Tuesday, July 13, 2021

Communication Systems: Liquidation with a Speculative Kicker

Communication Systems Inc ("CSI", Ticker: JCS) is a mini conglomerate that announced earlier this year they would be selling their operating businesses and real estate assets, returning the capital to shareholders and then merging the empty public shell with privately held Pineapple Energy, a recently formed company intending to pursue a rollup of residential solar businesses.  By my estimates, the sale proceeds from the legacy businesses could roughly equal the current market cap (~$67MM or $6.75/share), with a $3.50/share special dividend coming shortly and 90% of the remaining via a contingent value right within 18 months, leaving pre-deal shareholders with a stub position in the new Pineapple Energy (ticker will switch to PEGY) as a speculative kicker.

This is a strange transaction, CSI is effectively liquidating and as part of the garage sale is getting paid in PEGY stock for the public listing "asset", it is almost a SPAC (the merger deck resembles a SPAC deck) but Pineapple is not getting any SPAC trust cash, only the PIPE they're raising alongside the closing of the deal.  In SPAC-language, CSI is almost the SPAC sponsor and getting sponsor shares in PEGY for putting the deal together and getting it public.  The current Chairman of CSI will become the Chairman of the Pineapple and the CFO is staying on board too, so the start-up Pineapple is buying some public company management infrastructure and a public currency to pursue M&A.  But it is still a bit puzzling why either side is doing this particular deal with each other, other than both companies management teams and headquarters are based in Minneapolis, maybe they run in the same social circles.

Two events have happened since the initial merger announcement:

  1. CSI sold their largest operating business unit to Lantronix (LTRX) for $25MM in cash, plus an earnout of $7MM if the business unit's revenue roughly returns back to 2019 numbers in the 12 months after the close.
  2. Pineapple announced a PIPE financing that includes convertible preferred stock, warrants and a term loan to be used to fund operations (again, pre-merger cash is being returned to CSI shareholders) and close on two M&A transactions Pineapple intends to complete concurrently with the merger deal.
Interestingly, the convertible preferred stock "will have no liquidation or dividend preference over CSI common stock and no voting rights until after converted into CSI common stock", the conversion price is $3.40/share, the PIPE investors are also receiving warrants at the same price, but this provides a reference price for the post-merger PEGY common stock of somewhere above $0 and below $3.40 (depending how you value the warrants).

With these two events announced, the total sum of the parts value is coming together:
  • Cash and investments of $21MM
  • $25MM from the sale to LTRX, plus an earnout of $7MM
  • CSI owns their corporate headquarters in Minnetoka, MN, it is on the market for $10MM and a manufacturing facility in rural MN that is leased out to the purchaser of a business they previously sold, that facility is on the market for $975k.
  • Their remaining business segment (JDL Technologies and Ecessa) has yet to be sold, the Ecessa business was purchased in 2020 for $4MM, the combined segment did $8.8MM in revenue last year.
Back of the envelope math, in a pretty bullish scenario, pre-deal CSI investors can hope for up to $6.62 back and still be left with the Pineapple Energy stub that raised capital with a $3.40 strike on the convertible preferred stock.
Feel free to stress test it on your own, maybe the earnout should be valued at zero and some discount applied to the real estate.

Why does the opportunity exist?  First, it's small and illiquid, roughly half the liquidation proceeds will be in a non-traded CVR that might not pay for 18 months.  Second, no one interested in Pineapple Energy would buy this yet.  Post merger it might catch a bid as solar is over indexed in ETFs and ESG mandates.  I know nothing about residential solar other than being frequently approached by Sunrun reps at Home Depot, but Pineapple *might* be something worthwhile.  The CEO, Kyle Udseth, seems like your prototypical founder type, he's a Stanford MBA, well spoken, did a tour of duty at McKinsey, stints at Caesars and Netflix, and has worked for several previous residential solar names before branching off on his own with Pineapple.  Public policy is pushing solar, people are building new homes, moving to warmer/sunnier climates, etc.  Maybe it actually works, maybe it's zero or maybe it just gets lucky and catches fire with retail investors, its sort of a free upside kicker in the liquidation.

Risks:
  • Deal fails to close, but then it likely turns into more of a straight liquidation and your downside is somewhat protected.
  • Cash or sale proceeds that should be distributed via the CVR gets used for the new business, doesn't appear to be the intention of the transaction, but funny business does happen with CVRs.
  • My estimates are wildly off or missing something big, there shouldn't be material taxes as they do have an NOL, but there could be unforeseen expenses or the real estate assets might sell well below list price.

Disclosure: I own shares of JCS

15 comments:

  1. Interesting idea, as always. Do you have any expectation as to the total return over time? Also, what are the tax implications for investing in JCS? Wouldn't an investor get hit with taxes from the dividends or is your cost basis adjusted? Thanks.

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    1. Your cost basis should be adjusted, if it is not, you'll have plenty of time to sell PEGY before the year is over to realize the loss and it should net out. As for total return, I think it's fairly open ended, depends on your view of how PEGY trades.

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  2. Haha need I even mention that I own this? Bought it at around net cash 2(?) years ago because it seemed like something would happen eventually. I like small industrials HQed in MN, because in my possibly-skewed experience they tend to be parsimonious, decently-capitalized, and somewhat shareholder-friendly.

    Anyway, have done zero work on the liquidation/reconstitution, but am still holding a position (sold 1/3 on the initial spike), so thanks for this.

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    1. There is something about Minnesota, surprisingly a lot of well run businesses!

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    2. NVEC comes to mind. Not exactly cheap but seems like a great business.

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  3. Thanks for this interesting opportunity and thanks for operating such an inspiring blog.
    I am pretty new into special situations investing but a big fan of Greenblatt and his book on the topic.
    I hope it is okay for me to ask some questions to get a better understanding of the situation. Is it correct understood that the expected final payout would be 10.02 from 6.62 (special dividend and a contigent value right) and a stub position in Pineapple Energy valued at 3.4 (expected due to the 3.4 strike price on the convertible preferred stock)? Thus, leaving us with return opportunity of 48.4% based on a price of 6.75?

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    1. "return opportunity" is a good way to put it, I would stress that its pretty squishy, do your own due diligence sort of thing, that's why I didn't really state a target price or upside. I just like that you'll get about half your money back right away, that derisks some of the unknowns regarding the ultimate value of CVR and PEGY shares.

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    2. I understand. Yes, that is derisks some of the unknowns. How is these contingent value right and the stub normally treated on ones account in terms of corporate actions? Never tried that bedre...

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    3. There's no action for you to do if you're an owner, the record date for vote has passed, so if it is approved, you'll just receive the three pieces ($3.50, CVRs, PEGY shares) in your account on the closing date. The CVRs will likely show up without a value, they're not traded, so they'll look a little odd in your account.

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  4. Hi MDC, your write-up seems to imply that one JCS share gives right to one PEGY share. Maybe its obvious, but I could not find this information (only that JCS shareholders will own 37% of the new entity).

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    1. Yes, it’s a one for one. Basically you JCS shares remain and the ticker will just change to PEGY; JCS is issuing shares to Pineapple as part of the merger, current shareholders keep their holdings, just get diluted down (it’ll be below 37% after the PIPE).

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  5. I like how the merger deck misspells the chairman's name.

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    1. Ha I missed that, right in line with a SPAC-like deck

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  6. "90% of the remaining via a contingent value right within 18 months". What happens to the remaining 10%?

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    1. It stays with the new company, so its not lost value, but ends up on PEGY's balance sheet.

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