American Capital: Complicated Structure, NOLs, Pending AM Spinoff

Expanding on the externalizing management theme, American Capital (ACAS) is a business development company ("BDC") that was an epic disaster during the financial crisis, it has somewhat recovered, but due to their NOLs the company has elected to not resume their dividend payments making it out of favor with the traditional BDC investor (muppet retail, dividend focused).  On 11/4/2014, the company announced a long awaited plan to separate their asset management division (American Capital Asset Management, or "ACAM") from their traditional BDC assets by creating and spinning off two new BDCs with the remaining parent company, ACAM, becoming a pure play permanent capital asset management company.  The two BDCs will then turn on the dividends making them more attractive to retail investors and ACAM will enter into highly valuable asset management agreements with the spinoffs.  American Capital's shares trade for $14.50, a significant discount to their self-reported NAV of $20.50 (as of 9/30), which doesn't include the incremental value of the two new BDC asset management agreements to ACAM.

The idea is well known among special situation investors and the separation of the asset management company from the BDCs has been well telegraphed, so why is it still trading at such a significant discount to it's NAV?  I believe the many blowups in popular event-driven names in 2014 has caused managers to reduce exposure and the spinoff of two new BDCs is extremely complicated and has required more patience than many short term focused traders have been willing to give American Capital.

For this situation to work out two questions need to be answered positively: 1) What will be the normalized run rate EBITDA for ACAM including fees received from the two new BDCs? and 2) Will the BDC spinoffs trade near NAV?  And of course, this situation needs time to play out before another recession takes a bite out of American Capital's risky assets.

Background
American Capital was founded in 1996 and went public in 1997, ACAS is based out of the DC area and like other BDCs traditionally invests primarily in debt and equity of small and middle market companies who can't access capital through traditional bank loans or the corporate debt markets.

BDCs like REITs are pass-through structures for tax purposes, if the BDC passes along 90% of its taxable income to shareholders its exempt from paying corporate income tax and instead the earnings are only taxed at the individual level (although at ordinary rates).  Since BDCs have limited retained earnings, they need access to the capital markets in order to grow their asset base and increase fees to the management company.  The ability to arbitrage their cost of capital against that of the assets they're purchasing can add value as the BDC turns illiquid risky assets into a liquid asset that appeals to retail investors reaching for yield.  This arbitrage only works if the company's shares trade for above net asset value (NAV), otherwise equity issuances will dilute current shareholders and destroy value.

Back to American Capital, from their 1997 IPO until the second quarter of 2008 the company's shares traded above NAV allowing the company to continually issue shares and grow their asset base.  The great recession brought American Capital to the brink as their risky loans to mediocre businesses took significant losses (creating its net operating loss carry-forwards).  The company turned off the dividends and sealed their fate with dividend focused retail investors as a toxic dump (that's still somewhat fair).  American Capital's management knew they could no longer issue shares to grow and now had a valuable tax asset to monetize, so in 2011 they changed corporate structures switching from a regulated investment company (RIC) to a traditional c-corp allowing the company to retain its earnings.  Retaining their earnings allowed them to repurchase shares in the years since the crisis at significant discounts to NAV and utilize their NOL position.

American Capital Asset Management
Back to the current situation, after the proposed spinoff ACAS (ACAM) will become a valuable permanent capital asset manager with external management agreements with 5 publicly traded BDCs or mortgage-REITs, 3 private equity funds, and 5 collateralized loan obligations (CLOs).  The management agreements with the 5 publicly traded vehicles are particularly valuable as they represent the holy grail of permanent capital, unlike open end funds investors can't withdraw their funds directly from the manager, they must sell their shares to another holder.

In a previous post on another permanent capital asset manager, Ashford Inc, I was likely too conservative by backing into a 10x EBITDA valuation, this multiple is more accurate for a traditional open-end manager but the new breed of permanent capital managers are trading at higher multiples, closer to 14-16x as their fees are nearly annuities.  Additionally, managers typically have a wide ability to push their expenses directly onto their captive vehicles and get fully reimbursed at full cost. Questionable?  Yes, but in this low rate environment, many retail investors continue to pile into dividend focused vehicles as a bond substitute allowing managers to get away with exorbitant fees.

So what is ACAM worth?  Below are their externally managed vehicles with the earning assets under management of each:

 

A couple of assumptions here, there are some moving parts with the two new BDCs and what the ultimate fee agreements will be, but I'm assuming a 1.5% fee on assets and ACAM only adding a little bit of leverage (when they'll probably add a lot more).  Additionally, most of their vehicles have incentive fees, so you can layer that on top as well, and then I'm using a 15x EBITDA multiple, which one can argue is high but the permanent nature of their AUM deserves a premium over the typical fund manager.  ACAM also has shown the ability to raise capital in different credit segments and aren't as concentrated to the shaky middle market as recent BDC manager IPOs have been.

