Friday, September 25, 2015

Sycamore Networks: Activists Pursuing NOL Shell

This is a small opportunity that's not suitable for everyone, but it has significant upside if recent activists get their way and could be interesting as a small addition to an NOL shell basket. Sycamore Networks (OTC: SCMR) is a former dot-com optical networking darling that at one point was valued at $44.8B before the bottom fell out as late 90s internet traffic estimates ended up being wildly optimistic.  In 2013, the company sold the last of its operating businesses, shareholders voted to dissolve the company and commenced a liquidation.  Today, Sycamore's market capitalization hovers around $15MM.

Sycamore uses liquidation accounting and estimates the potential payout to investors each quarter.  The main sticking point to wrapping up the company is the 102 acres they own in Tyngsborough, MA that's under contract but the closing date keeps getting pushed back.
Companies in liquidation tend to overestimate their expenses, so it's likely that the final outcome will be slightly higher than $0.33 per share, maybe something closer to $0.40 per share.  It's trading for around $0.50, so why is it interesting?  It has a large NOL in comparison to it's market cap, from the 10-K:
As of July 31, 2014, the Company had federal and state net operating loss ("NOL") carryforwards of approximately $856.46 million and $34.9 million, respectively.  The federal and state net operating loss carryforwards will expire at various dates through 2034.  The Company also has federal and state research and development credit carryforwards of approximately $11.31 million and $9.98 million, respectively, which begin to expire in 2020 and 2015, respectively.  The occurrence of ownership changes, as defined in Section 382 of the Internal Revenue Code of 1986, as amended (the "Code"), is not controlled by the Company, and could significantly limit the amount of net operating loss carryforwards and research and development credits that can be utilized annually to offset future taxable income.  The Company completed an updated Section 382 study through July 31, 2011 and the results of this study showed that no ownership change within the meaning of the Code had occurred through July 31, 2011 that would limit the annual utilization of available tax attributes.  The Company has evaluated the positive and negative evidence bearing upon the realization of its deferred tax assets and has established a valuation allowance of $325.56 million and $330.43 million as of July 31, 2014 and July 31, 2013, respectively, for such assets, which are comprised principally of net operating loss carryforwards, research and development credits and stock based compensation.
Recently two different investors have filed 13Ds pushing for the company to withdraw the liquidation plans and instead raise equity, buy an operating business, and monetize the NOLs.  Lloyd Miller, who fishes in many of these Ben Graham like microcap securities recently disclosed a position and then General Holdings came into the picture too, below is the language General Holdings used in their recent 13D:
The Reporting Persons have engaged, and intend to continue to engage, in discussions with the Issuer’s management and members of the Issuer’s Board of Directors (the “Board”) on multiple topics, including the Reporting Persons’ suggestion that the Issuer should revoke its Certificate of Dissolution filed with the Secretary of State of Delaware on March 7, 2013.  Such discussions have also touched on corporate governance and corporate finance matters, including but not limited to the potential adoption of a shareholder rights plan, additional equity issuances, the use of net operating losses and other suggestions for maximizing shareholder value.  The Issuer has not taken any action with respect to the Reporting Persons’ suggestions described above.
The manager of General Holdings is Andrew Bellas, who was a partner at "Tiger Cub" firm Tiger Global Management where he specialized in technology stocks but left in January 2015 to start his own fund according to the Wall Street Journal.  Some light Googling found that he had been rumored to take a job at Latimer Light Capital, but it's unclear if he took the job or if he just went solo with General Holdings.  My guess is he could be looking to take control of Sycamore, put himself in charge and could use the shell as an acquisition vehicle.

It's difficult to value NOLs, but even after the recent excitement in SCMR shares, the NOLs are only being valued at a $5-6MM, if the company were to switch strategies and somehow utilize the NOL, the company would be worth multiples of it's current value ($5-7 wouldn't be out of the question).  Similar to WMIH, it's hard to point to a specific valuation as a shell, but with a 20% downside to $0.40 if the liquidation continues and a 10 bagger upside if it's reversed, the risk/reward seems worthy of a small position.

