In the book Spin-off to Pay-off, author Joseph Cornell cites a number of reasons why corporate spinoffs are ideal for finding highly compelling investment opportunities. And with companies struggling to grow in the current market environment, the timing is proving ideal for spinoffs because they represent a great way to enhance shareholder value.

A spinoff occurs when a company breaks one or more of its businesses off into a separate company. The motivation for the original firm is to create shareholder value by allowing the market to better value the separate businesses. Spinoff stocks are generally underfollowed by Wall Street and individual investors. It takes time for public information on these new companies to become widely available. But this lack of attention can spell opportunity for smart investors.

Two examples of spinoffs that have done well are Dr. Pepper Snapple (NYSE: DPS) and Metavante. Beverage giant Dr. Pepper’s stock has risen close to 50% since it was spun off from British confectionary giant Cadbury on May 5, 2008. Metavante, which processes financial transactions, was spun off from M&I Bank on Nov. 2, 2007. The firm was later bought out by Fidelity National (NYSE: FIS) for a 23% premium on April 1, 2009.

As was the case with Metavante, new freedom can catch the attention of rivals who may be interested in acquiring a newly-minted spinoff to grow market share. The potential for a buyout for a hefty premium to the current share price forms yet another reason spinoffs can turn out extremely profitable for investors.

An interesting opportunity in the spinoff realm I’ve been tracking is industrial conglomerate ITT Corp. (NYSE: ITT). Back in January, ITT announced it would be breaking itself into three separate companies. The key reason is one I cited above: management believes the market is not properly valuing its businesses. A key reason behind this is its defense unit, along with the entire defense industry, is facing pressure as the U.S. government cuts defense spending. ITT believes this is dragging down the value of its other two business segments: water treatment and industrial products.

As a result, ITT plans to split itself into three publicly-traded companies by the end of the year. The new defense firm will be called ITT Exelis. It focuses primarily on selling communications systems to the to the Department of Defense to help soldiers talk during combat, along with warfare systems that let pilots and unmanned aerial vehicles (UAVs) detect threats. The water company will be named Xylem and is focused on helping clients treat and handle wastewater. It also sells pumps, filters and other supplies that are critical to managing water systems. The industrial group will remain known as ITT and serves a variety of industries, such as automotive, aerospace and healthcare. It sells a wide array of shock absorbers, pumps, monitoring systems, and related products.

Last year, the entire company reported sales of $11 billion. Defense was the largest business at 54% of sales, with water and industrial accounting for the remaining 33% and 13%. ITT estimates the defense business will generate sales of nearly $6 billion for all of 2011. It projects water sales of close to $4 billion and sales of the “future ITT” industrial unit at just greater than $2 billion.

Projected profits by each business are still being worked out, but ITT overall is growing and solidly profitable. Last year, sales grew 3% while earnings grew 24% to nearly $800 million, or $4.30 per diluted share. Free cash flow was even stronger, coming in at $906 million, or almost $4.90 per diluted share. 

Action to Take –> ITT currently trades at a very reasonable forward price-to-earnings (P/E) ratio of 10.6, which happens to be right in line with rival defense firms. In contrast, leading firms in the water industry trade at forward P/Es closer to 16, while the largest firms in the industrial segment trade closer to 12 times earnings expectations for the coming year.

This fully supports management’s thesis that Xylem and the new ITT Corp should eventually see higher valuations when they are independent. Overall, there should be considerable potential to make money in ITT’s break up. Each of three firms will likely be better run as independent companies and there is plenty of room for multiple expansion when the market better realizes the value of the water and industrial businesses. Finally, I see the potential for a rival defense, water, or industrial firm to swoop in and buy out one of these coming spinoffs at a hefty premium.

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