Computer Sciences: Gov Services Spinoff, Commercial Business For Sale?

Computer Sciences Corporation (CSC) is primarily an IT services firm that is spinning off its U.S. government services business (targeted by the end of November) and immediately merging the spinoff with SRA International which is another contractor in an industry that's seen a lot of spinoffs and consolidation activity.  The spinoff will be recapitalized and paying out a special dividend to shareholders (versus the typical scenario where the spinoff dividend goes to the parent) of $10.50 per share.  There's been a lot of takeover speculation regarding both the parent and spinoff, that along with the dividend to shareholders leads me to believe the parent might be sold thus completing a breakup of the company.

Overview

CSC was founded in 1959 and today it is a $9B market cap global IT services company, they partner with various hardware/software providers (including some in-house) to provide clients with customized outsourcing and IT solutions.  This is a highly competitive business, CSC is in the midst of a turnaround similar to competitors IBM, HP, Xerox, among others.  Revenues continue to fall at a double digit pace and have each year since 2012 as the company changes their mix and moves towards the hot buzzwords - big data, cloud computing and cyber security. The company does have rocky recent past highlighted by the nearly $200MM fine the SEC imposed on them in June (that really muddies up backward looking earnings) for accounting fraud charges as the former management inflated earnings starting in 2011 and generally hid a troubled contract with the U.K's National Health Service.  In early 2012, Michael Lawrie joined the board and became CEO replacing disgraced management, he has both an IT services background (Misys PLC, IBM) and was also briefly a managing director at the hedge fund ValueAct.

CSC reports in three segments, each contribute roughly the same amount of revenue:

Global Business Services is the consulting and services piece of the business, it has respectable 10% operating margins; Global Infrastructure Services provides data center management, cloud, infrastructure as a service type offerings, its more product/hardware intensive and has the lowest operating margins of the three at 6%; North American Public Sector is the U.S. government contractor business, almost entirely IT services offerings and has the highest operating margin at 14%.  There's been speculation that the company has been looking to sell itself; In September 2014, Bloomberg reported that CSC had contacted private-equity firms to gauge interest in an LBO and then this past February DealReporter said CSC is in talks to sell itself in a two-part deal to a foreign strategic buyer and a private equity firm.  It seems like the two-part deal might be in play as in May, the company announced plans to spinoff the North American Public Sector unit as Computer Sciences Government Services (many government contracts have restrictions against foreign contractors), leaving the two commercial/international business behind to potentially be taken out.

Computer Sciences GS + SRA
I tend to like government services businesses, they have low capital requirements, fairly consistent and predictable revenues as once you win a contract it's hard to be unseated as the incumbent.  As a service provider, most of their expenses are personnel and many government contractor personnel are more tied to the individual contract versus the actual employer.  If you lose a contract rebid, the staff either gets reassigned, moved to the new contractor, or are laid off.  So given the predictable revenue steam and low capital requirements, the business can sustain a high debt load and use the free cash flow to delever, ultimately accruing more value to shareholders.

Along with the spinoff, CSC is immediately merging their government services business with competitor SRA International which is owned by private equity and management.  I like these multi-step spinoff and merger transactions (think ATK/ORB and SSP/JRN) as it shows a little more foresight and thoughtfulness to the corporate action, rather than just doing a "garbage barge" spinoff, management is putting together a company that's setup to succeed.

Notably the spinoff is assuming SRA's debt adding even more leverage to the company, although still at reasonable 3.75-4x EBITDA levels.  The company will be roughly split 50-50 between defense/intelligence contracts and civil agencies, SRA's book of business is a little more diversified than legacy CSC further reducing concentration risk to losing any one large contract.  When announcing the SRA merger, management provided some expense synergy and EBITDA numbers for the combined entity along with some easy public comparables of very similar businesses.

CSC Government Services will have $2.7B in net debt, plus they're taking the $400MM pension liability with them in the spinoff, for a total adjusted net debt of $3.1B.  For EBITDA, I'm taking out the expected synergies for now and using proxy/estimates swags for earnings and FCF.  Their competitors are all of relative similar size, similar debt levels, and trade within a tight range of 9.5-11x EBITDA.

