Ashford Inc: New Trend of "Externalizing" Management

Ashford Inc (AINC) is the asset management spinoff of Ashford Hospitality Trust (AHT) that a reader recently alerted me to, so I did some digging and while I don't think it's particularly appealing at current levels, it could provide some insight into similar upcoming spins/breakups at American Capital Ltd (ACAS) and Prospect Capital (PSEC), both BDCs, which are also spinning off their asset management businesses.  Most corporate governance groups and investors would prefer to see REIT/BDCs internalize management, but now there is this new trend to externalize management with asset management spinoffs, not something that happens at market bottoms.  External asset managers have a number of potential conflicts with the entities they manage, what's good for AINC shareholders (AUM growth) may not be best for AHT shareholders if they end up over paying for growth or issuing shares/debt at less than ideal levels.

In November 2013, AHT spun-off its luxury hotels into a separate entity Ashford Hospitality Prime (AHP) in an effort to obtain a premium valuation and a lower cost of capital.  As part of the AHP spinoff, AHP entered into an external management agreement with a subsidiary of AHT which laid the groundwork for the AINC asset management spinoff.  Ashford Inc (AINC) was then spun-off on 11/12/14 with an odd 1 share of AINC for every 87 shares of AHT ratio, it started trading in the mid-$40 and quickly traded all the way up to over $130 (quick triple for some) a share with CEO Monty Bennett buying in the open market along the way.  It's now trading around $93.

Ashford Inc currently manages the Ashford complex's two REITs (AHT & AHP) on 20 year contracts and is in the process of setting up a real estate focused hedge fund under the Ashford Investment Management banner which will be 40% owned by Monty Bennett and one of his lieutenants.  They're also interested in a few future growth platforms as shown below:

Asset management companies are of course great businesses, they have substantial operating leverage with minimal capital expenditures, a small increase in AUM can disproportionately increase earnings in a hurry.  What makes Ashford more attractive than other small cap asset managers is their capital is essentially permanent, while their market caps can certainly decrease, Ashford's REITs won't be subject to outflows like a traditional mutual fund manager in a market decline.

The spinoff wasn't without some controversy, labor union UNITE HERE staged some opposition to the transaction by creating a website (http://www.unlock-ashford.org/) outlining some of the real or perceived conflicts of interest created by the structure.  Ashford also instituted a poison pill that expires in March and has a staggered board, both anti-shareholder friendly, which was picked up by the Wall Street Journal on Monday. 

Ashford Hospitality Trust (AHT) & Ashford Hospitality Prime (AHP)
Ashford Inc is really a leveraged bet on the growth (and to an extent the performance) of both AHT and AHP as Ashford will be paid a 70bp base fee on the total enterprise value (but including cash) and an incentive fee based on the relative stock performance versus a peer group for both entities (determined annually but paid over three years), so it makes sense to analyze each briefly.

AHT considers itself an opportunistic hotel investor, having a wide mandate to invest across sector subclasses and across the capital structure.  It also utilizes significantly more leverage (both debt and preferred stock) than the average REIT, and is quick to refinance non-recourse mortgages to raise cash as it did recently.  Management likes to tout their 19% insider ownership at AHT as a method of aligning shareholder interests, and there seems to be some truth to that as AHT was savvy during the financial crisis and was able to repurchase a substantial amount of their float at advantageous valuations.  Including cash, the enterprise value of AHT is around $4.2B.

AHP on the other hand is marketed as the lower risk, higher quality portfolio compared to AHT.  At the time of the AHP spinoff they articulated a clear strategy of targeting hotels with RevPar (revenue per available room) of at least two times the national average and located in major gateway and resort market.  AHP will also have a  lower debt profile than AHT, with a target of 5x EBITDA by the end of 2015 and going forward.   Ashford also recently announced a share repurchase plan at AHP, again something you wouldn't expect if you're extremely cynical about external management.  They plan to sell one of their hotels and buy back shares, essentially reversing the private/public arbitrage that REITs generally exploit.  Including cash, the enterprise value of AHP is around $1.4B.

I didn't spend too much time on the above table (so don't trust every number), but compared to peers, both look slightly undervalued on a relative basis and not particularly expensive on an absolute basis.  However, Hotel REITs are a risky bunch that should trade at a discount to other REITs, their leases are the opposite of the triple-net lease industry in that their "leases" are extremely short term (overnight) in nature, meaning in a recession earnings can evaporate pretty quickly.

Valuation
The pro-forma financials in Ashford Inc's propectus are pretty messy and I'm not sure they really tell us a whole lot about what the future operating performance will be.  For instance, proforma 2013 numbers indicate an operating margin of just over 10%, extremely low for an asset manager, should be more in the 30-40% range and I would expect the company to right size costs as a standalone entity.  Let's approach valuation another way, a common valuation metric for asset management companies that I've seen is 10x pre-tax earnings, not entirely sure of the origin, but it seems reasonable to me.  Using that as a yard stick, I backed into what the market is currently pricing in as their pro-forma operating margin and an implied AUM figure below:

So it appears that the market is a little ahead of itself or expecting a lot from Ashford's hedge fund effort and their incentive fees.  While I'm passing on AINC for the time being, it's been an interesting exercise and as a result I'm going to be taking a closer look at both the ACAS (the management company will keep the NOLs) and PSEC asset management spins coming in 2015.  Are there any others to keep an eye on?

Disclosure: No Position

Year End 2014 Portfolio Review

The back half of 2014 was a wild ride for my personal account, I was up almost 30% at the half way mark of the year and at one point in the fall I had lost all my paper gains for the year.  I sold most of my mistakes in energy (Civeo, Paragon Offshore and to lesser extent Ultra Petroleum) and with a little luck the market perked back up salvaging much of what I gained in the first half.  But onto the results, there were no deposits or withdrawals into the blog portfolio during the period:

Another good year, and I'm pleased to keep my lifetime-to-date IRR above 20% which is my goal over the course of the market cycle(s).  I really enjoy the investing process over the proceeds, but if I'm not out performing, might as well consolidate my holdings into index funds and focus more time/energy on my day job.  Moving to 2015, my aim is to reduce the number and impact of my mistakes, which will likely mean fewer trades and potentially more diversification, but I'll continue to highlight interesting ideas for the blog, even if they don't make it into my personal account.

Below is breakdown of the attribution of each holding during the year to my performance, which is interesting at least to me, the grayed out holdings were closed out during 2014:

And then below are my current holdings as of end of day 12/31/14:

Additional Miscellaneous Thoughts:
New Media vs News Corp
Missed the opportunity in New Media (NEWM), Fortress has executed nicely on their plan to rollup small local newspapers and basically doubled this year.  I might have to change my strict rule against third party management agreements to just a higher hurdle to overcome.  I picked the wrong horse in the newspaper spinoff crowd (at least in the short term) with News Corp (NWSA), it's my lowest conviction holding currently, while incredibly cheap on a sum of the parts basis, shareholder returns don't seem to be their top priority.  If you listen to CEO Robert Thompson on any of their quarterly calls, its more about story telling, empire building and self promotion than actual business results.  I like their assets, but may find a better use for this cash soon.

Civeo Corp
Obviously was a disastrous investment for me, I got a little too excited with REIT conversions and then add the spinoff dynamics with a couple respected hedge funds backing it... turned out to be peak everything in one.  Luckily I trimmed some of my position in July at $26.50, but still took a big hit with the downgrade in guidance and rejection of the REIT conversion, and sold everything in October at $12.00, was lucky to avoid the next leg down this week.  There's some good discussion in the comments section of my two posts on Civeo, could be an interesting addition to a basket trade of washed out energy names in 2015.  Not that I'll likely be participating, need to recalibrate my ability to take the market temperature in commodity industries, have some work do before I'd feel like its in my circle of competence again.

