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HC2'sDealMakingOffersSignificantUpside
Sep.3,20145:00AMET
by:WhopperInvestments
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Summary
SignificantNOLsandshiftingbalancesheetobscurecompany'svalue.
Whilecontroversial,managementhasasignificantownershipstakeandishighlyincentivizedtoincreasenet
assetvalue.
NeartermcatalystsincludeclosingofSchuffdealanduplistingtomajorexchange.
WheneverIhaveabigwinnerorloser,Itrytostepbackanddeterminethetwoorthreekeycharacteristicsthatwent
intothatinvestment.Ithenlookforthoseinfutureinvestments,andifIseeasimilarsetupor"pattern"Iknowtopay
extraattention.Forexample,I'velostmoneyseveraltimesrelyingonthevalueofuniqueoroffbalancesheetassets
thatweren'treadilysalable,sonowwhenIlookatinvestmentswithuniqueoffbalancesheetassets,Isendoutamental
redflagandsubjecttheinvestmenttoahigherbar.
This"patternrecognition"skillmayseemsilly,butI'mnotaloneinthinkingit'sanimportantskillseparating
good/experiencedinvestorsfrompoororinexperiencedinvestors.IfyoureadanyinterviewwithAliceSchroeder(author
ofTheSnowball,WarrenBuffett'sbiography)oneofthethingsshealwayspraisesBuffettforishistremendouspattern
recognitionskills(here'sanexamplewhereshepraisesBuffett'spatternrecognition),andoneofthereasonssomany
specialsituationsinvestors(myselfincluded!)praiseYouCanBeAStockMarketGeniusisbecauseitintroducesthe
readertospecificpatternsandsituationstolookoutforwheresignificantvalueappreciationcouldbeonthehorizon.
OneofmybigwinnersinthepastyearhasbeenALJJ.IfirstwroteabouttheminlateOctoberlastyear,whentheyhad
justannouncedabigacquisitionandthestockwasat~$1.05.IdidafollowupinmidJulythisyearwiththestockat
~$2.50.Thecompanycurrentlytradesfor~$3.50ashare.BelowarethecommonelementsIfoundintheALJJpattern.
Amanagerwithahistoryofsuccessfuldealmakingandsignificantequitystake
Transformativetransactionthatmakespastfinancialscompletelyirrelevanttofuturefinancials,settingup
potentialissueswiththemarketrecognizingthecompany'svalueintheshorttermthatwouldslowlyalleviateas
thecompany'snewfinancialrevealedtheirresults.
SignificantNOLsthatcouldbeusedtoshieldtaxesandcreateadditionaldealvalueandcashflow
Leveragedacquisitionsofcompaniesatlowmultiplesthatwouldamplifyshareholderresultsifsuccessful.
GivenhowsuccessfulALJJhasbeen,I'veobviouslyaddedtheALJJ"pattern"tothetypesofsetupsIlookfor.AndHC2
Holdings(OTCQB:HCHC)hasseveralsimilarcharacteristicsthatcouldbesettingitupforasimilarmove.
Thelargestshareholder,Harbinger(NYSE:HRG)owns~40%ofthestockandhasahistoryofproducingbig
gainsincontrolledcompanies(though,asdiscussedintherisks,it'salsoquitecontroversial).
HC2justacquiredmajoritycontrolofSchuff(OTCPK:SHFK)andstartedconsolidatingitintheirfinancial
statements,sotheirfuturefinancialswilllooknothingliketheirpast.Inaddition,theirbalancesheethasmultiple
movingpartsthatmaketheirunderlyingvaluedifficulttosee.
HC2hassignificantNOLsthatwillshieldfuturetaxliabilitiesoncetheyacquireenoughofSchufftoconsolidate
fortaxpurposes(80%+)ordootherdeals
HC2usedsignificantleveragetobuytheirSHFKsharesanddidsoataverylowmultiple:~11xtrailingP/Eand,
basedonbacklog,around5xforwardearnings.