Sorry if that's a bit small, but I wanted to try and show the industry's valuation using a series of multiples and give a fairly conservative valuation to CSC Government Services, using a 9.5x EBITDA value I'm coming up with a market cap for the spinoff at $5.08B.  Current CSC shareholders are going to own 84.68% of the spinoff, so net to CSC shareholders the spinoff should be worth approximately $30.55 per share, add in the $10.50 special dividend for a total of $41.05 per share in value.

Computer Sciences Commercial Business
I feel pretty comfortable valuing the government services business, much less so with the remaining commercial business, but if you net out the government business using the above comparables, the remaining parent looks very cheap despite the industry headwinds.  The purple row in the table below is showing just that, netting out the $41.05 and holding the current price constant at $64.62 (went up more today) the stub is trading at: 9.1 P/E, 3x EBITDA, and a 14% FCF yield, all very cheap metrics that would be enticing to any potential financial or strategic buyer.

In yellow, I put the remaining CSC at 6x EBITDA and come up with a $7B market cap, or $50.09 per share, in purple (netting GS out of the current price) it's $23.57 per share, so a lot of the value creation could come from this gap closing.  In the meantime, CSC continues to make bolt-on acquisitions (UXC Limited, Furition Partners, Fixnetix) in the commercial business as they continue to move towards higher margin offerings.  The company will be hosting an investor day on November 5th, hopefully they provide a little more clarity on what the plans are for the remaining business, but at today's prices I think you're paying a cheap price for a fair business that's likely an acquisition target.  Sum of the parts gets me to $91.14 pre-spin for a ~40% upside, although I'll probably sell for something close to $80 per share.

Disclosure: I own shares of CSC

American Capital: ACAP Form 10 and Proxy Notes

I was starting to get nervous there that American Capital (ACAS) would miss their own self imposed September deadline to file the Form 10 for their proposed BDC spinoff American Capital Income (ACAP), but on 9/30 ACAS filed a draft proxy statement (along with the Form 10) with several proposals to put to a shareholder vote that will move the long anticipated spinoff forward.

To recap my earlier post, American Capital will be spinning off a BDC that will pay dividends (hopefully attracting retail investors and raising the valuation), leaving ACAS with the management company that will have almost $23B in AUM inclusive of the spinoff (most of which is permanent capital).  The company pegs its current NAV at $20.35 per share, which includes the value of the management company, the stock currently trades for $12.50, a ~40% discount to NAV.

American Capital Income (ACAP)
There's a bifurcation between the valuation of internally managed BDCs and externally managed ones, with internally managed BDCs being valued at slightly over NAV, and externally ones below NAV, in some cases substantially under.  BDCs require shareholder approval to issue shares below NAV, so there's a strong incentive over time for externally managed BDCs to increase their share price through fee reductions, share repurchases or simply better performance.  Below is a table of prominent BDCs (and less prominent ones like ACSF) to give an idea of how they currently trade.

The BDC spinoff, American Capital Income (ACAP), will be one of the largest BDCs and has a close peer in Ares Capital Corp (ARCC).  Both implement a similar strategy, are roughly the same size, externally managed, and the external managers are publicly traded.  But besides a more stable history, ACAP has a few hurdles to overcome before it can trade inline with ARCC's 92% of NAV.

1. ACAS, the asset manager, is going to charge ACAP a 1.75% base management fee on assets (not equity and including cash) plus incentive fees which will charge ACAP an additional 20% of gains as long as they hit the 8% hurdle rate.  The base management fee is 25 bps more than Ares Management charges Ares Capital, but the incentive fee has a slightly higher hurdle rate (7% versus 8%), in most circumstances ACAP will be paying 0.35-0.50% more in fees for comparable performance as ARCC (remember, it's an extra 0.25% on assets not equity).  While it's good for ACAS, hopefully they reconsider and move the base management fee down to 1.5%, management will be disproportionately invested in ACAS going forward but much of the value creation from the spinoff is coming from ACAP moving closer to NAV.
2. The ACAP portfolio is going to initially be a little funky with about $1B in equity/control investments that were previously sourced by American Capital's "One Stop Buyout" program, which they've shuttered.  Since they won't be able to raise equity for a while the equity investments can be a source of funds, the plan is likely to exit these over time and reinvest in middle market and syndicated bank loans creating a more diversified, simpler to value portfolio.
3. ACAP's proforma leverage is around 140%, well below peers, which along with the equity slug and relatively overweight senior bank loans (where they're parking the leverage) means it's going to under earn initially until they get their portfolio ramped up and more inline with peers.