Additional Assets: ACAM will also be structured as a c-corp and will keep the $620MM in NOLs that were created by the poor investments within the BDC portfolio but will now be applied to the earnings stream of the asset management company, a nice bit of financial engineering and tax avoidance.  In the investor presentation, ACAS guided to $1B in equity being available to the company, this appears to include the European Capital business ($680MM at NAV) which could be an additional spinoff in the future and also allows ACAM to seed new strategies before placing them in new public vehicles like they've done with American Capital Senior Floating (ACSF) in early 2014.

Value of ACAM = $2.5B (including European Capital, but giving you the NOLs for free)

American Capital Growth & Income and American Capital Income - BDC Spinoffs
The other key to this situation is determining what the new BDCs will trade at once the dividends are turned on and Seeking Alpha articles start getting circulated.  BDCs are pretty terrible investments, they charge high fees and mask those fees with risky loans and high leverage, most retail BDC investors would be better off investing in a low cost stock/bond mix and peeling off their own "dividend" by selling shares.  There is a noticeable bifurcation in valuation between internally and externally managed BDCs with the internal ones selling a sizable premium to NAV where the external BDCs are lucky to trade at NAV.

I don't have a lot to add specifically regarding the new BDCs.  American Capital Growth & Income will include the operating companies (thus able to be a tax-free spinoff) paired with the syndicated bank loan/CLO equity portfolio where they'll use all their available leverage and pile on debt.  Bank loans generally held up during the great recession and belong in a permanent capital vehicle instead of a traditional open end fund or ETF.   I could see this larger BDC transforming into something like their ACSF vehicle, syndicated bank loans are more transparent and easier for ACAM has a manager to service.  American Capital Income will have their third party middle market type loans, nothing particularly interesting about it, but the key is both of these BDCs will start paying "market rate" dividends.  In a record low interest rate environment, retail investors will continue to flock to BDCs as a fixed income replacement, once American Capital's BDCs start paying dividends they should trade near NAV or just below.

Value of the BDCs = $3.6B ($4B with a 10% haircut)

Adding up ACAM and the BDCs, I come up with a total valuation of $6.1B, or $23 per share, above the $20.50 estimated NAV because of the two new asset management contracts and a higher permanent capital manager multiple assigned to ACAM.  It should be noted that ACAS has over 54 million in options outstanding at an average exercise price above $9 per share,  ACAS will probably cover some of this dilution with share repurchases, but that will knock the $23 estimate down a notch or two.
 
Risks

• Breaking apart the tangled corporate web is complicated and could take longer than anticipated, American Capital hasn't guided to a specific transaction date yet which is likely holding back some event-driven investors
• If American Capital's publicly traded vehicles don't trade above NAV, AUM growth will be stunted and it will be more difficult to "cover up" bad assets with new assets potentially spiraling the discount to NAV problem
• In 2014, a few BDC managers went public (ARES, FSAM, MDLY) and haven't fared well, mostly due to BDC market specific concerns and in FSAM's case, questionable corporate governance and management
• If you think a recession is around the corner, this is not the situation for you, BDC assets are typically made to shaky middle market companies that can't get financing through traditional channels.  The syndicated loan book and CLO equity should be okay in a recession (relatively minimal losses there in 2008-2009), but I'd be more concerned with the middle market loans and operating companies that will be in the BDCs
• Management pays themselves lavishly, at ACAS and in the BDC industry in general, eventually if BDC managers don't add value for their clients the industry is going to suffer and some of that sentiment is already in BDC market values

American Capital is a combination of a few themes that I like right now: (1) it has a complicated structure and balance sheet that doesn't screen well and requires some work to dig through; (2) the remaining asset management company will be a c-corp (versus a partnership, no K-1s, widens the investor base) with a significant NOL tax asset; (3) it's a company that currently doesn't pay a dividend in a dividend focused sector, essentially getting punished for displaying rational capital allocation; (4) and of course it's about to embark on a break-up/spinoff which will force the market to value it on a sum of the parts basis (and create AM agreements with two new BDC vehicles).

I'm more interested in the asset management company for obvious reasons, but one might need to hold onto the BDCs for a quarter or two after the spinoffs to give time for the market to re-rate them inline with peers.  I bought a mid-sized position this week around $14.40, will look to potentially supplement my shares with LEAPs as well. 

Disclosure: I own shares of ACAS

Signature Holdings Group: NOLs, Aluminum, and a little Promotion

An investment theme I continue to like is companies with significant net operating loss carry-forwards (NOLs), they are typically small and have ownership restrictions in order to stay in compliance with IRS NOL rules making them out of reach for larger institutional funds (meaning less competition).  Signature Holdings Group (SGGH) is an NOL shell company formed in 2010 after one of the worst sub-prime operators Fremont General emerged from bankruptcy.  Since emerging as Signature, the company has been through two different proxy contests, the second one ending in the summer of 2013 with Craig Bouchard taking the CEO and Chairman roles with the backing of Sam Zell's distressed debt fund (same one as Par Petroleum).  It's main asset is roughly $890MM in NOLs which should keep it from paying income taxes for the better part of a decade in the most optimistic scenarios.

