Tuesday, December 11, 2018

Mitek Systems: Elliott Bear Hug

Mitek Systems (MITK) is a small software company that a decade ago invented the image capture technology enabling check deposit now embedded in almost every bank's mobile app.  The product is loved by both banks and their consumers, for banks it is much cheaper to process a mobile deposit than to maintain the ATM/branch infrastructure and for consumers they can make a deposit instantaneously from anywhere without needing to stand in line.  While growing -- Mobile Deposit is 65-70% of Mitek's business -- mobile check deposits only make up a small percentage of the overall number of bank transactions, however paper checks continue to decline in use and Mitek needed a second act for its image capture technology.  They turned to mobile identification verfication; to open a bank account in the U.S., banks need to complete a series of steps to "Know Your Customer" (KYC) and that includes getting a government ID.  If banks or other regulated entities want to source customers through their mobile app, they need a way to verify their identity, opening up another growth path for Mitek.  The user takes a picture of their government issued ID and a selfie, Mitek's software compares to the two to confirm a match and also ensures the government ID is valid.

It's an interesting business and a nice little growth story, but what makes it especially interesting is Elliott Management (via a portfolio company called ASG Technologies) has made a hostile bid for the company, first at $10/share and now at $11.50/share in cash, MITK trades a touch over $10 today.  Elliott is of course a famous large activist investor known for getting their way, I personally recall how quickly American Capital (ACAS) changed course and folded to their demands a couple years ago before being pushed into the hands of a strategic buyer.  Mitek is a much smaller company at ~$370MM market cap, no debt, and no controlling shareholder.  Until recently, the company didn't have a CEO or a CFO, presumably that's when Elliott smelled blood and made their initial bid for the company.  Prior to the bid becoming public, but after it was made privately, Mitek did a strange thing and established a shareholder rights plan to protect the NOL, despite the NOL being only $27MM and thus insignificant to the value of the company.  More likely they were trying to prevent Elliott from acquiring a significant stake in the company in order to buy time and possibly end up in the arms of someone of their own choosing.  Mitek issued a statement regarding the most recent $11.50 offer, in it they disclosed that "other parties have expressed interest in Mitek" and also disclosed that Elliott is looking to replace the board with its own slate of directors.  With the shareholder base turning over quickly to arbs and others sympathic to Elliott, management is likely overmatched here.

At current prices you have low teens upside to Elliott/ASG's $11.50 offer, with the potential for more if the board is able to squeeze out a third bid from Elliott or able to quickly find a white knight strategic partner willing to pay an even higher premium.  If not, the stock probably falls temporarily but with the growing business providing some downside protection as mobile deposits continues to grow and identity verification gains traction.

Disclosure: I own shares of MITK

Friday, November 30, 2018

Northstar Realty Europe: CLNY Out, Reviewing Strategic Alternatives

Northstar Realty Europe (NRE) is kind of an odd duck, it's a U.S. listed REIT that is externally managed and only owns assets as the name would suggest in Europe.  Specifically, NRE owns 23 buildings, primarily Class A office buildings in Germany, France and the United Kingdom.  There are plenty of European listed REITs that own European assets and U.S. listed REITs that own U.S. assets, so it's hard to see the logic in having one that crosses the two.

In 2014, the old Northstar Realty Finance (NRF) spun off their management company, Northstar Asset Management (NSAM), which was a popular move at the time, hoping to create a permanent capital asset manager that would trade at a high multiple.  After the initial spin, NSAM wanted to create several externally managed vehicles to generate fees, thus NRE was formed via a second spinoff from NRF in November 2015.  This model ultimately failed because the market rightly valued the externally managed REITs at a substantial discount to NAV preventing the manager from growing their fee revenue streams.  Only a few months later, in June 2016, NSAM and NRF entered into a complicated merger with Colony Capital (CLNY) without NRE that ended up orphaning the REIT and left it to continue to trade below NAV with the new Colony as the manager.

Between the NSAM/NRF/CLNY merger and a few weeks ago, the company slimmed down their portfolio from a grab bag of sectors and countries down to something more streamlined, repurchased $83.4 million of shares well below NAV, restructured the management agreement to be more favorable to shareholders, and some activists got involved (read the Senvest letter here) pushing the company to liquidate or sell itself.  