Even given these challenges, ACAP should at least trade for 80% of NAV, or $3.3B, inline with its sister BDC in ACSF (which is a dedicated bank loan BDC) within a quarter or two of reinstating the dividend and overtime close the gap with it's closest peer ARCC.

New American Capital (ACAS)
ACAS will be primarily an asset manager with some assets set aside to seed new strategies/funds before they eventually get sold into those vehicles.  Including the new BDC, ACAS will manage 4 publicly traded companies, two BDCs in ACAP and ACSF, and two mortgage REITs in AGNC and MTGE, along with 14 private funds (private equity and CLOs primarily) totaling $22.75B in fee earning AUM (in some of their strategies they only get paid on the equity, not the assets).

82% of American Capital's assets will be in permanent capital vehicles which should garner a premium over time.  I have a hard time determining if they're good investors, but it's fairly clear they're good asset gathers.  Interest rates are likely to stay low for some time, forcing investors to chase yield, and most of American Capital's strategies cater to those yield chasers.  ACAS puts a value on the asset manager each quarter, the latest was $1.1B, I tried unpacking that in my earlier post in February so I won't rehash that now.  They're also going to include roughly $1B in investments on the balance sheet of the manager.  My guess is the asset manager is going to be the preferred security of the two and should be valued at close to $2.1B.

Using the fully diluted share count of 283 million shares = $11.53 (ACAP) + $7.41 (ACAS) = $18.95 per share, or 50% upside from current ~$12.50 prices.

Incentive Plan & Option Tender Proposals
One of the primary knocks on ACAS is they pay themselves handsomely, siphoning off value from shareholders and re-directing it to insiders and management via stock options.  Many of their options were issued deep in the crisis, and don't expire for 10 years, just look at the CEO's:

Even at today's depressed prices these options have a current value of $24MM, and they've created an overhang on the share price.  Adding to the dilution pain, because of the spinoff, employee options holders are forced to exercise their options (issuing shares below NAV) prior to the spinoff:

"... we are prohibited under the 1940 Act from issuing options in ACAP stock to American Capital employees."  

"... because option holders are not able to participate in the spin-off and option holders have thus had to exercise vested options earlier than necessary and at lower than optimal prices, the options previously granted under our existing plans have lost significant retention value."

In their second quarter investor presentation they laid out the impact of employees exercising their stock options earlier:

This dynamic has created some forced sellers in the market, presumably ACAS employees don't want to exercise their options ahead of the value unlocking spinoff, but they have to, potentially putting unwarranted downward pressure on shares recently.  On August 5, the company announced they would buyback $300-600MM worth of shares, in part to counterbalance the options being exercised and as of the end of the third quarter they bought back $134.6MM at an average price of $13.82 per share.

Tucked into the proxy, ACAS is proposing an interesting solution that would help both employees looking to exercise their in-the-money options and current shareholders who want to reduce the dilutive effects of the options.  By law BDCs can't issue shares below NAV without shareholder approval.  Typically this is a great protection as it prevents managers from increasing the share count, and more importantly their fees, at the expense of current share holders.  ACAS is requesting the ability to tender employee stock options and issue shares covering only the net after-tax gain amount on employee's options, versus the entire amount via exercising the option.  Essentially this would drastically reduce the amount of shares that would be issued below NAV due to employee stock options.  This maneuver may also additionally reduce the selling pressure by encouraging employees to hold onto to their newly issued shares.  They won't need to sell for tax reasons (the company would pay out the amount due in taxes in cash), and you'd reasonably assume that if they haven't exercised their options and sold already, they believe the shares are undervalued and would continue to hold their exercised shares.

