Wednesday, September 22, 2021

Consensus Cloud Solutions: Quick Thoughts on Garbage Barge Spin

Just to get this out of the way early, I don't own J2 Global (JCOM) and this spinoff is pretty dicey, but I find the setup pretty fascinating from several angles, more from a case study perspective and want to throw this out there in case others want to share their thoughts as well.  

Consensus Cloud Solutions (CCSI) will be spun off from J2 Global in the coming weeks, Consensus is JCOM's legacy eFax business.  It is a high-margin subscription business, one of those that people often forget they even have especially if their employer is paying for it, that allows you to receive faxes in your email.  Surprisingly, many industries, particularly health care and financials are still heavy users of fax as it's viewed as a secure communication method.  Even if you only get a fax occasionally, you still want to have that capability to receive them and end up keeping your subscription until your last client stops faxing, even then you might keep it just in case.  But unlike Jackson (okay, some may disagree with that), eFax is a melting ice cube, faxes are converting everyday to other communication methods and I can't imagine many use cases converting from something else (snail mail?) to fax.

Over the past decade or so, JCOM has been using the cash flows from eFax to diversify their business by buying a bunch of legacy internet media companies, the parent after the spin will be renamed Ziff Davis (and trade as ZD) which is the old holding company name of PC Magazine.  In one more attempt to extract value from the eFax business, JCOM is effectively selling the company via a spinoff.  Their tax basis is too low to just sell it outright for cash, so instead they're going to encumber Consensus with $800MM in debt, which is about 4x EBITDA.  Probably not too different than what they'd be able to sell the business for entirely and possibly more than they'd get after tax.  Additionally, they're retaining just under 20% of the CCSI shares to divest over time, so it's really economically and strategically a sale from the parent's perspective.  That's going to leave a levered stub equity in a declining business, the textbook "garbage barge" spinoff.

What makes Consensus different than many other garbage barge spinoffs is while it is a declining business, the business itself has some attractive qualities to it.  It's reasonably sticky (as said earlier, you want to keep your subscription just in case), it is high margin (50+% EBITDA margins) and fairly asset-lite, despite the debt, they're projecting $100MM of free cash flow to the equity on $200MM in EBITDA.

A few quick thoughts on the investor presentation which you can find here.


They're doing what most declining businesses are doing and split themselves up into two segments, one that is the slow-or-declining business (SoHo, which is their small and home office segment) and corporate which is where they're focusing on the healthcare vertical and is showing growth.  Now the big question that always been around JCOM, how much of the growth is organic versus M&A, many of the bear writeups in the past have made that argument.  And its hard to tell, they do a good job obscuring their financials, in the Form 10, the proforma financials only show the proforma numbers for 2021 and 2020 and everything prior is obscured by JCOM's segment reporting (only the eFax business is being spun, JCOM is retaining the rest of their cloud segment). 

But if this is really a mid-single digits grower on an organic basis with 50+% EBITDA margins, CCSI would trade multiples of where this is likely to trade.  It seems reasonable that the revenue growth guidance includes M&A, but hard to tell how much, and thus hard to trust that FCF number, how much of it is really capex via M&A?

Again, showing growth even in the legacy segment, one question could be how much was this business a covid beneficiary?  I could see them gaining some marginal subscriptions from people moving from the office to home and instead of buying a fax machine, employers signed everyone up for eFax.  Maybe that's a permanent shift as with each passing day it seems like a full return to office is off the table.

Management is saying this is a $100MM free cash flow business, mirrors their LTM proforma net income which makes sense for a business like this with limited capex.  I've only seen one sell side report thus far, but they're comparing this business to other declining businesses, oddly in cable networks, but pegging this at 5x EBITDA.  At 5x, the EV would be approximately $1B, with $770MM of net debt, the equity stub would be $230MM with $100MM of earnings/free cash flow, obviously on a very levered basis, on an unlevered basis CCSI would only be a ~15% UFCF yield.

They plan to de-lever, the proforma income statement seems to suggest the bonds will have a 6.5% coupon (second thought, this will probably have a term loan above the bonds, so the bonds will have a higher coupon which makes sense), maybe that could be interesting to some fixed income investors.  Could be a great short if management misses guidance early and the market questions the sustainability of their business, but could also work tremendously well if they can steady the business for a few years, de-lever and harvest the cash flows into something with a longer term growth profile.  But with the debt, they'll really need to thread the needle, I'll probably stay away and just watch as a spectator.  Curious if others have more complete thoughts.

