The Tortured Spinoff of Gartner Group

There may be value here, but you'll have to wade through a lot of muck before you get to it.
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In the not-too-distant past I wrote about investing in spinoffs, and specifically mentioned Gartner Group (IT) - Get Report, whose ongoing (and rather tortured) spinoff might create a buying opportunity due to the short-term supply-and-demand issues that so frequently accompany these corporate weanings.

To refresh your memory,

IMS Health

(RX)

owns 46% of Gartner Group. IMS wants to make itself into a pure play (take a hard look at that business model while you are at it; it is a thing of beauty) and decided, therefore, that Gartner had to go.

The problem for IMS was that it was itself a spinoff from

Dun & Bradstreet

(DNB)

, which means IMS was restricted from divesting itself of material assets due to certain

IRS

prohibitions. So spinning off its Gartner shares has become a near-Herculean task (music to lawyers' and bankers' ears, I'm sure) that is in the wind-up phase, even as you read.

After IMS' simple "just dump it on the open market" plan was greeted with horror by Gartner management, there began a series of long-winded negotiations that, incidentally, make lovely reading in Gartner Group's proxy. The final iteration of the plan was finally implemented this week.

A Simple Plan

Specifically, Gartner several weeks ago paid a $125 million cash dividend to its shareholders, including IMS. Call it the Bribe.

Two Mondays ago, IMS exchanged 40.7 million Gartner shares into B shares, which are essentially the same as the A shares except they carry supervoting rights for the board. In almost all other matters of corporate governance, they are equal. That seemed to get past the IRS problems, and Monday these B shares were distributed to IMS shareholders.

Now, we think we're pretty good at valuing companies and we think Gartner is worth a heck of a lot more than $21 a share, based on some fairly conservative estimates of future free cash-flow growth. Admittedly, what we are not so good at is handicapping the current short-term game.

Our initial thought a few months ago was that we would buy a "quarter position" with the stock at $21. This helped us balance our longer-term attraction at that price, with the expectation that the flood of shares being spun off would be sold by mostly disinterested IMS shareholders, driving the stock price down into the teens and creating a wonderful shooting-fish-in-a-barrel situation for us.

We thought this way for two basic reasons. First, IMS was in the

S&P 500

and Gartner wouldn't be. So there go all the index funds --

Vanguard

and friends -- out the door. And when they leave the party, it's not a pretty sight.

Second, when a tiny portion of stock is spun off to shareholders, most nontaxable portfolio managers will be thinking: I have a little position worth practically nothing. Not only is it untidy -- even if I buy some of the conceptual attractions behind investing in some spinoffs, I have a 0.2% position in my portfolio, and it would take a 500% gain in the stock to provide 100 basis points of performance -- I have to either buy more or just blow it out without looking.

According to the proxy statement, Gartner management couldn't sleep at night with thoughts like these hanging over their heads. So Gartner committed to holding a Dutch auction for at least 15%, or 15 million, of its shares outstanding (a mix of A and B in proportion to how many of each are outstanding). This auction is going on even as we, ahem, interact. Gartner also committed to buying back an additional 5% of its outstanding A and B shares over the next two years.

So the stock is stubbornly hanging in there in the 21-to-23 range, making us actively reconsider Plan A, based on the following:

  • Is everyone else thinking the same thing? And are some, therefore, stepping up to the plate now, making the Dutch auction an effective mechanism for mopping up demand for the stock?
  • Or is this a temporary floor under the stock, and once the auction is over there will be 25 million or so unaccounted-for shares to be absorbed?
  • And while we're at it, just how much money is indexed to the S&P Mid Cap index -- which just added Gartner -- anyway?

Second-quarter earnings came out a few weeks ago and were, unsurprisingly (given the unpleasantness that a poor earnings report would have thrown on top of a difficult situation), pretty good, which is probably helping a bit.

One of the nicer ways to create performance and sidestep unnecessary headaches as an institutional portfolio manager is to avoid starting a new position that tanks the minute you are done buying. In a market where we'd be happy being even for the rest of the year, there is a huge difference between paying $22 and paying $18 a share.

Buying Value or Buying Votes?

Then, of course, there is the whole issue of which stock to buy, the A shares or the B. Given the minor difference in voting power, it seems to make sense to buy the cheaper paper. Interestingly, you might expect the voting-rights B shares to trade at a slight premium, but as in a number of similar situations, including

Raytheon

(RTN.B)

and

Brown Forman

(BF.B)

, it doesn't. You also have to factor in liquidity issues and of course, index representation. That's why I say: Buy the cheaper paper.

So in our classic fashion -- which favors incremental moves rather than grand, bold gestures -- we have just taken our position up to half a unit from a quarter. In my gut, I still think Gartner has a chance to get clobbered down to 18, which I would somewhat welcome as an opportunity to back the truck up and buy all we can.

But we have done a heck of a lot of work on this opportunity and to miss the boat just to save a buck or two would drive us bananas. As a rule, being too cute works better for puppies than it does for portfolio managers.

Jeffrey Bronchick is chief investment officer at Reed Conner & Birdwell, a Los Angeles-based money management firm with $1.2 billion of assets under management for institutions and individuals. Bronchick also manages the RCB Small Cap Value Fund. At time of publication, RCB was long Gartner, IMS Health, Dun & Bradstreet and Raytheon, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Bronchick appreciates your feedback at

jbronchick@rcbinvest.com.