Here's the example they use in the proxy filing:

Using current market prices and the actual ~32 million options outstanding number should actually produce a better result than the example above since options are worth less at the $12.50 stock price, meaning less cash for taxes and less shares issued below NAV.  It seems like a win-win both for share holders and employees, and I hope it passes.

Since the employee stock options will either be exercised or out of the money after the spinoff, another one of the proxy proposals is for the 2016 incentive plan.  The plan calls for an additional 8% of shares to be set aside for employee options and another 0.5% for non-employee board members.  This might strike some as just another round of management raiding the cookie jar but if the current management options are gone, then this new plan kind of presses the reset button, almost like a new spinoff issuing the new management "founder" incentive options.  Not ideal, but not completely terrible either as they're not immediately dilutive, although issuing any shares/options below NAV is going to be dilutive, so it's a careful balance.  I'm willing to give them a break on it.  Management's record of share buybacks and now the tender offer tells me they're not quite as bad as their reputation suggests.

At this point, my biggest concern is around the timing of the spinoff.  It's been a long time in the making and if the option tender proposal isn't approved, I'm worried that management will put off the spinoff to allow additional time for employees to exercise their options and that would put more downward pressure on the share price.  Back in July I added some calls that expire in January, seems now that was a little optimistic hoping the spin would happen before then.  Either way, this is still one of my favorite ideas and I'll likely add to it before the year is done.

Disclosure: I own shares of ACAS (and Jan '16 calls)

Journal Media Group: Sold to Gannett

Two of the (very) recent publishing spinoffs are going to continue the industry's consolidation trend; Gannett (GCI) announced last night the purchase of Journal Media Group (JMG) for $12/share in cash for nearly a 50% premium.  The purchase price values Journal Media at around ~6x my swag of EBITDA.  I previously mentioned that Journal Media made a natural acquisition target for Gannett before it was spun out of the Scripps/Journal Communications transaction back on April 1st.  Journal was setup for an acquisition with no debt, no controlling shareholder and papers that fit well into Gannett's portfolio of mid-sized city publications.  Sounds a lot like Cable ONE (CABO) which was recently spun out with the implied purpose of being acquired.

The timing of the transaction is somewhat surprising as spinoffs typically wait two years before being acquired to avoid IRS scrutiny around their tax free status.  But Journal Media has provided its former parent E.W. Scripps with an opinion reaffirming the tax free nature of the transaction.  Gannett looks a little bit cheap here, but along with New Media (NEWM) they'll be the consolidators in an industry that I don't want to hold through the next recession (whenever that might be) as advertisers move toward other platforms.  The broadcast/newspaper spinoff trade has worked out well this year, but time to close it out, I sold my shares today and will let arbitragers get the last percentage points.

Disclosure: No positions

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.

Risks
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

LiLAC Group: Liberty Global's New Tracker

I realize LiLAC has been covered plenty on Twitter and other blogs, but I just wanted to memorialize my thoughts along with some of those in our recent CFA Society Chicago's Special Situation Research Forum meeting.  Others have provided far better financial models than I could create, so I'll focus more on the qualitative reasons why LiLAC is attractive and why the opportunity exists despite John Malone's track record.

Overview/Background
LiLAC Group is the tracking stock that began trading on 7/2/2015 to represent Liberty's Latin American and Caribbean ("LiLAC") Group assets.  Liberty Global, is of course the John Malone controlled entity which sought to recreate the original TCI in international markets, that story is mostly complete in Europe now they're switching their roll-up focus to Latin America.  LiLAC Group today is made up of two entities, 100% ownership in VTR (Chile's largest cable company and around 70% of LiLAC's revenue) and 60% ownership in Liberty Cablevision Puerto Rico which recently completed the purchase of Choice in June 2015.  In total, LiLAC passes approximately 4 million homes, has 3.2 million RGUs off of 1.5 million customers.  The accounting is muddied up enough as it is, so I'm going to discuss LiLAC without adjusting for the minority interest in Liberty Puerto Rico, in the end it doesn't make much difference.

