Spin-offs are a plus, not a guarantee

When a company sets up one of its subsidiaries or divisions as a separate company and hands the stock out to its investors as a special dividend, it tends to unlock hidden value. Over time, the combined value of the post-spinoff parent and spun-off company usually exceeds the value of the parent before the spin-off.

Mind you, this is a general tendency, not a guarantee of continued profit. Nor does it provide protection against the effects of a bad market. During the Internet boom of a few years ago, for instance, many tech stocks spun off their Internet divisions. When that boom turned to bust, these Internet spin-offs plunged with the rest of the sector.

Here is our updated analysis of spin-offs carried out by stocks we recommended. All three paid off and helped unlock some of the hidden value in the parent company. But not all of them are buys.

MOTOROLA INC. $22 (New York symbol MOT; WSSF Rating: Above average) is the world’s second-largest maker of mobile phones, after Nokia Corp. This business supplies about 55% of Motorola’s revenue. The company also supplies infrastructure equipment to wireless phone companies, and makes other communications gear such as two-way radios and high-speed Internet modems.

In December 2004, Motorola handed out its remaining 68% stake in chip maker Freescale Semiconductor to its investors, as part of a broader restructuring.

In the three months ended December 31, 2005, Motorola earned $0.47 a share from continuing operations, up 67.9% from $0.28 a share a year earlier. If you exclude unusual items, the company would have earned $0.35 a share in the most recent quarter. Revenue rose 18.2%, to $10.4 billion from $8.8 billion.

Much of Motorola’s recent success is due to strong demand for its ultra-thin Razr phones. Razr shipments doubled in the fourth quarter from the third, and accounted for 20% of Motorola’s total mobile phone sales. That’s particularly good news, since Razr’s generate higher profits than other Motorola phones.

Motorola recently teamed up with Apple Computer to develop a combination phone and music player called the Rokr. However, Apple limited the Rokr’s music storage capacity, to avoid competing too fiercely against the iPod, so Rokr sales suffered.

Motorola still feels a phone/music device has huge potential. It plans to launch a new music service called iRadio, which will let users download music to their phones for $7 a month. This service should help Motorola compete with satellite radio services, as well as a rumored iPod phone from Apple.

The stock fell to $15 in April 2005, but rose to $25 in November. It now trades at 17.3 times the $1.27 a share that the company should earn in 2006. That presents an attractive buying opportunity, especially since Motorola spends 9% of its revenue of roughly $14.60 a share on research, so it’s more profitable than it looks. The $0.16 dividend yields 0.7%.

Motorola is a buy.

FREESCALE SEMICONDUCTOR INC. (New York symbols FSL $27 and FSL.B $27; WSSF Rating: Extra risk) makes chips for a wide variety of products such as automobiles, computer networking equipment and wireless communication equipment. Motorola accounts for 30% of its total sales.

In the past few months, Freescale has done a good job of cutting its costs. That helps explain why its profit in the fourth quarter of 2005 jumped to $0.45 a share (total $192 million) from $0.01 a share ($5 million) a year earlier. The latest quarterly results included an $8 million reversal of a previous writedown, while the 2004 fourth quarter included $84 million in one-time charges related to the spin-off from Motorola. Revenue rose 3.5%, to $1.48 billion from $1.43 billion.

Like most technology companies, Freescale spends heavily on research, typically around 20% of its revenue of $13.80 a share.

This high commitment to research let it develop a new way to make chips using gallium arsenide, which conducts electricity about 20 times faster than silicon.

Silicon is more abundant and easier to work with than gallium arsenide, so gallium arsenide accounts for just 3% of the global chip market. But Freescale’s new method makes it easier for chipmakers to incorporate more of this material into their chips, using current manufacturing equipment. Wider use of gallium arsenide could lead to more powerful chips that also use less power.

Freescale’s strong balance sheet should let it fund the development of new products. It has $1.4 billion (or $3.30 a share) in cash, and $1.2 billion in long-term debt (0.3 times equity). Since the initial spin-off from Motorola, Freescale’s stock has more than doubled. But it still trades at a reasonable 16.2 times the $1.67 a share it will likely earn in 2006.

Freescale is a buy for aggressive investors. The multiple voting ‘B’ shares are the better choice.

AMERICAN EXPRESS CO. $55 (New York symbol AXP; WSSF Rating: Average) is one of the world’s largest financial services providers, with operations in over 130 countries. Its well-known credit card business accounts for roughly 90% of its revenue. The remaining 10% comes from its travel services business.

In September 2005, Amex handed out all of its shares in subsidiary American Express Financial Advisors (now called Ameriprise Financial Inc.) to its stockholders as a tax-deferred dividend.

As part of the spin-off, it restructured its remaining operations. These moves cut its pre-tax profits in the three months ended December 31, 2005 by $65 million. However, it also received a $60 million gain from a tax settlement. To put these figures in context, Amex earned $0.60 a share (total $751 million) from continuing operations in the fourth quarter of 2005, up 13.2% from $0.53 a share ($669 million) a year earlier. Revenue grew 8.5%, to $6.4 billion from $5.9 billion.

