How to play the spinoff game
When big companies spawn smaller firms, the new stocks often thrive. These four are the tops.
By Shawn Tully

(FORTUNE Magazine) – THE MARKET'S DRAMATIC, HEADLINE-grabbing upswing in acquisitions during the past few months is masking another key trend that often follows a merger wave: the return of the spinoff. For investors who crave adventure, no area is more fraught with extremes of profit or doom than businesses newly liberated from the grip of corporate giants. Right now the surge in the ranks of spinoffs is offering investors a choice of freshly minted companies in fields as diverse as biotech, natural gas exploration, and videogame retailing that, on paper, seem likely to profit mightily from their independence.

But investors should proceed with caution: The spinoff field is littered with as many dogs as gems. You need to be highly selective and demand that candidates pass a strict series of tests, including the ability to handle often heavy debt loads. "You probably won't do well buying a random portfolio of spinoffs," says Chuck Lucier, a consultant with Booz Allen Hamilton, "but if you find the good ones, the returns are fabulous."

"Spinoff" is a broad term that covers two main types of transaction. The first is the pure spinoff, in which the parent simply distributes new, publicly traded shares in a division or a subsidiary to its existing shareholders.

The second is the "carve-out," which is typically less alluring for profit seekers. In a carve-out the parent sells only part of the sub or division (typically around 20%) to the public through an IPO. By keeping its offspring on a leash, the parent withholds one of the big advantages of a pure spinoff, the ability of the new company to follow a daring entrepreneurial path by investing capital freely and making acquisitions. Carve-outs, however, aren't as big a negative as they appear, because they're often a prelude to a full spinoff. In about half of all carve-outs, the parent eventually leaves the picture. Last year, for example, energy and real estate company Allete did a carve-out of its auto-auction business to create ADESA in June, then spun off its majority stake to its shareholders in September. Since then, investors have cheered ADESA's freedom by boosting its stock price 30%.

Many spinoffs are run a lot better as independent companies than as wards of huge corporations. "You attract far better managers to a spinoff than to a division of a big company," says Warren Batts, who in the 1980s ran Premark, the highly successful spinoff from Dart & Kraft that owned Tupperware. "People can see they're really making a difference in the value of the stock--and their own stock options."

The rub is that the parent will frequently set a business free for the most obvious reason: It's a troubled, unprofitable sideshow the parent can't wait to dump. To make matters worse, the parent frequently loads down the spinoff with baggage ranging from heavy debt to rusting plants.

What makes spinoffs worth exploring is that those that succeed provide some of the most spectacular payoffs around. Just think of Sara Lee's spinoff of Coach Inc., which has seen its stock price increase tenfold since it went public in 2000, and Merck's creation of newly independent Medco Health Solutions, which has jumped 73% since its introduction in late 2003.

After a long slump, investors are getting a rich menu of spinoffs to choose from. The total jumped from 21 in 2003 to 35 last year, and the pace is accelerating, according to Spin-Off Advisors, a Chicago research firm. Big companies that traditionally do lots of spins returned to the game last year: GE freed up insurance provider Genworth Financial, and Motorola created Freescale Semiconductor. In one of the biggest deals of 2004, Viacom handed its stake in Blockbuster to its shareholders. This year Sara Lee has announced it will spin off its apparel businesses. And since Carly Fiorina's departure from Hewlett-Packard, speculation is rampant that HP will jettison its troubled PC business, reversing Fiorina's disastrous 2002 acquisition of Compaq.

Investors should profit if they apply five criteria. First, as discussed, pass up most carve-outs in favor of pure spinoffs. Second, look at the level of debt. Big debt isn't a killer if the new company has the earnings to carry it. But many spinoffs don't. Third, look for a growth story. If the old management was holding back expansion and the new team has a clear strategy for building businesses that were starved for capital, you can bet that the market will reward the risk. Four, search for hidden assets not reflected in book value, such as land holdings or lucrative brands.

And fifth, remember that small is beautiful. Don't be afraid of spins with modest market caps. A McKinsey & Co. study of spinoffs in the 1990s showed that new companies with market caps below $1 billion returned almost twice as much as the S&P 500. The reason is obvious: Since they're often neglected by analysts, smaller spinoffs don't get a lift from Wall Street hype, so they're frequently undervalued.

Here are four recent spinoffs that meet all (or almost all) of our criteria:

●Eagle Materials (EXP, $81). This construction-materials maker, a spinoff from homebuilder Centex, boasts strong sales growth of more than 17% a year and is highly profitable. Yet its P/E is a modest 16. The smart money says the building boom will stay with us even if home prices fall. Plus, Eagle is strong in the commercial and industrial construction arena, which is bouncing back.

●Wright Express (WXS, $18). A spinoff from real estate and travel giant Cendant, Wright is a classic outsourcing story: It tracks data and manages payment processing for corporate and government fleets of cars and trucks. Last year it earned $39 million, a gain of 13% over the previous year. Yet its market cap is less than $800 million, giving Wright a P/E of 20, modest for a briskly growing business. Another plus: low cap ex, so almost all profits go straight to free cash flow.

●GameStop (GME, $20). Here, new freedom should mean bigger profits. This retailer of videogame hardware and software--brands from Nintendo to PlayStation--has traded publicly since 2002 but was controlled by former parent Barnes & Noble until B&N sold its remaining shares in November. GameStop has extremely low debt for a spinoff, and profits are growing at more than 15% a year. With such strong earnings gains, its trailing P/E of 18 makes the stock a bargain.

●Neenah Paper (NP, $33). This Georgia manufacturer of fine and technical paper, a former unit of Kimberly-Clark, is the riskiest bet of the lot. That's because Kimberly burdened Neenah with a ton of debt and a high-cost pulp mill of questionable value. Still, Neenah is interesting for two reasons. First, the paper businesses are highly profitable and are even showing good growth. Second, Neenah owns one million acres of Canadian timberland, currently valued at $200 million, that are on the books at $5 million. This one carries the classic pluses and minuses of spinoffs all in one package. On balance, we're betting the capitalist vigor that's a spinoff's biggest gift brings good things to Neenah's investors.

Divided and ready to conquer

With strong growth rates relative to their industries, these recent spinoffs should thrive.

[This article contains a table.  See below.]