Spin-off Case Study: Long NTGR, Short ARLO

Last week, I executed a pair trade involving buying Netgear (NTGR) and shorting Arlo (ARLO). I’ve underwrote the trade to generate a ~17.5% return and a ~56% IRR over a 4 month time period. I was in the process of writing it up as an official recommendation, but unfortunately, ARLO stock has cratered recently and the implied return and IRR decreased to 5.2% and 15.8%, respectively. While this is still moderately attractive, it isn’t attractive enough to warrant an official recommendation.

However, I thought I would publish my work so my readers can monitor the trade in case the implied return improves. I’ve also included an excel template at the bottom of this post that readers can use to track this opportunity. The template should be useful to track this trade and other opportunities involving a partial IPO followed by spin-off (they are fairly common).

Important note: the analysis below assumes a NTGR share price of $67.76 and ARLO price of $19.49. These are the prices at which I executed my trade.

Background

Netgear (NTGR) is a global technology hardware company which manufactures networking and internet connected products for consumers and businesses.

Netgear reports revenue in the following three segments: Arlo, Connected Home and Small and Medium Business.

Source: Netgear Slide Deck

Arlo

The Arlo segment is focused on intelligent internet-connected products for consumers and businesses that provide security and safety. Arlo’s main product line is its smart security cameras. Arlo’s remote video security systems provide remote video and audio monitoring and recordings, accessible by smart phones, tablets or PCs and MACs through WiFi or LTE. Arlo is NTGR’s fastest growing segment by far. In Q2 2018, Arlo revenue grew 33% to $104.8MM. Arlo represents ~29% of revenue.

Connected Home

The Connected Home segment is focused on consumers and consists of high-performance, dependable and easy-to-use LTE and WiFi internet networking solutions.  Connected Home products consist of anything that helps consumers conveniently access the internet. Products include routers, modems, WiFi range extenders, WiFi hotspots, and many more.

In the Q2 2018, Connected Home revenue grew 2.8% to $191.2MM. Connected Home revenue represents ~52% of total NTGR revenue.

Small and Medium Business

The Small and Medium Business segment is focused on small and medium-sized businesses and consists of business networking, storage and security solutions that bring enterprise-class functionality to small and medium-sized businesses at an affordable price. Products include devices that let employees hook up to the internet such as routers and modems.  However, this segment also sells other products such as ethernet switches, wireless controllers & access points, unified storage, and internet security appliances.

In Q2 2018, Small and Medium Business revenue grew 7.2% to $79.8MM. Small and Medium Business revenue represents ~22% of total NTGR revenue.

Arlo IPO

On February 6, 2018, NTGR announced that it would be separating its Arlo (Ticker: ARLO) segment into an independent public company by initially holding an IPO for less than 20% of ARLO common stock and subsequently, distributing the remaining shares to NTGR shareholders.

The ARLO IPO was priced on Friday, August 3, 2018 at $16. Share opened 15.6% at $18.50 and peaked in late August at $23.08. Shares currently trade at $19.49.

Upon closing of the IPO, 11,747,250 shares were sold (15.8% of ARLO shares), and NTGR continues to own 84.2% of the 74,247,250 ARLO shares outstanding.

NTGR plans to distribute its remaining ARLO shares to NTGR shareholders after a 145 day lock-up. The lock-up period will end on December 25, 2018 (Merry Christmas!).

What is the opportunity?

If you back out NTGR’s 84% stake is ARLO, NTGR is trading at 5.8x EBITDA. While Netgear isn’t the best business in the world, it should not trade at 5.8x EBITDA. I believe 7.5x EBITDA is a more appropriate multiple (I will justify that multiple later on).

By buying NTGR and shorting ARLO, we can synthetically buy NTGR at 5.8x EBITDA. If my thesis is correct and NTGR trades at 7.5x EBITDA after it spins out ARLO, then I stand to make a ~17.4% return in ~4 months and an internal rate of return of ~56%. Not too bad.

NTGR-ex-ARLO Valuation

Let’s walk through the math.

First let’s figure out what EBITDA NTGR will earn once its completes the spin-off of ARLO. We can get NTGR’s EBITDA from its 2017 10-k and then back out ARLO’s EBITDA. Simple arithmetic shows that NTGR-ex-ARLO earned $103.2MM in EBITDA in 2017 and an EBITDA margin of 10.0%.

In 2018, I conservatively (revenue is up 5% through 1H 2018) assume that revenue grows 3% and that NTGR-ex-ARLO’s EBITDA margin stays constant at 10.0%. This results in a 2018 EBITDA estimate of $106.3MM.

Now let’s look at NTGR’s enterprise value excluding its 84.2% stake in Arlo.

Arlo is currently trading at $67.76. With 31.808 shares outstanding, its market cap is $2,155MM.

