There are several corporate events that unlock value and lead to higher returns. One of these events is a spin-off. Joel Greenblatt provided an excellent summary of this investment strategy in You Can Be A Stock Market Genius. If you haven’t read this book yet, you should. In his first quarter investor letter Dan Loeb mentions that he is currently invested in 6 spinouts and details his reasoning behind three of those investments. Here is an excerpt from Third Point’s letter:
Beginning in the Fourth Quarter of 2010, we started focusing on transactional activity in the energy sector, specifically spin‐outs of embedded business units. Many of these transactions include use of an MLP structure, which confers tax advantages for investors and therefore leads to higher multiples for the entity following the spin. These investments are based on the classic event‐driven recipe of unlocking shareholder value through restructuring, as opposed to directional bets on energy prices. Our current portfolio has six of these energy infrastructure spin‐out positions, with an overall concentration of ~12%. Below are highlights of three of these positions. While each of the below has its own unique elements and specific catalysts, the basic blueprints are similar.
The Williams Companies is a diversified energy company with two primary segments: energy exploration and pipelines. It had long been seen as an attractive candidate for a spin‐off restructuring. In 2005, the Company had spun out a portion of its pipeline business into a publicly traded MLP (Williams Partners LP – WPZ) but had never moved seriously to split the two businesses completely. However, in the Fourth Quarter of 2010, two important “tells” suggested to us that the situation had changed. First, the Company’s long time CEO, who had been opposed to pursuing a spin‐out, announced his retirement.
Second, in November the Company announced the acquisition of some attractive acreage in the Bakken Shale, an acquisition that we believed was at least partly motivated by a desire to improve the standalone investment appeal of its E&P business segment. We invested around this time, and were rewarded in February when the Company announced it would split the Company via an initial IPO of the E&P business (selling 19% of that business to the public) in the second half of 2011 and then execute a full spin of the remaining 81% to shareholders in early 2012.
Since our initial investment, prospects for the company and its valuation have continued to improve due to factors including: 1) the recent IPO of Kinder Morgan, a similarly positioned company, which highlighted the value of General Partnership (GP) interests in MLPs, 2) continued execution by the WMB management team on additional midstream investments, and 3) improved liquefied natural gas prices due to strong chemical demand and higher oil prices. We believe that the shares remain significantly undervalued and have added to the position.
El Paso is also a diversified energy company with the same two primary segments: energy exploration and production and pipelines. We purchased the position early in the First Quarter of 2011 on the thesis that it would follow the same playbook as Williams, and were gratified when management announced in mid‐February that they were open to exploring a spin‐out of the segments to enhance the value of the company and would closely watch the performance of peers pursuing such strategies. We believe that the company’s shares are currently significantly undervalued because: 1) disaggregating the affiliated pipeline company is complex since the company has a portion of some of its units in an MLP structure, 2) analysts are overlooking the value of the GP interest, which, while small today, should see a significant increase in value as the MLP should grow dramatically over the next 3‐5 years, 3) the company has several major pipeline products ramping up over the next year, which we believe will substantially increase EBITDA, and 4) while many analysts conduct “sum of the parts” analysis, we believe they are flawed because those that primarily follow the pipeline business dramatically undervalue the E&P side of the business, and those that primarily follow the E&P side undervalue the pipeline business. We see 40‐60% upside from the levels where we initiated our position.
CVR Energy has two assets: an oil refinery and a nitrogen fertilizer plant, both located in Coffeyville, Kansas. Each of these assets is benefiting from huge structural tailwinds, and the Company is pursuing a spin‐out of the fertilizer business that will, consistent with the theme described above, highlight the value of these assets. We originally purchased CVR in November 2010 on the belief that the Company would be an ideal spin‐out candidate, added to the position in a February secondary offering, and subsequently have purchased additional shares in the market.
CVR filed an S‐1 for the IPO of its fertilizer business in late March. Based on comparable valuations, CVR’s geographically advantaged assets, and the strong outlook for nitrogen fertilizer, we believe the Company will receive a robust valuation for these assets at the time of the IPO. Additionally, CVR is pursuing an MLP structure for this offering, which we believe will result in the fertilizer plant trading at a very high valuation due to investors’ desire for yield in today’s low interest rate environment.
The outlook for CVR’s refining business is likewise strong. The facility recently underwent an extensive upgrading process and is ideally located to take advantage of the oil supply/demand imbalance in the Cushing market. In short, increased supply of oil is flowing into Cushing, and there is presently inadequate take‐away capacity in this market. The result has been that WTI oil prices are at a large discount to oil delivered at other locations, creating the prospect of windfall profits for refineries in this region, as the competition in other regions must source higher‐cost oil. We think that this imbalance should persist for at least the next twelve‐to‐eighteen months (and quite possibly much longer). As a result, we are very constructive on mid‐continent refineries. Further, netting the value of the fertilizer spin, we believe we are creating the CVR refinery operation at a 50% discount to the mid‐continent comparables.