Monday, October 3, 2016

Donnelley Financial Solutions: New RRD Spin, Asset-Light, Recurring Revenue

Donnelley Financial Solutions (DFIN) is one of two fresh spinoffs of RR Donnelley & Sons (RRD) that provides services to help create, manage and deliver financial communications to investors and regulators.  This means the unwanted paper annual reports and prospectuses you receive for equities, mutual funds and insurance products, much of that is printed by Donnelley Financial.  This is a slowly dying business that represents about 42% of DFIN's revenue, its declining low single digits annually, and being mostly held up by regulations that require funds to physically mail annual and semi-annual reports to investors.  The other half of Donnelley Financial's revenue is generated by software and cloud like solutions that assist companies in putting together filings and data rooms that are used as depositories for M&A and IPO transactions.  This is the growth side of the business and one where RRD had been actively acquiring technology and software companies to compete in an increasingly paperless world.

The company breaks out their lines of business into three segments, mostly by customer type:
  • Global Capital Markets: Clients consist of primarily publicly traded companies that are subject to the Securities Act of 1933 and the Securities Exchange Act of 1934 who need to make periodic regulatory and investor filings along with transactional filings when M&A, IPOs, bankruptcies or other large corporate actions happen.  About half of the revenue from this segment is recurring in nature, the other half is transactional and depends heavily on deal making activity in the financial markets.  Donnelley Financial did business with 422 S&P 500 firms in 2015 via this segment.
  • Global Investment Markets: Clients consist of mutual funds, hedge funds, insurance companies that use Donnelley Financial's products to create reports, prospectuses, fact sheets and other marketing materials.  Almost all of this segment is recurring in nature, although it may face broader secular headwinds as active management strategies continue to face challenges outperforming and the resulting outflows.
  • Language Solutions: DFIN's smallest segment provides translation services that adapt business content into different languages for specific countries.  This segment could be where future acquisitions are made as the market is highly fragmented.
Overall DFIN believes 62% of their revenue is derived from recurring sources and 38% from transactional deal related activity.  Some products that those in finance might recognize: EDGAR Online, EDGAR Pro, Venue, FundSuite Arc, Proxy Design, ActiveDisclosure.

RR Donnelley didn't run what is now DFIN as a separate business vertical prior to the spinoff making it difficult to see historical numbers or business trends.  Besides reading the Form 10-12, it might be helpful to go back and review Bowne & Co (BNE) which RR Donnelley bought back in 2010 for ~$460MM, significantly beefing up their financial communications business.  For cyclicality context, Bowne's revenue dropped about 20% from 2007's peak to 2009's trough.

Why do the spinoffs?
RR Donnelley split up into three companies which itself could create some market uncertainty (seems to have today at least) as investors digest the prospects for each separate business.  Donnelley Financial appears to be the best business of the three, but to complicate matters RRD CEO Thomas Quinlan jumped to what looks like the 'garbage barge' retail printing business (LSC Communications) and the remaining RRD will be maintaining a 19.25% interest in both spin-offs for up to a year which could result in exchange offers for fans of those transactions.
But overall, the spinoffs seem to be designed to separate the headwind facing business, LSC Communications, from the parent that has moved to a more value add business model.  Secondarily highlighting the high margin, low capital intensive financial communications business (DFIN) from the parent, which should lead to DFIN trading at a higher valuation.  Most of the legacy pensions, PP&E, and other old-economy like cash drags will be either going to LSC Communications or staying with RR Donnelley.

Daniel Leib, the old CFO of RRD, is now the CEO of DFIN.  He's been the CFO of RRD for many years and before that was their internal M&A and strategy lead.  I generally like when CFO's take over the head job, especially of a company like DFIN that is expected to generate a lot of free cash which management will need to allocate and DFIN's entire business model is based around financial statements and regulatory disclosures, Daniel Leib as a former CFO should be intimately aware of these challenges from a client prospective.  The board will be led by Chairman Richard Crandell, 77, he like the rest of the board don't appear to have much of a printing industry background, more technology and software, lending more credit to the strategy of shifting the company to software products.

Donnelley Financial will be substantially asset-light, they outsource much of the physical printing during peak times around proxy season, and have minimal capital expenditures ($20-30MM) as they shift their business to more software and cloud offerings.

