Monday, September 11, 2017

Perfumania: Prepack Bankruptcy, Small Equity Consideration

Here is another small special situation -- Perfumania (PERF) is the largest specialty retailer and distributor of fragrances and related beauty products in the United States, they've suffered from the Amazon effect and resulting decrease in mall traffic like many other specialty retailers.  On August 26, Perfumania filed for chapter 11 bankruptcy protection, primarily as a way to bring their mall landlords to the table as they explicitly call out that significant landlords would only negotiate with them if the company was in bankruptcy.  All of their other creditors will be unimpaired including the controlling family, the Nussdorfs, who are both their largest creditor and equity shareholder.

The Nussdorf family owns just under 50% of the equity, they're proposing to pair up with another large investor, the Garcia family, to recapitalize the company and inject $14.2MM into Perfumania.  Their plan is to take the company private and then shutter much of the 226 retail store footprint, instead focusing on the distribution side of the business.  In order to speed things along and ensure a quick stay in bankruptcy, they're throwing a bone to the minority shareholders by giving "the opportunity to receive consideration of $2.00 per share in exchange for completing a shareholder release form."  The company's financial advisers call it a "gift" and that the company has no value on a going concern basis.

There are some NOLs here to protect, and the Nussdorf family has loaned the company $85MM, their interests are somewhat aligned to see this company restructured and perform well moving forward.  But time is critical for any retail turnaround story, hence the need to rid themselves of any delay from angry shareholders.  The opt-in date for the shareholder release form is 10/6/2017, or less than a month away, and shares currently trade for just over $1.80 per share representing a fairly decent short term return opportunity.  There's risk here, if the deal gets pulled or the plan doesn't get approved by the court (both seem unlikely?), we already know the equity is worthless, size appropriately.

Disclosure Statement:

Disclosure: I own shares of PERF

Wednesday, September 6, 2017

ZAIS Group: Going Private Offer

This news hurt a little this morning, but there's a potential silver lining, I mentioned ZAIS Group (ZAIS) last year on the blog as the external manager of ZAIS Financial Corp (ZFC) that was being merged into Sutherland Asset Management (SLD).  ZAIS Group at the time was a struggling structured credit manager, their flagship hedge fund was bleeding AUM (still kind of is) and their base management fees didn't cover their operating expenses (still don't).  In February of this year, the company announced they were looking at strategic options and hinted at a going private deal which makes sense since this a controlled entity with the founder Christian Zugel maintain voting control of the former SPAC.

Since then, they've issued a sixth CLO and are warehousing a seventh, they've posted positive gains in their two main hedge funds for the year, and as a result are back to earning performance fees.  Their accounting is a little tricky with consolidation accounting for some of their CLOs and not others, plus it was a micro-cap and very illiquid, I tried for a while to establish a position and come up with my own valuation, no real luck.  But this morning, Christian Zugel filed a 13D in a manner similar to what Icahn did over at Tropicana (TPCA), but here he's already entered into a transaction with one major holder of ZAIS shares for $4 and wants the board to consider the $4 cash offer for the remaining shares he doesn't already own.
The stock traded below $2 yesterday, its still just at $3.38, I'm guessing this goes through without much of a problem and its mostly illiquidity, micro-cap, and obscureness causing the wide spread.  Kicking myself for not being more aggressive about buying it earlier, but I bought into today's news.

Disclosure: I own shares of ZAIS

Tuesday, September 5, 2017

NACCO Industries: Hamilton Beach Spinoff

For the first time in a while there are a number of interesting spinoff situations on the horizon, one of which is NACCO Industries (NC) separating their small household appliances business, Hamilton Beach Holdings (HBB), from their legacy lignite coal mining business.  This split was announced in August with a quick turnaround for the spin to be done around the end of September.  From the surface this spinoff makes a lot of sense, why is a manufacturer of blenders and toaster ovens paired with a coal miner?  Who knows.  Both businesses should trade for different multiples and its no surprise that paired together they trade at a discount to peers.

