Tuesday, July 13, 2021

Communication Systems: Liquidation with a Speculative Kicker

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

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

Two events have happened since the initial merger announcement:

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

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

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

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

Disclosure: I own shares of JCS

46 comments:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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  7. I'm coming with complete novice questions about all the form 4 filings the past 3 days. Management in CSI redeemed all their old incentive RSU's, options, etc...

    1. Why does everyone redeem at the same time?

    2. How come every common stock is disposed of at $7.15?

    3. Did they have to sell most of their awards at $7.15? I mean, if they were bullish on the liquidation and transaction with pineapple, they could keep the majority of their stock and play out the situation.

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    1. I think they did have to exercise to participate and get the dividend/CVR, at least they were guiding to that in their press releases when they mentioned the share count.

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  8. Good questions, I was wondering about this too. I think the answer is in the August 2 8K. The Lantronix sale qualified as a 'change of control'-transaction and that caused all incentive awards to settle immediately. Now, I haven't done a deep dive in the compensation plan but let's look at what happened with Michael Zapata. He held 10k options with a $4.94 strike. These were automatically exercised due to the change of control. However, he doesn't pay the exercise price in cash but in specie, using the closing price as of the day the options settled.

    In other words, he gets 10k shares, but has to pay $49400 in stock. Using the $7.15 closing price on August, 2 that happens to be $49400/7.15 = 6909 shares. So, net he receives 3091 shares but the transaction is reported as a buy at the strike price and a partial sell at the closing price. But he didn't actually sell any shares. In some cases (e.g. Roger Lacey) there are even more sales booked, I think that is due to taxes.

    Options with a strike above the market price were cancelled. After August 2 no more options and RSU's are outstanding.

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  9. https://seekingalpha.com/pr/18470501-communications-systems-declares-special-dividend

    $3.50 dividend officially declared, the smaller property sold and the Pineapple deal is apparently still on despite relative silence and lack of a proxy. Pumpers have it this morning and I've sold out, think it might retreat back to the ~$6.90-$7.00 range (including the dividend).

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  10. Odd to see JCS rise 30% for announcing what they had promised to announce.

    Pineapple still pretty unevaluatable; slide deck notes annual revenue declines for Hawaii Energy and no profit metrics.

    Any insight into $7mm earnout peospects?

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    1. Very odd, was worried that the deal was going to fall apart and clearly was close to it if they lost one of the PIPE investors.

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    2. Did you buy JCS back again after the recent fall?

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    3. I didn't, I think the drop was because it went ex-dividend, but I haven't been following quite as closely.

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  11. Recently updated the equity offering (https://seekingalpha.com/news/3739917-communications-systems-updates-32m-equity-financing-for-closing-pineapple-merger)
    Merger conditions didn't change - JCS shareholders still get the CVRs and PEGY stock (conversion price hasn't been changed, $3.40) - maybe now is the more tax-efficient way to play the merger as you don't pay tax on the special dividend and get the stock worth around 6-6.5

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    1. Why do you think the stock is worth $6-6.50? The dividend has been paid, so now its just the CVR and PEGY stock. I think I'd like it below $4, hope that it gets memed again once the merger closes.

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    2. CVR 3.12 + PEGY stock ~3.4 (effectively the private market value, confirmed by recent additional PIPE financing at the same conversion price (I mean preferreds and warrants). They found new investors and additional capital on the same terms so the conversion price is not way out of touch I think). By the way, while I'm talking, the stock is below 4, like you said)

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    3. Agree, it is interesting again

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    4. Are you sure that the ex-div date did not include the CVR's? It says under "Right to Receive Dividends and CVR relating to Pre-Merger CSI" that:

      "Dividends will consist of the $3.50 per share to be paid on October 15, 2021 to shareholders of record as of September 30, 2021 .In addition, these shareholders will receive any cash generated on the sale of CSI's Services & Support segment, real estate holdings, investments, and remaining cash - either through a cash dividend or through distributions pursuant to the CVR"

      When they're writing "these shareholders", are they referring to the shareholders of record as of september 30 (oct 18)?

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    5. Could you help me, I couldn't find that passage, what filing?

      I think the intention is for the CVR to be for pre-merger shareholders, so the "these shareholders" are JCS shareholders and not PEGY shareholders (since there are Pineapple investors coming in with the merger)

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    6. First table under "The following chart summarizes the treatment of the different shareholders of CSI" in their latest DEFA14A-filing (https://www.sec.gov/Archives/edgar/data/22701/000089710121000768/csi211156_defa14a.htm)

      Yeah, they're probably referrig to "CSI Shareholders immediately prior to the CSI-Pineapple Merger". The phrasing is quite awkward imo.