I know what you're probably thinking, this sounds a lot like NYRT did prior to the liquidation and didn't that blow up?  Painful memory!  But hold onto that thought.

In early November two important events happened that make this situation particularly interesting today:
  1. NRE sold their largest asset, Trianon Tower in Frankfurt, for approximately $762MM.  Trianon makes up 37% of their published NAV and NRE expects to net $360MM after paying off the property level mortgage and transaction costs.
  2. NRE announced a process to review strategic alternatives and more importantly reached an agreement with Colony to terminate the external management agreement for $70MM effective upon the consummation of a sale of NRE or if there's no sale, an internalization of management.
Today it trades for approximately $16 per share with 50.1 million shares outstanding for a $800MM market cap.  After the sale of Trianon closes, NRE will have $425MM in cash (there was $65MM as of 9/30), then subtracting out the $70MM owed to Colony, and NRE will be sitting on roughly $7 per share in cash.

European REITs publish an NAV in accordance with the European Public Real Estate Association's (EPRA) best practices guidelines, think a trade association similar to NAREITs guidelines around AFFO and FFO standardization.  NRE's published NAV utilizing a third party firm was $20.85 as of 9/30 (likely down slighly due to currency movements) or about $19.40 after subtracting out the termination fee due to Colony.  We can gain a little comfort in the NAV calculation in a few different ways: 1) Trianon, again their largest asset by far, sold inline with the NAV valuation; 2) over the past several years NRE has been selling assets and on average they've been above the stated NAV at the time; 3) it's performed by an independent party in Cushman & Wakefield.

Here's a sample of a REITs located in NRE's markets that report EPRA NAVs and their current premiums/discounts:
I don't necessarily expect NRE to be taken over by a public REIT, but I gain some additional comfort in that most of larger office REITs in Europe trade within a reasonable range of their reported NAV.  On the flip side, NAV is used as the fee basis for CLNY's management fee so there's some incentive to goose it a bit and shouldn't be fully relied upon.

So unlike NYRT, where the largest three components of the asset value (1WW Plaza, Viceroy Hotel, and 1440 Broadway) all had some hair on them, needed repositioning or were underperforming.  NRE's portfolio has now been substantially de-risked with the Trianon sale, the next largest asset has a book value of approximately $170MM, meaning substantially smaller chunks remain.  The portfolio is also 97% leased, a weighted average lease life of over 6 years and we have reasonable debt levels with $7 per share in cash.  NYRT also paid out a dividend that wasn't covered (typical of an external REIT) that limited their ability to reinvest in their properties, NRE's dividend policy has always been reasonable allowing them to make improvements to drive leasing and rent growth activities.  NRE's downfall was more the initial management contract that stalled growth and permanently assigned a discount to the shares than the performance/management of the underlying assets which was solid.

I don't see internalization of management as a real alternative, the company is simply too small to make it a viable path forward, the likely outcome now that Colony is out of the way is a sale of the company in pieces or preferably in its entirety.  There's probably $2.50-3.00 of upside on a $16+ stock in the next 3-6 months.

Disclosure: I own shares of NRE

Friday, August 3, 2018

KLX Inc: Boeing Merger, KLX Energy Services Spin

KLX Inc (KLXI) is familiar to many special situation oriented investors, it was a December 2014 spinoff of BE Aerospace (BEAV), BEAV has since been acquired by Rockwell Collins (COL) in April 2017.  KLXI combined two unrelated businesses, Aerospace Solutions Group ("ASG") which is a distribution business to the aerospace industry and Energy Solutions Group ("ESG") which is an onshore oil and gas services business.  Both segments were rollups designed with the underlying theme of providing mission critical products/services that were relatively low cost in the context of the overall project, but for which the cost of failure is high enabling higher margins for KLXI.

Fast forward to today, Boeing (BA) is purchasing the ASG business for $63 per share in cash.  KLXI originally wanted to sell both the ASG business and ESG business to separate parties but couldn't come to agreement with any buyers for ESG.  As an alternative, KLXI is going to spin off ESG as KLX Energy Services (KLXE) simulatenously with the closing of the ASG deal with Boeing (guided to a Q3 close).  I have zero expertise in energy related businesses, most of the time I've dipped my toe into the sector I've gotten my face ripped off, but this deal reminds me quite a bit of LaQuinta/CorePoint (LQ/CPLG) that I've decided to give it another try in hopes to expand my circle of competence marginally.