NOL Shells
I like the NOL theme right now, most of these companies seem below the radar (or restricted) of larger hedge funds/other investors, and a less crowded theme than spinoffs.  I've highlighted a few this year in Green Brick Partners (GRBK), MMA Capital Management (MMAC), Par Petroleum (PARR), Tropicana Entertainment (TPCA), and Cadus Corporation (KDUS).  Others that I'm looking at and might blog about in upcoming posts include Signature Group Holdings (SGGH), WMI Holdings (WMIH), and Special Diversified Opportunities (SDOI); Signature has made it's operating company purchase and WMIH and SDOI are still looking at potential acquisitions.

Thank you to everyone for reading and happy new year.

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.

Tropicana Entertainment is Still Cheap

It's been a little over a year since I've discussed Tropicana Entertainment on the blog and a lot has happened during that time, but you wouldn't know it if you look at TPCA's stock chart which has done almost nothing for two years now.  The illiquidity of the shares is a good mental exercise, it's the equivalent of investing in a private company and you need to look through the stock price feedback loop and analyze the results to determine how the company is really doing.  I've discussed Tropicana in the past (here and here), but to briefly recap it's the Carl Icahn controlled gaming company that emerged from bankruptcy in 2010.  The company owns 7 casinos mostly in drive up markets across the United States and a small temporary casino located in Aruba.  At this point the company is substantially undervalued as moves they've made are starting to pay off and troubles in the industry could yield future acquisition opportunities.

Atlantic City
Atlantic City has been a mess for years now, the root of the problems stems from increased competition along the east coast, particularly starting in 2006 when the first casino opened in Pennsylvania.  Previously Pennsylvania residents would travel across the border and spend money in Atlantic City casinos, now Pennsylvania has passed New Jersey to be the second largest gambling revenue state behind Nevada.  Maryland has a bunch of new casinos opening up too and Massachusetts just granted a couple casinos licenses, competition is not going to let up anytime soon, and thus the Atlantic City market has been forced to shrink dramatically.  We started 2014 with 12 casinos in Atlantic City, 4 casinos have closed so far (Trump Plaza, Revel, Showboat, and Atlantic Club) and the Trump Taj is likely to make it 5 when it finally shuts its doors in the next month or two (Icahn is Trump Entertainment's largest creditor).

The decreased competition has increased foot traffic at Tropicana's flagship Atlantic City casino and resort.  The company made a savvy purchase of Atlantic Club's patron database and gaming equipment that has led to increased slot customer volumes (the most predictable kind of gaming revenue).  While overall Atlantic City gaming revenue declined 9.3% across the city, Tropicana's casino revenues were up $21 million in Q3 2014 or 33% compared to Q3 2013.  New Jersey has also approved the use of $18.8 million in CRDA deposits (otherwise basically restricted cash) and $4.8MM in grant money through the New Jersey Economic Development Authority to invest in the Atlantic City casino, all in, Tropicana is going to spend nearly $40MM upgrading the property while weaker players have been putting off capex and exiting the market.  Previously seen a source of risk, the Tropicana Atlantic City has the potential to provide continued upside surprises as the AC market rebalances itself.

Another piece of good news happened this past January when the company received $32MM in cash as part of their property tax dispute with the city, previously it was going to be in the form of annual tax credits going out to 2017.  A lot of this money will go to upgrading the Atlantic City property, but it also skews the first quarter results so keep that in mind when running your own numbers. 

Real Estate Value
Most gaming companies have extensive real estate holdings, and in today's market that means activist pressure to re-evaluate capital structures and spinoff the real estate into a REIT.

• Penn Gaming (PENN) did a PropCo spinoff of their real estate assets in November 2013 which created Gaming & Leisure Properties Inc (GLPI), a REIT that triple net-leased backed the casinos to Penn Gaming and is pursuing additional acquisitions.
• Pinnacle Entertainment (PNK) announced plans to spinoff its real estate into a REIT on 11/6/14, activist Orange Capital had been pushing Pinnacle for a REIT conversion since Penn completed the GLPI transaction.
• Boyd Gaming (BYD), owner of the Borgata in Atlantic City, discussed the possibility of a REIT conversion on 10/30/14 and engaged Greenhill as an adviser.
• Caesars Entertainment (CZR) announced on 11/18/14 that they've approached their senior lenders about a plan to convert the company's 44 properties (including several in Atlantic City) into a REIT in order to help their over leveraged balance sheet.  Caesars is a distressed play at this point, and the REIT conversion would likely be part of a bankruptcy reorganization.

A REIT conversion is not an option for Tropicana (but maybe a sale leaseback?) as Icahn's controlling position would violate REIT ownership rules (no one can own more than 10%), but none the less exposes the value in their real estate and signals M&A activity in the sector.  Tropicana has a flexible balance sheet, with net debt of only 1x EBITDA, Tropicana has the ability to leverage up and potentially buy up weaker competitors or end up buying the operating casinos after they've split off the real estate.  As part of these REIT conversions, each company will be evaluating their casino portfolios and looking to sell assets that don't meet their new strategy for one reason or another.  I could see Tropicana as part of it's rollup strategy and strong balance sheet being a natural acquirer in 2015.

In addition to owning most of their casinos, Tropicana also owns some other real estate assets including the two luxury hotels in St. Louis that were part of their Lumiere purchase, the HoteLumiere and the Four Seasons, the replacement cost is likely in the $150-200MM range for the combination of the two.  They also own "The Quarter" adjacent to their Atlantic City casino, a 200,000 square foot Havana-themed mixed retail development featuring shopping, restaurants, nightclubs and an IMAX theatre, the development cost $285MM to build in 2004, even if its worth just a fraction of that, its still significant when compared to Tropicana's $520MM enterprise value.

Valuation
The best comparable private market value transaction is still the December 2012 purchase of Ameristar by Pinnacle Entertainment for $2.8 billion including the assumption of debt for a 8.4x EBITDA multiple.  But Icahn Enterprises (IEP) makes it a little easier coming up with a value by publishing a quarterly NAV estimate which gives a valuation for Tropicana at 7.5x EBITDA, about a turn lower than it's larger more liquid peers which seems appropriate.

At 7.5x EBITDA, Tropicana would be worth $27 per share, or about 80% higher than the $15 its trading for today.

Of course, we're tied to the hip with Icahn (plus its only a small fraction of IEP) as minority investors and might not see that valuation unless there's a liquidity event.  But I also think there's plenty of potential for additional upside, we might start to see improved wage growth in 2015, and in combination with lower gas/energy prices should increase discretionary incomes in Tropicana's middle class demographic market.  It might be a stretch, but just maybe with the economic recovery picking up steam, states and municipalities budget's could improve enough to not turn to casinos revenue to plug holes and restore some sanity to the competitive landscape.  Even if you have a more cynical view of the industry landscape, Tropicana's valuation provides a nice margin of safety with the benefit of having Carl Icahn, an experienced gaming investor, making the capital allocation decisions and hopefully unloading it at a cyclical top.

Disclosure: I own shares of TPCA

ATK's Sporting Division Spin: Vista Outdoor

I have made a few mistakes this year in spinoffs, particularly energy related ones like Civeo and Paragon Offshore (washed out/sold out of both) that looked cheap using past earnings but their futures have been brought in question with the quick drop in oil prices.  An upcoming non-energy spinoff, but also one with a potential cyclical earnings top is Vista Outdoor, the ammunition and hunting accessories business of Alliant Techsystems.  So before following me into another spinoff consider that risk up front.

Alliant Techsystems (ATK) has three main lines of business: aerospace, defense, and sporting goods.  In February 2015, the sporting goods business ("sporting goods" might be a stretch, really ammunition, guns, and hunting accessories with grander plans to diversify) which makes up 39% of ATK's revenue will be spunoff as Vista Outdoor (VSTO) to ATK shareholders, and the remaining aerospace and defense businesses will be merged via a Morris Trust transaction with fellow aerospace and defense contractor Orbital Sciences (ORB) immediately after to form Orbital ATK (OA).