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    7. I think they are, yeah, but it is awkward, everything about this deal has been a bit clumsy

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  12. The securities registration document is now available, with more background information. Apparently, Pineapple has negative equity and zero sales, but an interesting datapoint is that debt raised by Pineapple people prior to the merger (if I understand that correctly) is valued at 2 USD per share...

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    1. Thanks - I think you're reading that correctly, I'll be curious if Pineapple exercises that option to raise additional capital, more from the perspective that some private investor is agreeing to the $2/share number versus just a theoretical $2/share if they do raise.

      And you're right about Pineapple, it is basically just a calling list and a bet on Kyle Udseth. They do also show some financial projections on p88 but hard to really square those with the actual results.

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  13. Building sale 30 cents per share below forecast.

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    1. Yeah not a great result, only good thing, its prior to the close of the merger so CVR holders should get 100% vs 90%.

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  14. It dropped a lot here at the latest. Did you guys add to your position?

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    1. I've been adding. Not sure what's with the weakness in the price. It's fairly likely to be lower than the future distribution amount. A lot depends on the remaining operations. The $5m value is reasonable but could be a bit low.

      The solar business is being assigned a decent negative value at current prices. It should probably be positive. The pro forma numbers indicate somewhere between $18-41.5m in revenue for the solar business (which is made up of 3 companies merging together). If it were valued anywhere in the same realm as similar publicly traded solar companies then it's worth a lot.

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  15. Could somebody walk me through the PIPE investing deal in laymen terms?

    The PIPE investors get (for their $32M investment) 32,000 series pref A shares รก $1,000 per share, convertible at $3.40. Plus five-year warrants to purchase an additional $32M worth of shares at $3.40. These pref A shares will convert into 9,411,764 of CSI common plus an additional 9,411,764 of CSI common from warrants.

    The warrants I believe I understand, if $PEGY share price >=$3.40 within 5 years, the PIPE investors can exercise the warrants and get 9,411,746 shares for $3.40 per share.

    What about the newly issued pref A:s? They get their investment worth of pref A:s which can convert 1:294 into $PEGY if $PEGY share price >= $3.40.

    CSI common = PEGY, 1:1, right? Please enlighten me if I'm misunderstanding, thanks.

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    1. Sorry, missed this, but yes, that sounds directionally right.

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  16. MDC, What are your thoughts on this currently? Seems from a high level there is still roughly $3 of value vs current $2.30 price. Plus any kicker on the Pineapple being worth above 0.

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    1. I'm out of the stock, but give me a day, it might be interesting again here.

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    2. I'm coming up with a lower value:

      About $0.64/share of cash and investments
      About $0.51/share for Ecessa, IVDesk, JDL (S&S Segment), this is just a guess, probably too low as CSI paid $4.67 for Ecessa in May 2020 and $1.37MM for IVDesk in Nov 2020, both seem to be doing well and masked by JDL losing the big education contract.

      $0.78/share in real estate sales, the benefit here is the HQ sale should close prior to the merger closing and get paid out as a dividend versus being included in the CVR which had its maturity date pushed out from 18 to 24 months, that impacts the IRR.

      Then we have the Lantronix earnout, hard to know the chances of that hitting, but open to others thoughts there. But let's say 50%, that gets me a total of $2.27/share in pre-PEGY merger dividends and/or CVR.

      The proxy had a concept around a "Convertible Note Financing" where Pineapple was free to raise additional cash at a $2/share value. So if they're able to do that, then maybe its $4.27/share of overall value versus today's price of $2.38? Yeah cheap. But there have been several disappointments along the way here and hard to have confidence in Pineapple, the proxy statement made it seem like little more than a calling list. I am still interested.

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    3. Yeah if you discount the Lantronix earnout then you're definitely correct on valuation. I really don't know what value to assign Pineapple, that $2 a share peg could be realistic. They will have some capital available to them. Maybe the right way to think about it is using a similar model you would for a biotech startup? They will most likely be cash flow negative for some time before they see returns on their investment. Like you said in your original post, they could catch a bid in market craziness. Im buying but this will be far from a major position for sure.

      Side Note: What do you think would be going in the CVR at this point? I would take the position that at least another $1.25 gets returned Pre-CVR based on the sales of the real estate and cash on Balance Sheet... or do you think I'm beyond optimistic?

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    4. No, I think that's correct. The CVR will be mostly the S&S Segment and Lantronix earnout if any.

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  17. Gabelli intends to vote against the merger

    https://www.sec.gov/Archives/edgar/data/22701/000080724922000016/jcs_21.htm

    Not sure what their game is, it seems one loses the optionality from the Pineapple investment in this way.

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    1. The plot thickens! Yeah, to me, seems late in the game to come out against the merger, not sure what the alternative looks like right now?

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