How is it similar?  First, the deal will be taxable to KLXI shareholders, thus removing the tax-free two year safe harbor on a business that management clearly wanted to sell in the first place.  Second, the management team is moving to the spinoff and in this case, foregoing cash compensation to take stock in the spin which will likely trade poorly initially due to typical spinoff dynamics when management knows that they'll be looking for a buyer.

A little more on KLXE, the form 10 can be found here, it was formed as a rollup of 7 regional players, all the deals were done in the 2013-2014 timeframe before oil prices collasped for a combined price tag of ~$700MM.  The business did $100MM EBITDA in 2014 before the bottom fell out completely, with oil prices rebounding the past year, they're guiding to $110MM for 2018 which is significantly more than the $27MM in EBITDA in 2017.  During the sale process, they received bids for the ESG business in the range of $250MM to $400MM, the leading bid was a SPAC, so mostly financial buyers were interested.  The proxy pointed to the poor trailing twelve months results and a lack of credit available to finance energy deals as reasons for the disappointing bids for ESG.  The management team is interesting here as well, Amin Koury is 78 years old, lives in Florida (no major onshore energy basins there as far as I know), he's getting cashed out of ASG and was already cashed out of BEAV, his son runs his family office and isn't involved in the energy business, this is the last and smallest piece of his empire, all signs seem to point to KLXE not being a public company for long.

KLXI trades for $72.75 today, backing out Boeing's $63 cash offer and KLXE's implied market cap is ~$500MM, it will have no debt and KLXI is gifting KLXE $50MM in cash immediately prior to the spinoff.  So the implied EV is about ~$450MM, using the $110MM EBITDA estimate, and we come up with a 4.1x EV/EBITDA multiple, certainly cheap for any viable business.  Most oil services businesses trade a lot higher, I don't know of a perfect comp, but a similar setup to look to could be Dover's recent spinoff of Apergy (APY) which has done well since the spin.

Of course the problem with these types of ideas, they're hard to size up, even if we assume KLXE is worth 8x EBITDA, then the pre-spin KLXI is worth $81 or about 11% higher than today's trading price, not a home run, but I think it's an interesting short term idea that gives you a toehold position in KLXE at a cheap price.  After the deal closes you can decide to sell or add to the stub, that's my plan at least.

Other thoughts:
  • As far as I can tell, the taxable piece is fairly straight forward at this point, similar to LQ you'll receive cash and shares in the spinoff, the taxable amount will be $63 + KLXE's share price on day one over your original basis.  At the corporate level, KLXE has a tax basis of $600MM, if the day one value of KLXE is above this amount, then KLXE will be on the hook for any taxes.
  • KLXE will have a tax shield of approximately $32MM per year due to amortization of intangible assets, if you want to get cute on the valuation you could put an NPV on the tax attributes and KLXE would look even cheaper.
  • Cash at KLXE will also likely be higher than $50MM, KLXE is entitled to any free cash flow generated from 5/1 to the closing date.
  • KLXI is not an S&P 500 component, but it is in aerospace indexes and not in energy indexes, so along with dropping down in market cap indexes, it'll be removed from industry ones as well, potentially creating some forced selling from ETFs.  I would imagine there are few holders of KLXI that were involved for the energy business.
Disclosure: I own shares of KLXI

Monday, July 2, 2018

Dell Technologies: Dell Class C Reverse Merger via DVMT

Today we received the answer to the question of how much of a discount Dell was going to force down on the DVMT tracker? Turns out, quite a bit!  While I'm disappointed in the result as the discount is essentially unchanged from the day after the Dell EMC deal closed, the current price bakes in a significant discount for the Class C shares and you might see activists push for an even better deal.

Dell bought EMC in the fall of 2016, EMC owned 80% of VMWare (VMW) and Dell issued a tracking stock (DVMT) for much of that 80% VMWare ownership position that in spirit was meant to be economically equivalent to one share of VMW.  Turns out that was a lie!  Maybe lie is too strong of a word, Dell always had several options available to it in the DVMT documents to provide less than VMW value to DVMT share holders, but its certainly against the intention of the tracker and the EMC board should be a little embarrassed, with today's new, Dell essentially engineered a way to pay a lot less for EMC/VMW.