NACoal/NACCO Industries (NC)
North American Coal Company (NACoal) is the coal mining operating subsidiary of NACCO Industries, despite being in the coal industry its structured as a fairly decent business.  Much of their operations are conducted in their "unconsolidated mines" segment where NACoal functions more as a service provider earning a small cost-plus margin arrangement and avoiding commodity related pricing risks.  How this works is their customers are large electric utilities that run coal fired power plants, often times these coal plants are located on top of or next to their coal power source.  The utility companies will finance and take on the cleanup cost liabilities for the mine, and will contract out the actual operations to NACoal.  There is no pricing risk as each mine exists to service one customer in perpetuity, their contracts are long dated, often times the length of the expected life of the mine.  For accounting purposes these mines are VIEs and since the customer has most (almost all) of the risk in the venture, NACoal is not considered the primary beneficiary and thus doesn't consolidate the results.

The business spits out a lot of cash, but it is declining albeit in a slow fashion.  What utility would invest significant sums to build a new coal fired power plant today?  Very few, if any.  Power plants last decades and even if the current political administration is coal friendly, I doubt many future ones will be the same.  As a result, NACoal's reinvestment opportunities in the coal business are pretty nil, they do have some small side businesses doing mining related services that operate under similar cost-plus arrangements and that's likely where any future cash will be deployed going forward.  Not great, but NACoal shouldn't be viewed as a royalty trust with a finite life.

In valuing the coal business, I think it should more closely resemble the multiple of an independent power producer versus the recently reorganized coal miners, most of which trade for 4-5x EBITDA.  The power plants NACoal services are primarily base load plants, there's some fluctuation in the results due to power demand/pricing, operational turnarounds, etc., but mostly its a fairly steady predictable business.  They should see some uplift in the coming years due to new contracts coming online (maybe the last of the new coal plants?) and something like fellow blog-name Vistra Energy (VST), which actually does its own coal mining, trades for around 7.5x EBITDA.  I think that's a fair multiple for NACoal given the drivers of the business, they did $35MM in EBITDA in 2016, 2017 will be higher, but we'll just go with $35MM, at a 7.5 multiple that's a $262MM enterprise value.

Hamilton Beach Holdings (HBB)
The spinoff will house a fairly popular small household appliance brand (they outsource all their manufacturing) in Hamilton Beach and then a struggling retailer that has little value in Kitchen Collection.  Hamilton Beach makes blenders, coffee makers, toaster ovens, juicers, indoor grills, etc., it sits mostly in that middle ground between a consumer staple and a durable, these aren't everyday purchases, but aren't large appliances that are big ticket items.  In terms of branding, Hamilton Beach sits in the middle again, they sell through Walmart, Target, Kohls, and Amazon, maybe not the best positioning to take, but they are moving more upscale with their recently launched co-branding efforts with the high end Wolf appliances.  That move upscale has flowed through in their results with widening margins and anticipated revenue growth for 2017 (much of their business is weighted towards the holiday selling season).

Kitchen Collection is a small household appliance retailer (they sell other brands in addition to Hamilton Beach) that operates primarily in outlet malls.  The concept has been hit pretty hard by declining mall traffic, NACCO has been closing stores pretty consistently since 2012 when they had 312 stores to just 209 today.  Kitchen Collection about breaks even and is likely of little value, hopefully they can manage the wind down as to not disrupt the overall HBB results.

There are a number of consumer brand rollups, Newell Brands (NWL) or Spectrum Brands (SPB) for example, that would be a logical buyer of Hamilton Beach at some point.  Both NWL and SPB trade for 14-15x EBIT, Hamilton Beach (with no contribution from Kitchen Collection) should do at least $45MM in EBIT in 2017, even putting a discounted multiple on the business of 12x would equal ~$565MM for the spinoff.

Add the two pieces up, $262MM for the parent and $565MM for the spinoff, minus $54MM of net debt (which is at the parent) and you get an estimated equity value of ~$775MM versus a current market cap of $475MM.  Another way to put it, the market is likely putting little to no value on the coal business despite its asset light nature and consistent cash flows.