Why a Tracking Stock?
Liberty Global co-CFO Bernie Dvorak said at the annual meeting, "LiLAC tracking stock represents another milestone and we're eager to take advantage of this new structure to tap into further growth opportunities in the region."  John Malone seems alone in having success with the tracking stock structure, it's rather rare at least in U.S. markets but it creates a potential acquisition currency, capital allocation flexibility and allow's management to highlight the value of a particular set of assets, all while keeping the tax and cost advantages of one balance sheet together under one corporate umbrella.

• The Latin American cable market is still relatively early in its development, much of the population doesn't have access to broadband, and much of those that do are covered by "mom and pop" type operators. Establishing the tracker gives Liberty Global a pure play currency to offer (LILAK, the non-voting C shares) to acquisition targets that may want to have continued exposure to cable growth story but be relieved of running the day to day operations. 
• John Malone is famous for playing all aspects of the capital structure, most management teams focus primarily on the debt side, structuring their liabilities in such a way to minimize rates, recourse, covenants, etc, but few spend time optimizing the equity cost of capital like Malone.  By creating the two tracking stocks, Liberty Global will be able to simultaneously buyback shares in LBTYA while issuing shares of LILA for acquisitions and more effectively manage each group's cost of capital than could be done with a spinoff.
• By maintaining the larger corporate entity there should be some cost savings, one management team spread out over a larger asset base, more leverage with vendors, greater balance sheet capacity.
• The primary downside being added complexity and if one group gets into financial trouble, it will drag the other with it since they're not formally separated.

Valuation
Thanks at least partially to the recent worldwide selloff, LiLAC is an absolute bargain today at roughly 7.0x a run-rate EBITDA inclusive of the Choice acquisition in Puerto Rico but without any credit given to potential M&A, comparable cable companies trade for 9-10x representing significant upside.  Even with a one turn discount for being a tracker to 8x, LILA/LILAK should be worth $44-45 per share.

• Balance Sheet: $2.4B in debt, $232MM of cash, $1.5B market cap = $3.77B enterprise value
• One question that I still have on the balance sheet, per the 10-Q: "On June 30, 2015, in order to provide liquidity to fund, among other things, ongoing operating costs and acquisitions of the LiLAC Group, a subsidiary attributed to the Liberty Global Group made a $100.0 million cash capital contribution to LiLAC Holdings" - Is this just an initial reattribution for the tracker spinoff or something else?  It didn't appear in the initial S-4 or the LiLAC road show presentation.  Also it clearly signals acquisitions coming soon as it doesn't appear VTR or Liberty Puerto Rico need the cash for their day-to-day operations.
• Comparables: Cable & Wireless (CWC) trades at 9x EBITDA, Malone owns 13% (more $ wise than LiLAC) via Columbia acquisition that was done at 12x EBITDA, one could get folded into the other at some point; MegaCable Mexico trades at 9x EBITDA; Groupo Televisa bought Cablevision Red for 10x EBITDA
• On 3/14/2014, Liberty Global bought out their 20% minority partner in VTR (Chile) with $422MM worth of LBTYK shares, implying a $2.11B valuation for VTR.  If you discount that amount by the depreciation in the Chilean Peso since that time, you still get a value of ~$1.84B for the equity in VTR, versus a market cap of $1.5B for LiLAC which also includes 60% of Liberty Puerto Rico. ** Edit: I might be wrong about this piece, since the VTR secured notes were issued in January 2014, figured that the LBTYA shares were a straight equity swap?  If not, only used it as another valuation data point
• On a per RGU and per customer basis, LiLAC is significantly cheaper than Liberty Global, Charter, or Cable ONE (aware that they're unfair comparisons, but still somewhat interesting to see the relative value):

Upside Scenarios

• M&A, LiLAC has $467MM in liquidity and all signs point to management continuing the successful levered equity playbook by rolling-up Latin American assets using mostly debt; if you run a model assuming free cash flow gets directed toward M&A and their leverage ratios stay fairly constant you can quickly get to some 20-30% annualized returns.
• The June acquisition of Choice in Puerto Rico should provide both cost synergies and revenue growth opportunities since most of Choice's clients were primarily broadband only clients, there's an opportunity to up-sell them video and voice services.  In the Q2 earnings presentation, management quoted a 3.5x net leverage ratio giving proforma effect for the Choice acquisition.  I had a hard time squaring that number, but using a $2.1B net debt position, that means OCF is ~$600MM?  Seems like they're projecting some significant growth from Choice.
• VTR Wireless - they currently only have a little more than 100,000 customers, or 1% of the market in Chile, but there should be some opportunity to cross sell and create a 4 play model (video, internet, land based voice, wireless) to increase RGUs.
• Eventual full spinoff once the LiLAC business matures, closes tracker discount, or Liberty Global could sell LiLAC to another industry consolidator like Altice or Cable & Wireless.