Signature Holdings aims to be an acquisition platform targeting the transportation, food, water and energy sectors to utilize the company's NOLs which begin to expire in 2027.  In order to fund these acquisitions, they plan to use the Covanta (CVA) playbook of raising equity through serial rights offerings in order to stay within NOL ownership restrictions.

GRSA Acquisition
In October 2014, the Bouchard led management team landed their first large scale acquisition (after bidding and losing 6 deals previously) with the purchase of the Global Recycling and Specifications Alloys ("GRSA") business of Aleris Corporation for $525MM.  GRSA is the largest aluminum recycling business in North America and Europe (largely fragmented industry), with this purchase Signature is hoping to ride the trend of auto companies using more aluminum over steel in order to meet their government mandated fuel efficiency standards.  The Ford F-150 is just one high profile example of this but expect more makes and models to start switching in the coming years.

The headline acquisition multiple was 6.5x EBITDA, but how did they arrive at this figure and how many adjustments were made to an already non-GAAP figure?  The below table is from page S-22 of the company's recent prospectus:
That's a long list of EBITDA adjustments!  Including even a line item for extreme weather as last winter's polar vortex drove up the company's natural gas energy costs.  There's also a little deception stripping out some SG&A above the GRSA business unit at Aleris, some of that overhead is necessary to run a business even if it's not directly related.  Signature has about a $9.5MM SG&A run rate, so I'm going to subtract that from their adjusted number and come up with about $72.5MM (after also adding back weather and other adjustments) in EBITDA; maintenance capex is pegged at around $35MM annually, so free cash flow is around $37MM.

One look at Signature's balance sheet before the acquisition announcement would make it clear that they don't have the $525MM necessary to close this transaction.  With only $44MM in cash, the plan is to take out significant debt, tap their asset-backed credit line, conduct both an equity issuance and rights offering, and a $30MM in non-convertible preferred note to Aleris in order to pay for GRSA.  Additionally, Signature sold its only small operating business NABCO for $78MM to raise cash, with a net of $56MM after paying off the debt associated with the business (NABCO was purchased for $37MM in 2011 by prior management).

The bond issuance ended up being fairly expensive, $305MM sold at a discount of 97.2% at a 10% coupon rate, and well in junk bond range with a B3/B rating by Moody's and S&P respectively.  I think the aluminum recycling business might be a little more cyclical than Signature lets on in their presentation materials.  Without knowing too much about the aluminum industry, it just strikes me as being heavily tied to capital spending, a heated automobile market (we've all seen the subprime auto loan numbers) and potentially the Chinese economy too which scares me.

So what does the proforma EBITDA, earnings, and free cash flow look like?  Below are my back of the envelope numbers:

There are a number of moving parts in this acquisition, so please double check my numbers, the main assumption is around the upcoming rights offering happening in the next month.  I'm assuming the NABCO net proceeds are coming out of the original $125MM Signature intended to raise via both the rights offering and the stock offering that's already been completed.

It certainly looks cheap on the surface, the current price is around $8 per share which is in between the prices paid in the two equity offerings ($10.00 and $6.50).  Signature has also stated they want to do roughly one acquisition of similar size a year which should provide some additional operating leverage as some of that corporate level SG&A can be spread over a larger base.  Plus it sounds like they see some increase in GRSA's EBITDA through both organic growth and bolt on acquisitions.  But I'm on the fence on whether it deserves a spot in my portfolio, on top of the cyclical nature of the business and the potential for further declines in their earnings, something just doesn't feel authentic about management.

Promotional Management
CEO Craig Bouchard is a charismatic serial entrepreneur who has run several successful companies in a variety of industrial sectors (Shale-Inland, Esmark, NumeriX) and written two books, including a children's book for charity.  Clearly he's a talented individual, but I can't shake the feeling that his individual brand comes before all else.  He has his own personal website that reads very promotional, including a quote that he seems shy about when he's saying it, but continues to throw it out there that "one outcome (of Signature Holdings) would be to become a mini-mini Berkshire Hathaway."  That's one cringe worthy goal that I'm sure has gotten some his investor base excited.  Then there's his LinkedIn profile, it's rare that someone of his accomplishments flat out brags, such as the line about becoming the 3rd fastest to SVP at First Chicago (regional bank that is now part of JPMorgan), who keeps track of that and then who brags about it 20 years after the fact? And how Esmark was the highest appreciating stock in 2008; hopefully he didn't write is own profile.

Additionally, smaller things like their cheesy PowerPoint templates and use of overly promotional language like "the World's Largest" are picky, but still strike as questionable.  Sure, Signature needed/needs to raise a lot of capital and other companies have done much worse, but it seems to be in the DNA.

There is still quite a bit to like here, curious to see how the rights offering shakes out and what others have to say.

Disclosure: No position

Ashford Inc: New Trend of "Externalizing" Management

Ashford Inc (AINC) is the asset management spinoff of Ashford Hospitality Trust (AHT) that a reader recently alerted me to, so I did some digging and while I don't think it's particularly appealing at current levels, it could provide some insight into similar upcoming spins/breakups at American Capital Ltd (ACAS) and Prospect Capital (PSEC), both BDCs, which are also spinning off their asset management businesses.  Most corporate governance groups and investors would prefer to see REIT/BDCs internalize management, but now there is this new trend to externalize management with asset management spinoffs, not something that happens at market bottoms.  External asset managers have a number of potential conflicts with the entities they manage, what's good for AINC shareholders (AUM growth) may not be best for AHT shareholders if they end up over paying for growth or issuing shares/debt at less than ideal levels.

