Friday, May 12, 2023

First Horizon: Broken Merger Arb, Regional Bank Storm

First Horizon Corp (FHN) ($5.3B market capitalization) is a fairly vanilla regional bank serving a balance of both commercial and consumer customers in 12 states throughout the demographically desirable southeastern United States.  Unlike other troubled banks, their clientele is less chunky, less hot money, less return motivated.  First Horizon doesn't have customer concentration in asset managers, investment funds, tech start-ups or a large wealth management practice where deposits are less operational in nature.  It's just a boring middle American bank with a history of above average, low-to-mid teens ROE. 

Back in early 2022, First Horizon agreed to be bought out by TD Bank (TD) for $25/share plus a small ticking fee, however on 5/4, the two banks mutually agreed to terminate the merger due to regulatory approval timing uncertainty.  It was later reported by the WSJ that the OCC had concerns about TD Bank's anti-money laundering policies and blocked the deal.  The merger arb spread had already widened ahead of the termination signaling the market was highly skeptical of this deal going through, but shares tanked anyways as merger arb holders are selling shares at a time when there are few enthusiastic buyers of regional bank shares to match the liquidity.  As of this writing, shares trade around $9.60, less than half of where TD was prepared to take it out.

The current banking crisis is different than 2008, there's less concern about the ultimate recoverability of securities on bank balance sheets (AAA CDOs for example, weren't AAA, but there isn't that question with agency MBS), rather the market is more worried about the mark-to-market losses in bank held-to-maturity ("HTM") portfolios if banks are forced to sell securities to meet deposit outflows.  First Horizon's use of HTM accounting is relatively small (just 12% of the securities portfolio), deposits (which totaled $61B as of 3/31) large and small would have to flee in mass before the bank would need to realizes losses in their HTM portfolio.

As specified in the merger agreement, TD paid First Horizon a $200MM break fee and $25MM in merger expense reimbursement.  TD also bought $494MM of Series G preferred stock at the time of the merger announcement, which was used to fund retention bonuses for First Horizon's people, that tranche automatically converts to common stock with the deal breaking at the $25 deal price.  Both adjustments help boost their capital. 

What could FHN be worth once all the clouds clear?  Prior to 2022, First Horizon traded around ~1.5x tangible common equity.

If we incorporate the mark-to-market losses on the HTM portfolio, the termination fee and expense reimbursement, and the conversion of the Class G preferred, I get the below:

There are few more banks that I'm kicking around, feel free to mention some that you like in the comment section, but FHN seems unfairly punished.  I doubt it would be trading here if they never came to an agreement with TD, similar but larger peer Regions Financial (RF) trades for 1.5x tangible equity.

Other thoughts:
  • Prior to the termination, some rumors were floating around that TD was looking for a price cut due to market conditions, but First Horizon management stated on their investor call that TD never broached the subject.
  • The TD-FHN merger happened due to an unsolicited offer, the bank wasn't running a sale process, so it is unlikely FHN will get scooped up by another bidder in the near term, but also means the board and management take their fiduciary responsibility seriously and would consider other bidders.
  • Duration of the investment portfolio is only 5.2 years, each quarter that passes some of the losses will flip as par is realized.  The Federal Reserve also appears to be done hiking which should put a floor on the securities portfolio losses.
Disclosure: I own shares of FHN

Monday, April 3, 2023

Pardes Biosciences: Failed Biotech/SPAC, Trading Below Cash

Pardes Biosciences (PRDS) ($90MM market cap) is another biotech for the basket, this morning the company announced poor clinical results, an 85% reduction in their workforce and the decision to pursue strategic alternatives.  The company has a questionable history, it was founded shortly after the covid pandemic began in 2020 to pursue new treatments for viral diseases that lead to pandemics, they entered into a merger agreement with a SPAC in June 2021 and completed the deSPAC process in December 2021.  Luckily for them, this was before we started seeing heavy trust redemptions, with almost all of the SPAC cash being delivered to Pardes plus a $75MM PIPE investment.  Pardes has one asset, Pomotrelvier, a covid treatment that just failed to meet its Phase 2 primary endpoint, thus triggering the halt of their development program.  Even if trial was successful, it seems like society has moved on from covid and the share price reflected the skepticism that this could be a commercial product.