Quite a few moving parts, but let's focus on Vista Outdoor.  Starting in 2001, ATK entered the sporting business with the acquisition of Blount International's ammunition group, and recently added BLACKHAWK! in 2010, and firearm manufacturer Caliber and accessories maker Bushnell in 2013.  All rolled up, Vista Outdoor will be the number one provider of ammunition for various markets, and then also sell hunting accessories, rifles, gun cleaning products, targets, tactical accessories, goggles/glasses, and range finders.  Below is a slide from their investor presentation to give you an idea for their product offering:

The sporting business has seen 15% annual growth for a decade, spurred on even more recently with the "surge" in gun demand due to the real or perceived threat of tighter gun controls under the Obama administration.  Only about 10% of their revenues are firearms, so think of Vista Outdoor as more the razor blades piece in the razor/razor blade analogy business model.  With the rise in number of guns purchased in recent years, the number of potential customers for Vista to sell ammunition and accessories into has also increased (also good demographics, young males, more females coming into the sector, etc).

Transaction Details
On April 28, 2014, ATK and Orbital Sciences entered into a deal in which ATK would spinoff Vista Outdoor first, and then merge with Orbital Sciences to form Orbital ATK, original ATK shareholders will own 53.8% of the new company, with Orbital Science's shareholders receiving the other 46.2%.  The deal was originally scheduled to close this year, but has been pushed back to February 2015 pending shareholder approval on 1/27 due to a rocket launch failure at Orbital (more on that in a bit).

What really makes this transaction work is both entities should be better off afterwards, I don't see a dump transaction taking place here.  Orbital trades at a significant premium to ATK, so this deal should be accretive to Orbital shareholders.  Institutional and long term investors in ATK should also end up sticking with the new Orbital ATK, ATK has been a defense and aerospace contractor first and foremost for its history, and the new company will remain in the same industry/market cap indexes.  The typical spinoff forced selling dynamics don't appear to be at play here.  There should also be a number of operational and financial synergies in the new Orbital ATK, the two appear to have a lot of complimentary business lines, natural fit between the two companies that should result in both cost efficiencies and revenue synergies.

ATK's CEO Mark DeYoung will be coming over to Vista Outdoor, he's been with ATK since 1985, well before they entered the sporting business space.  He lead the push towards sporting and his move to the spinoff is a further sign that Vista is really the crown jewel asset and not a dump transaction.  I believe it should end up with a premium market multiple as a niche consumer staple company over the old ATK which as a defense contractor has seen its margins and multiple contract in recent years.  Vista will also have limited debt, just $350MM in net debt, or about 1x EBITDA giving it flexibility to make additional acquisitions to diversify away from guns and ammo.  ATK acquired Bushnell in 2013 for $935 million in debt (10x EBITDA purchase price), interestingly most of the debt associated with the deal is going to end up on Orbital ATK's balance sheet making the spinoff even more attractive.

Antares Launch Failure
On October 28th, Orbital Sciences had an Antares rocket explode spectacularly on live TV 14 seconds after launching from NASA's Wallops Flight Facility in Virginia.  The rocket is contracted to provide periodic supplying trips to the International Space Station for NASA, although a significant reputational loss, insurance proceeds are supposed to minimize the financial impact of the launch failure.  Both Orbital and ATK's shares took a 10-15% hit in the aftermath of the failure as there was concerns the deal would fall through, but both sides have agreed to continue, yet the shares have only partially recovered providing an opportunity to buy Vista Outdoor synthetically even cheaper since the rocket business has no relationship with the sporting business.

Valuation
In the first six months of ATK's fiscal year (starting 4/1/14), the sporting business has done $1.1B in sales, annualizing that figure gets you to $2.2B for the year which is slightly below management forecasts of $2.3B at the time of the spin announcement.  Using a 13% EBIT margin and $73MM in annual depreciation, I come up with roughly $360MM in EBITDA.  After interest expense and a 35% tax rate, Vista should have about $5.50 per share in projected earnings.  What is the market currently valuing Vista at?

Below is a quick comparables table I built using other mid-to-large capitalization defense and aerospace contractors.  If we assume the new stronger Orbital ATK trades at a peer average of 8.5x EBITDA and a market multiple of 15 (and roughly between where ATK and Orbital trade separately), my math shows the current share prices of Orbital and ATK essentially reflecting those valuations. 

By piecing out ATK, and backing out the Ortibal ATK position, the market is currently valuing VSTO at $53.59 per share, just under a 10 P/E or 5.7x EV/EBITDA.  That's pretty cheap for a company with a double digit long term growth rate, but that comes back to the question of peak earnings?  Management thinks the slowdown in the gun market should reverse itself in the back half of 2015, there's a decent amount of data to back that up (Black Friday had record gun sales), but just from a big picture viewpoint I can't see America's love affair with guns fading anytime soon?  But I could be wrong.

I struggled a bit on how to put this position together, the ATK options look a little expensive to my untrained eye, and by my math Vista Outdoor is really the undervalued entity, one can go long 1 share of ATK and short 2.23 shares of ORB to synthetically create a long position in VSTO ahead of the transaction.  So that's what I did today, the short ORB will cancel out the shares in OA I receive and will leave me with just the VSTO shares if/when the transaction is completed in February.  Within a few months, I would expect VSTO to be trading much higher than the mid-$50s.

Hat tip to a reader who brought me this idea.

Disclosure: I'm long ATK / Short ORB (synthetically long VSTO)

Follow-Up on Green Brick Partners

I haven't posted in a while, been mostly idle the last month or two, but I thought I'd sum up some additional thoughts on Green Brick Partners now that the deal has closed, 9/30 proforma results came out, and the company hosted its first conference call as a home builder.

The headline Q3 results were down across the board, but with a relatively small home builder, I think it's safe to expect lumpy earnings results quarter to quarter.  With maybe only 25% of the shares outstanding in the float, Green Brick is essentially a private company and can be managed in a way that puts the long term results ahead of meeting estimates and smooth out earnings.  I was a little surprised to see as part of the deal closing that Green Brick took down the entire $150MM expensive term loan from Greenlight, but that gives the company approximately $40MM in cash to grow the business, especially in its two large communities coming online in 2015.

Below is the breakdown of the company's communities and lot position as of the S-1:

25% of the company's assets are in the Twin Creeks and Bellmoore Park communities that come online in 2015 and have a 6-8 year build out runway.  Additionally, there are several mid-sized communities debuting in Atlanta next year that add up to a little more than another Bellmoore Park.  In total, 75% of their lot inventory is in communities that will start delivering in 2015, making the initial 50% revenue jump buried in the company's management projections seems more plausible.

But with that said, the current stock price looks a bit stretched, based on the proforma numbers, Green Brick has a book value of about $156MM with a full allowance for the deferred tax assets, so at $8.85 its trading for 1.7x book, a little rich.  Or if you assume a 15x earnings multiple, the market is baking in $0.59 per share, which is a little higher than my adjusted earnings estimate I made in September that included cost cuts, term loan refinancing, etc., so the market is likely a little ahead of itself there as well. 