In November 2013, AHT spun-off its luxury hotels into a separate entity Ashford Hospitality Prime (AHP) in an effort to obtain a premium valuation and a lower cost of capital.  As part of the AHP spinoff, AHP entered into an external management agreement with a subsidiary of AHT which laid the groundwork for the AINC asset management spinoff.  Ashford Inc (AINC) was then spun-off on 11/12/14 with an odd 1 share of AINC for every 87 shares of AHT ratio, it started trading in the mid-$40 and quickly traded all the way up to over $130 (quick triple for some) a share with CEO Monty Bennett buying in the open market along the way.  It's now trading around $93.

Ashford Inc currently manages the Ashford complex's two REITs (AHT & AHP) on 20 year contracts and is in the process of setting up a real estate focused hedge fund under the Ashford Investment Management banner which will be 40% owned by Monty Bennett and one of his lieutenants.  They're also interested in a few future growth platforms as shown below:

Asset management companies are of course great businesses, they have substantial operating leverage with minimal capital expenditures, a small increase in AUM can disproportionately increase earnings in a hurry.  What makes Ashford more attractive than other small cap asset managers is their capital is essentially permanent, while their market caps can certainly decrease, Ashford's REITs won't be subject to outflows like a traditional mutual fund manager in a market decline.

The spinoff wasn't without some controversy, labor union UNITE HERE staged some opposition to the transaction by creating a website (http://www.unlock-ashford.org/) outlining some of the real or perceived conflicts of interest created by the structure.  Ashford also instituted a poison pill that expires in March and has a staggered board, both anti-shareholder friendly, which was picked up by the Wall Street Journal on Monday. 

Ashford Hospitality Trust (AHT) & Ashford Hospitality Prime (AHP)
Ashford Inc is really a leveraged bet on the growth (and to an extent the performance) of both AHT and AHP as Ashford will be paid a 70bp base fee on the total enterprise value (but including cash) and an incentive fee based on the relative stock performance versus a peer group for both entities (determined annually but paid over three years), so it makes sense to analyze each briefly.

AHT considers itself an opportunistic hotel investor, having a wide mandate to invest across sector subclasses and across the capital structure.  It also utilizes significantly more leverage (both debt and preferred stock) than the average REIT, and is quick to refinance non-recourse mortgages to raise cash as it did recently.  Management likes to tout their 19% insider ownership at AHT as a method of aligning shareholder interests, and there seems to be some truth to that as AHT was savvy during the financial crisis and was able to repurchase a substantial amount of their float at advantageous valuations.  Including cash, the enterprise value of AHT is around $4.2B.

AHP on the other hand is marketed as the lower risk, higher quality portfolio compared to AHT.  At the time of the AHP spinoff they articulated a clear strategy of targeting hotels with RevPar (revenue per available room) of at least two times the national average and located in major gateway and resort market.  AHP will also have a  lower debt profile than AHT, with a target of 5x EBITDA by the end of 2015 and going forward.   Ashford also recently announced a share repurchase plan at AHP, again something you wouldn't expect if you're extremely cynical about external management.  They plan to sell one of their hotels and buy back shares, essentially reversing the private/public arbitrage that REITs generally exploit.  Including cash, the enterprise value of AHP is around $1.4B.

I didn't spend too much time on the above table (so don't trust every number), but compared to peers, both look slightly undervalued on a relative basis and not particularly expensive on an absolute basis.  However, Hotel REITs are a risky bunch that should trade at a discount to other REITs, their leases are the opposite of the triple-net lease industry in that their "leases" are extremely short term (overnight) in nature, meaning in a recession earnings can evaporate pretty quickly.

Valuation
The pro-forma financials in Ashford Inc's propectus are pretty messy and I'm not sure they really tell us a whole lot about what the future operating performance will be.  For instance, proforma 2013 numbers indicate an operating margin of just over 10%, extremely low for an asset manager, should be more in the 30-40% range and I would expect the company to right size costs as a standalone entity.  Let's approach valuation another way, a common valuation metric for asset management companies that I've seen is 10x pre-tax earnings, not entirely sure of the origin, but it seems reasonable to me.  Using that as a yard stick, I backed into what the market is currently pricing in as their pro-forma operating margin and an implied AUM figure below:

So it appears that the market is a little ahead of itself or expecting a lot from Ashford's hedge fund effort and their incentive fees.  While I'm passing on AINC for the time being, it's been an interesting exercise and as a result I'm going to be taking a closer look at both the ACAS (the management company will keep the NOLs) and PSEC asset management spins coming in 2015.  Are there any others to keep an eye on?