New IPOs and deal making activity was a little muted during the first half of the year, particularly the first quarter, pushing down DFIN's numbers year over year.  I'm going to use a rough $200MM EBITDA number, below the current run rate to account for both some peak market activity risk and the inherent carve out risk of using proforma Form 10-12 numbers.  DFIN has approximately $600MM in net debt and 32.4 million shares outstanding (which includes the stake retained by RRD), at $24.50 per share, DFIN is trading at 7x EBITDA for a mostly recurring revenue stream, with strong margins and minimal cap ex requirements.  Seems too cheap to me.

Disclosure: I own shares of DFIN

Wednesday, September 14, 2016

ZAIS Financial: Merger w/ Private REIT, Tender Offer, ZAIS Group

ZAIS Financial Corp (ZFC) is a $125MM market cap residential mortgage REIT that failed to gain size and operating leverage, ZFC's external manager ZAIS Group (ZAIS) is reeling from some poor performance at its main credit hedge fund and decided to refocus efforts away from the sub-size mortgage REIT.  In April 2016, ZAIS Financial announced it was merging with Sutherland Asset Management, a private commercial mortgage REIT, ZAIS Group's management agreement will be cancelled and Waterfall Asset Management, Sutherland's external manager, will take over the combined company with a typical base/incentive fee structure.

The merged company will take the Sutherland Asset Management name and trade under the symbol SLD.  Sutherland's strategy is to acquire and originate small commercial loans and SBA loans, they classify small commercial loans as those ranging from $500k to $10MM that often have a personal guarantee attached back to the business owner.  This is a bit of a niche non-bank lender sector made possible by the retreat in community and regional banks from making riskier loans that come with greater capital requirements.  Sutherland both originates their own loans and acquires portfolios of performing and non-performing loans from larger banks and the securitization market.  There might be an opportunity for alpha in this niche as these loans are too small for larger institutional investors but too risky for small banks, but it's not without risk as these are loans to franchisees and small time commercial real estate investors, basically borrowers without any scale or significant enough collateral for traditional lenders to touch.

Additionally, Sutherland is one of a few non-banks with an SBA license, borrowers that take out SBA loans are even shakier than their core small commercial loan business but with SBA loans the government guarantees a (senior) portion of the loan.  The guaranteed portion is then sold and securitized into the secondary market, there's usually a nice premium for the lender in the sale as these loans have a wide spread compared to traditional treasuries or other government sponsored enterprises.  The lender of an SBA loan keeps the servicing relationship whether they choose to keep the guaranteed portion on balance sheet or not, if the guaranteed portion is sold as the servicing relationship is kept, that effectively increases the interest and fees earned on the remaining portion held by the lender.  Originating SBA loans is a good business.

So that's Sutherland's business, lending to riskier small commercial lenders, it should do well during good times and not so good during bad times.  It's effectively a commercial mortgage REIT with elements of a residential mortgage REIT.

Why merge with ZAIS Financial?  
Sutherland attempted an IPO in January 2015 and ended up pulling the offering when it couldn't raise capital within the desired range.  Sutherland is about 3 times the size of ZAIS Financial, so merging with ZFC can effectively be thought of as a reverse merger and a way to backdoor list Sutherland.  Further to that point, ZAIS Financial has sold most of their liquid assets leaving their mortgage servicing operation, a business unit that a fund managed by Sutherland sold to ZAIS Financial a couple years earlier.

Why is this deal interesting?  
If shareholders approve the issuance of shares to complete the merger on 9/27, then ZAIS Financial is going to commence a tender offering for approximately 47% of their shares outstanding (cash from selling down their liquid RMBS assets) at $15.36 per share, the shares trade for a $14.07 per share, or a 9.2% premium that should happen fairly quickly.  Additionally, ZFC is paying a $0.40 dividend to shareholders on 10/17 with a record date of 9/30, for another 2.8% return.
Per the merger agreement, both sides adjusted their book values down to account for intangible assets, litigation costs, transaction fees, and ZAIS Group's termination payment.  If you follow the math, assuming everyone tenders their shares (the math gets better the fewer people tender), an investor can create shares in the new Sutherland (SLD) at 73% of tangible book value.  The deal should close in the 4th quarter assuming both sides approve the deal on 9/27.

