From Seeking Alpha blog y Lou Baenese on Wednesday:
After a dearth of activity in the early stages of the bull market, corporations now appear dead set on unlocking hidden value via spin-offs. Case in point: Two dozen deals have already been completed this year. And at least another two dozen are officially in the works, including American Express & Co.’s (AXP) spin-off of its business travel division.
Ever the impatient lot, analysts and investors aren’t waiting for new spin-offs to be announced, though. Instead, they’re out trying to predict the next corporate breakup in advance – much like they try to predict the next takeover target. The latest company garnering attention is an $8.8-billion coal company that’s been around since the U.S. Civil War. Analysts at Deutsche Bank AG (DB), Raymond James Financial and Nomura Holdings estimate that a spin-off could trigger a 30% profit windfall for shareholders.
Who doesn’t want a piece of that action, right? Well, there’s always a dumb (read: risky) way and a smart way to go about things. Today, I want to share the latter with you.
Show Me the Money
The company at the epicenter of the latest bout of spin-off speculation is none other than CONSOL Energy (CNX). As I mentioned, the company has been mining coal since the U.S. Civil War. In recent years, though, it expanded into the booming natural gas business and now controls over approximately 750,000 acres of prime assets in the Marcellus shale formation.
Now, CONSOL’s coal and natural gas divisions are at different ends of the spectrum in the company’s business cycle. The coal assets are mature and primarily produce cash, whereas the natural gas business is in the “early innings of a material growth mode,” according to Curt Woodworth at Nomura. Generally speaking, income-producing assets and growth assets attract two different types of investors. Like oil and vinegar, they don’t naturally mix well together. Or as Lucas Pipes at Brean Capital LLC says, “The gas guys don’t really understand the coal business, and the coal guys don’t really understand the gas business. So ultimately, this ought to be two separate companies.”
It appears that management might be waking up to this reality, too. Last week, the company announced that it’s considering “all options” to unlock the full value of its assets. Of course, those two simple words prompted every analyst and their mother to assume that CONSOL is considering a spin-off. In turn, they all whipped out their excel spreadsheets to compile a sum-of-the-parts model.
At the low end, analysts believe that CONSOL is worth $39 per share, which isn’t much higher than its current price. At the high end, they think the company could be worth $50 per share, which represents an attractive 30% upside. True to form, investors focused on the optimistic outlook and piled into shares. Don’t be so eager to follow them, though. If the breakup never materializes, you’ll be left holding a conglomerate that’s destined to frustrate investors.
Like the classic chicken versus egg debate, investors will always question whether CONSOL is an income-producing coal company or a rapidly growing natural gas company. In other words, without a spin-off or asset sale, the stock will never trade at its true value. So how can we play the upside of a CONSOL breakup without exposing our portfolios to that risk?
It’s simple, really; take the money we would spend on purchasing shares outright, and split the capital evenly between the Market Vectors Coal ETF (KOL) and the Guggenheim Spin-Off ETF (CSD). Doing so will put us in a better spot, no matter what the company decides to do.
Let’s break it down so you see what I mean.
Scenario 1: Spin-off Announced
CONSOL represents the biggest holding in the KOL fund, at 8.73% of assets. So if a spin-off is announced, and shares pop, the fund is bound to enjoy a meaningful boost, too. Plus, as I told you earlier in the month, spin-offs tend to outperform the broader market by an average of 13 full percentage points, according to Credit Suisse (CS). And since there’s no doubt that the CSD fund will own a stake in any eventual CONSOL spin-off, this allows us to capture the additional upside after the breakup. What’s more, we stand to profit from both funds while we wait for an official spin-off announcement.
Scenario 2: No Spin-off Announced
If CONSOL decides against breaking up – no harm, no foul. We won’t be stuck with a dead money investment in shares. Instead, we’ll own a portfolio of undervalued coal companies that are springing back to life. (Since August 7, the KOL fund is up almost 15%, compared to only a 3% rise for the S&P 500 Index over the same period.) We’ll also own a portfolio of up to 40 of the market’s most compelling spin-offs via the CSD fund. No guesswork involved. As I’ve shared before, it’s dramatically outperforming the broader stock market this year, too. And all signs point to that trend continuing.
Bottom line: I believe CONSOL will ultimately find a way to unlock the hidden value for its shareholders. But there’s more than one way to profit from it. I prefer an investment that both reduces my risk, and allows me to profit while I wait.*
Chesapeake Energy Corp,the Oklahoma-based firm is the No. 1 driller in Ohio.
Rig Count Interactive Map by Baker Hughes, an energy services company.
Shale Sheet Fracking, a Youngstown Vindicator blog.
The Ohio Environmental Council, a statewide eco-group based in Columbus.
Earthjustice, a national eco-group.
People's Oil and Gas Collaborative-Ohio, a grass-roots group in Northeast Ohio.
Concerned Citizens of Medina County, a grass-roots group.
No Frack Ohio, a Columbus-based grass-roots group.
Fracking: Gas Drilling's Environmental Threat by ProPublica, an online journalism site.
Pipeline, blog from Pittsburgh Post-Gazette on Marcellus shale drilling.
Allegheny Front, environmental public radio for Western Pennsylvania.