Here are the terms of the deal, as of Monday afternoon, DVMT is trading for ~$91.50, a 16% discount to the headline $109 number and a full 43% discount to VMW's current price of ~$160.  Even at the full $109 number, DVMT shareholders are accepting a 31% discount to VMW:

Dell Technologies is a private company, the main goal of the DVMT conversion is to do a reverse pseudo-merger with the tracking stock to bring Dell Class C public again without going through the costly traditional IPO process.  The headline number is $109 for DVMT with an election between cash or Dell C Shares, although if you pick cash you'll likely be significantly pro-rated (cash is capped at 41% of the total).  Coinciding with this transaction, VMWare is going to pay a special dividend to its shareholders (including Dell Technologies which owns 81% of VMW) and then Dell is going to turn around and use the $9B they receive from VMW to finance the cash consideration portion of the transaction with DVMT.  Smart, Dell is using VMW's own cash to buy DVMT at a 31% discount to VMW, an immediate gain to Dell Technologies' equity value.

Valuing the Class C shares get a little tricky.  Dell has a significant amount of debt and owns stakes in three publicly trade subsidiaries (VMWare, Pivotal, Secureworks).  Dell provides a slide using the $109 headline number:
If you recreate this slide and plug in $91.50 at the top, the implied equity valuation of Dell ex-public subsidiaries drops from $17.5B to $750MM.  Core Dell has about $32B of net debt (not including their financing subsidiary or debt at VMW) and did $6.9B in EBITDA over the last 12 months, with the $750MM implied market cap today, the market is placing a 4.75x EBITDA multiple on the old Dell/EMC businesses, seems quite punitive to me.  Or even more ridiculous (maybe just meaningless) but at a $750MM market cap, Dell's P/E off of their "adjusted net income" ex-public subsidiaries number would be less than 1x.

Now there could be good reasons for the discount.  Class C shares have essentially no voting rights, so while the tracking stock discount will be removed when the new shares are issued, the "Michael Dell minority shareholder" discount will still be present.  Similarly, but does the old tracking discount just move over to being a HoldCo discount at Dell Class C?  About half the enterprise value and the majority of the equity value at Dell is its stake in VMWare, will it trade at a big discount like we see other HoldCo's trade at today?  That's the more likely answer, the whole enterprise is being discount, not just the legacy business.

Reading the press release, you can see that management is spinning the conversation away from the DVMT/VMW discount and referencing the headline premium to Friday's close.  In fact, if you flip through the presentation, its almost like DVMT wasn't intended to ever track VMW, no mention of "track" or "tracking" anywhere, just a pre-IPO roadshow deck .  Elliott Management and Carl Icahn both own DVMT, Dell's press release states that Dell consulted with owners of 40% of DVMT and "received feedback", doesn't say that those giving their feedback agree with the consideration DVMT shareholders are receiving, so I wouldn't be surprised if one or two put up a stink about accepting such a large discount.  DVMT shareholders will get to vote on a deal in October, maybe this transaction goes through as is but something just feels a bit wrong accepting such a wide discount two years after the tracker was issued.

I'm continuing to hold as the market seems to be overly discounting the new Dell shares and under estimating the potential for some additional shareholder pressure to sweeten the deal.

