Friday, August 3, 2018

KLX Inc: Boeing Merger, KLX Energy Services Spin

KLX Inc (KLXI) is familiar to many special situation oriented investors, it was a December 2014 spinoff of BE Aerospace (BEAV), BEAV has since been acquired by Rockwell Collins (COL) in April 2017.  KLXI combined two unrelated businesses, Aerospace Solutions Group ("ASG") which is a distribution business to the aerospace industry and Energy Solutions Group ("ESG") which is an onshore oil and gas services business.  Both segments were rollups designed with the underlying theme of providing mission critical products/services that were relatively low cost in the context of the overall project, but for which the cost of failure is high enabling higher margins for KLXI.

Fast forward to today, Boeing (BA) is purchasing the ASG business for $63 per share in cash.  KLXI originally wanted to sell both the ASG business and ESG business to separate parties but couldn't come to agreement with any buyers for ESG.  As an alternative, KLXI is going to spin off ESG as KLX Energy Services (KLXE) simulatenously with the closing of the ASG deal with Boeing (guided to a Q3 close).  I have zero expertise in energy related businesses, most of the time I've dipped my toe into the sector I've gotten my face ripped off, but this deal reminds me quite a bit of LaQuinta/CorePoint (LQ/CPLG) that I've decided to give it another try in hopes to expand my circle of competence marginally.

How is it similar?  First, the deal will be taxable to KLXI shareholders, thus removing the tax-free two year safe harbor on a business that management clearly wanted to sell in the first place.  Second, the management team is moving to the spinoff and in this case, foregoing cash compensation to take stock in the spin which will likely trade poorly initially due to typical spinoff dynamics when management knows that they'll be looking for a buyer.

A little more on KLXE, the form 10 can be found here, it was formed as a rollup of 7 regional players, all the deals were done in the 2013-2014 timeframe before oil prices collasped for a combined price tag of ~$700MM.  The business did $100MM EBITDA in 2014 before the bottom fell out completely, with oil prices rebounding the past year, they're guiding to $110MM for 2018 which is significantly more than the $27MM in EBITDA in 2017.  During the sale process, they received bids for the ESG business in the range of $250MM to $400MM, the leading bid was a SPAC, so mostly financial buyers were interested.  The proxy pointed to the poor trailing twelve months results and a lack of credit available to finance energy deals as reasons for the disappointing bids for ESG.  The management team is interesting here as well, Amin Koury is 78 years old, lives in Florida (no major onshore energy basins there as far as I know), he's getting cashed out of ASG and was already cashed out of BEAV, his son runs his family office and isn't involved in the energy business, this is the last and smallest piece of his empire, all signs seem to point to KLXE not being a public company for long.

KLXI trades for $72.75 today, backing out Boeing's $63 cash offer and KLXE's implied market cap is ~$500MM, it will have no debt and KLXI is gifting KLXE $50MM in cash immediately prior to the spinoff.  So the implied EV is about ~$450MM, using the $110MM EBITDA estimate, and we come up with a 4.1x EV/EBITDA multiple, certainly cheap for any viable business.  Most oil services businesses trade a lot higher, I don't know of a perfect comp, but a similar setup to look to could be Dover's recent spinoff of Apergy (APY) which has done well since the spin.

Of course the problem with these types of ideas, they're hard to size up, even if we assume KLXE is worth 8x EBITDA, then the pre-spin KLXI is worth $81 or about 11% higher than today's trading price, not a home run, but I think it's an interesting short term idea that gives you a toehold position in KLXE at a cheap price.  After the deal closes you can decide to sell or add to the stub, that's my plan at least.

Other thoughts:
  • As far as I can tell, the taxable piece is fairly straight forward at this point, similar to LQ you'll receive cash and shares in the spinoff, the taxable amount will be $63 + KLXE's share price on day one over your original basis.  At the corporate level, KLXE has a tax basis of $600MM, if the day one value of KLXE is above this amount, then KLXE will be on the hook for any taxes.
  • KLXE will have a tax shield of approximately $32MM per year due to amortization of intangible assets, if you want to get cute on the valuation you could put an NPV on the tax attributes and KLXE would look even cheaper.
  • Cash at KLXE will also likely be higher than $50MM, KLXE is entitled to any free cash flow generated from 5/1 to the closing date.
  • KLXI is not an S&P 500 component, but it is in aerospace indexes and not in energy indexes, so along with dropping down in market cap indexes, it'll be removed from industry ones as well, potentially creating some forced selling from ETFs.  I would imagine there are few holders of KLXI that were involved for the energy business.
Disclosure: I own shares of KLXI