This week will look at a corporate spin off. Earlier this month, Xerox (XRX) spun off their Business Process arm into a new company called Conduent (CNDT). The interest in this particular situation is partly from reading a book by Joel Greenblatt, a value investor and hedge fund manager who is also an adjunct professor at Columbia University’s Graduate School of Business.
(Some investment areas are) surprisingly unappetizing. (One such) area of discarded corporate refuse is usually referred to as “spinoffs.” – Joel Greenblatt
Companies sometimes grow so much that they realize that they have business arms that are no longer part of their core business. The business leaders realize that they need to get back to their roots and find that they need to rid themselves of the business that is not part of their core business. When this happens, they can sell that portion of the business to another company or they can spin it off into its own entity. Hewlett Packard did this a couple of years ago and plans to do so again on April 1st. Since they split Hewlett Packard, the company has done well as management has been able to focus on their core business. The spinoff is usually out of favor with institutional investors when it is first created primarily because it could be too small of a company for the mutual fund or in a different sector than that of the parent company. The company may also have few analysts covering it making an opportunity to purchase it at a lower price than normal. The interesting fact is that these situations typically create opportunity for superior returns.
Let us apply this thought process to CNDT.
CNDT is the world’s largest provider of diversified business process services. When looking at the SEC Form 10 (the SEC form a company files when it creates a spinoff), it is surprising to find that this company serves 19 of the 20 top commercial healthcare payers in the United States. They also have contracts with 49 of the 50 states for regulatory compliance and data needs. They provide services to government healthcare programs in 29 states, and services for 9 of the top 10 global pharmaceutical and life science companies in the world. In the public sector segment, CNDT provides services for 25 countries for transportation. In their commercial industries segment, they provide end-to-end business-to-business and business-to-customer services in order to optimize their processes.
These contracts provide recurring revenue to CNDT. The Form 10 talked about the company’s target renewal rate of 85-90% which was met for the past two years. The company consistently generates cash flow according to its Cash Flow Sheet. The company seems to have been put into a precarious position with a very low current ratio. This appears to be XRX’s path to success-to unload it’s debt onto the spinoff so that XRX can return to profitability a normal action by many companies participating in spinoffs. The most recent quarterly filing with the SEC indicates that the company is reducing its debt load improving the current ratio. The quarterly statement does show that the company is heading for a cash flow loss in this first year of existence with a $38M loss in the nine months ended September 30, 2016. In short the company should begin its life struggling to exist.
This is reflected in the number of institutional investors: 9.77% of the company’s stock is held by them. The company’s first year results (due around the 10th of next month) should help determine if this will change. This presents an opportunity to get into this company at a very low relative price.
The company’s new CEO should be considered, his name is Ashok Vemuri. Vemuri’s experience is with Infosys and IGATE. At IGATE, Vemuri kept the company afloat when the prior CEO was embroiled in a sexual harassment lawsuit. When he worked at Infosys, he had mixed results, some say that he was successful, others state he was not a star player and contributed to Infosys’ weak results when a member of the board. The question to ask is, “Will Vemuri be motivated to make CNDT a successful organization?” His fortunes are tied to the success of the company amounting for approximately $5M in recompense over the next two years if he makes the company profitable. Vemuri appears to be a multi millionaire already, he is probably worth around $30M, so the $5M appears sufficient to keep him focused.
Another person to consider is Carl Icahn, he has control over three of the board seats in this new company. The activist investor is finding a way to get his money’s worth out of his investment in XRX. Icahn’s investment style should be considered to see what he is doing. It is important to know that he orchestrated this spinoff to have three seats on the board the investor should want to know why he wanted so much control over the new company.
Annual results next month should help identify what the company is worth. $14/share may or may not be the best price for the company. Is this corporate refuse or a diamond in the rough? The company’s first annual statement should help determine this.