Disclosure: I own shares of and call options on DVMT

Friday, June 29, 2018

Mid Year 2018 Portfolio Review

It's halfway through 2018 already, time to check the scoreboard, and its not pretty, during the first half of the year my personal account dropped -6.44% compared to a positive 2.56% for the S&P 500.  I have nothing too insightful to say, made some mistakes, waiting on a few situations to fully play out and just going to keep moving forward.
Updated Thoughts:
  • Green Brick Partners (GRBK) looks pretty cheap again.  To recap, Green Brick is a homebuilder that did a reverse merger with an NOL shell in 2014, its essentially controlled by Greenlight Capital and is run by veteran Dallas based developer Jim Brickman, who is a close business friend of David Einhorn.  To begin 2018, Green Brick had only $67MM in NOLs remaining and will likely come close to burning it off this year, if not early 2019.  Once the NOL is gone, the reason GBRK exists as a public entity will cease and restrictions around its ownership will no longer limit the company's strategic options to either be acquired or use its stock and merge with another homebuilder.  Third Point, who had owned ~17% of the company, recently did a secondary to sell their position and the news took GRBK's stock down from the low-to-mid $12s to the low-to-mid $9s.  Initially the company planned to raise capital alongside Third Point, but then reversed that idea when the secondary priced at $9.50.  Why the company would want to raise equity capital is a bit of a head scratcher, every quarter management puts out a slide showing how their leverage is lower than everyone elses and how they plan to add leverage but that curiously never happens.  Green Brick will earn at least $1/share (GAAP) this year and likely more, meaning the shares trade at a sub 10 P/E despite a high growth rate, strong balance sheet, and operating in blistering hot job markets.  It doesn't seem that Jim Brickman is ready to retire for a second time, but given Greenlight's performance woes, they might need a win and push the company to be sold once the NOLs are gone.  One lesson learned here so far, stay away from NOL shells that are trying to become the next mini-Berkshire and instead look for ones that make one acquisition that instantly generates taxable income.
  • Earlier this year iStar (STAR) made what looked like a weak effort at evaluating strategic options and has opted to accelerate the divestment of their more liquid legacy assets and continue to grow their core businesses of CRE loans and net leases (which is basically status quo, but with more effort!).  The one interesting thing to note is they've all but announced a dividend, stating several times that they're evaluating one and even amended their bank debt to remove previous dividend restrictions.  iStar has been disappointing so far, CEO Jay Sugarman seems overly distracted by their ground lease vehicle SAFE which only makes up a small fraction of iStar but seemingly takes up far more of his time.  Additionally, we've gone through a couple CFOs over the past two years and disclosures remain opaque making it hard for the market to value their assets.  It's still stupid cheap on a sum of the parts basis, but hard to know when that narrative will change, I thought it would by now, but we could be in the same situation in another 2-3 years still talking about monetization of legacy assets.
  • I've owned Dell Technologies Class V (DVMT) shares, which are meant to track VMWare (VMW), since Dell completed the purchase of EMC in 2016.  In early February, news broke that Dell was considering its either going public itself or doing a complicated merger with VMware that might or might not include the DVMT tracking shares.  The market reaction was all over the place, the craziness fired up my animal spirits and I bought some July options that will likely expire without much fanfare as the negotiation drags out between Dell, VMW and DVMT holders on how the tracker discount will get divided up.  I'd still fall on the side of Dell being somewhat fair to DVMT holders (maybe a 20% discount to VMW) as his reputation and that of is his PE partners is still important, plus you've got activists lining up on both sides of the DVMT/VMW trade ready to sue if either side feels too much pain.