  • This is a family controlled company, there will be a dual share class at HBB as well, which speaks to some of the discount.  Maybe HBB should be 10-11x then?  Still cheap.
  • NACCO did another spin in 2012, Hyster-Yale Materials (HY), which performed great post-spin but has since normalized.  Different business, different time, but I think it shows the lift in multiple possible at HBB after it gets free of the NACCO conglomerate discount.
  • There are two mines that are consolidated at NACoal, one is shutdown and in runoff which is causing some impairments and messy accounting, the other, Mississippi Lignite Mining Company is run in a similar fashion as the unconsolidated mines, however NACoal is on the hook for the operating costs.  The majority of the capex for the business is related to operating the consolidated mine.
  • Management is pitching the spinoff partially as a talent planning event, current CEO Al Rankin Jr (part of the controlling shareholders) is stepping down as CEO, elevating the two executives who currently run NACoal and Hamilton Beach to CEO of each respective company.  Rankin will then become Executive Chairman of Hamilton Beach and Non-Executive Chairman of NACCO Industries, not quite the same as "going with the spinoff" but noteworthy and sounds like he'll have more of an active role in the spinoff than the parent.
  • HBB certainly has some private label risk, some Amazon risk, etc., but doesn't appear to be immediately in the cross-hairs of either.  On the positive side, its a way to "play" the millennials finally moving out of their parent's basement theme, increased household formations, and other demographic tailwinds.  Additionally, HBB's business is mostly domestic, they're making a push to expand to developing markets where there is growth in the middle class.
Disclosure: I own shares of NC

Inotek Pharmaceuticals: Selling Below NCAV, Exploring Strategic Options

Inotek (ITEK) is a rather simple and small idea that adds to my recent theme of buying up the scraps of busted biotech companies.  Inotek was focused primarily on the treatment of glaucoma, an eye disease with a high unmet need, however their only drug, Trabodenoson, failed recent trials and it appears to be the end of the road for Inotek.  They've suspended research and development, hired Perella Weinberg Partners to pursue strategic options, and now sell below net current asset value.

Their balance sheet is now mostly cash and short term investments, offset by some convertible notes:
The current market cap is around $27MM, they'll burn ~$4MM a quarter on G&A and interest costs, and NCAV is ~$57MM.  Inotek does also have $105MM in NOLs, but the company should probably just call it a day and liquidate, hopefully we know more soon, but this seems like a fairly straightforward bet.  The biggest risks are the burn rate being higher than anticipated and/or a bad reverse merger transaction happening, both are more likely than I'm probably baking into the situation.

Disclosure: I own shares of ITEK

Tuesday, July 25, 2017

STORE Capital: Berkshire Deal, High Risk Lender?

STORE Capital (STOR) is an internally managed triple-net lease REIT, I don't own it (and usually don't like to write about companies I don't own), but Berkshire Hathaway (BRK) recently made a direct investment of $377MM for a 9.8% stake that deserves a closer look.  STORE is acronym for Single Tenant Operational Real Estate, basically it means they lend money primarily to middle market retail and service businesses using a sale-leaseback structure where the single tenant box is the collateral.  While STORE Capital is a REIT, it's closer to a BDC type lender than it is to an office, multifamily or even a mall REIT.  The tenants come to them because they need financing and can't get financing through more traditional bank lending.  The tenants then still control the property, pay the taxes, capex, and insurance, plus these are very long term leases, usually 15+ years.
STORE currently has 1750 properties, they're focusing on service sectors (restaurants, movie theaters, health clubs) as a way to mitigate the threat of online shopping, their largest tenants include Art Van Furniture, AMC Entertainment, Gander Mountain, Applebee's, Popeye's and Ashley Furniture.  Often the tenant is really a local franchisee of Applebee's or Ashley Furniture, and not the parent company.

There are plenty of triple-net lease REITs out there, it's a fairly common structure and a commodity business, if STORE does have a "secret sauce" its their focus on unit level profitability.  From their 10-K (click to expand):
To summarize, they strive to have each location be profitable to the tenant, not just the overall tenant themselves, that way if the tenant does get into financial trouble they'll want to hang onto those profitable locations through restructuring and not hand back the keys to STORE.  Again, think of STORE as a lender and not a landlord, they're not in the business of re-positioning a failed retail box into a higher and best use, just like a bank is not in a great position to manage the sale of a foreclosed home.  To facilitate this level of underwriting, STORE receives unit level financials on 97% of their locations, surely a useful data point that helps manage the growing portfolio.