I expect SLD shares to trade poorly after the deal happens as previously locked up (and mostly retail) shareholders now have liquidity and can sell their shares.  But most mortgage REITs trade somewhere between 0.9-1.1x BV, residential mortgage REITs on the low side, commercial mortgage REITs on the high side, Sutherland should trade somewhere in between the two sectors overtime as it has elements of both, but either way above 73% of book value.

Sizing a situation like this is important, you'll get about half your money back quickly and don't want to worry about the remaining stub if the new SLD gets sold off once the deal closes.

ZAIS Group
ZFC's soon to be former external manager, ZAIS Group (ZAIS), might be a situation worth digging into further.  After losing ZFC's management contract, ZAIS will have a little more than $3B in AUM primarily across two hedge funds that have good long term records but poor short term (far from their high water marks) and 4 CLOs, one of which they closed this year which is a feat for a small manager like ZAIS.  As a result of losing their incentive fees, their operating expenses are greater than their run rate management fees putting them in a tight spot.  The stock is down 80+% in the past year.  There are some corporate governance issues, its a former SPAC, and one of those structures where the public company owns 2/3rds of the operating LLC and insiders own the rest.  But at a $28MM market cap, its trading below book value (mostly cash) and other CLO managers have been sold recently at nice premiums (see CIFC), ZAIS could be another.

Disclosure: I own shares of ZFC, no position is ZAIS

Friday, September 2, 2016

Dell Technologies Class V: New VMWare Tracking Stock

I'm posting this on Friday afternoon before a long holiday weekend for a reason, smarter people than I have written on this topic so not much of the below is new but I wanted to memorialize some thoughts as part of my process.

Last October, Dell and Silver Lake (their PE backers) announced the acquisition of EMC in a cash and stock deal worth $67B.  Dell is a private company and wants to stay that way, so the stock part of the merger consideration is a bit tricky.  EMC owns 81% of VMWare, a software company that sells virtualization technology that helps large enterprise servers share resources and become more efficient, the remaining 19% stake is publicly traded under the VMW symbol.  But Dell is a recent leveraged buyout, and they didn't have the available financing to buy both EMC and their stake in VMWare simultaneously, so instead of paying cash for all of EMC and their 81% stake in VMWare, Dell is issuing a tracking stock that represents 65% of EMC's 81% interest in VMWare to former EMC shareholders to bridge the funding gap, but still get to control VMWare.

In Dell's own words (Denali is Dell's parent company):
Q:           Why is a tracking stock being used to finance the acquisition of EMC?
A:           The Class V Common Stock will afford EMC shareholders the opportunity to benefit from any value creation that may result from any revenue synergies of the Class V Group with Dell. Collectively, EMC shareholders indirectly own approximately 81% of VMware as of the date of this proxy statement/prospectus. Upon the completion of the merger, EMC shareholders will receive shares of Class V Common Stock that will be publicly traded and that are intended to track, in the aggregate, an approximately 53% economic interest in the VMware business (assuming no change to the percentage economic interest of EMC in the VMware business prior to the completion of the merger and that EMC shareholders either are not entitled to or do not properly exercise appraisal rights).
Owning EMC’s interest in the VMware business is a fundamental part of Denali’s strategic rationale for this transaction. VMware’s success is important to the business strategy of a merger combining Dell and EMC, and Denali believes it will be in the best interests of its common stockholders after the merger to retain a large economic interest in the VMware business. Additionally, given constraints on the amount of cash financing available for the transaction, the issuance of the Class V Common Stock enables Denali to pay a higher purchase price for EMC than it could in a transaction consisting entirely of 100% cash consideration.
Shares of the tracking stock, Dell Technologies Class V, started trading recently in the when-issued market under the symbol DVMTV and will start trading regular way as DVMT after the deal closes on 9/7/2016.  Each share of DVMT represents the same economic equivalent of each share of VMW, there will be 223MM shares of DVMT outstanding compared to just 80MM of the regular VMW common shares, meaning the tracker should be more liquid than the real thing, an odd situation.