What makes Pardes slightly more interesting is their limited history, unlike others, they haven't had time to build up significant NOLs (only have $66MM) that might be attractive to a reverse-merger partner.  Pardes also doesn't have a significant lease or other major shutdown costs, so while a reverse-merger is likely still the first option, this one might be a strong candidate for a fairly clean liquidation.  I do wonder when we see a shift towards more liquidations, as we get more and more of these pursuing strategic alternatives, there can't be enough reverse-merger deals to go around (we still have dozens of SPACs doing the same too).

In their 8-K released today, Pardes disclosed a current cash balance of $172.4MM and $5.7MM of severance related costs to be incurred in the second quarter related to the workforce reduction. For the margin of safety swag, I included a year's worth of G&A, it won't be that high but should give plenty of room for unforeseen expenses. I bought a small position today.

Disclosure: I own shares of PRDS

Thursday, March 23, 2023

Star Holdings: iStar Spin, Familiar Monetization Strategy

Star Holdings (STHO) (~$225MM implied market cap) is the upcoming spinoff of the merger of iStar (STAR) and Safehold (SAFE) targeted to be completed on 3/31/23.  Similar to other real estate spinoffs, STHO will be stuffed with legacy assets with a stated strategy to monetize the portfolio over time and return sale proceeds to shareholders.  

iStar was a commercial mREIT prior to the great recession, during '08-'09 many of their commercial mortgage loans went bad and the company ended up foreclosing on various property types across the country.  In the years since, they've run off much of that legacy portfolio (I previously owned it for the legacy assets) and then several years back launched a new ground lease strategy under the Safehold (SAFE) banner, a REIT that is externally managed by iStar.  As the SAFE strategy succeeded in the low rate environment (a ground lease is typically 99 years, about the longest duration asset you'll find) and iStar's legacy portfolio ran off, there was little need to maintain two separate public companies with related party arrangements.  iStar with its management contract and SAFE shares was basically an asset backed tracking stock of SAFE.  Last August, iStar and SAFE announced a merger transaction where SAFE would internalize management and iStar would spinoff its non-ground lease assets into STHO.  Similar to other real estate spins (SMTA, RVI, etc), the new combined SAFE will be the external manager of STHO.

As usual in spinoffs now, iStar will be receiving a dividend back from STHO, the use of funds is to pay down iStar's debt and leave primarily just SAFE shares to then swap for new SAFE.  In order to facilitate that dividend, STHO is receiving $400MM in SAFE shares that they will then take a $140MM margin loan out against and send that, plus a $115MM term loan collateralized by all of STHO's assets back to iStar.  The term loan will amortize down quickly as all cash above $50MM will sweep to pay down principal and the margin loan will be in place at least 9 months per a lockup agreement on STHO's SAFE shares.  The proforma STHO looks something like this (note, the STHO share count will be approximately 13.3 million, or 0.153 shares for every STAR share):

The legacy portfolio is a mix of assets, the two largest ones that account for roughly half of the book value are smaller master plan communities, one is Asbury Park Waterfront (a collection of developed and pre-development mixed use properties) on the Jersey Shore and Magnolia Green (a golf course centered 1900 acre single family home community) just outside of Richmond.  STHO will also have some legacy commercial real estate loans and a parcel of land in Coney Island NY, they anticipate it will take 3-4 years to monetize most of the legacy assets.

The trickier, and possibly scarier part of STHO is the SAFE shares, as mentioned, its basically a perpetual bond masquerading as an operating company.  But with the rate curve substantially inverted, the market is pricing in quite a few rate cuts that would be beneficial to SAFE shares.