Jim Brickman
The other interesting piece of this story is Jim Brickman.  Being backed by Greenlight and Third Point will entivably generate some headlines, but Jim Brickman is really the jockey we're betting on, so who is he?  Back in 2002, David Einhorn presented a short thesis on Allied Capital, a large BDC that had a lot of toxic assets hidden underneath the surface, but still managed to pay a high dividend and attract a loyal retail investor base.  David Einhorn ended up writing a book "Fooling Some of the People All of the Time" about his journey as a short seller in Allied, in the book Brickman plays a central role as he independently researched Allied and came to similar conclusions regarding their faulty asset base.  Below is the way David Einhorn introduced Brickman:

"However, a benefit of publicly discussing Allied was hearing from others.  Jim Brickman, a retired real estate developer from Dallas, introduced himself by e-mail.  Someone had pointed him to Greenlight's analysis because of his background in SBA lending... Brickman's e-mail began a long dialogue.  While I've spent more time on Allied than I can quantify, Brickman has spent much more; he is retired and his kids have grown.  As he sees it, "These people believe they are above the law."  He has become an expert at searching public records, analyzing information, and has been a major collaborator in identifying problems at Allied and BLX.  He is one of the best forensic detectives I have ever met." p137-138

Brickman was also very active on the Yahoo! message boards detailing his findings on Allied, The Wall Street Journal picked up the story and wrote a front page piece about him in 2004: A Retiree in Texas Gives a Firm Grief With Web Postings

I'm an avid golfer, but I find the line about getting bored playing golf as an early retiree great, just the kind of person that I want to be invested alongside.  You also get the strong sense that he created JBGL/Green Brick very opportunistically, the financial crisis lead to such dis-allocations in the real estate market that he couldn't help himself but to jump back in and restart his career.  Says even more that a message board poster built a strong enough relationship with a highly respected hedge fund manager to seed him with millions of dollars to start JBGL/Green Brick.  Pretty fascinating story.

So that's probably it on Green Brick for a while, it's up 50% over the last couple weeks and is no longer obviously cheap, but with such a small float, I wouldn't be surprised to see it become a good value again, keep it on your watchlist.  I'm going to just hold my position for now as I don't like booking short term taxable gains this late in the year, but wouldn't fault people for selling some here.  I like the long term setup and could see Green Brick being acquired by a larger builder in a few years once the NOLs are used up and Brickman wants to retire again.

Disclosure: I own shares of GRBK

MMA Capital Update: New Name, Up-Listing, Still Cheap

MuniMae recently changed its name to MMA Capital Management (MMAC), instituted a reverse split and up-listed to the NASDAQ from the pink sheets.  I invested in MMA Capital back in the spring with the basic thesis centered around GAAP accounting obscuring some of the underlying value in this post crisis busted financial.  Read the old post for the background story, but a couple transactions have happened since March to move items from the "grab bag" asset pile to the easy to value pile making balance sheet adjustments a little more straight forward.

International Housing Solutions Equity Investment
MMA Capital operates a multi-family real estate asset management company in South Africa called International Housing Solutions (IHS).  IHS closed on their second multi-investor fund ($70MM) in the second quarter, and at the same time MMA Capital increased their ownership stake in IHS from 83% to 96% for $1.6MM.  The GAAP balance sheet doesn't give credit for IHS at all, and the company conservatively only adjusts for their own investment ($3.7MM) in the South African funds along with the company's equity balance ($1.2MM) in the management company.  This understates the value of the management company greatly, by taking the $1.6MM valuation for 13% of IHS and interpolating it over the 96% ownership stake and MMA Capital's equity in IHS should be closer to $11.6MM.  Add the $3.7MM fund investment, and the company's total SA fund investment line item is worth $15.34MM.

Tax Credit Equity Business to Morrison Grove
Today MMA Capital announced they sold their LIHTC funds business to Morrison Grove Management for $15.9MM.  This is the tax credit business that causes most of the accounting problems, and unfortunately those won't be going away as MMA Capital will still be on the hook for the investor yield guarantees.  However it does unlock the value of the business that was previously hard to quantify and wasn't on the balance sheet.  MMA Capital is providing seller financing for the entire amount, including a $17.3MM senior bridge loan and in $13MM subordinated debt for a total cash outlay of $14.4MM.  MMA Capital is providing the bridge loan so Morrison Grove can buy out certain outside ownership interests, the loan is due in December with penalties if extended.  But the end net effect will be additional net $15.9MM added to the adjusted NAV.  The company also negotiated an option to purchase Morrison Grove starting in 5 years time, so the company monetizes the business today and maintains some of the future upside.

Below is the adjusted balance sheet as of 6/30/14:

Using the reverse-split adjusted share count of 7.9 million, the adjusted book value per share is $9.25, well above its close today of $8.41.  If you make the additional adjustments for IHS and the Morrison Grove transactions, the adjusted book value is roughly $12.50 per share.  This doesn't include the $400MM in NOLs and their REO assets which could have significant value.  The company has also been repurchasing stock regularly with a maximum price of $9.60, every time they buyback stock below book they drive the NAV up even further.

So why didn't the stock price react on today's news?  MuniMae/MMA Capital was already a forgotten company, but with the name and ticker change it almost seems like very few people are still paying attention anymore.  The up-listing and reverse split could potentially widen the investor base, which should make it easier to raise capital to expand the business and monetize those NOLs.  Management has made admirable progress in 2014, and I think it's arguably cheaper now than it was back in March at prices 40% lower due to value highlighting transactions made recently.

Disclosure: I own shares of MMAC

BioFuel Energy (Green Brick Partners) Revisited

BioFuel Energy (BIOF) is a shell company with $181MM in net operating losses that I first toyed with in April as Greenlight Capital and developer James Brickman proposed the NOL shell buy JBGL Capital for $275MM in a convoluted transaction that many including myself misjudged.  Combining the star appeal of David Einhorn with the previously sexy BIOF ticker and a small cap float, the company became a favorite of day traders.  I let the price action and the craziness of others skew my view of how the rights offering math worked and the underlying transaction's value.

JBGL Capital is a residential land developer with 4,300 lots spread pretty evenly between the Dallas-Fort Worth and Atlanta markets.  They own a 50% interest in a few different home builders that operate in their communities, this appears to be a point of emphasis going forward as the home building margins are better than just straight land sales, but there is value in the hybrid model.  JBGL was formed in 2008 during the financial crisis and as a result doesn't have the legacy issues of other home builders, also much of the land on the books is likely understated.

To reiterate, the $275MM price tag will be paid as follows:

1. $150 million in debt financing provided by Greenlight, 10% fixed interest rate for a 5 year term with a 1% prepayment penalty during the first two years.
2. A rights offering of at least $70 million at a $5 offering price.  The rights trade under the ticker BIOFR, 2.2445 shares per right, expiring on 10/17/14.
3. Equity issuance to Greenlight/Brickman, this will ensure that Greenlight owns 49.9% of the shares following the rights offering and James Brickman will own 8.4% of the shares.
4. $8 million cash currently held by the company.

Additionally, Third Point agreed to backstop the rights offering and is expected to own 16.7% of the shares.  After the rights offering is completed 75% of the shares will be in the hands of essentially insiders (85% if you look at it on an enterprise value basis), these shares will be relatively restricted due to the NOLs, aligning insider interests with long term shareholders.  Real estate development requires smart capital allocation, and it seems to be a natural fit to have an asset manager like David Einhorn as the Chairman of the Board (see Bill Ackman at Howard Hughes).

Proforma Income Statement
Eventually the market momentum traders will exit and fundamental investors will move in and value the company based on its assets and earnings stream.  Below is the proforma income statement for the first six months of 2014, there are few items included in the proforma that are hiding the true earnings power of the new Green Bricks Partners (it will lose the BioFuel name after the transaction is finalized).

The SG&A at BioFuel Energy is overstated and double counted with JBGL this year as the company evaluates and goes through this reverse merger process, strip out $3MM there.  Additionally, the proformas are including a 40% income tax expense even though taxable income will be shielded by the NOLs for the foreseeable future, add back another $1.6MM.  Lastly, the interest rate on Greenlight's debt is above market and should be refinanced after Green Brick seasons a bit as a credit.  At a 7.5% interest rate, Green Brick would save $1.73MM over the six month time period. Making those adjustments and the proforma Green Brick Partners would have net income of $0.28 per share, or $0.56 per share annualized.  Even putting a 15x market multiple on Green Brick, and the shares could be worth ~$8.40.  Keep in mind that management has projected 50.4% revenue growth in 2015 creating additional potential upside as BioFuel transitions to Green Brick Partners and becomes valued as an operating company versus an NOL shell.