Where the story gets a little promotional for me, STORE rates the credit quality of each tenant with an internal metric dubbed "The STORE Score".  Their tenants are almost entirely non-rated entities, last year they average an 8% cap rate on new investments, and again, these are entities that typically don't qualify for traditional bank financing.  Yet, based on SCORE's internal metric, 75% of their tenants would be investment grade if rated, or at least default at rates similar to a Baa2 rating.
Here's where I question the validity of the score, if I look at bank loans rated Baa2, I see the average coupon being something like LIBOR + 200 bps, no where near the equivalent to an 8% cap rate that STORE is receiving, what's the explanation?  The management team here is well thought of here, STORE was originally created by Oaktree in 2011 before going public in 2014, they're focused on doing smaller one off deals for the time being (likely will become more difficult as they grow), so maybe its just better management and the ability to do bespoke deals?  Possible, to me it seems questionable that they're tenants are really investment grade but at least STORE is doing their own underwriting work.

But promotion is part of the REIT game, STORE's real product is their own shares, in order for them to continually grow they need to raise more capital by issuing shares.  It's not entirely different than an asset management company marketing their funds and selling the product.  Berkshire Hathaway bought at $20.25, today the shares trade for $23.25, so accepting BRK's stamp of approval lowered their cost of a capital, probably a smart capital raise on STORE's part.  Depending on your assumptions for the fresh BRK capital, STOR trades for about a 6.0-6.5% cap rate today and if they're continually able to invest at 7.5-8.0% cap rates they'd be smart to continue to issue equity.

I'd peg STORE Capital at about fair value today and think it's reasonable to assume a ~10% annual return from here going forward.  Management lays out the math a bit in their presentation, but if you're buying in at a 6.5% cap rate today, levering it, reinvesting some of the cash flows, raising rents 1.8% per year, issuing equity to buy at 8%, dock something for defaults/recovery and the returns lay themselves out pretty well.
This is a better mouse trap than many other alternative investment products out there or a BDC/CEF, at least here you have the real estate as collateral, it should perform close to the overall market with lower volatility.  Given Berkshire's cash hoard, can't blame them for taking that proposition.
I co-chair a monthly investment research group where we discuss special situations and just general value investing ideas, yesterday the topic was STORE Capital, if you're in Chicago and free on the 4th Monday of every month come join us.