  • Earlier in June, the SEC approved a rule that will change the default notification option for mutual fund investors from physical mail to email starting in 2021 (sounds further away than it is in reality).  Donnelley Financial Solutions (DFIN) is one of the largest printers of mutual fund materials and stands to lose a fair amount of business once this rule takes effect, its not unexpected as it was discussed in detail at their recent analyst day (guided to a ~$12MM hit to EBITDA if the rule passed), but its just another in a series of setbacks for this spinoff as they try to stabilize themselves as a standalone company.  Shortly after, Groveland Capital and Denali Investors appeared on the scene with strikingly similar letters (here and here) to the board of directors asking DFIN to explore strategic alternatives as the market is valuing DFIN at a 6x EBITDA multiple.  October 1st will mark the two year anniversary of the spinoff, opening up a few more options for DFIN, but I'm skeptical anything will happen as management seems set on pursuing (attempting?) the difficult print to SaaS company transition.
Closed Positions:
  • Exantas Capital (XAN), formerly known as Resource Capital (RSO), was one of my favorite ideas for a while but the more I tried to do the math, the less confident I became that XAN could trade at book value, at least anytime soon.  XAN's manager, C-III, also did a couple of unfriendly things with their management agreement: 1) they locked in a fixed base management fee for 2018 after redeeming the preferred shares and 2) they reset the incentive fee hurdle which was previously all but out of reach. The base management fee reverts back to a bps calculation at the end of 2018 does put a little fire under management, they've changed the corporate name, are out there giving investor presentations and have a new CRE CLO in warehouse.  But I still struggle with how this gets close to a 10% ROE at its current size given the risk profile of their assets and the expense drag, I recently sold.
  • La Quinta Holdings (LQ) worked out almost perfectly as expected, I sold the REIT spinoff CorePoint Lodging (CPLG) the day following the spin at $28, only wish I would have sized this idea up more and look forward to what Wyndham Hotels & Resorts (WH) can do with the LQ brand -- I'm still very optimistic on both WH and WYND despite them trading poorly after the spinoff (maybe S&P 500 selling pressure?).
  • I sold LGL Group (LGL), they hinted at an acquisition of their operating business around the same time as the rights offering, that didn't come to pass and their disclosures around the process seemed woefully absent, so I sold for about my cost basis.  This is hopefully my last "micro cap NOL shell that's pursuing acquisitions to utilize their tax asset" idea, seen enough of these flounder to have had enough.
  • Along with being 'done' with NOL shells, I think the same could be said for reverse morris trusts (RMTs), I was originally attracted to Entercom Communications (ETM) for the RMT and related discount through CBS, but stayed for the free cash flow story management was spinning along with the incredible insider buying that continues to this day by the founding Field family.  But I don't actively listen to terrestrial radio, if I do its a much more passive experience, with streaming/podcasting options I'm getting exactly what I want which is what makes it more valuable to advertisers.  Even with sports or news, many will point to this being an issue in today's divisive society, but I can listen to a podcast that matches my view, whether its a sports team or a political view, that kind of targeting is hard to compete with in traditional radio.  I should have stuck with my gut on it and sold after the deal was completed, but instead I got punished by thesis drift, this is a heavily levered company that will likely report poor earnings again for Q2, might be more interesting to re-enter then?  But yes, RMTs, less attractive than spinoffs, they seem to be even more levered that spins as they need to keep the 51/49 ownership structure and then a common misconception seems to be that former CBS holders are indiscriminately selling here but CBS holders elected to take ETM stock, it didn't just appear in their account like a normal spinoff.  Entercom might turn out well, but I decided to sell and move on to other opportunities.
  • VICI Properties (VICI) is a the REIT that was created out of the Caesar's Entertainment (CZR) bankruptcy, my thesis was simple, it traded slightly cheap to gaming REIT peers because it was listed over-the-counter and wasn't yet paying a dividend.  Both of those have changed and its bounced around a bit to actually trading expensive to peers do to its perceived independence compared to MGP which is controlled by MGM.  I made out with a small profit.
  • The management buyout of ZAIS Group (ZAIS) was completed and I was cashed out of that position for a nice profit.  
Current Holdings:
*Additionally I have CVRs related to GNVC, MRLB and INNL 
Disclosure: Table above is my blog/hobby portfolio, I don't manage outside money, its a taxable account, and only a portion of my overall assets.  The use of margin debt/options/concentration doesn't represent my true risk tolerance.