Duff & Phelps Fairness Opinion
Another fun piece of this transaction is the Duff & Phelps fairness opinion of the $275MM price tag for JBGL Capital.  Fairness opinions are used by boards as a CYA tool, almost always the adviser hired by the board will back into the price paid by cherry picking comps and adjusting the discount rates around to achieve the desired result.

I would argue that both the 14-16% discount rate is too high and the 9-10x net income terminal value is too low, using the lower end of both (16% & 9x) Duff & Phelps was able to back into the $275MM number.  Using more reasonable values would result in a much higher value for JBGL.

As I write this, BIOF is trading for $6.21 and BIOFR is trading for $3.03 (implying a $6.34 share price (2.2445*5+3.03)/2.2445)) making BIOF the better bargain, but the relationship has been moving around a lot so double check before making any decisions.  BIOFR also includes the possibility of an over-subscription allocation that could sweeten the pot a bit as well.  I didn't anticipate Greenlight putting such a valuable asset inside of BIOF, but in hindsight it does make sense as it needs to generate a lot of taxable income to monetize the NOLs and make the transaction worthwhile.

Disclosure: I own BIOFR, plan to fully subscribe to the rights offering

Par Petroleum: Zell Controlled + NOLs

Par Petroleum (PARR) was created through the reorganization of Delta Petroleum in 2012.  Sam Zell, via the Zell Credit Opportunity Fund, and Whitebox Advisors held significant stakes in the unsecured debt which were converted to equity in the reorganization preserving the $1.3B in net operating loss carry forwards.  Post reorganization, Par's assets included a minority stake in a natural gas E&P and NOLs, but the company is now focused on downstream assets with the stated strategy to "create ongoing, stable earnings capable of predictable monetization of NOLs."

Will Monteleone is the CEO, 30 years old, and receives a small base salary at Par, he also serves as an associate at Equity Group Investments where he oversaw the initial restructuring of the company and appears to be Sam Zell's main deal guy focused on the energy sector.  The company recently uplisted from the OTC to the NYSE, and the CEO has talked about engaging analysts a bit more to get the story out.  The financial statements are a bit of a mess, the company isn't currently profitable, but the platform is in place for management to make opportunistic acquisitions to where the future business is not going to look a whole lot like the current.  The three main assets currently are Hawaii Independent Energy, Piceance Energy, and then the large tax assets: 

Hawaii Independent Energy
In the summer of 2013, Par purchased a mothballed refinery on the island of Oahu from Tesoro Corporation for $325MM (including the working capital/inventory) plus up to $40MM in earn outs due to Tesoro if the 94,000 bpd refinery meets certain operating performance targets.  Included in the acquisition were some distribution and storage assets, along with a retail channel under the Tesoro brand name.  Par renamed the company Hawaii Independent Energy and has spent the last year or so reestablishing the asset in the marketplace.  Hawaii is a difficult location to compete, their refinery competes with others all across the Pacific and it's expensive to export refined products out of the islands due to its remote location.  Chevron operates the only other refinery in Hawaii, and announced today their plans to divest it due to its "somewhat isolate and finite market".

Due to this isolated market position, it makes sense to find additional ways to sell their product within Hawaii, to that goal they announced the acquisition of Mid Pac Petroleum in June for $107MM.  Mid Pac operates or owns over 80 retail sites and four terminals across Hawaii, and 22 of the retail locations are fee-owned (although partially encumbered by debt), which is a nice added perk in Hawaii.  The Mid-Pac acquisition helps Par internalize the consumption, thus reducing reliance on exports.  Management put the margin improvement at $6-10 barrel on what they sell on island compared to what its exported.  Additionally, Par will receive both the retail and refinery margin for anything sold through Mid Pac's distribution channel.

It takes time to turnaround a business, they've had to re-engage the market there in Hawaii after Tesoro essentially exited the market 2+ years ago.  The company believes it will be profitable in this segment next year which should make it a little easier for the market to value.

Piceance Energy
Par Petroleum's main upstream asset is a 33.34% non-operated equity interest in Piceance Energy, a primarily natural gas focused E&P in western Colorado.  The majority owner/operator is Laramie Energy II, the first Laramie Energy was previously sold to Plains Exploration and Production (now part of Freeport-McMoRan) for $1B in 2007 (peak of the natural gas boom) after being setup for $200 million only a few years earlier.  They currently have a one rig program running, and management has hinted that results have been good, a previously required capital contribution was put off due to strong operating results at Piceance.  Using the NYMEX forward curve as 12/31/12, Par Petroleum interest in Piceance resulted in estimated proved reserves of 433.4 Bcfe with a PV-10 value of $291.6MM (this was the upper end valuation at the time).  In investor calls, Par is optimistic the next reserve report will be even better.

NOLs
The most interesting asset to me is the $1.3B in net operating loss carry forward captive inside Par Petroleum.  This will shield an awful lot of taxable income if they can turn the corner.  The company has large aspirations, the acquisitions they have made so far aren't large enough to move the needle much on their NOLs.  With Sam Zell's team at the helm, I would imagine they'll be pretty selective buyers and apply a value/distressed approach while meeting their target hurdle rate of 15-20% returns.

In order to pursue their rollup strategy and fund these acquisitions Par has been a serial issuer of rights offerings.  Rights offerings create an efficient way for the controlling shareholders to maintain their ownership percentage which is key to the NOL eligibility.  So if you own shares in Par, be prepared to re-up via a rights offering at least once a year for the next several. 

Conclusion
Besides Sam Zell and Whitebox Advisor, respected investors Lee Cooperman of Omega Advisors, Andrew Shapiro of Lawndale Capital, and Horizon Kinetics are also shareholders.  You'll see I haven't really discussed valuation at all, I struggle to put a specific value on Par Petroleum, but I feel its one of those situations where you don't need to guess someone's weight to know they're fat.  Par is setup to be a potential long term compounder as management pursues an ambitious roll-up strategy to monetize the large NOLs.

Disclosure: I own shares of PARR

Paragon Offshore: Cigar Butt Spinoff

Paragon Offshore (PGN) is a 'standard specification' offshore rig business that was spun off of Noble Corporation (NE) and began trading on 8/1/2014, standard specification in the offshore industry means old and shallow water.  Noble initially attempted to conduct an IPO of the unit, but later scrapped that idea in favor of a rushed spinoff that ended up putting $1.6 billion in debt on Paragon, but immediately improved the optics of Noble's fleet.  Noble CEO David Williams said on a conference call to analysts that without the spinoff, Noble's fleet would have an average age of 35 years by 2016, now that it has shed the older equipment, the average age is 13 years.  

Paragon is once again, your classic spinoff of the 'bad asset' business to make the parent company appear more attractive.  In these situations we can often expect investors who receive shares in the spinoff to sell indiscriminately.  Since Paragon began trading it has basically been a falling knife, down more than 50% as it has suffered both from spinoff dump dynamics and poor timing as clouds have formed over the offshore drilling market.  

The offshore drilling market, especially the deepwater market, can be thought of as the marginal oil supply.  As the onshore/fracking market has increased oil supply, the result has been a pullback in the development of more expensive offshore oil and gas plays by the national and independent oil companies.  At the same time, many offshore rigs that were ordered in good times are scheduled to be delivered in the next 1-3 years just as the market softens creating an excess supply of rigs, particularly in the deepwater segment.  Day rates for jack-ups have stayed fairly steady, but there's some concern that oversupply in the deepwater market will force some high-specification floaters to move down market and compete in the standard-specification market (where Paragon primarily operates) driving down utilization and day rates there as well.  There are 139 (or an additional 30%) new build jack-ups scheduled to be delivered through 2017, however some of these might never make it to market as more than half are being built by speculative non-operating buyers.  The bull case rests on shallow water demand being there, and supply being more spread out than it currently appears.