Disclosure: No Position

Friday, June 30, 2017

Mid Year 2017 Portfolio Review

My portfolio is up 15.75% for the first six months of 2017, pulling up my since inception IRR to 23.74%, and comfortably ahead of the S&P 500's 9.34% gain so far this year.  Significant winners have been Tropicana Entertainment, MMA Capital, Pinnacle Entertainment and Resource Capital, the only significant loser has been New York REIT.
Closed Positions:
  • ILG Inc (ILG): In hindsight, this was one of my favorite special situations of the past several years.  ILG (f/k/a Interval Leisure Group) had entered into a reverse morris trust transaction with Starwood prior to the announcement of Starwood's merger with Marriott, thus those that wanted to play the merger arb on the Starwood/Marriott transaction had to short out both Marriott and ILG against Starwood creating an uneconomic selling pressure on ILG's shares.  Since the deal has closed, ILG has run up well over 100%, I unfortunately sold a little too soon in the low $20s as ILG is now being bid up under speculation of a merger with Marriott Vacations Worldwide (VAC).  I'll be looking closely for ideas like this in the future, something similar was the Dell buyout of EMC/VMWare which created a coiled spring in VMWare stock that's caused the DVMT tracker to do very well too.
  • Actelion (ALIOY):  The Actelion/J&J deal closed and the development stage biotech company that was created out of the merger, Idorsia, has done very well too.  I bought the unsponsored ADR, there was a short week or two there when the shares dropped and people started speculating on why and if withholding taxes were going to be an issue, I got scared out of my position, ended up making a small amount of money but left some on the table.
  • CSRA (CSRA):  CSRA is the government services spinoff of CSC, with CSC I had the right idea at the time of the spinoff, CSC was setup to be sold and it was earlier this year when it merged with a division of HP Enterprises in a reverse morris trust to create DXC Technology (DXC).  I haven't spent much time on DXC, but CSC turned out to be the better side of the CSC/CSRA split.   I ended up selling CSRA earlier this spring in a slight fit as I didn't realize pension income was being included in their "adjusted" EBITDA figure they were presenting.  It caused the shares to look artificially cheap compared to peers and I just missed it, lesson learned.
  • WMIH Corp (WMIH):  The white whale of NOL shells, with over $6B in NOLs and apparently no dance partner in sight, it appears like the company's sponsor KKR is unable to find a deal that makes sense, they can walk in January, and will likely use that as leverage to strike an even more advantageous deal with WMIH.  If a deal does happen in the meantime, there still could be money to be made after but I don't see a reason to wait around any longer.
Previously Unmentioned New Positions:
  • Miramar Labs (MRLB):  Miramar Labs is another CVR opportunity, and even smaller than the others mentioned on the blog, but they make a medical device that's used to reduce underarm sweat and hair.  It's more of a elective beauty and/or lifestyle product that is sold to plastic surgeons, spas, etc, and its treatments are paid in cash and not processed through insurance companies.  Sientra (SIEN) is buying Miramar for $0.3149 per share upfront and $0.7058 per share in contingent payments for a total just over $1.02 per share.  The contingent payments are a little unique, where the milestone is a cumulative net sales number with no deadline.  Unlike the other CVRs that rely on an FDA approval, here Miramar already has an approved and commercialized product, so unless the sales flop going forward, the payout should occur, its just a matter of when.  The big payout is for $80MM in sales, Mirmar did $20MM in sales last year, but they're seeing some growth, I'm modeling out a 3-3.5 year timeframe to hit the milestone payment which at current prices of around $0.55 per share generates a pretty nice IRR.  Thanks to @yolocapital on Twitter for pointing it out to me.
  • Sound Banking Company (SNBN):  Sound Bank is a tiny North Carolina based community bank that is being acquired by another small bank but with high growth ambitions, West Town Bancorp (WTWB).  There are many small bank mergers happening, if I was less capital constrained, or had a lower risk mandate I'd probably be diving head first into more of these as the spreads are fairly wide for what should be low risk deals.  West Town Bancorp is offering $12.75 in cash or 0.6 shares of WTWB for each share of SNBN.  With SNBN currently trading at $13.40, you could create shares of WTWB for $22.33 when they currently trade for $24.45.  There is a cap on the cash/stock consideration, so proration is likely with the stock trading over the $12.75 cash payout, but it still seems/seemed like a good bet, the merger is expected to close in the third quarter.
  • Interoil Corp (IOC) Contingent Resource Payment:  I got bored and ended up trying this CRP/CVR the day or two before the merger with Exxon Mobil was completed, no view on how much natural gas is actually in PNG, so its a pure speculation that should be decided in the next quarter.
Current Holdings:
I added a little money earlier this year, the performance figures take that properly into account.

Disclosure: Table above is my blog/hobby portfolio, its a taxable account, and a relatively small slice of my overall asset allocation which follows a more diversified low-cost index approach.  The use of margin debt/options/concentration doesn't represent my true risk tolerance.

Friday, June 9, 2017

Merrimack Pharmaceuticals: Broken Biotech with CVR-like Optionality

Over the last couple months I've been developing a basket of small broken biotechnology companies that all peaked around the sector's euphoric days in 2015 only to be forced to sell themselves more recently to larger companies as their funding has dried up.  Merrimack Pharmaceuticals (MACK) is one such company, they're focused on developing therapeutics for the treatment of cancer, in 2015 their first commercial product was approved by the FDA, Onivyde, a second-line treatment for those with pancreatic cancer.  Merrimack has struggled to market Onivyde effectively, its current addressable market is rather small as its not approved yet for front-line treatment, and its a difficult proposition to scale a sales force from nothing quickly and efficiently.  Add in the expensive nature of conducting clinical trials for the remaining cancer drugs in their pipeline, and it became clear that Merrimack needed to raise cash quickly.

