In Nook and AOL Wins, a Kinder, Gentler Activist Emerges (Update 1)

(AOL, Nook activist investor story, updated for analyst comment)

NEW YORK ( TheStreet) -- Carl Icahn and the old guard of corporate raiders may still prefer the second hand of a watch to the calendar as the primary mechanism for plotting investments, but it's a more deliberate type of activist fund that is walking away with big profits in targeting of stock market laggards.

Roughly ten years into a gradual decline of their respective dial-up internet and bookselling businesses, AOL ( AOL) and Barnes & Noble ( BKS) are surging in 2012. Microsoft ( MSFT) has played a major role in both cases, buying AOL's patent portfolio -- which may give AOL the cash it needs to shift course, and creating a joint venture with Barnes & Noble's to spin off the Nook E-reader -- which may provide Barnes & Noble with the partner it needs to survive in the intensely competitive E-reader and tablet war.
A kinder, gentler activist helps turns Barnes & Noble into a page-turner in 2012.

And at first glance, the 35%-plus share gains of AOL and Barnes & Noble in 2012 show that companies can be pushed to accelerate strategy changes by monetizing assets in coordination with a deep-pocketed partner.

However, it is the emergence of large activist investors Starboard Value and Jana Partners behind the scenes of these stock market turnaround stories -- companies that had seemingly lost Web-battles to more adept technology giants like Google ( GOOG), Apple ( AMZN) and Amazon ( AMZN) -- that offers a larger lesson in how investors identify and plan stakes in low-priced companies requiring radical change.

Starboard Value owns more than 5% of AOL shares, while Jana Partners bought a near-12% in Barnes & Noble shortly before the Nook spinoff was announced. The funds are known for an activist bent. Recent successes include planned divestitures at McGraw-Hill ( MHP) and Progress Software ( PRGS), and the full sale of El Paso ( EP) and TNT Express. Yet in targeting turnarounds at AOL and Barnes & Noble, both funds said they planned for multiple outcomes and only bought shares after they made sense on traditional value investment criteria. The prospect of monetizations was only one aspect of the bets.

Indeed, there's an important lesson for investors in these stories: put the speculative headlines to the side and first zero in on a straightforward value analysis, looking for a disconnect between embedded value and market sentiment.

"I'd like to take all of the credit for the patent portfolio... to be fair we didn't know what it was worth when we made the initial investment," said Starboard Value CEO Jeff Smith at this week's IMN Active-Passive Investor Summit.

Starboard made its AOL bet, the firm's single largest investment according to Bloomberg data, without expecting much out of the company's patent portfolio. When unveiling its 4.5% stake in AOL in December, Starboard said that the company's investment in its money losing display business had diminished the value of its shares, in a letter directed to AOL chief executive Tim Armstrong.

In the letter, Starboard pointed out that investors were giving little worth to AOL's valuable media assets like The Huffington Post, its search business and its advertising network -- signaling room to lift shares -- but didn't mention the patents that are driving 2012 gains.

"Barnes & Noble was not an activist investment," said David DiDomenico of Jana Partners at the same conference. "We focus on value plus catalyst opportunities... companies at a discount and with a reason to overcome it," DiDomenico said.

In early January, Barnes & Noble said it was exploring a spinoff of the Nook unit from its traditional brick and mortar bookselling business after cutting its 2012 earnings outlook, and it was then that Jana Partners began accumulating its 11.56% share stake , said DiDomenico. But Monday's deal with Microsoft adds what could be an unexpectedly powerful technological and financial partner in a spinoff that likely materialized faster than investors expected.

Still, Microsoft's minority stake may not be a panacea. Credit Suisse analyst Gary Balter wrote in research note that there is still a risk Microsoft could view the deal as just one of many options for its upcoming Windows 8 launch, without contributing the needed cash to fully develop Nook. "While $300mm or even $600mm over time clearly helps, it is a drop in the bucket for Microsoft, with the bigger question being can any product not using either Apple's or Amazon's or possibly Android's operating system be successful," added Balter.

Goldman Sachs analyst Matthew Fassler pointed to the inclusion of Barnes & Noble's College Bookstore business as an "interesting angle" within the partnership because the unit hadn't previously been a part of divestiture plans and could mesh well with Microsoft's existing PC and Windows products, in addition to its tablets push.