Tougher new bankruptcy laws led to a surge in bankruptcy filings under the old rules in the most recent quarter, and this sparked a $192 million jump in Amex’s U.S. credit card loss provisions. However, bankruptcy filings have dropped sharply since the new law came into affect. Non-performing loans accounted for 1.6% of Amex’s credit card loans in 2005, down from 1.8% in 2004.

The Ameriprise spin-off let Amex focus on expanding its card business. It recently formed new alliances with MBNA (now owned by Bank of America), Citigroup and HSBC. Thanks to these deals, the number of cards outstanding rose 9% in 2005, while spending per card grew 7%.

These figures should continue to rise as more individuals and businesses pay for everyday items with credit cards instead of cash and checks.

Amex’s stock fell below $47 after the spin-off, but it has moved up in the past few weeks. It now trades at 18.6 times Amex’s forecast 2006 profit of $2.96 a share. The $0.48 dividend yields 0.9%.

American Express is a buy.

AMERIPRISE FINANCIAL INC. $45 (New York symbol AMP; WSSF Rating: Average) provides wealth management, brokerage and insurance services through a nationwide network of over 12,000 advisors. It currently owns, manages or administers assets worth $428.1 billion.

In the three months ended December 31, 2005, Ameriprise’s income from continuing operations fell 52.2%, to $0.44 a share (total $111 million) from $0.92 a share ($226 million) a year earlier. If you disregard costs related to the separation from American Express and other one-time items, per-share profits fell 6.1%, to $0.77 from $0.82. Revenue crept up to $1.87 billion from $1.84 billion. However, excluding discontinued operations, revenue grew 5%.

The company prefers to focus on wealthier individuals to whom it can market a variety of financial products. In the most recent quarter, 44% of the company’s clients paid fees to subscribe to an Ameriprise financial management plan, up from 42% a year earlier. These long-term plans give Ameriprise steadier revenue streams than one-time sales of insurance or other financial products.

Ameriprise also aims to spur demand for its RiverSource family of mutual funds. These funds have performed poorly over the past few years, and sales have suffered. A recent $15 million fine for improper trading also hurt RiverSource’s reputation. Ameriprise hopes that a recent restructuring will improve this division’s performance. It may also start selling these funds through independent brokers, instead of relying on its own salespeople.

Although Ameriprise plans to spend more on new computers and marketing in 2006, earnings will probably rise to $3.10 a share and the stock trades at 14.5 times that figure. The $0.44 dividend yields 1.0%.

Ameriprise is a hold.

BARNES & NOBLE INC. $43 (New York symbol BKS; WSSF Rating: Average) is the world’s largest bookseller, with 824 bookstores in 50 states. It also sells books and other products over the Internet.

In November 2004, the company handed out its 63% stake in video game retailer GameStop Corp. to its own stockholders as a special dividend. The spin-off hurt Barnes & Noble’s short-term prospects. But it also let it focus on improving profitability at its less-risky book selling business.

In the nine weeks ended December 31, 2005, sales at its Barnes & Noble superstores rose 5.2% to $1.1 billion from a year earlier. Same-store sales grew 2.3%. However, sales at its B. Dalton mall-based stores fell 18.4% to $41.3 million as the company continued to close unprofitable outlets. On a same-store basis, sales at this division grew 3.0%. Sales at the online operation rose 1.0%, to $106.1 million.

Greater efficiency and fewer inventory buildups at its stores should lift Barnes & Noble’s profits in the fiscal year ended January 31, 2006 to $2.02 a share, up 12.8% from $1.79 a year earlier. The stock now trades at 21.3 times that estimate.

The higher earnings have also let Barnes & Noble expand its stock buyback program. In the first nine months of fiscal 2006, it bought back roughly 10% of its shares. It also started paying a quarterly dividend of $0.15 a share. The annual rate of $0.60 yields 1.4%.

However, the company faces increasing competition from other online booksellers and large discount retailers such as Wal-Mart and Costco.

Barnes & Noble is a hold.

GAMESTOP CORP. (New York symbols GME $41 and GME.B $37; WSSF Rating: Extra risk) operates over 4,400 stores in the United States and Europe that sell video game players and software. It also publishes a video game magazine.

In October 2005, GameStop paid $1.44 billion (70% in cash and 30% in stock) for rival video game retailer Electronics Boutique. That’s a huge investment for the company, which earned $1.17 a share (total $67.7 million) in the fiscal year ended January 31, 2005.

Thanks to the takeover, GameStop’s sales in the nine weeks ended December 31, 2005 rose 133% to $1.35 billion. However, if you assume that GameStop acquired Electronics Boutique a year earlier, pro forma same-store sales fell 1.5% due to shortages of Microsoft’s new Xbox 360 video game console.

While the Xbox shortage has hurt demand for new games, the company’s used game business is booming. That’s good news for GameStop, since it earns about twice as much profit reselling older games than new ones. New game consoles from Sony and Nintendo should also spur sales in 2006.

GameStop is beginning to realize some cost savings from the merger with Electronics Boutique. However, the stock is expensive at 23.3 times the $1.76 a share it will probably earn in its current fiscal year (21.0 times for the multiple voting B stock). The growth of online gaming services could also eventually cut into sales of video games at its stores.

GameStop is a hold for aggressive investors.