Disclosure: No Position

Year End 2014 Portfolio Review

The back half of 2014 was a wild ride for my personal account, I was up almost 30% at the half way mark of the year and at one point in the fall I had lost all my paper gains for the year.  I sold most of my mistakes in energy (Civeo, Paragon Offshore and to lesser extent Ultra Petroleum) and with a little luck the market perked back up salvaging much of what I gained in the first half.  But onto the results, there were no deposits or withdrawals into the blog portfolio during the period:

Another good year, and I'm pleased to keep my lifetime-to-date IRR above 20% which is my goal over the course of the market cycle(s).  I really enjoy the investing process over the proceeds, but if I'm not out performing, might as well consolidate my holdings into index funds and focus more time/energy on my day job.  Moving to 2015, my aim is to reduce the number and impact of my mistakes, which will likely mean fewer trades and potentially more diversification, but I'll continue to highlight interesting ideas for the blog, even if they don't make it into my personal account.

Below is breakdown of the attribution of each holding during the year to my performance, which is interesting at least to me, the grayed out holdings were closed out during 2014:

And then below are my current holdings as of end of day 12/31/14:

Additional Miscellaneous Thoughts:
New Media vs News Corp
Missed the opportunity in New Media (NEWM), Fortress has executed nicely on their plan to rollup small local newspapers and basically doubled this year.  I might have to change my strict rule against third party management agreements to just a higher hurdle to overcome.  I picked the wrong horse in the newspaper spinoff crowd (at least in the short term) with News Corp (NWSA), it's my lowest conviction holding currently, while incredibly cheap on a sum of the parts basis, shareholder returns don't seem to be their top priority.  If you listen to CEO Robert Thompson on any of their quarterly calls, its more about story telling, empire building and self promotion than actual business results.  I like their assets, but may find a better use for this cash soon.

Civeo Corp
Obviously was a disastrous investment for me, I got a little too excited with REIT conversions and then add the spinoff dynamics with a couple respected hedge funds backing it... turned out to be peak everything in one.  Luckily I trimmed some of my position in July at $26.50, but still took a big hit with the downgrade in guidance and rejection of the REIT conversion, and sold everything in October at $12.00, was lucky to avoid the next leg down this week.  There's some good discussion in the comments section of my two posts on Civeo, could be an interesting addition to a basket trade of washed out energy names in 2015.  Not that I'll likely be participating, need to recalibrate my ability to take the market temperature in commodity industries, have some work do before I'd feel like its in my circle of competence again.

NOL Shells
I like the NOL theme right now, most of these companies seem below the radar (or restricted) of larger hedge funds/other investors, and a less crowded theme than spinoffs.  I've highlighted a few this year in Green Brick Partners (GRBK), MMA Capital Management (MMAC), Par Petroleum (PARR), Tropicana Entertainment (TPCA), and Cadus Corporation (KDUS).  Others that I'm looking at and might blog about in upcoming posts include Signature Group Holdings (SGGH), WMI Holdings (WMIH), and Special Diversified Opportunities (SDOI); Signature has made it's operating company purchase and WMIH and SDOI are still looking at potential acquisitions.

Thank you to everyone for reading and happy new year.

Disclosure: Table above is my blog/hobby portfolio, its a taxable account, and a relatively small slice of my overall asset allocation which follows a more diversified low-cost index approach.  The use of margin debt/options/concentration doesn't represent my true risk tolerance.

Tropicana Entertainment is Still Cheap

It's been a little over a year since I've discussed Tropicana Entertainment on the blog and a lot has happened during that time, but you wouldn't know it if you look at TPCA's stock chart which has done almost nothing for two years now.  The illiquidity of the shares is a good mental exercise, it's the equivalent of investing in a private company and you need to look through the stock price feedback loop and analyze the results to determine how the company is really doing.  I've discussed Tropicana in the past (here and here), but to briefly recap it's the Carl Icahn controlled gaming company that emerged from bankruptcy in 2010.  The company owns 7 casinos mostly in drive up markets across the United States and a small temporary casino located in Aruba.  At this point the company is substantially undervalued as moves they've made are starting to pay off and troubles in the industry could yield future acquisition opportunities.

Atlantic City
Atlantic City has been a mess for years now, the root of the problems stems from increased competition along the east coast, particularly starting in 2006 when the first casino opened in Pennsylvania.  Previously Pennsylvania residents would travel across the border and spend money in Atlantic City casinos, now Pennsylvania has passed New Jersey to be the second largest gambling revenue state behind Nevada.  Maryland has a bunch of new casinos opening up too and Massachusetts just granted a couple casinos licenses, competition is not going to let up anytime soon, and thus the Atlantic City market has been forced to shrink dramatically.  We started 2014 with 12 casinos in Atlantic City, 4 casinos have closed so far (Trump Plaza, Revel, Showboat, and Atlantic Club) and the Trump Taj is likely to make it 5 when it finally shuts its doors in the next month or two (Icahn is Trump Entertainment's largest creditor).