NOL rules are fairly complex, Section 382 of the IRS code stipulates change of ownership rules around net operating loss carryforwards.  I'm not a tax accountant, but I'd be curious if Andrew Bellas and his 14+% stake will limit the use of the NOLs going forward?  Even if the NOLs were limited annually, it wouldn't be the end of the world, the $856MM NOL is so large that it would be difficult for Sycamore to utilize it quickly without a huge equity raise in the first place.

Andrew Bellas and Lloyd Miller aren't the first investors to spot Sycamore's net operating losses, there have been others since it was clear the company was going down the liquidation path to push for a different strategy to utilize the valuable tax assets.  I can't be certain if there are other roadblocks pushing the company toward liquidation versus NOL monetization, but at today's prices its worth a small tracker position that can be added to as the situation becomes clearer.

Disclosure: I own shares of SCMR


  1. A few questions from a novice here:

    1) Why do they have to issue more equity?
    2) Wouldn't the future issuance be dilutive to a shareholder today? i.e. if I buy at todays price, and in 6 months they issue more equity, I'd make a loss?
    3) What the difference between the Net operating losses and Deferred Tax Assets? Which actually has "value" here?
    4) When trying to capitalise on Net operating losses and Deferred tax assets, does the company have to acquire a business of the same operating nature or type? For instance, it can't just by stocks generally or real estate etc. and still claim benefit?

    1. Thanks for questions:
      1) SCMR has $11MM in cash, after the land sale $13.5MM, if they wanted to make a dent in the NOL and fully monetize it before they begin expiring the company will need to make a sizable acquisition, above and beyond what they currently have on hand.
      2) It depends. If they buy an undervalued business that generates a lot of taxable income (which increases the value of the NOL since it brings forward the benefits) then the equity raise could be a net positive. Typically companies issue secondaries as a way to shore up a deteriorating balance sheet which would usually be dilutive to current shareholders.
      3) They're kind of one in the same, SCMR has a full valuation allowance against their NOL that prevents it from becoming a DTA, that's the $326MM number. There are DTA recognition rules that I'll screw up explaining, but in general, management needs to determine that the company is likely to use the NOL in order for it show up as DTA.
      4) No, the company doesn't have to stay in the same industry. Lots of recent examples, GRBK was a biofuel company before switching to a homebuilder, RELY was a subprime mortgage lender before becoming an aluminum recycler, PARR stayed somewhat similar by moving from an E&P to more of a downstream energy company. They could move to real estate, Carl Icahn has done that in both KDUS and VLTC, I'm unsure about stocks generally, I don't know if that would qualify against the NOL, might need to be an operating business of some type, but I could be wrong.

  2. From SCMR's 10-K:
    Recent SEC filings by investors suggest that there may have been significant trading in the Company’s stock by 5% Shareholders. Consequently, the current ownership change percentage in the Company’s stock for purposes of Section 382 of the Code is uncertain, and it is possible that Company may have undergone, or may soon undergo, one or more ownership changes for purposes of Section 382 of the Code.

    1. Looking at the Section 382 rules some more, if a change in ownership has occurred, it does essentially wipe out all the NOLs in contrast to just limiting them annually as I said in the post, downside is still around $0.35-0.40/share.

    2. This is a risk and I believe the company is obligated to disclose this in a CYA way. One would also assume that the activists have done their homework re: 382 and would not make an investment that essentially destroys the value they are trying to unlock

  3. Any updated thoughts on this? Traded down to near liquidation value for awhile recently.

    1. They're paying out a liquidation distribution at the end of April, it appears the dreams of it becoming an NOL acquisition vehicle are over. I'll probably move on since its a small position and my thesis is busted, but from here if you believe their is value in Tejas, it might be worth investigating further.