Paragon's strategy is to be a low-cost, efficient provider focused on the shallow market.  Management claims to have the "best of the old rigs out there", a fleet of 34 jack-ups and 8 floaters.  The main concern around Paragon's assets is the age of their rigs, the average is over 35 years old.  However, some context, the majority of their rigs are jack-ups designed for shallow water, the average age of rigs in that market is more than 25 years old.  Yes, Paragon's rigs are on the older end, but it's generally unfair to compare the fleet to a modern deepwater driller like Seadrill (SDRL) whose EV/Rig ratio is many multiples of Paragon's.  Additionally, Noble spent approximately $1.8B on Paragon's fleet since the beginning of 2010, including $900MM on the floaters where much of the backlog is and all of which have been rebuilt since 2009.

There also seems to be some concern around Paragon's $2.3B backlog, much of it rolls off by mid-2015 potentially exposing the company to the worst of the oversupply situation.

However, key markets like Mexico have been opening up their energy markets, thereby potentially increasing drilling activity there (mostly shallow water gulf drilling), and Paragon's management has guided that the 4 jack-up rigs in the Middle East which are idle are expected to be operational in Q1 (which matches up with what other competitors are calling a hot market in the Middle East).  Another concern is around the 4 floaters which are currently contracted out to Petrobras (with 2-3x the typical jack-up day rate), Petrobras has 29 floaters coming online which could force out Paragon's older floater rigs when they come up for renewal.  But as mentioned earlier, Noble rebuilt each one of these in the past few years, and hopefully they'd be able to place them with new clients with only moderate downtime or expense.

Capital allocation is a bit of a question market with Paragon being such a recent spinoff.  In the initial prospectus, Paragon guided to a $80-90MM annual dividend, at the mid-point, the current yield would have been 14-15%.  Today they announced a $0.50 dividend on an annualized basis, which is roughly half the original guided amount, but still a 7% yield that should attract income based investors.  It also gives management more room to maneuver and address some of the market's concerns about their fleet.  Another option for excess free cash flow is buying back some of their debt in the open market, it's currently trading at a fairly significant discount (80-90) making any buybacks immediately accretive to the equity.  Paragon doesn't have any new builds in the pipeline, but they have stated in investor calls they'd be open to being a buyer of distressed rig assets as well if the industry does experience a downturn.

Valuation
Paragon is in deep value territory assuming you believe it can survive the current cycle.  With a current market capitalization of $575MM and net debt of $1.61B, Paragon has an enterprise value of $2.19B, analysts estimate 2015 EBITDA at $767MM giving PGN a EV/EBITDA multiple of just 2.9x which is basically unheard of in today's market.  Hercules Offshore (HERO) is Paragon's closest peer, operating a number of standard-spec jack-ups in the Gulf of Mexico, trades at 4.7x EBITDA even in this depressed market for offshore drillers.  On a P/E basis, Paragon is expected to earn $157MM in 2015, for a forward P/E of 3.66x.

Even if these estimates are too high, if you cut the $827MM in EBITDA for 2014 in half to $413MM it's still trading at just over 5x EBITDA.  So the market is pricing in the worst, half the rigs working and at lower rates.  Liquidity shouldn't be an immediate concern either as their first maturity is a $650MM term loan due in 2021, and then two tranches of senior unsecured debt due in 2022 and 2024.  They also have in place an undrawn $800MM revolving credit facility at LIBOR + 2.00% if needed.

Risks:

• Paragon's rigs are old, even if well maintained, many will likely need to be retired or rebuilt in the next several years; scrap value for jack-ups = $5MM, floaters = $10MM
• High effective tax rate (50%) in 2014 and early 2015 due to poorly executed/rushed spinoff; Noble skimped on a few corporate structure items that would have delayed the spinoff, tax rate should be in the mid-20s by 2016
• Half of Paragon's contracts come up by Q3 '15; modern-high specification rigs may move down market if deep water market is oversupplied and complete with Paragon's standard specification rigs, driving utilization and day rates lower
• Petrobras has 29 floaters coming online, but repeatedly delayed; Paragon's floaters may not get renewed or have significant downtime in the future as they find new projects; 18% of Paragon's EBITDA is to Petrobras
• CEO Randy Stilley was previously at a similar standard-spec spinoff Seahawk Drilling, which went bankrupt and was liquidated (assets were sold to HERO) after the BP Macondo disaster disrupted Gulf of Mexico drilling
• Offshore drilling is extremely cyclical; stocks in cyclical industries look the cheapest at the top

There seems to be a lot of fear and concern around the offshore drilling industry, I'm honestly a relative novice in this sector, only really deep diving into it in the last several weeks, so do your own research here.  It appears to me that Paragon could be a classic "cigar butt" trade, not one that will generate great returns over the long run, but it really needs to only survive long enough for the market to rebalance itself to be a satisfactory investment.  I initiated a starter position yesterday.

Disclosure: I own shares of PGN

Ebates Deal Pushes Comdisco Closer to Liquidation

"Liquidations require an extended investment horizon, and therefore are of little interest to the majority of investors.  The timing of the payout, if any, is unpredictable.  However, if and when it comes, it may handsomely reward the investor's patience." - Horizon Kinetics

The above quote is from Horizon Kinetics' September 2013 research note on liquidations, which everyone should read.  One current liquidation they own, and are the largest shareholder of, is Comdisco Holding Company (OTC:CDCO) which I discussed in May 2013 but didn't purchase until recently.  To give a brief overview, the original Comdisco was a computer leasing and disaster recovery company that invested its free cash into ~900 start-ups during the middle of the dot com bubble, the company went into bankruptcy, and after restructuring the new Comdisco set on a liquidation track.

Fast forward a decade or so and Comdisco assets consist primarily of cash and three remaining stakes in the dot com start up portfolio valued at $8,875,000 as of 9/30/13.  All three investments are private companies awaiting liquidity events for Comdisco to exit and appear to be the primary hurdle remaining before the company can make a final distribution (although they do have a few claims against former customers that they're still pursuing).  During the company's fiscal second quarter, one of the investments was sold for just over $1MM.

The bigger liquidity event happened this week, when Ebates (As of 9/30 93% of the equity portfolio) was sold for $1B in cash to Rakuten.  I haven't been able to determine what percentage of Ebates the company owns (any help here would be appreciated), so it's difficult to determine if the exit price is higher or lower than the ~$8.25 million it was valued at back in September.  The Ebates position is a little hidden in Comdisco's filings, you have to go back to the 2012 10-K where the company mentions they participated in an additional round of financing for Ebates to see the position called out.  Competitors RetailMeNot and Coupons.com both conducted initial public offerings in the past year and have seen their market values cut in half since, so I'd err on the conservative side and view this as a positive news story in terms of bringing the liquidation wrap up timing forward and not a potential windfall.  There's now potentially one other private equity investment that's of insignificant size (hopefully they just dump it), and some other bad debt they're chasing down before all operations are wrapped up, the end looks near.

The company has contingent distribution rights (CDRs) that are entitled to a 37% sharing percentage of the total amount distributed to the CDRs and equity holders.  Comdisco currently estimates their CDR liability at $11.2MM, meaning the equity distribution is estimated at $30.1MM ($7.50/share), the current market cap is $24.2MM ($6/share) representing a 24% upside.  There could be additional upside depending on the amount they net from Ebates and other bad debts, and again the main risk here is the timing of the final payment.  If this situation appeals to you, be careful, it's a very illiquid stock with a large bid/ask spread.

Disclosure: I own shares of CDCO

Newspaper Spinoffs

I did another lunch investment pitch roundtable today, this time the topic was "Impact of Technology on Communication and Stocks".  I was already looking into the recent news/print spinoffs, so I decided to squeeze them into the topic and pitch the whole basket.

Below is my deck with some commentary, outside of News Corp and New Media Investment Group, I've only looked into these spins at a surface level, so some numbers might be completely wrong.  But the sector seems attractive as its bottoming and figuring out the correct corporate structure, digital strategy and industry dynamics to survive.