The decreased competition has increased foot traffic at Tropicana's flagship Atlantic City casino and resort.  The company made a savvy purchase of Atlantic Club's patron database and gaming equipment that has led to increased slot customer volumes (the most predictable kind of gaming revenue).  While overall Atlantic City gaming revenue declined 9.3% across the city, Tropicana's casino revenues were up $21 million in Q3 2014 or 33% compared to Q3 2013.  New Jersey has also approved the use of $18.8 million in CRDA deposits (otherwise basically restricted cash) and $4.8MM in grant money through the New Jersey Economic Development Authority to invest in the Atlantic City casino, all in, Tropicana is going to spend nearly $40MM upgrading the property while weaker players have been putting off capex and exiting the market.  Previously seen a source of risk, the Tropicana Atlantic City has the potential to provide continued upside surprises as the AC market rebalances itself.

Another piece of good news happened this past January when the company received $32MM in cash as part of their property tax dispute with the city, previously it was going to be in the form of annual tax credits going out to 2017.  A lot of this money will go to upgrading the Atlantic City property, but it also skews the first quarter results so keep that in mind when running your own numbers. 

Real Estate Value
Most gaming companies have extensive real estate holdings, and in today's market that means activist pressure to re-evaluate capital structures and spinoff the real estate into a REIT.

• Penn Gaming (PENN) did a PropCo spinoff of their real estate assets in November 2013 which created Gaming & Leisure Properties Inc (GLPI), a REIT that triple net-leased backed the casinos to Penn Gaming and is pursuing additional acquisitions.
• Pinnacle Entertainment (PNK) announced plans to spinoff its real estate into a REIT on 11/6/14, activist Orange Capital had been pushing Pinnacle for a REIT conversion since Penn completed the GLPI transaction.
• Boyd Gaming (BYD), owner of the Borgata in Atlantic City, discussed the possibility of a REIT conversion on 10/30/14 and engaged Greenhill as an adviser.
• Caesars Entertainment (CZR) announced on 11/18/14 that they've approached their senior lenders about a plan to convert the company's 44 properties (including several in Atlantic City) into a REIT in order to help their over leveraged balance sheet.  Caesars is a distressed play at this point, and the REIT conversion would likely be part of a bankruptcy reorganization.

A REIT conversion is not an option for Tropicana (but maybe a sale leaseback?) as Icahn's controlling position would violate REIT ownership rules (no one can own more than 10%), but none the less exposes the value in their real estate and signals M&A activity in the sector.  Tropicana has a flexible balance sheet, with net debt of only 1x EBITDA, Tropicana has the ability to leverage up and potentially buy up weaker competitors or end up buying the operating casinos after they've split off the real estate.  As part of these REIT conversions, each company will be evaluating their casino portfolios and looking to sell assets that don't meet their new strategy for one reason or another.  I could see Tropicana as part of it's rollup strategy and strong balance sheet being a natural acquirer in 2015.

In addition to owning most of their casinos, Tropicana also owns some other real estate assets including the two luxury hotels in St. Louis that were part of their Lumiere purchase, the HoteLumiere and the Four Seasons, the replacement cost is likely in the $150-200MM range for the combination of the two.  They also own "The Quarter" adjacent to their Atlantic City casino, a 200,000 square foot Havana-themed mixed retail development featuring shopping, restaurants, nightclubs and an IMAX theatre, the development cost $285MM to build in 2004, even if its worth just a fraction of that, its still significant when compared to Tropicana's $520MM enterprise value.

Valuation
The best comparable private market value transaction is still the December 2012 purchase of Ameristar by Pinnacle Entertainment for $2.8 billion including the assumption of debt for a 8.4x EBITDA multiple.  But Icahn Enterprises (IEP) makes it a little easier coming up with a value by publishing a quarterly NAV estimate which gives a valuation for Tropicana at 7.5x EBITDA, about a turn lower than it's larger more liquid peers which seems appropriate.

At 7.5x EBITDA, Tropicana would be worth $27 per share, or about 80% higher than the $15 its trading for today.

Of course, we're tied to the hip with Icahn (plus its only a small fraction of IEP) as minority investors and might not see that valuation unless there's a liquidity event.  But I also think there's plenty of potential for additional upside, we might start to see improved wage growth in 2015, and in combination with lower gas/energy prices should increase discretionary incomes in Tropicana's middle class demographic market.  It might be a stretch, but just maybe with the economic recovery picking up steam, states and municipalities budget's could improve enough to not turn to casinos revenue to plug holes and restore some sanity to the competitive landscape.  Even if you have a more cynical view of the industry landscape, Tropicana's valuation provides a nice margin of safety with the benefit of having Carl Icahn, an experienced gaming investor, making the capital allocation decisions and hopefully unloading it at a cyclical top.

Disclosure: I own shares of TPCA

ATK's Sporting Division Spin: Vista Outdoor

I have made a few mistakes this year in spinoffs, particularly energy related ones like Civeo and Paragon Offshore (washed out/sold out of both) that looked cheap using past earnings but their futures have been brought in question with the quick drop in oil prices.  An upcoming non-energy spinoff, but also one with a potential cyclical earnings top is Vista Outdoor, the ammunition and hunting accessories business of Alliant Techsystems.  So before following me into another spinoff consider that risk up front.