Sowiththatinmind,let'sstartwithsomebackground.HCHCisnameoftheformerPTGI.Thiswasatelecomcompany
thatendedupbeginningaliquidatingprocesslatelastyear.Theysoldoffthevastmajorityoftheirassetsandpaidouta
significantdividendwiththeproceedshowever,beforetheycouldfinishtheliquidationprocess,Harbingeracquired
about40%oftheirsharesfor$4.00pershareandsentaletterdemandingboardrepresentationandthecompanystop
theirdelistingandliquidationprocess.
WhatdidHarbingerseeinPTGIthatmadethembuythesesharesandtakecontrolofthecompany?WhilePTGIdidstill
haveasmalloperatingbusinessandsomecashinescrowheldbackfromtheirsales,therealthingthatHarbingersaw
wasalloftheirNOLs.PTGIhad$241minNOLs(fromtheir10K),ofwhich$116mwerenotsubjecttosection382
limitations,whichlimittheabilityofacompanytoutilizeNOLsintheeventthereisachangeofcontrol.Inotherwords,
HarbingersawacompanythattheycouldtakecontrolofanduseasavehicletoutilizeNOLs.
BecausePTGI/HCHChadalreadysoldoffthevastmajorityoftheirassets,theonlywaytoutilizetheirNOLswastobuy
otherbusinesses.Andthey'vealreadyannouncedtwoacquisitions:apurchaseofanaturalgasmotorfueldistributor,
andthepurchaseof65%ofSchuff.Termsofthenaturalgaspurchasehavenotbeendisclosed,andit'slikelysmall
comparedtotheSchuffdeal,sothisarticlewillnotfocustoomuchonitexcepttonotethatitwilllikelyfurtherhelpthe
companyutilizetheirNOLs.
ThesearecompletelynewacquisitionsthatformthebulkofHCHC'sassets.Goingforward,HCHCwillstartto
consolidatetheirresults,andtheirperformancewill,whencombinedwithanyfuturedealsHCHCdoes,driveHCHC's
resultsgoingforward.
However,justbecauseHCHChasmajorityownershipandconsolidatesthesecompaniesdoesnotmeantheycanutilize
theirNOLs.There'saninterestingpiecetotaxlawthatsaysjustbecauseacompanyhasmajoritycontrolofanother
companydoesnotmeantheycanconsolidatethecompanyfortaxreasonsinstead,80%ownershipisrequiredfor
consolidationfortaxreasonsandtoallowintercompanydividendstobenontaxable.BecauseHCHConlyowns70%of
SHFK(the65%theyownedbecame70%whenSHFKboughtsomesharesbackfromformerexecs),HCHCcurrently
cannotconsolidateSHFKortakedividendsfromthemwithoutpayingtaxes.Soit'snosurprisethatHCHCiscurrently
tryingtobuyoutthe30%ofSHFKtheydon'town.
Atthispoint,it'sprobablytimetodoabitofdiscussiononSchuff.Thestockhasactuallybeenwrittenupseveraltimes
onseekingalpha,soIwouldencouragereadingthoseformorebackground(I'dstartwiththisone).
Schuffisasteelfabricationanderectorcompany(checkoutthispageontheirwebsiteformoredescriptiononwhatthey
do).Thisisabusinessthatishighlyexposedtothenonresidentialconstructioncycle,whichisobviouslycyclicaland
volatile.Asyoumightimagine,resultsfelloffacliffduringtheGreatRecession.Revenuesdroppedfrom$736min2007
to$288min2011,operatingincomefellfromalmost$100mto$4m,andbacklogfellfromalmost$400mtounder
$200m.However,thecycleappearstobeturning,asbackloggrewtoover$425mattheendof2013andindustry
trendscontinuetoimprove.RevenuesforSchuffinQ1wereupalmost20%,andoperatingincomewasup75%toover
$5m.
