If you have gone through Warren Buffet’s early partnership letters, you would find that he had spilt his partnership portfolio into three categories and one of most interesting category was work-outs

So what are work outs ?

Our second category consists of “work-outs.” These are securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities. In other words, they are securities with a timetable where we can predict, within reasonable error limits, when we will get how much and what might upset the applecart. Corporate events such as mergers, liquidations, reorganizations, spin-offs, etc. Lead to work-outs. companies.

If you want to learn on how to invest in work outs (also called special situation investing / Risk Arbitrage Investing) the best book to pick up is Joel Greenblatts – You can be a stock market genius

In this post we will learn about spin off investing through a live example

First understand what is Spin offs

spinoff-1

There are various reasons corporations opt for spin-offs, the primary ones are

spinoff-2

spinoff-3

spinoff-4

spinoff-5

Spinoff-6

Reading the scheme of amalgamation shared by company in their regulatory fillings to stock exchanges would spell out reason for spin off.

Let’s introduce a case study here, Recently Transport Corporation of India ltd (TCI Ltd) informed its shareholders as below

Transport Corporation of India Ltd has informed BSE that the Board of Directors of the Company at its meeting held on October 08, 2015, has approved the Scheme of Arrangement between Transport Corporation of India Limited (TCI) and its wholly owned subsidiary, TCI Express Ltd. (Formerly known as TCI Properties (Pune) Ltd.) for Demerger and Transfer of Express Distribution (XPS) Undertaking, & delayering of TCI’s global holding structure by liquidation of its wholly owned subsidiary, TCI Global Holding (Mauritius) Ltd. and consequent capital reduction pursuant to Sections 391 to 394 & Section 100 to 103 of the Companies Act, 1956 read with Sections 52 of the Companies Act, 2013, as reviewed and recommended by the Audit Committee of the Company and subject to requisite approvals of the Shareholders and creditors of the respective companies and the sanction of the Hon’ble High Court of Hyderabad for the State of Telangana & for the State of Andhra Pradesh, Stock Exchanges, SEBI or such other competent authority(ies) and other necessary statutory/other approvals.

If one seeks to understand the rationale of this spin-off they can read the scheme of arrangement available on their website, I am reproducing section for your reference

spinoff-7

Clearly management’s objective is to attract better valuation for their carved out entity which is growing with tailwinds from boom in e-commerce space in India.

Joel Greenblatts pointed out that there are three reasons for success of spin off investing operations

spinoff-8

The institutions don’t want it because many a times a carved out entity is a small cap and fund managers may not have mandate to invest in small cap companies .

spinoff-9

This is the most important item to track in any spin off situations, if management is not gung-ho and are keeping or building their interest then as minority shareholder you should be very interested.

Did you notice this significant event for TCI Ltd prior to announcement of demerger

spinoff-10

A significant portion of outstanding options were exercised by insiders and was converted into equity shares. ‘The insiders are in’

spinoff-11

A spin off could result in a bargain stock (many times the parent) or a creation of previously hidden great business

Applying some common sense and doing some school grade maths may give some decent edge to your portfolio.

Let’s continue with our example TCI Ltd

The existing shareholders of the company would be given one equity share of the new company for every two share of the parent company held by them. If you look at the operating performance of the units which is also present in scheme of arrangement document you will get a glimpse of on how the two new entities would look like

spinoff-12

The spin-off is an asset light better ROA business and this is line with management’s rationale that the new business would attract different set of investors and would have better price discovery

TCI Ltd has some history of spinning off companies, Like in 2011 it spun off its real estate arm

spinoff-13

An investment operations in that spin off made some handsome returns for their existing shareholders, See below snap shots from Katalyst wealth

spinoff-14 spinoff-15

Would history repeat, Will existing shareholders make such returns this time around as well ?

Only time will tell but if you want to participate understand the next steps

  • Shareholders have to approve this scheme and given promoters have a significant stake, this should be easy
  • Post that High court of Telangana needs to approve this scheme
  • A record date would be set
  • Shares of the parent company would then trade at demerged value
  • New company’s share would be listed on exchange

Now earlier I was talking about using some school level maths and common sense has to be used in spin off situations

The current m-cap of TCI is INR 2300 Crore

TCI Express Rest TCI
Spilt Market Cap (INR Cr) 767 1150
PAT FY15 (INR Cr) 28 48
Sales FY15 (INR Cr) 659 1550
Sales FY16 (INR Cr) – 15% growth 758 1628
PAT FY16 (INR Cr) – 15% growth no margin improvement 32.2 50.4
PE FY16 23.81 22.82
P/Sales FY16 1.01 0.74

In 2014, an ICICI securities research pointed out this

spinoff-16

If one goes by above then at current m-cap there is no MoS for TCI express,However if we see  a couple of peers they are richly valued, although Brand wise and Margin wise they are ahead of TCI

Company Name CMP EPS TTM PE Ratio Market Cap Sales P/Sales PAT%
Blue Dart 6877.45 67.94 101.23 16,318.77 2268 7.20 5.60%
Gati 145.8 3.43 42.51 1,275.42 443 2.88 5.40%

If the market values TCI express like it’s peers than things could become interesting

This post is not a recommendation to buy TCI ltd or participate in this spin off situation. This post is purely for educational purpose, I am not a SEBI registered analyst so please consult your Financial adviser before making any investing decision