Risks
LiLAC has some unique risks, it's a highly leveraged emerging market company in an industry that some have technology disruption concerns about:  

• LiLAC in typical Malone fashion is a heavily levered equity, does it work in countries with a high cost of capital?  70% of revenues are in Chilean Peso (remainder in USD - Puerto Rico) which is near 12 year lows against the dollar thanks the slide in commodities; VTR debt is in USD, but hedged into Chilean Pesos through 2021, the all in cost of the debt is 11.1%, management must expect strong growth to overcome that hurdle.  If the dollar does begin to weaken, it could result in a significant tailwind when combined with mid-to-high single digit organic revenue growth.
• Chilean economy heavily tied to copper and natural resources, also in an earthquake zone with the potential to damage infrastructure type assets.  Taxes are also rising in Chile on a laddered basis, topping out at 27% in 2018.  Counter -- Chile enjoys the highest economic freedom in Latin America and the Caribbean (ranked 7th overall, ahead of the United States), generally viewed as the most modern Latin American country.
• Puerto Rico has well known economic problems, in default on debt, may face austerity measures.  Counter -- as CEO Michael Fries is quick to point out, these are not new economic issues for Puerto Rico, LiLAC has been able to consistently grow through them despite the macro concerns. 
• Malone has less than 3% economic stake in LiLAC, owns significantly more of CWC in region, any potential conflicts arise from that?  Counter -- Cable & Wireless provides a natural acquisition partner, opportunity to fold one into the other.
• General technology disruption concerns: cord cutting, OTT, satellite providers, consumers might move down from triple play packages to just two services or down to just broadband.
• Competition for deals: Cable & Wireless, Digicel are active in region, Altice active everywhere, could drive up the price of M&A opportunities.  Are there enough attractive acquisition targets in business friendly countries?

Why Is It Cheap?

Everyone knows John Malone's incredible record, spinoffs are popular and every event-driven analyst is trained to look at them, so why is LiLAC undervalued?

• Tracking stock complexity - as mentioned earlier, it's a rare type of security that many traditional managers aren't going to be interested in from the beginning; it's also unlikely to be in any indexes, doesn't pay a dividend, has a limited natural shareholder base.  If the tracking stock doesn't work out, Liberty Global can either spin it out or fold it back into the parent company and close any tracker discount.
• Small size in relation to Liberty Global Group - shareholders of Liberty Global received 1 share of LILA/LILAK for every 20 shares of LBTYA/LBTYK owned, roughly in line with the size of the entities, LiLAC group is roughly 5-6% of the overall entity, creates some uneconomic selling as investors treat it like a special dividend and sell.
• Dislike for Emerging Markets - Latin American stocks are down roughly 50% from September primarily because of the region's emphasis on natural resources and the China bubble deflating reducing demand for commodities.  South American countries have a reputation for being unfriendly to business and heavily corrupt.

I ended up drinking the kool-aid and started a position on Wednesday around $33, made it a medium sized position that leaves some room to add if the sell-off continues.  My head hurts after looking at this for the past two weeks, if one wants to invest in a Malone levered equity, buying Liberty Broadband is probably a much simpler way to do it, no currency risk, cheaper debt, and much cleaner financials.