While neither DVMT or VMW have any material voting rights, the two stocks are significantly different in that DVMT is exposed to Dell's highly leveraged balance sheet as DVMT is a share class of Dell Technologies (the merged Dell and EMC) not VMWare.  After the deal closes, Dell will be levered about 6 times and their debt is rated below investment grade, Dell's stated plan is to deleverage (as they did following their 2013 buyout) over the next 18-24 months in order to re-achieve an investment grade rating.  Their debt facilities do allow for some share repurchases but I would expect those to come second to the initial de-leveraging.

The big question is what discount should be applied to the DVMT tracker for taking on the additional balance sheet risk?  I think most scenarios where Dell ends up in serious financial trouble so does VMWare.  Several have speculated that Dell is really interested in VMWare over the rest of EMC, VMWare's software will be a key differentiating factor in Dell's enterprise business going forward.  If one falters the other will, Dell is in complete control of both.  The circumstance where Dell's balance sheet could be an issue for DVMT is a near term slowdown in their business that puts a wrench in the de-leveraging plan.  What discount is that risk worth?  I'd vote a 15-20% discount is fair for DVMT, it's currently trading at $43.90 and VMW at $72.88, or a 40% discount.  I don't have a strong opinion on VMW's valuation but its trading for a forward P/E of ~17x or fairly close to the market as a whole for a company that's generating mid-single digits topline growth.

How does this structure get fixed long term?  Dell has the option to swap VMW shares for the tracker, but likely won't do so for both tax reasons and they don't want to give up control.  The more likely scenario is after paying down debt from the EMC transaction, Dell might come back for the tracker and VMW shares in another deal.  Dell's initial management buyout was scrutinized for being unfair to minority shareholders, so the prospect of Dell doing it again to VMWare is another possible reason for a high discount rate.  Either way, 40% seems too high and is worthy of a small position.

Disclosure: I own shares of DVMT

Thursday, August 25, 2016

iStar: Non-Dividend Paying REIT with Significant Development Assets

iStar (STAR), f/k/a iStar Financial, is an internally managed former commercial mortgage REIT that ended up foreclosing on a variety of land, development projects, and operating assets (office, hotel, condo projects) across the country following the financial crisis.  Over the last several years iStar has poured money into these foreclosed assets to reposition them for an eventual exit, much of that investment should start showing up in asset sales over the next 1-3 years.  Cash from the sales could then be recycled into their core commercial mortgage and net lease business making the company easier to understand and value.

iStar is an odd REIT that doesn't pay a dividend, REITs are generally under-invested in by institutional investors (although that may change now that REITs have recently been carved out of financials into their own S&P sector) but are generally favored by retail investors because of their high dividends.  iStar misses both investor bases.  iStar is a unique pass-through entity that has NOLs from the financial crisis (similar to ACAS in the BDC industry) and are using their tax asset to shield taxable income (bypassing the 90% distribution rule) in order to reinvest in their business and repurchase shares.  They're not getting credit for this strategy as it doesn't immediately result in higher dividends or in a clearly articulated higher NAV value.  Instead, iStar uses a gross book value metric in their press releases which adds back depreciation on their real estate but does not give any credit to the increase in real estate values since they acquired the development assets via foreclosure or the additional value created above cost as they've deployed capital into those properties.

iStar breaks out their business into four main buckets: 1) Real Estate Finance, 2) Net Lease, 3) Operating Properties, and 4) Land and Development.  Real Estate Finance and Net Lease are complementary businesses as a triple net lease property is essentially a financing transaction.  The Operating Properties and Land and Development segments are the assets iStar acquired through foreclosure, over time these segments should shrink from 36% of assets to become a smaller part of the pie.
2015 10-K
Their asset base is pretty well diversified across geography and real estate subsectors, although the public market likes clean pure-play REITs, diversification still reduces risk, especially in the land and development asset class.  If one area of the country is seeing a slowdown, they can pull back their development plans and focus on other opportunities (seeing this with HHC shifting capital away from their Houston assets).
Q2 16 10-Q
There's a lot of noise in their Operating Properties and Land and Development businesses as earnings are lumpy based on when assets are sold.  iStar breaks out their commercial Operating Properties between stabilized, those that are leased up at prevailing market rents, and transitional, those that have low occupancy and need to be re-positioned.  I think it makes the most sense to value iStar's core Real Estate Finance, Net Lease business lines and the stabilized Operating Properties as if it were a typical straightforward REIT that pays a dividend.  The below is a bit of a crude back of the envelope valuation, but it shows that the market is giving little credit to the value in iStar's transitional operating properties and in their land and development holdings.