The first quote from David Carr of the New York Times came from his column "Print Is Down, and Now Out" published on 8/10/14 after the announcement of Gannett's newspaper spin.  His column and this quote sum up the consensus view of the newspaper industry, it's ugly, unwanted, and destined for red ink in the digital age.  However, news and content is still valuable, it just needs to be more tailored to its audience.  A (digital) subscription to The Wall Street Journal is virtually a requirement for anyone in finance or a senior management position in corporate America.  On the other end of the spectrum, community newspapers are the only news source for many small cities and can provide valuable targeted advertising.

As for the spinoff dynamics, most newspapers have been essentially hiding within otherwise growing media conglomerates, by exposing the print business, management will be forced/incentivized to adapt their product to the current marketplace.

There's nothing really new in this slide compared to my post on News Corp nearly a year ago, but REA Group's market value continues to rise, Harlequin was added, and hopefully Amplify is closer to wider acceptance.  One minor complaint, the quarterly conference calls sound like management is telling a story rather than a business update, makes the lack of a clear capital allocation plan even more of a concern.  But it's clearly cheap.

This is another update slide for blog readers, I'm still on the fence about New Media, like the strategy but I remain concerned about the third party management agreement and how that might be bought out or internalized.  Fortress is a savvy shop, and they've executed on the plans they've laid out.  Their quarterly presentations are transparent, a little promotional, but it clearly presents the investment thesis and should net investors high teen returns as they buy local papers cheap and they're rerated in the public markets.

Now we get to recent spins, Tribune Publishing is the riskiest of the bunch, its leveraged and doesn't have the benefit of its real estate assets.  Its papers are primarily large metropolitan newspapers, a segment that's similar to a JCPenney's in the retail space, stuck in the middle without a loyal customer base.  However, its very cheap and has a lot of upside if turned around, parent Tribune Media emerged from bankruptcy about 2 years ago and former creditors (unnatural holders) might be taking advantage of the liquidity of an NYSE listing and selling.

The newspaper spins really picked up in the last two weeks, Gannett announced they were going to spin off the publishing business earlier in the week.  I don't know the exact timing of the filings, but Carl Icahn curiously filed a 13D after the spin was announced, suggesting the spin.  There might be some upside left, but this transaction is well publicized and pretty straightforward.

E.W. Scripps & Journal Communications
The more interesting transaction is the "double spin/double merger" of E.W. Scripps and Journal Communications, where both will combined their TV/radio broadcast divisions and then spinoff their newspaper segments into a new company to be named Journal Media Group.  Both companies would be free of cross-media ownership rules and could therefore pursue acquisitions in markets they were restricted from as combined broadcast and print companies. 

Today the two companies have a combined $1.5B market cap, if you take management's guidance of $200MM EBITDA and use a 9x multiple (low end of comparable broadcast companies due to radio exposure) the "new Scripps" is worth roughly the current market cap and you get the Journal Media Group newspaper business "for free".  It's a complicated transaction that won't close until sometime in 2015, and there are more merger details including a $60MM special dividend to Scripps shareholders, but with more consolidation in both industries likely, it initially appears to be an attractive deal for both future companies.

Each of the recent spins are a little different, but as a group they should outperform the broad market over a 2-3 year time.  I could also see regulations relaxing in this space, newspapers/radio/local TV entities aren't as influential as they once were, encouraging more consolidation.

Disclosure: I own shares of NWSA

Mario Gabelli: "Activism - New Catalyst to Surface Value... Good or Bad?" - Notes

I attended an enjoyable luncheon today titled "Activism - New Catalyst to Surface Value... Good or Bad" with Mario Gabelli, Founder, CEO, and PM for the value strategies at GAMCO (GBL), he's as talented of a speaker as he is a value investor.  Here are some short form notes I took and wanted to document:

• Gabelli manages the Gabelli Asset Fund, a $3.8 billion dollar five star fund with an amazingly low 6% turnover ratio, he mentioned several names that he's held for over 20 years
• He's a believer in "POSP" or Plain Old Stock Picking, he researches one stock, one industry at a time and doesn't spend a lot of time worrying about economic indicators (showed a cartoon of an analyst flipping a coin) or overvalued sectors like biotech or social media - I particularly liked this point and its how I try to approach investing, it's fun to discuss where we are in the economic cycle, but I don't think there are many people smart enough to consistently exploit it
• Shareholders own the company; think like an owner
• In 1988, he posted a "Magna Carta of Shareholder Rights" and still stands by it today:

• He's fiercely against poison pills and actively works to remove them, compared the poison pill to the Berlin Wall and management trying to keep the shareholders out, entrenching themselves
• Wants short sellers to disclose their holdings, same with distressed debt buyers attempting to gain control of a company going through a restructuring
• He looks for companies trading below private market value that have a catalyst in place to close the gap, he's recently added activism to his list of potential catalysts alongside (1) regulatory changes; (2) industry consolidation; (3) death of founder; (4) stock repurchases; (5) sale of a division; and (6) management or capital succession
• Activism is a net benefit to shareholders
• Large inflows in recent years at activist funds, lots of OPM (Other People's Money) to play with
• Be aware of activist fund intentions, the 2&20 fee structure encourages activism, need for a big quick win, good for publicity to raise assets
• Lots of special situations as a result of activism (spinoffs, splitoffs, mergers, and liquidations), went through a few local Chicago examples like Fortune Brands and Kraft
• During the Q&A he dropped a quick stock pitch for GATX Corporation (GATX), a railcar lease company that should earn 12 or 13% CAGR over the next decade
• Also likes content and media companies, been on TV recently discussing Twenty-First Century Fox (FOXA) and others

He's an active alumnus of the Columbia Business School (interviewed in the Fall '11 copy of Graham and Doddsville), good to get a little Dodd/Graham philosophy reminder every now and then.

Exelis and its Spinoff Vectrus

Exelis Inc (XLS) is an aerospace and defense contractor that was originally spun off of ITT Corporation (ITT) on 10/31/2011, and now Exelis is following suit by spinning off its shrinking mission systems business line into a new company called Vectrus (VEC) later this summer or early fall.  This is the classic move to separate the declining business to highlight the attractive remaining business.  Exelis will be more of a pure play aerospace and defense products contractor focused on a few select growth sectors.  Vectrus will be a government services defense contractor with falling revenues, but strong cash generation due to the low capital requirements and a variable cost structure.

Both Exelis and Vectrus will benefit:

• Exelis benefits by shedding the underinvested services business which is experiencing severe declines in revenue due to budget constraints and the draw down of troops in Afghanistan.  The mission systems business is weighting on the rest of the business and masking the improved growth profile of Exelis's C4ISR segment and other growth initiatives, giving the remaining business a higher multiple.
• Vectrus is similar to other recent spins in the government services space (Engility Holdings & SAIC), declining revenues in the near term is less of a problem than it appears due to the low fixed costs, most of their costs are variable and attached to specific contracts.

With increased geopolitical tension defense contractors could once again see their revenues pick up from cyclical lows and Exelis represents an attractive event driven way to invest in that theme.

Vectrus
At the time of the Exelis spinoff from ITT, mission systems was the growth business and the rest of the business was flat or declining, times have certainly changed.  Shortly after the spinoff from ITT, defense spending came under a microscope with budget sequestration and the draw down of troops in Afghanistan.  In 2013 Vectrus had $1.5B in revenue with 100% of that coming from the U.S. Federal government, a full 92% from the U.S. Army, and 34% of 2013 came from Afghanistan which is quickly going away.  Revenues are expected to be down 25% in the mission systems business in 2014, with additional downward pressure in 2015.

Vectrus will operate in three main business lines: base operations (majority of the revenue), logistics, and network communications.