Friday, June 8, 2018

Perspecta: DXC Government Services Spin, CSRA 2.0

On 6/1, DXC Technology (DXC) completed the spinoff of its U.S. government services business and merged it with Vencore and KeyPoint, two PE owned government services businesses, to form Perspecta (PRSP).  There's been a lot of M&A in this industry, DXC was formed in 2017 via the combination of Computer Services (CSC) and Hewlett Packard Enterprise's (HPE) services business, prior to that merger, CSC had spun off its government services business as CSRA in November 2015 only to re-enter the business via the HPE deal.  Then in February, General Dynamics (GD) came in bought CSRA at a rich 12x EBITDA or 18x earnings multiple. Now once again DXC/CSC is returning to the same playbook and spun off its government services business.

Several years ago I profiled and owned several of the government spins (EGL, XLS, VEC, CSRA, LDOS), large defense contractors were dealing with the draw down of troops in the Middle East and sequestration started pinching Federal budgets by spinning off their lower growth and lower margin services businesses.  Now that the Federal budget is in growth mode again, projected at 1.5-2.0% annually through 2022, government services multiples are on the rise and you're seeing the opposite M&A trend taking place with GD buying CSRA.

If anyone in the industry reads this they'll likely cringe, but from an investment standpoint, most of these government services are very similar with nearly indistinguishable strategies making them fairly straight forward to value.  This kind of M&A in any industry would likely be disruptive to clients, but here deal teams work on individual government contracts and have more of an identity with the contract than the cute name currently on their business card.  It's a very competitive business where valuation multiples should converge over time as its nearly impossible for a firm to have a clear competitive advantage.  The nature of the business also makes these firms a bit of black box, many of their contracts are classified and its hard for the average investor to shift through the contract re-compete pipeline.

Perspecta is pitching their margin profile as their differentiating factor due to their heavy weight towards firm-fixed price contracts compared to peers.  This is partially the nature of the IT services business, CSRA featured similar EBITDA margins.
Fixed contracts are where the government and the contracting firm agree upfront on a price/value of a given engagement and its up to the contracting firm to make it profitable.  These types of contracts are potentially more lucrative if a management team can squeeze costs out as those savings don't have to be shared with the government (at least until the next re-compete).  But this can cut both ways, if Perspecta were to run into issues with cost overruns and or just flat out misprice a fixed-price contract in a competitive bid (animal spirits can get the best of anyone) then they could be stuck in a negative margin position unable to get out for several years.  Whereas the cost-plus contracts are safer, but with lower more predictable margins, as the contracting firm and the government agree on a specified margin upfront and the total value fluctuates with expenses (think timeshare resort management or Nacco's coal mining operating agreements).

As mentioned, all these independent government service providers trade in a pretty tight range, Perspecta has moved up a bit this week, but still remains at the bottom of the table on both an EV/EBITDA and P/E basis.
Perspecta has one large contract with the U.S. Navy servicing their intranet and related communication needs ("NGEN") that is coming up for re-compete, its a $3.5B 5-year contract, or roughly 17% of Perspecta's pro-forma $4.1B annual revenue base.  They're the incumbent on the contract through predecessor firms (was DXC, before that HPE, before that EDS) since the program was established in 2000.  The Navy is splitting the contract into two, one will be the services and the other the equipment side of the contract, Perspecta is likely to give up some of this revenue either by adding additional subcontractors to the team, or losing one side or the other, and then just general competitive pressures will decrease the profitability of NGEN through the re-compete process.  They're projecting flat revenue growth over the next year, given the healthy budget backdrop, I'm guessing its less the integration/new public company focus they've stated, and more an acknowledgment that NGEN will be rolled back for them this time around.  In the Form 10, the old DXC government services business ("USPS") had a 90% historical re-compete win rate and Vencore has a 97% historical re-compete win rate.  It's unlikely that the Navy would move completely away from Perspecta, incumbents are hard to beat, but that headline risk is out there and is potentially a reason why the stock is cheap.  I don't think the market is intentionally doing this but if you were to back out the NGEN contract entirely, Perspecta is trading for roughly the same multiple as its peers.

Perspecta has 165.6 million shares (old DXC shareholders own 86% of the company) and net debt of $2.7B, if it were to trade at a peer multiple of 12x EBITDA, the shares are worth $33/share versus the $24.25/share they trade at today.

Other thoughts:
  • DXC is a S&P 500 constituent, I haven't seen an announcement kicking PRSP out, presumably because there's nothing to announce if PRSP is just simply not added to the S&P, but we've likely seen some forced selling by index funds since the 6/1 spinoff.
  • Mike Lawrie is the CEO and Chairman at DXC, he'll be the Chairman at PRSP, since taking over CSC a few years ago he's done a tremendous job for shareholders in both creative M&A and operating performance.  Good manager that is worth following.
  • One thing about NGEN that feels a bit wrong to me, it's barely mentioned in the Form 10, and not in the risk section for concentration risk, despite being a material 17% of revenue.  Could be an intentional oversight because the risk of losing the contract is minimal, or a bit deceptive, I'm not entirely sure which?
  • Perspecta's leverage will be a little higher than peers to begin with which is pretty typical for spinoffs, the company is projecting $1.5B in operating cash flow over the next three years and have slated 35% of that to pay down debt which would get them to the lower end of their target range of 3 to 3.5x EBITDA.
  • Vencore filed an S-1 last year before pulling the IPO, the S-1 is worth reading, Vencore is more of a mission services business versus the IT services at DXC's old USPS business.  KeyPoint, the smallest of the three being merged together, is the leader in background checks and security clearance, good little niche.  Perspecta believes they can go after contracts they previously weren't qualified for now that they've merged the three entities (combining mission and IT services), that's possible, but doubt it moves the needle much.
Disclosure: I own shares of PRSP