NTGR has no debt, and $356MM of cash. However, NTGR will contribute $70MM of cash to ARLO prior to the spin-off.

NTGR is generating about $18.5MM of free cash flow per quarter so I assume NTGR’s cash balance will be $37MM higher once the spin-off occurs.

Finally, NTGR owns 84.2% of ARLO which is worth $1,218MM.

Adding it all up yields a pro-forma enterprise value of $615MM for NTGR. As such, NTGR-ex-ARLO is trading at an EV / ‘18 EBITDA of 5.8x and EV / ‘18 revenue of 0.6x.

What is a more appropriate valuation for NTGR-ex-ARLO?

We can look back to see the valuation range at which ARLO traded prior to the the emergence of its Arlo division. Back in the 2009 to 2013 timeframe, NTGR traded at a median EV/EBITDA multiple of 7.9x and a median EV / revenue multiple of 0.8x.

Another helpful data point is that one of NTGR’s competitors, Belkin, is in the process of being acquired by Foxconn for $866MM. Per this filing, we can see that Belkin most recently had sales of $789MM. This purchase price implies a 1.1x revenue multiple. Belkin is a private company, and thus, I’m not able to determine if Belkin has any cash/debt on its balance sheet (this would change the revenue multiple). Nonetheless, the transaction suggests NTGR-ex-ARLO is attractive at 0.6x revenue.

The Mechanics of the Trade

I have no experience shorting stocks so this was a learning experience for me.

First, I had to determine how much NTGR to buy and how much ARLO to short. NTGR still owns 62,500,000 ARLO shares (84.2% of shares outstanding). NTGR currently has 31,808,000 shares outstanding so I determined that NTGR will be distributing 1.965 shares of ARLO for every share of NTGR.

I wanted to establish about a ~$10,000 net long position in NTGR-ex-ARLO. So I bought 350 shares of NTGR and shorted 688 shares of ARLO (1.965 x 350).

Buying 350 shares of NTGR at $67.78 cost me $23,723, but I simultaneously shorted 688 shares of ARLO at $19.48 which resulted in Schwab depositing $13,404 in my brokerage account so my net position is $10,314 (excluding commissions) long NTGR-ex-ARLO.

Here’s how I am thinking about my expected return:

NTGR is made up of 1) its ownership in ARLO and 2) the NTGR-ex-ARLO businesses.

1) Every share of NTGR “owns” 1.965 shares of ARLO. The price of ARLO is $19.49. By multiplying 1.965 x $19.49, we can see that the value of ARLO per share of NTGR is $38.30.

2) NTGR trades at $67.76. Subtracting $38.30 from $67.76 yields $29.47. This is the value at which the market is effectively valuing NTGR-ex-ARLO.

I believe NTGR-ex-ARLO deserves to trade at 7.5x EBITDA or $35.20 per share. By buying 350 shares of NTGR at $67.76 and shorting 688 shares of ARLO at $19.48, I’m effectively buying NTGR-ex-ARLO at $29.47 in the hopes that it will trade at $35.20 once the spin-off occurs for a 19.4% return over 4 months.

It costs me 4.0% annualized to borrow ARLO (its a relatively hard stock to borrow according to Schwab). To calculate my expected interest charge, I divided 4.0% by 360 to get the daily interest rate = 0.011%. Then I multiple 0.011% by ARLO short position ($13,404) to get my daily interest cost = $1.49. Then I multiply $1.49 by 133 days (I assume spin-offs occurs in 133 days) to get the total dollar cost of the interest: $198. If I divide $198 by my net position ($10,314), it works out to a 1.9% interest charge.

I can subtract 1.90% from 19.4% to get my underwritten return of 17.5%.

Risks

  • The main risk is NTGR trades lower than 7.5x multiple after it completes the ARLO spin-off.
    • Mitigant: NTGR recently hosted an analyst day which it detailed its bullish expectations (mid single digit revenue growth and margin expansion). I think a 7.5x multiple is very reasonable given this backdrop. Further, by my math, NTGR-ex-ARLO only has to trade at 6.0x EBITDA for this trade to  break even.
  • Spin-off doesn’t occur.
    • Mitigant: Management has gone through a lot of work to complete the IPO and has communicated consistently that the spin-off will happen. Further, I’m effectively long ARLO the same amount of shares I’m short through my NTGR ownership which hedges ARLO exposure.

I’ve created an excel /google sheets template that you can use to monitor this trade. You can also use it to monitor other pair trades (partial IPOs followed by spin-offs are quite common).

While long NTGR/ short ARLO is an interesting opportunity it is not our favorite spin-off idea today. Want to know our favorite idea? Sign up to our premium plan for $29/month. There is a no risk (we offer a 30 refund policy).