Alliant Techsystems (ATK) has three main lines of business: aerospace, defense, and sporting goods.  In February 2015, the sporting goods business ("sporting goods" might be a stretch, really ammunition, guns, and hunting accessories with grander plans to diversify) which makes up 39% of ATK's revenue will be spunoff as Vista Outdoor (VSTO) to ATK shareholders, and the remaining aerospace and defense businesses will be merged via a Morris Trust transaction with fellow aerospace and defense contractor Orbital Sciences (ORB) immediately after to form Orbital ATK (OA).

Quite a few moving parts, but let's focus on Vista Outdoor.  Starting in 2001, ATK entered the sporting business with the acquisition of Blount International's ammunition group, and recently added BLACKHAWK! in 2010, and firearm manufacturer Caliber and accessories maker Bushnell in 2013.  All rolled up, Vista Outdoor will be the number one provider of ammunition for various markets, and then also sell hunting accessories, rifles, gun cleaning products, targets, tactical accessories, goggles/glasses, and range finders.  Below is a slide from their investor presentation to give you an idea for their product offering:

The sporting business has seen 15% annual growth for a decade, spurred on even more recently with the "surge" in gun demand due to the real or perceived threat of tighter gun controls under the Obama administration.  Only about 10% of their revenues are firearms, so think of Vista Outdoor as more the razor blades piece in the razor/razor blade analogy business model.  With the rise in number of guns purchased in recent years, the number of potential customers for Vista to sell ammunition and accessories into has also increased (also good demographics, young males, more females coming into the sector, etc).

Transaction Details
On April 28, 2014, ATK and Orbital Sciences entered into a deal in which ATK would spinoff Vista Outdoor first, and then merge with Orbital Sciences to form Orbital ATK, original ATK shareholders will own 53.8% of the new company, with Orbital Science's shareholders receiving the other 46.2%.  The deal was originally scheduled to close this year, but has been pushed back to February 2015 pending shareholder approval on 1/27 due to a rocket launch failure at Orbital (more on that in a bit).

What really makes this transaction work is both entities should be better off afterwards, I don't see a dump transaction taking place here.  Orbital trades at a significant premium to ATK, so this deal should be accretive to Orbital shareholders.  Institutional and long term investors in ATK should also end up sticking with the new Orbital ATK, ATK has been a defense and aerospace contractor first and foremost for its history, and the new company will remain in the same industry/market cap indexes.  The typical spinoff forced selling dynamics don't appear to be at play here.  There should also be a number of operational and financial synergies in the new Orbital ATK, the two appear to have a lot of complimentary business lines, natural fit between the two companies that should result in both cost efficiencies and revenue synergies.

ATK's CEO Mark DeYoung will be coming over to Vista Outdoor, he's been with ATK since 1985, well before they entered the sporting business space.  He lead the push towards sporting and his move to the spinoff is a further sign that Vista is really the crown jewel asset and not a dump transaction.  I believe it should end up with a premium market multiple as a niche consumer staple company over the old ATK which as a defense contractor has seen its margins and multiple contract in recent years.  Vista will also have limited debt, just $350MM in net debt, or about 1x EBITDA giving it flexibility to make additional acquisitions to diversify away from guns and ammo.  ATK acquired Bushnell in 2013 for $935 million in debt (10x EBITDA purchase price), interestingly most of the debt associated with the deal is going to end up on Orbital ATK's balance sheet making the spinoff even more attractive.

Antares Launch Failure
On October 28th, Orbital Sciences had an Antares rocket explode spectacularly on live TV 14 seconds after launching from NASA's Wallops Flight Facility in Virginia.  The rocket is contracted to provide periodic supplying trips to the International Space Station for NASA, although a significant reputational loss, insurance proceeds are supposed to minimize the financial impact of the launch failure.  Both Orbital and ATK's shares took a 10-15% hit in the aftermath of the failure as there was concerns the deal would fall through, but both sides have agreed to continue, yet the shares have only partially recovered providing an opportunity to buy Vista Outdoor synthetically even cheaper since the rocket business has no relationship with the sporting business.

Valuation
In the first six months of ATK's fiscal year (starting 4/1/14), the sporting business has done $1.1B in sales, annualizing that figure gets you to $2.2B for the year which is slightly below management forecasts of $2.3B at the time of the spin announcement.  Using a 13% EBIT margin and $73MM in annual depreciation, I come up with roughly $360MM in EBITDA.  After interest expense and a 35% tax rate, Vista should have about $5.50 per share in projected earnings.  What is the market currently valuing Vista at?

Below is a quick comparables table I built using other mid-to-large capitalization defense and aerospace contractors.  If we assume the new stronger Orbital ATK trades at a peer average of 8.5x EBITDA and a market multiple of 15 (and roughly between where ATK and Orbital trade separately), my math shows the current share prices of Orbital and ATK essentially reflecting those valuations. 