Disclosure: I own shares of LILAK

A Few Ideas From My Watchlist

I'm pretty comfortable with my current holdings, mostly just sitting on my hands during this bout of market volatility, but want to highlight a few interesting opportunities that might deserve further research:

Gabelli Securities Group (GSGI)
Mario Gabelli's GAMCO Investors (GBL) is spinning off their event driven alternative funds, research unit, and broker/dealer into a separate company dubbed Gabelli Securities Group (GSGI).  The larger GAMCO Investors has over $45B in AUM, much of it in retail mutual funds which are in secular decline, the event driven alternative fund business has about $1B in AUM, only a tiny fraction of the total and thus puts it on my radar for a potential post-spin dump.  So why do this spin?  Mario Gabelli is a good investor, a great marketer and asset gatherer, has a great brand name, and the event-driven space is a hot hedge fund category.  I'd guess that Gabelli is going to put a disproportionate amount of weight behind selling the spinoff's products in the early going and increase AUM quickly.  So this is a rare combination of a small spinoff that might get sold off by GBL shareholders, but is in fact the growth business of the two.  Mario Gabelli will maintain his 10% royalty on pre-tax earnings of the new entity, and control the company via super-voting shares, so that will limit the upside, as you're effectively paying a hedge fund like fee to invest in his hedge fund management business.

Hemisphere Media (HMTV)
Hemisphere is the owner of the largest Puerto Rican local broadcast station, WAPA, and 5 Spanish language cable channels (Cinelatino, WAPA America, Pasiones, Centroamerica TV, Television Dominicana) that are typically contained within Spanish language add-on packages.  Hemisphere has held up reasonably well in the overall cable content selloff.  It's controlled by InterMedia, and went public through a reverse merger with a SPAC in 2013.  The pitch behind Hemisphere is the young, growing, and underserved Hispanic population in the United States, plus they're pursuing adding advertising to their top cable channel Cinelatino (Spanish-language movie channel) that was previously advertising free.

Hemisphere doesn't appear particularly cheap on the surface, trades at 12x EBITDA compared with larger U.S. cable television peers like DISCA, VIAB, SNI, and AMCX in the 8-10.5x range.  But Hemisphere might deserve that premium as their subscriber counts are growing whereas most networks have seen reductions as cord cutting takes hold.  Additionally, larger peer Univision has filed for IPO at a hefty implied $10B market cap, look for some of that enthusiasm to spill over into Hemisphere Media.

National Beverage (FIZZ)
Not value or a special situation, but an interesting growth name.  National Beverage is all about the push into healthier/lifestyle focused beverages, mostly via their LaCroix sparkling water brand.  In total they're the 5th largest carbonated beverage company in the United States with a market cap just under $1.2B.  LaCroix is extremely hot, I can't log into Facebook without seeing pictures of someone trying out a new flavor or reading an article about the best LaCroix mixed cocktails.  National Beverage also has legacy soda brands that you forgot existed like Shasta and Faygo, the plan appears to be to milk the cash flow from these sugary beverages and direct it to LaCroix and other growth brands.  The company is family run, controlled by Nick Caporella (his son is the president) who owns 74% of the shares, making the float only $300MM or so and out of the range for a lot of institutional investors.

The company's quarterly news releases read like a small town newspaper, and there are very limited financial disclosures in the 10-Qs or 10-Ks, so it's hard to really get a good picture of how the business is doing.  But after Coca-Cola invested in both Monster and Green Mountain, why wouldn't they take a shot at the sparkling water leader too?

Newcastle Investment Corp (NCT)
I've been close to buying Newcastle several times this year, it's basically a forgotten stub after the Fortress controlled mREIT has spun-off three companies in the last 2-3 years - New Residential (NRZ), New Media (NEWM), and New Senior (SNR) - leaving a pool of legacy commercial mortgage loans/debt and a golf course management business behind.  The quick thesis is the pool of debt securities is near term and liquid, it covers the entire market cap and you get the golf business for free.  Fortress estimates the golf business will do $30-33MM in EBITDA in 2015, there's an easy public comparable in ClubCorp (MYCC) that trades for 10-11x EBITDA equaling ~$3.50 per share in value for NCT which trades just below $5.

Golf may or may not be in secular decline, but it's another similar business to New Media or New Senior where it has a long run away of "mom and pop" type acquisition opportunities to create a mini roll-up.  Wes Edens has also mentioned using ERP Properties as a model and diversify away from golf into other recreational real estate assets.  The downside is of course Fortress, and their external management fees and conflicts, its always going to deserve some discount and you have to be careful using their investor presentations as your investment thesis.  All private equity guys are great at spinning a story.