Monday, April 16, 2018

Tropicana Entertainment: Deal with GLPI & ERI, Merger Arb

This won't be actionable for some readers, but Tropicana Entertainment (TPCA, 84% owned by IEP) announced a deal today where Gaming & Leisure Properties (GLPI) will purchase the real estate and Eldorado Resorts (ERI) the gaming operations for a combined total of ~$1.85B, subject to adjustments.  One of those adjustments relates to Tropicana's Aruba property which needs to be sold or spun-off prior to the closing.

So here you have a controlled company, with an illiquid stock, entering into a complicated deal with two parties and an uncertain final cash amount all leading to a potentially attractive merger arbitrage spread.  If the headline number is correct, using the current share count of 23.8 million shares, gets you to $77.61 per share versus under $70 today.  Unpacking that number is a little more complicated, from the 8-K today:

(a)                                 $640 million, which reflects the consideration paid by Parent in respect of the Merger;

(b)                                 plus $1.21 billion, which reflects the Real Estate Purchase Price received by the Company;

(c)                                  plus the amount of net proceeds received by the Company in connection with the distribution, transfer or disposition of its Aruba Operations;

(d)                                 minus the Real Estate Purchase Tax Amount (as defined in the Merger Agreement); 

(e)                                  minus 50% of the Estimated State Income Tax Amount (as defined in the Merger Agreement), which Estimated State Tax Amount is limited to a maximum of $38 million;

(f)                                   minus the excess, if any, of the Estimated State Income Tax Amount over $38 million;

(g)                                  divided by 23,834,512, which reflects the aggregate number of shares of Common Stock that are issued and outstanding.

Without taking into consideration any net proceeds associated with the distribution, transfer or disposition of the Aruba Operations which is reflected in clause (c) above, the Company has estimated that the aggregate merger consideration, as adjusted to take into account the amounts set forth in clauses (d)(e) and (f) above, will be approximately $1.77 billion.

Couple things here, ERI is paying $640 in (a) and GLPI is paying $1.21B in (b) totaling up to $1.85B and from there we adjust down for taxes (there are NOLs at TPCA) but those are almost entirely offset by the expected sales price of the Aruba resort.  The footnote at the bottom, even if Aruba is valued at $0 then the total consideration is estimated at $1.77B or $74.26 per share, still a decent spread from today's price.

Tropicana Aruba is a fairly small operation, its a short walk from the beach (read: not beachfront) on 14 acres with 360 hotel rooms they've been renovating and converting into timeshare units over the past several years, there's also a 4000 sq ft casino property that mirrors what you see at a many Caribbean resorts.  In the financials, Aruba gets lumped in with their Baton Rouge and Greenville casinos making it difficult to determine what the property is worth, but at the $1.85B headline number its being valued at $80MM.  That feels high, but maybe I'm anchoring to the original thinking that Aruba was simply an option to build a larger property.

The deal is expected to close by the end of 2018, if we call the range of potential (positive) outcomes $74.26 - $77.61 on today's close of $69.75 that's a 6.5% - 11.2% absolute return in less than 9 months.  Unfortunately I sold last year into the tender, but given my comfort with the company and the attractive deal spread, I repurchased a position today.

From the buyers perspective, both are out touting the benefits of the transaction, GLPI is receiving $110MM annually in rent for their $1.21B investment for a 9.1% cap rate or 11x EV/EBITDA, and Eldorado is quoting a 6.6x pre-synergies (BYD is paying 6.25x for certain PNK/PENN casinos) and 5.0x post-synergies multiple on the operations that includes some net cash and cash build until close.  At 9.75x 2017 EBITDA of $190MM, Tropicana received a great deal (TPCA was trading at 4-4.5x EBITDA in 2013) that really touts the benefits of utilizing the REIT structure and its lower cost of capital to consolidate the industry.  But as someone invested in the gaming sector, is Icahn marking the top here?  He timed the cycle well pre-financial crisis, let's hope his timing isn't quite as perfect this time around and he has other motivations as it appears he's piling up cash throughout IEP.

Disclosure: I own shares of TPCA