On March 17th, iStar put out a press release estimating the consolidation ratio with SAFE (it will be finalized immediately prior to the merger using a VWAP calculation) at 0.15 shares of SAFE for each share of STAR.  Using that ratio we can back into the implied price of STHO:

At today's close, unless I made a dumb error (always possible), STHO shares are trading at roughly 40% of book value.  Shares could potentially get even cheaper after the spinoff occurs, STAR is a REIT and included in REIT indices, STHO will be a c-corp and will likely get sold by any REIT index funds (although the largest ones like VNQ now include non-REIT real estate companies as well) and it won't pay a dividend.  Owning real estate right now is a bit scary, but STHO's chunkier legacy assets are tied more to residential markets and we continue to have a shortage of housing in this country.

The management agreement is also worth calling out here, they've designed it to be a fixed fee versus a bps fee on assets, with the fixed amount going down each year to reflect the intention to liquidate over a 4ish year period.  Many externally managed entities will trade at a wide discount because the assets inside the holdco will never make it back to the shareholders, here the discount should narrow overtime as the assets are monetized and proceeds are used to either paydown debt or distribute back to shareholders.
Management Fees and Expense Reimbursements
We do not maintain an office or employ personnel. Instead, we rely on the facilities and resources of our manager to conduct our day-to-day operations.
We will pay our manager an annual management fee fixed at $25.0 million, $15.0 million, $10.0 million and $5.0 million in each of the first four annual terms of the agreement, and 2.0% of the gross book value of our assets thereafter, excluding the Safe Shares, as of the end of each fiscal quarter as reported in our SEC filings. The management fee is payable in cash quarterly, in arrears. If we do not have sufficient net cash proceeds on hand from sales of our assets or other available sources to pay the management fee in full by the original due date of the management fee, we will pay the maximum amount available to us by the original due date and the remaining shortfall will be carried forward and be paid within 10 days after sufficient net proceeds have been generated by subsequent asset sales to cover such shortfall in full; provided that in no event may such shortfall in respect of any fiscal quarter remain unpaid by the 12 month anniversary of the original due date.
I went synthetically long STHO this week by shorting out 0.15 shares of SAFE for each share of STAR.  You could also go one step further and short out the SAFE shares that STHO will own. 

Disclosure: I own shares of STAR and short shares of SAFE (synthetically long STHO)

Friday, March 17, 2023

PFSweb: Updated Thoughts After Sell Off

What a wild week in markets.  I'm finding plenty of new ideas, unfortunately don't have enough dry powder to throw at them all.  Instead, I'm going to re-highlight PFSweb (PFSW) ($87MM market cap) as a boring business that shouldn't be impacted by bank or market stress trading at an extremely low multiple while also pursuing a sale.  PFSW is a third-party logistics company primarily providing online order fulfillment services for 100+ retail brands.  In 2021, PFSW came on my radar when they sold a large business unit and were continuing to pursue strategic alternatives for the remaining 3PL business.  M&A markets have slowed since then but they're still guiding to wrap up the process sometime in 2023.  To be fair they could end up remaining public and pursuing a go-it-alone strategy but their posture has been a sale.  In PFSW's recently updated investor deck (whole thing is worth a look if you're interested in the idea), they lay out the following options:
#2 scares me a bit as it sounds like what ADES did, but PFSW already distributed most of their cash to shareholders in a special dividend last year, they don't have a huge cash balance burning a hole in their pocket.

Providing 3PL services to the retail industry, you'd expect PFSW to be in the midst of a covid hangover similar to UPS/FDX or Amazon, but the company has continued to grow on top of their covid gains and are similarly guiding to 5-10% revenue growth and 6-8% standalone EBITDA margin in 2023 (on their recent conference call, 2023 is off to an "very strong start" and later a "phenomenal start").  They also provide their estimate of public company costs of 2% of revenue that could be eliminated by either a strategic acquirer or if the company was taken private.  Following the 2021 asset sale and special dividend, PFSW has a clean balance sheet with $30MM in net cash.
The above is using the standalone EBITDA guidance (full corporate overhead), if we use the ex-public company cost guidance it naturally looks even cheaper.
A popular 3PL is GXO, a recent spin of XPO Logistics, GXO is a much larger, more scaled and diversified business, but it trades at 13x 2023 EBITDA guidance levels, well above PFSW that is under 4x EBITDA.
PFSW reported earnings on the 14th, its down about 30% since then despite no negative news coming out of the earnings report or the conference call.  My guess is either someone is getting liquidated, this is a relatively illiquid stock, or the revenue guidance is getting picked up by data aggregators as a significant decrease.  PFSW had a quirky contract where their GAAP revenue was distorted higher, but that ran off last year, their GAAP revenue will now match their previously reported "service fee revenue".  