On an FFO basis:
iStar has quite a bit of leverage, so a pure FFO multiple probably isn't appropriate but still shows the value embedded in iStar's complicated structure as the shares currently trade for $11.00, less than 14x FFO of just the core Real Estate Finance and Net Lease portfolios.

On an NAV basis:
The above analysis assumes a 6.5% cap rate for the net lease and stabilized operating property assets and values the rest of iStar's assets at book value despite many of the land and development assets being valued at 2010-2012 cost basis on the balance sheet.  One way to look at iStar's valuation, the market is hair-cutting the foreclosed assets by 70% despite significant progress made in recent years to entitle and further develop these assets.  It's likely that these assets could be worth 1.5-2.0x what they're carried at as value is realized over the next 1-3 years.

Land and Development Assets
iStar's Land and Development assets are quite extensive but there's not a lot of disclosure around the specifics of each asset in the 10-K, maybe something for the new CFO to implement?  In total they control land that will eventually contain over 30,000 residential units, not an insignificant number.  Management expects the back half of 2016 and into 2017 to be big realization years, with $500MM in exits targeted from the Land and Development and Operating Properties segments.  Below are a few projects that are currently in production or under development:
  • 1000 South Clark: 29 story, 469 unit luxury apartment complex located in Chicago's South Loop.  iStar partnered with a local builder in a JV, its both an equity investor and a lender in the deal, it will likely be sold after stabilization early next year.
  • Asbury Park Waterfront: iStar recently opened an "adult playground" hotel, The Asbury, in Asbury Park, NJ (Jersey Shore), the hotel/entertainment venue is meant to spur additional development in the surrounding 35 acres of land iStar owns that will eventually support over 2,700 residential units.  iStar is currently finishing up a small condo project, called Monroe, which is 40% sold and has plans to revive an uncompleted high rise construction project called Esperanza that was abandoned after the financial crisis.
  • Ford Amphitheater at Coney Island: iStar just recently completed construction on a 5,000 seat amphitheater along the boardwalk in Coney Island, the amphitheater was built to spur additional development around it, which iStar has 5.5 acres and plans for 565 residential units.
  • Grand Vista: 5,500 acres of mostly raw land on the outskirts of Phoenix that has plans for 15,000 residential units, this was a large failed project before the financial crisis and it may take a while before Phoenix builds out to this site.
  • Highpark: Formerly known as Ponte Vista, Highpark is a 62 acre former naval shipyard in San Pedro, California which will house 700 new residences.
  • Magnolia Green: A classic master planned communities outside of Richmond, VA with a golf course and room for 3,500 residential units.  It has an estimated sellout date of 2026 and another 2.400 units remaining to be sold.  Richmond is becoming a hot market, the city itself is pretty vibrant and it's in a good geographic weather location, it should attract both millenials and retiring baby boomers.
  • Marina Palms:  Two luxury towers along with a marina in North Miami Beach, the second tower is currently under construction and slated to be finished in December 2016.  The company partnered with a local builder and contributed the land for a 47.5% interest in the JV.
  • Spring Mountain Ranch Place: 785-acre master planned community located in the Inland Empire.  For the first phase of the development, iStar partnered with KB Homes and retained a 75.6% interest in the JV, the first phase calls for 435 homes, 200 of which had been sold as of 12/31/15.  Additional phases of the MPC will bring a total of 1,400 home sites.
iStar has $856MM of net operating loss carry-forwards at the REIT level that can be used to offset taxable income and don't expire until 2034.  The NOL allows iStar to utilize retained earnings to grow rather than tap the capital markets constantly like traditional REITs.  This is a plus for iStar as they trade for a significant discount to my estimate of NAV, if forced to pay out market rate dividends they might not be able to access enough capital to fully realize the value of their development assets.  Additionally, they have more available free cash flow to buyback shares which should ultimately be a better use of cash at these prices than paying out a dividend.