Disclosure: No position

Jackson Financial: Spin/Demerger, Technical Selling

Jackson Financial (JXN) is the largest variable annuity provider in the U.S. and was recently spun (or "demerged" in ex-US terms, good Google alert term btw) from Prudential PLC (different than Prudential Financial) which is a London listed insurance company that primarily operates in high growth areas of Asia and Africa.  Jackson is only listed in the U.S. and much smaller than its parent, as a result it is likely experiencing (or has already in the when-issued market) some forced selling by both geographically filtered and market cap filtered investment mandates or indices.  Directly from the Form 10:

Index funds that hold Prudential ordinary shares likely will be required to sell their shares of Class A common stock received in the Demerger to the extent we are not included in the relevant index. In addition, a significant percentage of Prudential Shareholders are not residents in the United States. Many of these shareholders may sell their shares immediately following the Demerger. The sale of significant amounts of our Class A common stock for the above or other reasons, or the perception that such sales will occur, may cause the price of our Class A common stock to decline.

In a variable annuity, the client deposits funds into a separately managed account in mutual funds that Jackson's asset management arm selects to be on its platform, then Jackson guarantees some minimal performance for a fee.  Jackson takes those guarantee fees and purchases hedges to protect against a sustained market downturn that would turn these insurance contracts upside down.  The hedges are marked-to-market in GAAP accounting while the corresponding liabilities are not, so a combination of opaque accounting with long dated market/longevity risk leads these variable annuity insurers being valued like death.  Jackson is insuring against the market collapsing, which seems like a difficult risk to forecast, especially in this environment when arguably the market is overvalued.  To see this in action, look towards Brighthouse Financial (BHF) which was spun from MetLife a few years back, BHF trades for 2.4x LTM adjusted earnings and 37% of adjusted book value (basically ex-AOCI), torturing value investors like David Einhorn for years.

Jackson just reported Q2 earnings last Friday, LTM adjusted earnings come in at roughly $2.4B or $25/share and adjusted book value at $91.38/share, versus the current trading price of $26/share which is 1x LTM adjusted earnings and 28% of adjusted book value.  So it's absolutely cheap and somewhat relatively cheap, but does have a lot of black box type risk to it, hard to fully grasp all the market risk they're taking and believe in their hedging strategies.  But just the math of something that's not a melting ice cube, trading at 1x adjusted earnings (feel free to pick at the adjustments), not a lot has to go right for that to work out reasonably well.

Other ways to look at the valuation:

  • Last summer, Jackson offloaded their fixed annuity risk to Athene (ATH, soon to be acquired by APO) and concurrently, Athene took an equity stake in Jackson.  Athene invested $500MM for an 11.1% economic stake in the business, which equates to a ~$45/share price, or 70+% above where it is trading today.  Apollo via Athene might have slightly overpaid, need to probably consider it in context of the reinsurance transaction as well, but unlikely they severely overpaid, especially when markets were still a bit dicey last summer.  I don't think ATH/APO would purchase the entire company as its now a pure play on variable versus fixed annuities (much different profile in my opinion for APO and investing the float), but a good valuation point nonetheless.
  • In the Form 10 and throughout their investor presentations, Jackson makes it clear that they will be a significant returner of capital to shareholders.  In year one, they expect to distribute $325MM to $425MM out in shareholder yield during the first twelve months.  At the midpoint of $375MM, that's 15% return of cash, either in the form of dividends or share repurchases.  Again, seems more of a black box than a melting ice cube, but over time that 15% return of capital should at least mirror the shareholders ultimate return without any re-rating of the rock bottom multiple.
  • Their statutory capital is about $4.4B, maybe a more conservative way to look at the book value, that would be $46.50/share or roughly trading at 56% of this more conservative number.  This is also an important number in context of the above bullet as they've guided to distributing 40-60% of the annual growth in statutory capital out to shareholders over time.
Other miscellaneous thoughts:
  • Another way I've thought about the cadence here, London based funds are selling and soon this will be have to be picked up by U.S. based funds and indices, so there could be a time period here where the stock is orphaned and as a result trading at an artificially depressed multiple.
  • Prudential PLC held back 19.7% of the JXN shares, they're going to monetize that over the next year, so maybe similar to the situation over at Technip Energies (THNPY), it could provide a small overhang until their divestiture is completed.
  • PPM is their internal asset manager, they mostly invest the corporate balance sheet in fixed income securities, they do manage some external capital for Prudential PLC related entities which may be at risk (they've had some of their funds withdrawn already) now that the companies are separate.
  • We all know about the long term demographic trends in this country, baby boomers are retiring and might look to annuities to offload that market and longevity risk.  They've even made some regulatory headway getting these products in 401(k)s, now I wouldn't recommend anyone actually buy them.  To that point, this is more a product that is sold rather than bought, maybe similar to a timeshare in that sense, and possibly the market is punishing this business similarly/unfairly.