The sale process has dragged on longer than anticipated, they wanted to dress up the company for sale and by the time the makeover was done, the markets have changed just a bit.  There should buyers for this business, dozens of private 3PL providers would make strategic sense and plenty of middle market PE shops that could also be interested.

Disclosure: I own shares of PFSW and calls

Friday, February 24, 2023

Sculptor Capital Management: Boardroom Fight, Cheap Stock

Sculptor Capital Management (SCU) (~$500MM market cap) is probably more familiar to most by their old name, Och-Ziff (OZM was the old ticker) or OZ Management, but the storied hedge fund manager (one of the first alternative managers to publicly list pre-GFC) has run into tough times in recent years.  There was a bribery scandal in the mid-2010s that saw the firm pay over $400MM in fines and in more recent years a public succession spat between founder Daniel Och and current CEO/CIO Jimmy Levin over Levin's pay package.

Sculptor today has approximately ~$36B in assets under management, roughly half of which is in CLOs that have lower management fees, with the rest in a mix of their flagship hedge fund, real estate and other strategies.  The publicly traded entity is a holding company that owns partnership units in the operating partnership (see the below diagram) which creates confusion around the share count and ownership percentages of the parties involved.

Och left the company in 2018, but continues to own a piece of the operating partnerships and controls ~12% of the vote (Levin has ~20% of the vote) through the B shares.  B shares don't have any economic interest in the publicly traded holding company, but are meant to match the economic interest in the operating partnership (if you squint, its one share one vote), if you see it reported that Och owns less than 1% of the company, that's just the publicly traded SCU shares.  He's presumably still a significant owner of the business, which makes the current situation awkward and certainly doesn't help capital raising efforts.  Och doesn't want Levin running what he views has his company, and Levin doesn't want Och owning a piece of what he views as his company.

In October, Och sent a letter to the board, the key excerpt:

I, as well as other founding partners, have been contacted by several third parties who have asked us whether the Company might be open to a strategic transaction that would not involve current senior management continuing to run the Company. It is not surprising that third parties would see the potential for such a transaction given that outside analysts have previously identified the Company’s management issues and concluded that, at its current trading price, the Company may be worth less than the sum of its parts.

Shortly after, Sculptor's board responded that they're always open to third party offers.  The back and forth went on from there, on 11/18 the board formed a special committee, presumably there's an effort being made to either sell the management company in whole to a third party or Levin taking it private and out of Och's hands, or possibly some combination where the CLO business gets sold to a third party and the remaining business is taken private.

What might it be worth?  The financials are pretty confusing here, there's a lot of operating leverage in the business, high fixed costs in the form of large minimum bonuses, the business isn't one you'd consider being run for the shareholders first.  Last year was a tough year, the flagship fund finished down mid-teens, but a few quarters back, Levin outlined the following "run-rate" expectations for the business:

Today, we have meaningful earnings power, and we generally think about this in 2 buckets. First bucket, management fees less fixed expenses or, said differently, earnings without the impact of incentive income and the variable bonus expense against that incentive income. And the second is inclusive of that incentive income and that variable bonus expense against it.

So in the first bucket, we look at it as management fees less fixed expense, and this went from a meaningfully negative number to what is now a meaningfully positive number, and that's the simple result of a couple of things. It's growing management fees while reducing or maintaining fixed expenses. And the growth in the management fees comes from the flow dynamic we discussed, and it comes from compounding capital within our evergreen funds. And so where that leaves us today is just shy of $1 of earnings per share from our management fees less fixed expenses.