Share Repurchases
The company is a large net seller of real estate, they will be selling down their portfolio as time goes on using the proceeds to pay down debt and repurchase more shares.  In the past twelve months iStar has repurchased 19% of their shares outstanding, after the second quarter they approved another $50MM increase to their repurchase program.  The combination of selling their non-core assets above book value and buying back shares below NAV is powerful and could lead to some substantial returns.

  • Jay Sugarman is the CEO of iStar, he's been in that position since the late 1990s and thus led iStar into the financial crisis, he has a lot of the trappings of a NYC real estate guy (owns a sports team, Philadephia Union of the MLS, and a massive home in the Hamptons).  But like Michael Falcone at MMAC, sometimes you need the guy who led you into the abyss to lead you out because they know each asset intimately and where the bodies are buried.
  • Does iStar go back to the "boring" business of real estate finance and net lease after diving into the glamorous development world?  Their website and headshots don't look like your typical REIT or credit shop, I worry the management team has fallen in love with real estate development and the portfolio won't ever resemble a clean REIT until iStar exhausts its NOLs.
  • Timing of asset sales, a few of iStar's land and development assets have long tails (10+ years), if they intend to do the development themselves versus selling to a local builder it could push out the value realization time frame.
  • Leverage, convertible bonds/preferreds, development assets all make iStar more vulnerable to a recession and a downturn in real estate prices.  They have some near term debt maturities and are generally dependent on the capital markets on an ongoing basis for both debt refinancing and asset sales.
iStar reminds me of a combination of HHC (hard to value development assets, atypical for a public vehicle), MMAC (real estate acquired through foreclosure that's difficult to piece out, cannibal of its own shares), and ACAS (pass through entity that doesn't pay a dividend due to its NOL assets).  Over time I think can generate similar gains as those previous ideas.  Thanks to the reader who pointed it out in a previous comment section.

Disclosure: I own shares of STAR

Monday, August 1, 2016

Verso Corp: Bankruptcy Reorg, Cheap Valuation

Verso Corporation (VRS) is a paper producer, primarily of coated papers used in magazines, catalogs, direct mailings, and other commercial applications.  They operate 8 paper mills, most of which are in the upper midwest.  This is a business in secular decline, shrinking mid-single digits annually the past five years as all media shifts to digital formats.  Verso was created by Apollo Global in a $1.4B 2006 leveraged buyout of International Paper's coated paper business, shortly afterwards the industry began to decline and Verso was sub-scale and had too much debt to compete.

In January 2014, Verso announced they would attempt to fix the scale problem and agreed to purchase competitor NewPage for another $1.4B.  The deal was heavily scrutinized by the Department of Justice fearing a monopoly in the coated paper market, all while both businesses were struggling and needed the combination to cut an estimated $175MM in costs.  Eventually the combined company agreed to sell 2 paper mills to appease regulators for $74MM and the deal was completed, but not in time to save Verso which filed for bankruptcy this past January with $2.8B in debt.  In July, Verso emerged from bankruptcy eliminating $2.4B in debt leaving it with $371MM split between an asset-back line and a term loan.  The former Verso and NewPage creditors became the equity shareholders and the company resumed trading under the symbol VRS.

After a company emerges from bankruptcy, the new equity is often in the hands of disinterested owners, the former debt holders, and similar to a spinoff there's no IPO road show to get investors excited.  The dream scenario is when a good business over-leverages themselves and a temporary setback in their business pushes them into bankruptcy while the underlying business is solid with long term growth prospects.  That's not the case here with Verso, the paper business is a declining commodity industry with high fixed costs and a variable priced end product that also has to compete against foreign producers benefiting from the strong dollar and lower labor costs.  But a cheap price can overcome a lot of flaws and Verso's equity is priced very cheaply.

Verso's management provided financial projections out to 2020 as part of the bankruptcy process, here's a link to the entire docket but I found the disclosure statement filed 5/10/16 to be the most helpful.
Verso expects to earn $145MM in 2017, it's current market cap is $404MM, so it's trading at a forward multiple of under 3 times earnings.  But P/E is probably not the best measure for Verso, they have a significant pension liability at $565MM that needs to be funded.
Verso expects to generate approximately $70MM annually in free cash flow after making pension plan contributions which works out to a 17% free cash flow yield.

