InformationWeek

February 28, 2000

Taking Stock:
Spinning Out Of Control?
Companies say spin-offs and tracking stocks gain recognition for undervalued embedded assets; analysts say most of them are merely exercises in accounting

By William Schaff

William Schaff s if the financial markets weren't crazy enough lately, I've had to deal with an increasing number of companies spinning off their subsidiaries or issuing tracking stocks, usually as an initial public offering. The management of these companies believes these practices will gain better recognition for undervalued assets. Financial analysts, however, debate the merits of spin-offs and tracking stocks since, in most cases, they amount to little more than accounting exercises.

Whatever the true worth of these maneuvers, I need to add them into a sum-of-the-parts analysis to get a conglomerate valuation. Judging by the following examples, the result sometimes makes little financial sense.

Daisytek International Corp. (DZT--Nasdaq), a Plano, Texas, wholesaler of nonpaper computer and office supplies, spun off 17.8%, or 3.1 million shares, of PFSweb Inc. (PFSW--Nasdaq), a provider of transaction-management services for E-commerce, in an IPO on Dec. 2. Daisytek still owns 14.3 million shares of PFSweb, which is trading at $34.44 a share. This means the embedded value of PFSweb in Daisytek is $492 million. However, the equity market capitalization of Daisytek is only $404 million since it's priced at $23.50 per share and there are 17.174 million shares of Daisytek outstanding. By buying Daisytek, not only are you getting the company's distribution business for free, but you also realize a further discount by owning PFSweb.

Daisytek shareholders own roughly 0.8327 shares of PFSweb per share of Daisytek. This means that at PFSweb's share price of $34.44, there is $28.68 worth of PFSweb in every share of Daisytek. But since Daisytek is priced at $23.50, is the rest of Daisytek really worth minus-$5.18 per share? I doubt it.

What I find amazing is that Daisytek's management plans to spin off the rest of PFSweb to its shareholders by midyear. Why buy PFSweb directly when you can buy it at a discount through Daisytek?

Another example of financial gamesmanship is being played by Intermedia Communications Inc. (ICIX--Nasdaq), a local phone company in Tampa, Fla., that owns 39.35 million shares of Digex Inc. (DIGX--Nasdaq), the No. 2 Web-hosting company. Digex will eventually be monetized (sold as stock on the open market or repackaged in a different security) or spun off to Intermedia shareholders. Digex is trading at $142.63 per share, which means Intermedia has $5.61 billion worth of Digex value embedded in its shares. Intermedia trades at $63.81 and has about 77 million fully diluted shares; this puts the equity value of Intermedia at $4.91 billion.

Even including the debt on Intermedia's balance sheet, about $4 billion, and deducting cash of $1.6 billion, you get a rough net of $7.3 billion of enterprise value. That implies you're paying about $1.69 billion for the entire local carrier business, which generates $1.2 billion in revenue and roughly $125 million in earnings before interest, taxes, depreciation, and amortization--the rough equivalent of operating cash flow. That's pretty cheap for any business, even in a competitive environment.

Now let's look at Retek Inc. (RETK--Nasdaq), a vendor of retail inventory-management software in Minneapolis. Retek also backs Retail.com., a business-to-business Web site; customers include drugstore chain Eckerd Corp. and Fogdog Sports. The stock had its IPO in November and is trading at $68.88 a share. However, 88% of Retek is still owned by HNC Software Inc. (HNCS--Nasdaq), a fraud-detection software company that has 18 of the top 20 credit-card processors as clients.

There are 40 million shares of Retek outstanding at $68.88 per share, or an equity valuation of $2.76 billion. Since HNC Software still owns 88% of Retek, there's $2.43 billion of Retek equity embedded in HNC Software. HNC Software has 24.56 million shares outstanding priced at $113.75, or $2.79 billion of total equity valuation. Therefore, shareholders get the parent that generates about three-quarters of the revenue for a miserly $360 million. There are capital gains taxes to pay, but management can drag out the taxes by cleverly monetizing the stock through a convertible offering or another tax-deferred financial instrument.

The message is clear, even if the stock manipulations aren't: Technology investors are operating in a strange new world.

William Schaff is chief investment officer at Bay Isle Financial Corp. in San Francisco, which manages the InformationWeek 100 Stock Index. You can reach him at bschaff@bayisle.com.

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