇️

A bumpy ride, but well worth it over the last 3 decades. It currently has an 80B USD Market Cap. (remember the original company traded at 1B in 1992). But before touting the buy-and-hold strategy and keeping this in your portfolio for over 30 years, here are the drawdowns you would have experienced.

➡️It’s always easy in hindsight.

What’s important is that Joel makes it seem as if his bet on HOST was easy, but when you look at the numbers it was not:

• Calculating an EV/EBIT for the host company didn’t make a lot of sense as the EV would be high due to all the long-term debt

• The only valuation you could do was to look at the market cap vs book value. After the forced selling, Host Marriott had a market cap of 550M USD with a book value for PP&E of 3.3B or 17% of the book. Based on tangible value, if you think this company would be able to respect its interest payments and could survive, it was indeed trading ‘cheap’

This is a clear case of being contrarian. In hindsight, it seems logical. At that moment, nothing was set in stone. This is what he saw the day before the spinoff:

The price of the stock continued to rise from October 1992 until one year later. In the meantime, class action lawsuits were undergoing, against the spinoff as certain fixed income holders felt duped by the upcoming transaction.

So, let’s summarize the most important questions to ask when looking at a spinoff ⬇️

The Checklist

• Identify why the company wants to do a spin-off

• Is there a chance of forced selling?

  • Because institutions own it and cannot own the spin-off

  • (the spin-off looks bad, or it might simply be too small compared to the parent)

  • It has to be something else than the investment case

• Does the spin-off CEO have a track record?

• Does the spin-off CEO (or other managers) have skin in the game?

  • Look at the statements on incentives and future holdings, is there something in there that states if the spin-off would lose, the management would share in the loss

• Do not disregard leverage. Can the company cope with it?

Are spinoffs still the way to go?

Logic dictates that spinoffs are still a source of mispricings in the markets. Of course, the cat is out of the bag. More people are looking. We now have specific websites focusing only on spinoffs (or other special situations):

• www.insidearbitrage.com (which lists the past and upcoming spin-offs (I believe focusing on the US))

• And of course, Toffcap ⬇️

• which is a newsletter that covers event-driven situations which I highly recommend

What about performance?

S&P has created a spinoff index. It has performed handsomely in 2024 with a YTD return of 43%:

Source: S&P Global

However, over the last 10 years, it returned 9.8%

One of the reasons I believe is the absence of forced selling, which is an important factor.

Here’s the definition of the index:

As you can imagine, the spun-off company has to have a minimum market cap of 1 Billion, which allows institutions to keep hold of the spun-off company. Also, how long does it hold the companies within the index? An event-driven situation like this does not allow for a typical buy-and-hold strategy.

My take: I believe spinoffs are still a worthwhile hunting ground, but I reckon fewer eyeballs are looking at spin-offs in Europe or Asia as opposed to the US.

Conclusion

As I stated in the introduction, I like to look at everything, but we need to know what we’re looking for. The checklist can help to quickly dismiss several spinoffs and only hone in on those that meet the requirements.

I plan to use it on a list of spinoffs and see if I can uncover something.

May the markets be with you, always!

Kevin