Many of you are probably familiar with spinoffs, especially since I’ve written about a few spinoffs here in the past. However, I bet most of you are not familiar split-offs, a close relative to spinoffs. I discovered my first split-off this past autumn and I’ve made some serious profits with these special situation opportunities since then.
What are split-offs?
Split-offs are a type of reorganization where the stock of a subsidiary is offered in exchange for shares in the parent company. A split-off differs from a spinoff in that the shareholders in a split-off must exchange their shares of stock in the parent company in order to receive shares of the subsidiary, whereas the shareholders in a spin-off do not need to trade in their shares in order to receive shares in the subsidiary. The key difference here is that you have to take action to opt into a split-off and you have to give up your shares in the parent company to receive shares in the subsidiary.
A split-off is also referred to as a tender offer exchange. This is often how you will find split-offs described in regulatory filings at the SEC. I actually discovered my first split-off opportunity when searching for odd-lot tender offers. Mixed in with other tender offers, I first ran across a tender offer exchange that was being offered by McDonald’s (MCD), which I describe in more detail below.
Why are split-offs profitable?
There are four main reasons why split-offs are profitable for individual investors.
- Exchange Premium: Split-offs often provide a premium for the share exchange. The split-offs I have participated in have offered a 7.5 to 11 percent bonus in the exchange of the parent stock for the split-off. For example, I received $1.11 dollars worth of Domtar (UFS) for every $1 in shares of Weyerhaeuser (WY) I tendered in the exchange. The exchange premium gives you an automatic boost in your potential return.
- Odd-Lot Preference: Split-offs are likely going to limit the number of shares that will be offered. If too many shareholders in the parent company opt to exchange their shares for the split-off stock, the amount of shares that are exchanged will be prorated to avoid an oversubscription to the offer. However, many split-off opportunities provide an odd-lot preference that allows all stock tendered by shareholders holding less than 99 shares (i.e., an odd lot) to be exchanged first before any prorating occurs. Whenever I see an odd lot preference, I know that this is a clue that individual investors might have an advantage to earn profits.
- Focus: A split-off often results in an increased focus of the parent company’s business, and also the split-off company is usually very focused in one line of business. A simplified business is often valued at a higher rate than a complex conglomerate. Some investors actually value businesses by summing values of the various parts of their operations. A split-off also often unlocks the value of stock in the subsidiary on the parent company’s balance sheet. In addition, the increased focus of the management of both the parent company and the split-off company tends to lead to better performance. The expectation by most investors is that both the parent company and the subsidiary will perform better as separate and more focused companies.
- Require Action: Split-offs are not something you can take advantage of by being a passive investor. In order to capture the exchange premium, you need to purchase shares in the parent company and then call your broker with instructions to tender your shares. Many shareholders will never read the filings concerning a tender offer exchange and still less will bother to call their brokers to take advantage of such opportunities. Hedge funds and institutional investors won’t make such a mistake, but the profit potential for them is limited because of prorating. As an active individual investor, you are in a small minority and can take advantage of this potential market inefficiency.
I’m sure there are other reasons why split-offs tend to be profitable investments. Please share your thoughts below in the comments section on other reasons why split-offs tend to be good opportunities.
What are some examples of profitable split-offs?
McDonald’s Split-Off of Chipotle
My first experience with a split-off was with the McDonald’s (MCD) split off of Chipotle Mexican Grill (CMG.B). I first heard about the McDonald’s split-off of Chipotle in September of 2006. McDonald’s offered to exchange up to an aggregate of 16,539,967 shares of Chipotle class B common stock for outstanding shares of McDonald’s common stock. The exchange offer was designed to permit holders of McDonald’s common stock to exchange their shares for shares of Chipotle class B common stock at a 10% discount to the calculated per-share value of Chipotle class B common stock. Stated another way, for each $1.00 of McDonald’s common stock accepted in the exchange offer, the tendering holder would receive approximately $1.11 of Chipotle class B common stock, based on calculated per-share values, subject to a limit ratio and to proration. However, odd-lot holders were exempt from proration.
I purchased 99 shares of McDonald’s on October 2, 2006. The tender offer was going to expire at 4:30 PM on October 5th, so I contacted my broker to make sure there was still enough time to process the tender offer exchange. All went well and on October 24th, I received 87 shares of Chipotle Mexican Grill class B shares (CMG.B) and $49.91 in cash. Since the class B were selling for a discount to the class A shares even B shares had superior voting right and it also looked like Chipotle’s incredible growth might continue, I decided to hang onto my CMG.B shares for a while.
I finally sold my CMG.B shares on February 27, 2007 for $56.90 after my $57.00 stop order was triggered. I decided to place a stop order because I was getting nervous about the market. Never the less, I made $1,013.45 in net profit in 148 days. That 26.1% gain produced an average annualized return of 64.4%. Given the impressive performance of this split-off, I decided to keep split-offs on my radar and also track them for members of Fat Pitch Financials Contributor’s Corner.
Weyerhaeuser Split-Off of Domtar
As my investment in Chipotle was coming to an end, I spotted a fat pitch opportunity in the announcement at the beginning of February that Weyerhaeuser (WY) was planning a split-off of their Domtar (UFS) subsidiary. Under the terms of the offer, participating Weyerhaeuser shareholders would receive approximately $1.11 worth of Domtar Corporation common stock for each $1 of Weyerhaeuser shares tendered in the exchange offer, subject to a limit of 11.1442 shares of Domtar Corporation common stock per Weyerhaeuser share. There was also a provision that odd-lot holders would not be prorated.
I backed up the truck on this deal and purchased 99 shares of Weyerhaeuser in my Roth IRA and I also told my wife to purchase 99 shares of Weyerhaeuser in her account. Ideally, I would have both these shares in the Special Situations Real Money Port, but that account lacked sufficient funds. I purchased the 99 shares in my account for $76.65.
A few days later, I sent an email to my broker instructing them to tender my shares for Domtar. I reminded them that I qualified for the odd lot preference. It cost me $25 to do the tender. On March 15, 2007, I received 1,103 shares of Domtar in my account (my wife also received the same amount). I planned on selling them right away, but I was in a conference all day and I did not notice that the shares had arrived until after the market closed. However, the next day I quickly placed a limit order to sell my shares close to the previous day’s closing price. I was able to sell my shares on March 16th near the close of trading for $9.38 per share. I received $10,339.19 in cash for a net profit of $2,718.89 (a similar amount of profit was also earned in my wife’s account). That was a gain of 35.8% in just 42 days! That comes out to an average annualized return of over 311%. This deal went down in the record books as one of the best special situations I’ve ever invested in.
Where can you find the next split-off opportunities?
I’m sure you can also discover this split-off opportunity in this very well known company on your own. You will need to search through the thousands of recent SEC filings and dig through dozens of recent tender offers filed with the SEC. It will take you time to sift through all the filings and then you will have to read though the details on many of the individual deals. I do this daily, so I’ve built up some methods to save myself some time. Thankfully, some of the members of Contributor’s Corner also help keep me up to date with all the various special situation opportunities we track.
Regardless of whether you research split-off opportunities on your own or with Contributor’s Corner, you will likely also find many profitable opportunities in these somewhat rare and unique special situations opportunities.
Full Disclosure: I do not currently own shares in McDonald’s, Chipotle Mexican Grill, Weyerhaeuser, or Domtar.