Alternative managers are typically valued on base management fees, incentive fees are often lumpy and shared heavily with the investment team.  If we're trying to derive a private market value, $1/share of management fees is a nice round number to use.  Most alternative managers trade for a high-teens multiple of management fee earnings, but we'll discount SCU here to 10x to account for the hair and past reputation.  Also a third-party might be worried that assets would flee without Levin in the CEO/CIO seat.

Sculptor's balance sheet is in fairly good shape, with $250MM in cash and ~$150MM in investments in their funds, backing out the remaining $95MM term loan gets you to $306MM of net assets.  Putting it all together, I get something around $15/share for SCU versus a current price below $8.50.

I'm over simplifying things here, I could be making an obvious error, but the current structure doesn't seem to work for Och, Levin or the business.  Some corporate action needs to happen and there's plenty of candidates that would be interested in this business.  If the status quo prevails for some reason, the stock seems cheap anyway, the company seems to agree as well, they have spent $28.2MM of a $100MM stock repurchase authorization (significant compared to the Class A float) as of their Q3 earnings.

Disclosure: I own shares of SCU

Talaris Therapeutics: Trading Well Below Cash, Strategic Alternatives

Talaris Therapeutics (TALS) (~$79MM market cap) is another failed biotech that recently announced they are pursuing of strategic alternatives after discontinuing a phase 3 trial and a phase 2 trial for their cell therapy intended to help those with kidney transplants.  Talaris hasn't completely raised the white flag, but close, they are still enrolling patients in another phase 2 trial, this time for scleroderma, and only laid off one-third of their workforce (112 employees as of the last 10-K).  However, Talaris is trading well below cash even in a conservative 4 quarters of cash burn scenario, any hint of a liquidation or other corporate action could spur the shares higher.

Talaris disclosed in their recent 8-K that they had $181.3MM in cash and securities remaining.  Using the implied Q4 cash burn rate for the remainder of 2023, I get a proforma net cash amount of $129.3MM against a current market cap of $79MM.  One benefit here is the presence of Blackstone's Life Sciences arm (Clarus Ventures) which owns just under 20% of the shares, hopefully enough to look out for shareholder value during the process.

Disclosure: I own shares of TALS

Saturday, February 11, 2023

Oramed Pharmaceuticals: Trading Well Below Cash, Strategic Alternatives

Oramed Pharmaceuticals (ORMP) (~$85MM market cap) is a biotechnology company that has a platform designed to reformulate injections/vaccines into orally administered drugs.  Their furthest along asset is ORMD-0801, orally administered insulin for diabetes patients, it recently did not meet its primary or secondary end points in their Phase 3 trial.  Previously, Oramed had been guiding to a 2025 anticipated FDA approval for ORMD-0801, given this sudden failure, the stock naturally dropped considerably on the news.  Then on 2/9, the company announced they were "examining the Company's existing pipeline and conducting a comprehensive review of strategic alternatives focused on enhancing shareholder value."  In addition to the diabetes trial, Oramed does have an ongoing Phase 2 trial for ORMD-0801 in patients with NASH, a liver disease without an approved FDA treatment.  Lastly, Oramed owns 63% of Oravax, a joint venture that is pursuing an orally administered COVID-19 vaccine and other applications of an oral vaccine.

Doing the same math as MGTA, below I took the 9/30 cash and subtracted four quarters of their cash burn (including the $1MM/quarter in interest income) since they're earlier in their busted biotech lifecycle, i.e. they haven't let go of their workforce (couldn't find the employee count in their filings, but Oramed only has 16 employees on LinkedIn) and haven't shutdown their other trials.  On the plus side, they only have a minimal lease obligation here, making it a bit of a cleaner balance sheet.

The same risks apply to ORMP as the rest of the busted biotech bucket, the company may decide to double down on their remaining pipeline, do a poorly received reverse merger, etc.  But the discount is significant and there might be some salvage value to their intellectual property.  

Keep in mind, I own all these in all small sizes, they're low conviction individually but I think should do well as a group.

Disclosure: I own shares of ORMP