Viad Corp (VVI)
Another company with a history of doing spins is Viad Corp, today it operates in two separate business lines, Marketing & Events Group (mostly conventions) and Travel & Recreation (hotels, lodges, adventure excursions), with no apparent synergies which will eventually lead to either a spin or sale of one of the businesses.  The travel business operates in and around Banff/Jasper, Glacier National Park, and Denali National Park, it's a good but niche business catering to seasonal adventure travelers.  The travel business does about $36MM in EBITDA annually, and would fit nicely into a travel and leisure portfolio like ERP or what NCT wants to build.  If you back out the travel business at 10x EBITDA, the Events/Conventions business is being valued at just under 6x EBITDA (including $10MM of corporate overhead).  Certainly cheap, but it's a cyclical business and a low margin one, it's on my long term watch list as something to return to coming out of a recession.

Side Note: If you're located in Chicago, there's a good special situations/"10-K" group that will be discussing Liberty Global's LiLAC Group tracking stock on Monday at 3:30pm at the CFA Society Chicago's office at 124 N LaSalle, come join, and I'll post my thoughts on the name here sometime next week.

Disclosure: No positions

WMIH Corp: KKR Controlled NOL Shell

A simple and brief investment idea today, it's been teased and mentioned a few times in earlier posts on other NOL companies.  WMIH Corp (WMIH) is the remaining shell of the former subprime lender Washington Mutual which became the largest bank failure before most of its assets were sold via the FDIC to JPMorgan Chase in September 2008.  What remains in the old corporate shell is approximately $6B in net operating losses, a small reinsurance business that's in runoff, and $600+MM in cash set aside for a future acquisition.

KKR is effectively in control of the company via the $600MM convertible series B preferred stock issued in January of this year, the proceeds of which are in an escrow account.  KKR is one of the original leveraged buyout shops and gives WMIH Corp access to deal flow and an experience management team.  SPACs and "platform companies" are a current rage, add that with the M&A reputation of KKR and any WMIH acquisition could be met with investor enthusiasm.

Valuation

WMIH Corp has cash of $670MM to use for an acquisition, $600MM in escrow and $70MM at the corporate level (I'm ignoring the cash and investments inside the runoff reinsurance company).

Let's assume KKR will just use the escrow funds and leave the $70MM for liquidity, they could make an acquisition using half equity, half debt for a $1.2B operating company generating $200MM in pre-tax earnings.  Using a 10% discount rate and assuming 3% annual growth rate in the pre-tax earnings the NOL could be worth an NPV of ~$750MM.  That's probably on the low side, 1) KKR will likely make a larger initial acquisition and raise capital via a rights offering (similar to GRBK, PARR, RELY) to bring forward the NOL value, and 2) there will be additional bolt-on acquisitions over time that will increase earnings at a faster clip than 3%.  But to be conservative, let's use the $750MM value for the NOL.

Assumes 3% earnings growth rate

WMIH Corp has also granted warrants for 61.4 million shares at an average exercise price of $1.38 per share which will raise nearly $85MM.  Add that with the $670MM in cash, plus the $750MM NPV of the NOL, totals $1.5B for WMIH.

The current share count doesn't include the dilution of the various warrants and convertibles in WMIH Corp's capital structure.  KKR's series B preferred stock will convert to equity at the time of an acquisition at a price of $2.25 creating 266,666,666 shares, add in the 1 million shares of Series A convertible preferred stock and the warrants will add another 61.4 million shares to the current outstanding 202.3 million, or a total of 531.4 million shares.  Using the $1.5B valuation number, that works out to $2.82 per share versus about $2.50 today.  So you're merely getting an okay deal today for the shell, but the incentives and potential leverage in an acquisition are such that there could be substantial value creation once a deal is commenced.

Risks/Other:

• KKR is unable to find a suitable acquisition, pays the wrong price, or just simply takes too long creating an opportunity cost for investors.
• At the time of an acquisition, there will probably a rights offering, so keep that in mind when sizing a position.  Trading around deal announcement, rights offering, and deal closings have been extremely volatile in these NOL shells, so even when there is good news, could be a wild ride.

Disclosure: I own shares of WMIH