By piecing out ATK, and backing out the Ortibal ATK position, the market is currently valuing VSTO at $53.59 per share, just under a 10 P/E or 5.7x EV/EBITDA.  That's pretty cheap for a company with a double digit long term growth rate, but that comes back to the question of peak earnings?  Management thinks the slowdown in the gun market should reverse itself in the back half of 2015, there's a decent amount of data to back that up (Black Friday had record gun sales), but just from a big picture viewpoint I can't see America's love affair with guns fading anytime soon?  But I could be wrong.

I struggled a bit on how to put this position together, the ATK options look a little expensive to my untrained eye, and by my math Vista Outdoor is really the undervalued entity, one can go long 1 share of ATK and short 2.23 shares of ORB to synthetically create a long position in VSTO ahead of the transaction.  So that's what I did today, the short ORB will cancel out the shares in OA I receive and will leave me with just the VSTO shares if/when the transaction is completed in February.  Within a few months, I would expect VSTO to be trading much higher than the mid-$50s.

Hat tip to a reader who brought me this idea.

Disclosure: I'm long ATK / Short ORB (synthetically long VSTO)

Follow-Up on Green Brick Partners

I haven't posted in a while, been mostly idle the last month or two, but I thought I'd sum up some additional thoughts on Green Brick Partners now that the deal has closed, 9/30 proforma results came out, and the company hosted its first conference call as a home builder.

The headline Q3 results were down across the board, but with a relatively small home builder, I think it's safe to expect lumpy earnings results quarter to quarter.  With maybe only 25% of the shares outstanding in the float, Green Brick is essentially a private company and can be managed in a way that puts the long term results ahead of meeting estimates and smooth out earnings.  I was a little surprised to see as part of the deal closing that Green Brick took down the entire $150MM expensive term loan from Greenlight, but that gives the company approximately $40MM in cash to grow the business, especially in its two large communities coming online in 2015.

Below is the breakdown of the company's communities and lot position as of the S-1:

25% of the company's assets are in the Twin Creeks and Bellmoore Park communities that come online in 2015 and have a 6-8 year build out runway.  Additionally, there are several mid-sized communities debuting in Atlanta next year that add up to a little more than another Bellmoore Park.  In total, 75% of their lot inventory is in communities that will start delivering in 2015, making the initial 50% revenue jump buried in the company's management projections seems more plausible.

But with that said, the current stock price looks a bit stretched, based on the proforma numbers, Green Brick has a book value of about $156MM with a full allowance for the deferred tax assets, so at $8.85 its trading for 1.7x book, a little rich.  Or if you assume a 15x earnings multiple, the market is baking in $0.59 per share, which is a little higher than my adjusted earnings estimate I made in September that included cost cuts, term loan refinancing, etc., so the market is likely a little ahead of itself there as well. 

Jim Brickman
The other interesting piece of this story is Jim Brickman.  Being backed by Greenlight and Third Point will entivably generate some headlines, but Jim Brickman is really the jockey we're betting on, so who is he?  Back in 2002, David Einhorn presented a short thesis on Allied Capital, a large BDC that had a lot of toxic assets hidden underneath the surface, but still managed to pay a high dividend and attract a loyal retail investor base.  David Einhorn ended up writing a book "Fooling Some of the People All of the Time" about his journey as a short seller in Allied, in the book Brickman plays a central role as he independently researched Allied and came to similar conclusions regarding their faulty asset base.  Below is the way David Einhorn introduced Brickman:

"However, a benefit of publicly discussing Allied was hearing from others.  Jim Brickman, a retired real estate developer from Dallas, introduced himself by e-mail.  Someone had pointed him to Greenlight's analysis because of his background in SBA lending... Brickman's e-mail began a long dialogue.  While I've spent more time on Allied than I can quantify, Brickman has spent much more; he is retired and his kids have grown.  As he sees it, "These people believe they are above the law."  He has become an expert at searching public records, analyzing information, and has been a major collaborator in identifying problems at Allied and BLX.  He is one of the best forensic detectives I have ever met." p137-138

Brickman was also very active on the Yahoo! message boards detailing his findings on Allied, The Wall Street Journal picked up the story and wrote a front page piece about him in 2004: A Retiree in Texas Gives a Firm Grief With Web Postings

I'm an avid golfer, but I find the line about getting bored playing golf as an early retiree great, just the kind of person that I want to be invested alongside.  You also get the strong sense that he created JBGL/Green Brick very opportunistically, the financial crisis lead to such dis-allocations in the real estate market that he couldn't help himself but to jump back in and restart his career.  Says even more that a message board poster built a strong enough relationship with a highly respected hedge fund manager to seed him with millions of dollars to start JBGL/Green Brick.  Pretty fascinating story.

So that's probably it on Green Brick for a while, it's up 50% over the last couple weeks and is no longer obviously cheap, but with such a small float, I wouldn't be surprised to see it become a good value again, keep it on your watchlist.  I'm going to just hold my position for now as I don't like booking short term taxable gains this late in the year, but wouldn't fault people for selling some here.  I like the long term setup and could see Green Brick being acquired by a larger builder in a few years once the NOLs are used up and Brickman wants to retire again.

Disclosure: I own shares of GRBK