Spinoff & Reorg Profiles

June 2005 Excerpt

Copyright 2005 William E. Mitchell

Omega Flex, Inc.

Tax-Free Spinoff

BACKGROUND

Mestek (NYSE: MCC) announced its intention to spin off its 86% share of Omega Flex to shareholders as part of a broader plan to voluntarily deregister Mestek stock. The stated reason for the Mestek deregistration is a variation on a popular theme these days: Mestek’s wide variety of operating businesses makes their Sarbanes-Oxley (SOX) compliance cost particularly high for a company its size. From this explanation, we may infer management considers the spinoff, Omega Flex, to make sense as a standalone public company, even net of SOX compliance cost.

TERMS

Separation will be effected as a tax-free dividend to shareholders of one share of Omega Flex for each share of Mestek.

CURRENT STATUS

The record date of the spinoff was June 23, 2005. The new company was expected to trade on a when-issued basis as of that date, but as of this writing is not listed or priced at Bloomberg, Nasdaq, or anywhere else we could find. It will trade on a regular-way basis in mid-July as OFLX.

ANALYSIS

Omega Flex is very small in both absolute and relative terms – sales are only 12% that of the parent. This is too small for many of the current institutional holders of its parent, so Omega Flex stands a good change of being dumped, without regard to price, by many of the mutual funds currently holding Mestek.

Omega Flex is also too small to be followed by analysts, and thus more likely to remain inefficiently priced for some time after the spinoff.

AUTHOR OWNERSHIP

At publication, author owned neither Mestek nor Omega Flex.

BUSINESS

Omega Flex manufactures flexible metal tubing for a variety of industrial and commercial uses. The business was acquired by Mestek as a private company in the 1970s, and at that time benefited from better access to capital by joining a public company. However, the company now cites better access to capital as one reason for separating as a public company, because it would no longer compete for capital with other divisions of Mestek.

The company is unusually profitable among manufacturers, with net income of 12%, 11% and 10% of sales in 2004, 2003 and 2002, respectively. Sales and earnings are up 37% and 68% from 2002 to 2004, respectively, while headcount increased only 1% over the same period. The rise in net income percentage with rising revenue, taken together with flat headcount, hints strongly at scale economies.

The company has been minting cash for its owners, paying a dividend equal to 19% and 24% of sales in 2004 and 2003, respectively. Long-term debt was a relatively low 23% of equity as of…

…stable 5-year earnings growth of 22% compounded in a mature industry, the attractive balance sheet, and the limited investment alternatives in the market today, this company might be attractive at as much as 20 times trailing earnings, suggesting $13.20 per share. This despite the uncertainty over book value.

For those investors accustomed to paying a premium for high growth, higher prices might be justified.

POSSIBLE TACTIC

Watch and wait until after the stock begins to trade. If possible, look for a temporary price depression caused by institutional selling pressure (see analysis section at left).  Buy OFLX below $13.20, and hold.

Rather than buy the parent and receive the spinoff as a dividend, it’s often better to wait and buy the spun-off entity directly, after the split, because you can benefit from the dip on institutional selling pressure. With this particular company, there is a second reason to wait: until the actual amount of the one-time dividend is disclosed (see above), we have only an estimate of the final book value of the separate entity.

ABOUT THE AUTHOR

William Mitchell is a private investor in Orange County, California. In addition to Spinoff & Reorg Profiles, he publishes IncomeProfiles.com, a conservative investing guide for individuals. He holds an MBA from Stanford University, a BS in engineering from Caltech, and a BA in physics from Reed College.