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The IRS Goes Activist on Jeff Smith, Starboard Value

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Over the decades, companies have developed a long-lasting practice of spinning-off their real estate assets into independent, publicly-traded Real Estate Investment Trusts (REITs), which allows them to unlock the intrinsic value hidden in those assets that is often not reflected in their market valuations. Often these transactions occur under pressure from some activist shareholders. One of the investors that has been very active in this area is Jeffrey Smith of Starboard Value, who over the last year has pushed for the spin-offs of real estate assets at companies like Darden Restaurants, Inc. (NYSE:DRI) and Macy’s, Inc. (NYSE:M). Smith was also one of the first investors who urged Yahoo! Inc. (NASDAQ:YHOO)‘s Marissa Mayer to consider a spin-off of the company’s equity position in Alibaba Group Holding Ltd (NYSE:BABA).

Jeff Smith

However, a recent guidance from the IRS regarding the spin-off of real estate can put the efforts of Smith and other activists in jeopardy. The IRS has expressed its concern with such transactions, stating that they might not align with the rules set against hiding taxable transactions under spin-off of real estate and other assets. The current legislation states that companies have to spin-off the real estate alongside a part of its active business and so far companies have been complying to this rule, but the tax authority now considers that the businesses that are included in the REITs are too small compared to the value of the real estate assets. For example, Darden Restaurants, Inc. (NYSE:DRI)’ spin-off plans also involve six LongHorn steakhouses in San Antonio, out of over 400 it owns.

Jeffrey Smith
Jeffrey Smith
Starboard Value LP

The IRS concerns don’t speak precisely that the authority is against such transactions and until the legislation is changed it can challenge some of the transactions. However, it will most likely put a stance on activist campaigns towards future spin-offs and will give companies ammunition to fight against them.

If the legislation is changed, it’s likely that activists like Starboard will have to realign their strategy and focus on other aspects for unlocking shareholder value, such as the separation of some more significant parts of businesses. Around a year ago, Starboard managed to replace the entire board of Darden Restaurants, Inc. (NYSE:DRI) with its own slate of candidates, so it has the means to push on with the transaction. Although a spokesman for Darden, quoted by The Wall Street Journal, said that the company is certain that it will manage to get through with its current plans.

The eyes are also set on several other companies, including Macy’s, Inc. (NYSE:M), which is also under pressure from Starboard to spin-off its real estate, which could make the company worth $125 per share, as Smith stated at the CNBC Delivering Alpha conference in New York earlier this year. The investor added that the company’s real estate alone is worth $21 billion, a significant part of its $29 billion enterprise value. In its 13F for the end of the second quarter, Starboard disclosed ownership of 2.92 million shares of Macy’s, roughly 0.9% of the company.

Following Smith’s comments at the conference, Macy’s, Inc. (NYSE:M) witnessed an increase in popularity among smart money investors. Among over 700 funds from our database, the number of investors bullish on Macy’s went up to 61 from 55 during the second quarter, while the total value of their stakes surged to $2.20 billion, equal to almost 10% of the company, from $1.21 billion at the end of March. We consider the hedge fund sentiment an important metric, because our backtests showed that imitating some of hedge funds’ long bets could help retail investors generate market-beating returns. Our strategy, which is followed on imitating 15 most popular small-cap picks among hedge funds from our database, has returned 118% since August 2012 and beat the S&P 500 ETF (SPY) by over 60 percentage points (see more details here).

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