Recently updated analyst price targets give AOL shares a value of between $27 and $33, according to Bloomberg data. New price targets for Barnes & Noble range from $18 to $32 a share on three buy ratings and three holds.

"For us, the way to avoid a value trap is to make sure that an investment is not only cheap, but that we have a plan to create value and a clear path in creating that value," said Starboard CEO Smith. When releasing the letter to AOL CEO Armstrong, Smith explained his views on why the company's shares were underperforming, focusing on the value of assets outside of AOL's dial-up business and its cash. Meanwhile, Smith noted that AOL spent $667 million or $6.85 a share since 2009 in deals to grow its display unit, capped by a $315 million investment in The Huffington Post.

After releasing the letter and upping the firm's AOL investment to over 5%, Smith said it was then that he found out about the high, but fading value of AOL's patent portfolio. "We got phone calls from people who wanted to buy the patent portfolio from AOL," said Smith, who relayed that interest to investors through public statements. In March, AOL hired Evercore Partners ( EVR) to explore a sale, which materialized a month later.

Smith's initial plan hasn't changed and he's sticking to it, maintaining that a strategic partner or even closure of some money-losing businesses like local news service may unlock the display unit's overall promise. After the patent sale, Smith says AOL is "cheaper than when we first looked at it."

After the deal, analyst David Joyce of Miller Tabak keyed in on the progress the company was making in building some media brands, while UBS analyst Brian Pitz noted that other assets remain under-appreciated by investors. With what Pitz estimates will likely be $10 in cash as a result of the deal, the company also has new money to invest in growth.

Starboard Value targets small cap companies -- usually smaller than AOL -- that are struggling to grow their earnings as their core cash generating businesses mature. Smith says the big challenge is for management to figure out how to use the remaining value of a declining core business to invest in new opportunities that will grow earnings over time. Though Starboard-invested companies oftentimes find their way on their own, Smith says he's ready to be an activist on every investment. "For every investment we make, we have the ability to run a proxy campaign." After patent sale, Starboard still plans to pursue the election of new board members at AOL's annual meeting.

When investing in Barnes & Noble, Jana felt share prices gave little to no value to its promising Nook unit, mirroring the sentiment of other investors and analysts.

"When we invested, the market was ascribing no value to the Nook business, which was absurd," said Jana Partners founder Rosenstein in a Monday statement.The fund is known for its large-cap and discreet activist campaigns in the planned split up of McGraw-Hill and a spinoff of El Paso's oil & gas exploration unit that precipitated 2011's largest merger .

"Jana's brand of activism is based on working with management teams... We've resolved all of the situations that we've been involved in without a proxy contest," added DiDomenico, who said the firm's investment time horizon is between 12 to 18 months. "We don't want to enter any situation where there is only one way out."

Investors may do well to think in these terms, taking AOL and Barnes & Noble's deals as a sign that it's still possible to identify undervalued businesses with multiple avenues for share returns. That focus may also benefit from dealmaking, as spinoffs remain popular after 2011 boom. Yet betting on headline scenarios like spinoffs and asset sales alone is a riskier bet than either of these funds was willing to make. And in the nebulous patent war that continues to grip the tech world there may be as many landmines like Eastman Kodak and InterDigital ( IDCC) as there are goldmines like AOL and Motorola Mobility ( MMI).

Investors may also be rewarded by paying attention to where these value-minded activists are looking for their next profits.

Jana Partners' DiDomenico explained why he thinks Marathon Petroleum ( MPC) may have unlocked value in energy infrastructure assets hidden within refining operations. With management open to an IPO of the midstream business and a newly launched share buyback program, DiDomenico says Jana is likely to add to an estimated $10 share gain since the fund built an over-4% stake in November.

Meanwhile, Starboard Value CEO Smith detailed why he thinks SuperCuts-owner Regis ( RGS) can trim rent and operating costs at its nearly 10,000 owned and franchised hair salons. Smith said that the company has a strong core hairdressing business with low operating margins that can be improved with cost cuts and improving same store sales. Starboard-nominated directors on Regis's board are also pushing for Regis to hire a new CEO to drive higher margins, said Smith.

For more on spinoffs, see why giant players in the pharmaceuticals sector are trimming their weight. See why timing is key in biotech takeovers for more on M&A ideas.

-- Written by Antoine Gara in New York.

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