PJT Partners, a 2015 Blackrock spinoff, was Verso's financial advisor through the process and provided their own valuation analysis.
A $700MM market cap would equal $20.35 per share (75% higher than today's $11.50) and value Verso at ~5x earnings, 10% free cash flow yield, and about ~4.4x EBITDA before pension contributions.  Sounds like valuations for other declining industries like newspapers and terrestrial radio stations.  Cheap and very reasonable even for a terrible business like coated paper.

The company is currently searching for a new CEO who would presumably have freshly struck options at today's depressed prices and a mandate for change, they wouldn't be tied to any of the decisions of previous management and could accelerate a shift to more profitable and less commodity specialty papers.  The ill-fated NewPage acquisition had strategic merit, the industry needs to consolidate and take capacity out of the system, Verso just had the wrong balance sheet and not enough time to experience the cost synergies of the merger.  By eliminating $200+MM of interest payments and realizing $175MM in cost synergies, new Verso should be more agile and able to adjust their business to the industry's realities.

Verso isn't a business you want to hold long term, I view this as a Graham cigar butt trade, get one last puff to the upside and move on to another one.

  • High fixed costs, variable input/outpost costs - Verso's input costs (timber, pulp, energy) are all highly variable and it's a price taker in their end coated paper markets, pair those dynamics with a high fixed cost expense base (expensive to maintain mills, unionized labor force) and a lot could go wrong.  A $25 change in pricing per ton would wipe out their entire annual EBITDA.
  • Paper industry is in secular decline - Demand for paper decline 10% from 2012 to 2015, expected to decline another 4% in 2016, and likely will continue to decline at a similar pace for the foreseeable future.
  • Verso hasn't been profitable since 2009 - I'm somewhat relying on management's financial projections and assuming they'll be able to come close to meeting those expectations which would be a significant turnaround from their results prior to bankruptcy.
  • Continued strong US dollar - many of Verso's competitors are foreign, a strong dollar makes Verso's paper less competitive both domestically and in overseas markets.
Disclosure: I own shares of VRS

Tuesday, July 19, 2016

Leidos Holdings: Reverse Morris Trust with Lockheed Martin

Following the draw-down of U.S. troops in Iraq/Afghanistan and the 2013 budget sequestration we've seen many defense and consulting firms spinoff their headwinds facing government services businesses (EGL, VEC, CSRA to name a few) as a way to continue to show growth.  In 2013, Science Applications International Corporation or "SAIC" spunoff it's slower growth technical services and IT divisions, the parent company changed it's name to Leidos Holdings (LDOS) and the slower growth government services division kept the name SAIC.  The reason for that spinoff wasn't entirely clear to me at the time, and still isn't, especially now that Leidos Holdings is acquiring the Information Systems & Global Solutions business of Lockheed Martin (LMT) in a Reverse Morris Trust transaction that will close in mid-August.

However after the transaction closes, Leidos will be the largest pure-play IT and government services contractor in the U.S., about twice as big as CSC's government services business CSRA.  They will be broadly diversified across government agencies, and internationally, in fact they'll be one of the few businesses to touch all seven continents as Lockheed's contract to run the U.S. research base in Antarctica will move to Leidos.  This is an industry where scale matters, in today's budget environment more and more contracts are being put out to bid as "Lowest Price Technically Acceptable".  Prior to sequestration, agencies used the "Best Value" method for determining a winning bid, allowing agencies to balance the trade-off between quality and cost, greater value for a higher cost was still okay.  Now the award goes to the lowest price as long as the bid meets all the technical requirements of the contract, there's less judgment on the contracting agency's part.  By being able to spread your corporate overhead over a larger contracting base, those with significant scale will be in a better position to compete on price.

Once a contract is won, it's often difficult to unseat the incumbent in future re-competes as the incumbent has the advantage of not needing to shoulder start-up and implementation costs, putting them in an advantage on price.  If a contract is lost, many of the employees working on the contract end up with the new contractor, the cost model for these firms is more variable than other industries allowing them to experience revenue declines but maintain acceptable margins.

Reverse Morris Trust Transaction
Below is an Leidos investor relations' slide outlining the transaction.  Lockheed Martin's IS&GS business generates about $500MM in EBITDA, at the $5B headline price, LDOS paid 10x EBITDA.
Leidos will be making a special dividend prior to the transaction closing to effectively true up the ownership bases of the two firms, in order for it to qualify as a Reverse Morris Trust and be tax free, Lockheed Martin shareholders need to own more than 50% of the combined company.  RMTs have been interesting to me recently because they pair the effects of a spinoff, but with immediate/improved scale and an in-place management team.