Disclosure: I own shares of JXN

Thursday, September 9, 2021

Atlas Financial: Senior Bonds Should Reject RSA, Reopening Play

At a certain point, I should probably turn this blog over to a few of my smarter readers, Atlas Financial Holdings (AFHIF) has been mentioned a few times in the comment section by ADL.  Be warned, Atlas has a lot of hair on it, thinly traded and the common stock is a nano-cap (sub $10MM).

Atlas is in the early innings of a business transition, previously they were an insurance company to the niche light commercial auto market (think taxis, limos, shuttle buses, etc.), that wasn't a great segment prior to covid and then really got crushed during the pandemic with rides down 90+%.  Anyone that has tried to get a ride-share or taxi lately knows, there's a massive driver shortage and fares have spiked significantly, eventually this will normalize and drivers will return.  The insurance subsidiaries of Atlas are now in receivership/liquidation, the remaining business and the go-forward strategy is a managing general agent ("MGA") model (d/b/a Anchor Group Management) where Atlas originates and services insurance policies for a fee but the risk is borne by third-party insurance company partners.  In addition, they've developed a mobile app targeted at ride-share drivers that offers micro-duration policies (essentially an hour-to-hour type thing) that would have sounded very SPACable earlier this year, but at the moment is more of a call option and not super material to the business as far as I can tell.

If they can return to writing the same volume as they did in 2018 (~$285MM, approximately 15% market share) under the MGA model (management put this goal out there in their recent investor call), this could be a multiple bagger (they take a 20% commission and guided to 20-30% pre-tax margins), but the path between here and there is highly uncertain and probably not realistic.  To put that goal in context, they currently have only 5% of that in-force, writing a bit more than on a run rate basis as new business is inflecting with the reopening.  To make it even hairier, the company has a quickly approaching $25MM debt maturity in April 2022, that security is a baby bond ($25 par, exchange traded) under the symbol AFHBL.  

The company missed the July payment on these bonds (although you would have no way of knowing unless you owned the bonds) and then last week the company announced it had come to a proposed restructuring support agreement ("RSA") with 48% of the noteholders to exchange the current bonds for a new security with similar terms (same headline 6.625% coupon, but the company has the option to PIK at 7.25% for the first two years) but pushing the maturity out 5 years in an amend and extend.  Troubling, alongside the restructuring of the bonds, Atlas is receiving rescue financing from "certain supporting noteholders" in the form of a 12% $2MM convertible term loan with an additional $1MM delayed draw.   As a "setup fee" the supporting noteholders are also getting a free 2,750,000 shares (and up to 5 million shares if the delayed draw is fully drawn), which is close to $1.4MM at current prices, quite the setup fee for a $2MM loan!  The loan has a conversion price of $0.35, which is in the money at today's $0.50 share price, so if fully drawn and converted, this rescue financing could end up with over 13.5 million shares compared to the current share count of just over 12 million shares.  The convertible loan is also senior secured and senior to the proposed restructured bonds, effectively these "certain supporting noteholders" are extracting value from the rest of the noteholders.  In a normal bankruptcy proceeding, all noteholders would be treated equally and would likely receive a pro-rata combination of new bonds and equity.

The bonds (AFHBL) did trade up on this news to $11-$11.50ish (par value is $25) creating a yield-to-maturity in the mid-to-high 20% range if the proposal is approved.  But I think there is an opportunity for a better, fairer deal for AFHBL noteholders, if you own the bonds feel free to reach out to my email and I can put you in touch with a group that is pushing for a better deal.  I plan on rejecting the RSA.  Either way, seems like an interesting quirky way to play a reopening or normalization of the post-pandemic economy.

Other thoughts:

  • Atlas has its corporate headquarters for sale (953 American Lane, Schaumburg IL) for $13MM, they do have a $6.5MM mortgage on the property that is held by the estate of one of their former insurance companies that are now in receivership.  So there should be some equity in the property, providing meaningful liquidity to a company of this size, potentially negating the whole need for the egregious convertible loan if they could get it sold quickly.
  • Atlas is heavily tied to two insurance providers, so this isn't quite the "originate to distribute" model it sounds like but more of an outsourcing model with two customers, so the customer concentration risk here is quite high.  National Interstate Insurance Company is the partner for shuttle buses and Buckle Corporation is the partner for the taxi and limo business.
  • It appears that Uber and Lyft are being more rationale in their pricing post pandemic, both are public now and no longer have near free cost of capital to sustain negative gross margins, maybe some market share stabilizes or inches back for taxis and limo services where Atlas's business historically focused.
  • The same CEO that drove this into the ground is still the CEO, which gives me some pause on the likelihood that they'll be successful executing the turnaround.
  • This likely isn't a takeout candidate, in the 10-K, they mention that as part of the insurance company liquidations, Atlas agreed that if they choose to sell the MGA operations, the insurance company estates would receive 49% of the proceeds.

Disclosure: I own AFHBL