Major contracts include (69% of 2013 revenue):

1. Kuwait Base Operations and Security Support Services (K-BOSSS) contract for Camp Arifjan: Base operations contract for one of the largest bases in the U.S. Military, services include: medical services, postal and maintenance, public works, transportation, and emergency services
2. Operations, Maintenance and Defense of Army Communications in Southwest Asia and Central Asia (OMDAC-SWACA) contract: Network communications contract expiring in 2018 supporting the O&M of the Army's largest network from locations in the Middle East.
3. Logistics Civilian Augmentation Program (LOGCAP): Logistics contract where Vectrus is a subcontractor for certain task orders, the subcontracting agreement ends in 2018
4. Kuwait based Army Prepositioned Stocks-5: Logistics contract storing and supporting a wide range of military equipment and supplies.

Despite the industry headwinds, Vectrus can be an attractive business due to its low working capital requirements, much of their employment base are subcontractors attached to single contracts, as the contracts wind down so does a lot of the expense base.  Operating margins aren't great, at 4.0-4.5%, but with a renewed strategic focus on the business (classic spinoff reasoning) there will likely be some additional restructuring and cost cutting in the months after the spin is completed.

Leading Vectrus will be Ken Hunzeker, he has been the president of the mission systems business going back to the ITT/XLS spin, and is in for a nice raise.  Slightly more interestingly, Lou Giuliano will become the Chairman, he's the former Chairman and CEO of ITT and ran what would become Exelis at ITT for 8 years before becoming the President and COO of ITT in 1998, so he's intimately familiar with the business and the defense industry cycles.

Like many spins, Vectrus will be take out debt in order to pay a dividend back to the parent, here they're targeting 2.5-3.0x EBITDA, or approximately $130-150MM (although that's been a moving target down recently).  Government services businesses generate a lot of cash, I view debt (as long as its reasonable) as a positive here, management will likely be focused on paying down the new term loan and potentially refinancing to a better rate once the company becomes more seasoned.

Vectrus should have EBITDA of $50MM in '15 EBITDA, assuming they max out the debt at the 3x range, and putting a discounted 7x EV/EBITDA multiple on it gives you $200MM in market cap, a small slice of the $3B combined Exelis market cap.  I would imagine there will be some selling once the spin appears in Exelis investor's accounts as it will be a small unwanted orphan (it's worth about $1 per XLS share), so one strategy would be to wait for the spinoff to occur and settle out a bit before snapping up Vectrus shares on the cheap.

Exelis
Exelis has identified four "Strategic Growth Platforms" in which they want to focus and invest going forward: (1) Critical Networks;  (2) Intelligence, Surveillance and Reconnaissance Systems & Analytics; (3) Electronic Warfare; (4) and Composite Aerostructures.  The Vectrus spin allows Exelis to appear more attractive to investors, post-spin it will have higher margins and a diversified revenue base less focused on the Department of Defense.

While top line revenue is down double digits YoY for the combined Exelis, the majority of the decline is the Vectrus business while the rest of Exelis is mostly flat with growth expectations going forward that should deserve a higher multiple.

Pension Liability
When Exelis was spun off of ITT, many called it a pension plan with a defense business attached to it, and that would have been a fair assessment.  Exelis has made significant progress on the pension (~$1.3 billion unfunded position as of the last 10-Q) and will retain and continue to service it after the spin.  The company has also frozen the pension plan of all future benefit accruals effective December 2016 and expects it to stop needing to make additional contributions to the plan after 2017.

Continued low interest rates have plagued companies with large pension plans because it lowers the discount rate at which a defined benefit plan calculates its future liability.  The lower the discount rate, the more current assets the plan needs to meet the future pension liabilities.  Tucked away in a transportation and student loan bill (MAP-21) was a pension funding relief provision that is likely going to get extended, it will reduce the amount Exelis will be required to contribute to its plans in the next several years from $225MM annually to $150MM.  This gives time for interest rates to normalize (bringing the discount rate up) and may reduce the overall contributions necessary by Exelis.

Post-Spin Cash and Capital Allocation
Vectrus will be paying Exelis a dividend of ~$150MM upon the spinoff giving the parent company amply liquidity when you consider the unused commercial paper program and credit facility with very little net debt.  Exelis anticipates maintaining their current quarterly dividend (2.5% yield), and could return additional capital to shareholders with their share repurchase program.  The flexible balance sheet also allows them additional room to invest in their Strategic Growth Programs and bolt on some smaller acquisitions like they recently did with the Orthogon airport management business.

Exelis Valuation

To value a post spin Exelis I added the $1.3B pension liability to the net debt, along with the $150MM dividend from Vectrus, subtracted out the $50MM in EBITDA that Vectrus is expected to earn in 2015 and then added back the pension contribution to EBITDA.  If Exelis were to be valued at 8x this adjusted EBITDA measure, I come up with a ~$24 price target for the remaining business.  Add the additional $1 for Vectrus, and the combined business is worth $25 per share versus $16.41 at today's prices.

Risks

• Greater than expected headwinds in the Vectrus mission systems business, especially in their major Afghanistan and Iraq contracts.
• Continued political pressure to reduce military and defense spending, although temporarily out of the headlines, the budget deficit is still substantial and unsustainable. 
• Exelis has a large unfunded pension liability in comparison to its market cap, if interest rates stay flat or decline it could force Exelis to make additional pension contributions above current projections.  Additionally, Exelis is assuming an 8.25% rate of return (down from 9.00% in 2012) which could turn out high given current elevated asset prices.
• The spinoff was guided earlier in the year for "Summer 2014", but has now slipped into summer/fall, further slippage or cancellation of the spinoff would reduce the attractiveness of Exelis, but it still remains an undervalued company in its current form.

Summary
With the defense industry near a cyclical bottom, the spinoff of the Vectrus mission systems business provides an attractive event driven investment opportunity by creating a higher growth products business and a headwinds facing services business.  I'm initially going with a Joel Greenblatt like call option strategy to enter a postion, the spin will expose value in both the parent and the orphan, but I'm extending it out with a January expiration to allow Vectrus a little time to find a following in the investment community.  Depending on where Vectrus trades after the spinoff, I may pickup some additional shares at that point.

Disclosure: I own XLS calls, anticipate buying VEC shares sometime after the spinoff is completed

Quick Post on PHH Corp

The PHH Corporation story is pretty well known at this point.  Before two weeks ago, it operated in two unrelated businesses: mortgage origination/servicing and fleet management leasing.  At the insistence of an activist campaign (which the activist curiously exited last week) the company sold off it's fleet management business to Element Financial Corporation for $821MM net of taxes ($1.4B pretax) to create a purer play on mortgage origination and mortgage servicing rights.

The mortgage origination business is struggling in the current environment, refinances have mostly dried up as those who could refinance already have and the home purchase market has yet to really show signs of strength as consumers are struggling with debt and stagnant wage growth.  The servicing side of the business however should become more valuable as interest rates rise and fewer mortgages are refinanced stretching out the length of time borrowers maintain their mortgage and increasing the servicing fees collected by PHH.  The business is at a cyclical low, layoffs are in the thousands across the industry, sentiment is low, and that creates a potential opportunity when teamed with the sale of the fleet management business.

The market cap of the company is only $1.4B, so the sale of the fleet management business represents a large cash infusion, PHH laid out it's plans in a recent investor presentation:

PHH is planning on repurchasing up to $450 million in stock over the next 4-5 quarters, including $200 million shortly after the 2nd quarter earnings release, or a total of ~32% of the market cap.  PHH's shares trade at 0.75x proforma tangible book value (with the optionality of the mortgage servicing rights value increasing in a rising rate environment) and within a few weeks there will be a large indiscriminate buyer in the market scooping up shares.  Approximately 30% of the shares are short, and 40% of the shares are in the hands of Hotchkis & Wiley, PIMCO, Citadel, and DFA, plus another 10% in index funds, sets itself up for a potential small short squeeze rally.  So in the end, you get a business that's retooling itself for the next stage of its business cycle at a cheap price with a near term catalyst.

Disclosure: Long a small amount of PHH