There will be approximately 151 million diluted shares outstanding after the transaction is complete, the Leidos special dividend will be $13.64 adjusting the pro-forma stock price down to $34.95 for a $5.3B market cap company.  Per the prospectus, the combined pro-forma EBITDA is $1.05B without any cost synergies which are expected to equal $120MM by 2018.
I have pro-forma Leidos trading for 8.2x EBITDA, 1-3 turns below most of their peers despite the company's new scale which should make them more competitive and lead to an increased win rate.  While 8x EBITDA might not be absolutely cheap for a business like Leidos, consider the U.S. Federal government has a budget for the first time in years with all sectors of government including the Department of Defense seeing increased appropriations.  The economy is still sluggish and treasury rates are near record lows, fiscal spending is likely to increase in an attempt to spur growth as deficit concerns and the risk of sequestration lessen.

Exchange Offer
There's a cheaper way to buy LDOS shares being offered right now.  Instead of spinning off LDOS shares directly to shareholders, Lockheed Martin is conducting an exchange offer where LMT shareholders can select to exchange their LMT shares for LDOS shares at a 10% discount rate (subject to an upper limit).  Even without the exchange offer this is an attractive deal and LDOS should be worth ~$44 per share (adjusted for the $13.64 special dividend) or 9.5x EBITDA.

Disclosure: I own shares of LMT (will be exchanging for LDOS) and CSRA

Hawaiian Electric: Public Utility Commission Denies NextEra Merger

Late last Friday, Hawaii's Public Utility Commission voted against NextEra Energy's (NEE) 19 month old deal to purchase Hawaiian Electric (HE) which provides electricity to 95% of the state.  I held out brief hope that the initial rejection would be a political move as the merger is deeply unpopular in Hawaii (they don't like outsiders) and both sides would come back to the table, make some concessions and the deal would get done.  No luck.  NextEra threw in the towel on Monday and terminated the merger transaction, Hawaiian Electric will receive about $95 million in a termination fee and deal expenses.  As part of that transaction, Hawaiian Electric was going to spinoff their bank subsidiary, American Savings Bank (ASBH), to HE shareholders but now that has also been shelved.

The shares sold off about 7% (to be fair they sold off about the same two weeks ago in anticipation of a no vote) as merger arbitrage investors exited the trade, when a deal breaks it often creates opportunities, time will tell if this is one with HE.  So what now?  Who would go through the pain of dealing with Hawaiian regulators to buy HE?  It's fairly clear that the utility can't go it alone and make the state's desired clean energy mandate by 2045.  Reports show that Berkshire Hathaway's energy subsidiary recently registered a business in Hawaii.  Berkshire has the brand recognition, deep pockets and commitment to moving towards clean energy that could appeal to the Hawaiian populace; Warren Buffett again playing the "friendly" acquirer role.

I continue to hold for the time being, if they were to find another buyer or just spinoff ASBH outright it could be a very attractive transaction.  To summarize the spin's appeal:
  1. Regulatory spinoff - 1) Anyone besides HE isn't allowed to own ASBH per Federal banking regulations, it's a strong bank that's capital allocation is being driven by the needs of a weakly positioned utility; 2) As part of HE, ASBH's debit card exchange fees are capped as part of the Durbin Amendment due to the overall size of HE.  If ASBH was independent it would fall under the threshold and regain $6MM in net income annually from debit card exchange fees (about a 11% increase).
  2. Differing investor bases, potential forced selling - 1) HE is primarily a utility and owned by many utility focused funds and ETFs, post deal these funds would be forced to sell ASBH; 2) HE is owned by many retail dividend focused investors who will likely sell ASBH as it only makes up a relatively small portion of HE's enterprise value.
  3. Strong local market - The Hawaiian banking market is strong, loans are growing at 8+% and deposits are growing at 5%, the two other publicily traded Hawaiian banks trade for 1.7x BV and 2.75x BV, choosing the lower of the two would put ASBH at about $8-9 per HE share.
Disclosure: I own shares of HE