So Merrimack sold their commercial business in Onivyde (along with a generic version of Doxil) to Ipsen (IPSEY) for $575MM in cash at closing, $33MM in near term milestone payments related to Onivyde sales through their licensing agreement with Shire (originally Baxalta), and up to $450MM in contingency payments based on additional regulatory approvals for Onivyde.  Following the sale, the company's plan was return cash to shareholders via a special dividend, pay off most of their debt, and refocus the company as a development stage biotech again.  The deal closed in early April, a $140MM special dividend was paid and their senior notes have been redeemed.  Today the company's market cap is roughly $200MM, or about the same as net cash following the closing of the Onivyde sale and resulting special dividend.

Merrimack 2.0
The company will now have a few different shots on goal, to be clear, this is all very speculative at this point and I know very little about the chances of any of these milestones being reached or the drugs in their pipeline ever being approved and commercialized.

Merrimack's board of directors has committed to passing through to shareholders any payments received net of taxes related to the Ispen deal in the form of special dividends.  In essence, these will function like contingent value right payments, but they're stapled together with the common shares and the company could go back on their word and find other uses for the cash in the future.

The three milestone payments are as follows:
  1. $225MM for FDA approval in first-line pancreatic cancer
  2. $150MM for FDA approval in small cell lung cancer
  3. $75MM for FDA approval in any third indication
There doesn't appear to be a deadline on any of these, at least one that's worrisome, that's good as it prevents Ipsen from delaying the approvals until just after the milestone date expires.
Milestone 1 is in a phase 2 trial, milestone is just beginning a phase 3 trial, and milestone 3 has a couple in phase 1 or beginning stages of phase 1 trials, translation, all are probably years away from potentially materializing.  Merrimack's financial advisers in the transaction estimated the probability weighted NPV of Ispen's offer at $685MM, with $575MM upfront and the Shire milestone payments of $33MM likely to hit this year, the bankers put the NPV of the contingency payments at roughly $77MM.  Seems fairly reasonable assuming a low-to-mid probability on either 1 or 2 being met in 3-4 year time and then discounting that back pretty heavily.

As part of Merrimack's restructuring, they've narrowed their pipeline to the three most promising anti-cancer products which they plan to focus their attention now as a new development stage company:
These three are also pretty distant catalysts, MM-121 has failed three phase 2 trials in non-small cell lung cancer, ovarian cancer, and breast cancer, so they're running out of options for that drug.  I'm curious to hear others thoughts on these three programs and their prospects as the company even after the restructuring is only funded through the end of 2019 - developing oncology drugs is extremely expensive.

Merrimack also has convertible debt outstanding, as part of the Ipsen deal the company eliminated their senior notes but conveniently left out any mention of their convertible debt, the convertible holders were understandably unhappy with the company.  Merrimack sold off their one commercial drug, bypassed them and distributed cash to shareholders, reducing the collateral backing the convertible notes which significantly increases the probability of default.  Bondholders are suing the company and as a result, Merrimack escrowed $60MM -- or about the amount it would take to redeem the upset bondholders.  The convertible bonds might be an interesting special situation in their own right, they trade in the upper 60s, way out of the money with a strike price of $6.25, have a 4.5% coupon, and if the lawsuit is successful they could be redeemed at par by year end.  If Merrimack is successful however, then the $60MM (or $0.45/share) will be distributed to shareholders as an additional special dividend.

Prior to the special dividend that's already been paid, MACK was trading between $3.30-$3.70 per share, after the $1.06 dividend it sold off down to $1.44 as of today, so roughly $0.80-$1.20 has come off the stock price for no other reason than the asset sale was completed and the dividend was paid.  There are a lot of upset retail shareholders and other day trader types in the stock, but it looks to be cheap and some forced selling happening after the restructuring has taken place as holders reassessed whether they wanted a pre-revenue stage biotech -- its almost like old spinoff selling dynamics taking place after the dividend was paid.

But at net cash, with new management taking over who were just issued a new options package, and the possibility of future contingent payments related to Onivyde, Merrimack seems like an another interesting speculation to add to my broken biotech bucket.  It'll be about 3 years before we know how this bucket turns out and that's likely a big part of the discount, but I think/hope I have the patience and ability to wait it out.

Disclosure: I own shares of MACK