ThisiswhereSchuff'scyclicalityandalloftheleverageHCHCisapplyingcomeintoplay.Attheofferedsharepriceof
$31.50,HCHCisacquiringSchufffor$122mmarketcap(basedonthisfiling,whichshows4.2msharesoutstanding
less328ksubsequentlypurchased)orroughly$140menterprisevalue.Schuffdid$22minoperatingincomeinthe
twelvemonthsendedMarch2014(wedon'thavefullresultsforJuneyet),butbasedonthehugeincreaseinbacklog,
it'slikelyconservativetosaythecompanydoes$550minrevenueand$33minoperatingincomethisyear.Basedon
thosenumbers,HCHCisbuyingSchuffat56xoperatingincomeatthestartofabigupswinginearnings.It'sworth
notingthatthelasttimebacklogswerethishigh,Schuffwasdoing~$700mannuallyinrevenueandover$90min
operatingincome,sotheupsidehereisquitehigh.BecauseHCHCisusingsignificantamountsofdebttopurchase
Schuff,ifthatoperatingleveragedoescontinueandSchuffgeneratessignificantcash,shareholderswillmakeout
extremelywellastheyusetheNOLstoshieldcashandrapidlyaccruevalue.
PerhapsitsoundslikeSchuffisgettingundervaluedinthisdeal.Andthat'scertainlyapossibilityoneofthereasonsI
liketheacquisitionisbecausetheneartermoutlookappearssobright,whichwillallowHCHCtoutilizealloftheirNOLs
quickly.Severalshareholdersarefloatingapresentationthatsuggestthetenderpriceismuchtoocheapandthat
sharesshouldbeworthatleast$50inatender,andsharesaretradingoverthedealprice,suggestinginvestorsthink
theultimatepricepaidtoshareholderswillbeincreased.
Idon'tnecessarilydisagreewithinvestorswhothinkHCHCisgettingagooddealonSHFK(again,oneofthereasonsI
likeHCHCisbecauseoftheupsideIseeinSchuff),butitisworthnotingthatHCHCacquiredtheirownershipbybuying
the(nowformer)CEO's60%shareownershipfromhimfor$31.50ashare.Givenitcouldbearguedthatpriceshould
incorporateacontrolpremium,itisn'thardtoarguethatminorityshareholdersarebeingofferedadecentdealtocash
outatthesameprice.Inaddition,asmentionedabove,SHFKboughtbacksharesfromformerexecsafterthedealhad
closedthatbroughtHCHC'sownershipfrom65%to70%intheir10Q,theydisclosedbuying327.6ksharefor$8.7m,
whichequatesto~$26.55pershare.Again,thisisn'ttoarguethatSchuffsharesaren'tcheapattheselevelsjustthat
it'stoughtoargueminorityshareholdersaren'tgettingatleastthesameorevenbettervaluethaninformedinsiders.
SowhatisHCHCultimatelyworth?Currently,theirvaluecomesfrom
Their70%SHFKownership
Plus$41mincashontheirbalancesheetatJune30th(someofthisbelongstoSHFK,butbecauseSHFKmade
thesharerepurchaseandhadlessthan$1montheirbalancesheetinMarch,it'ssafetosayalmostallofthisis
HCHC's.SomeofthiscashwillgotothepurchaseofANGHolding,butsincewe'reassumingthat'savalueneutral
purchasewewilljustusethe$41mnumber).
Plus$22.5mcashreceivedfromescrowinJuly(p.35of10Q,mostgoestowardspayingdowndebt)
Plus$11mstillinescrowthatshouldeventuallycometheirway(p.32oftheir10Qultimatelythiscashdeserves
somediscountuntilreceivedbutnotabigenoughvaluedrivertoadjusthere)
Plus$10mincashfromwarrantsexerciseinJuly(seep.2829oftheir10Q)
Less$70minHCHCdebt(thebalancesheetreports$86m,but$16mofthatisSHFK's)
Less$30minconvertiblepreferredstock(whichconvertsinto7.1msharesat$4.25mashare)
Pluswhatevervaluetheir$116minNOLsnotsubjecttolimitationand$125msubjecttolimitationareworth.
Ultimately,thevaluecomestonegative$20m($10mpositiveifyoubelievethecommonisworthmorethan$4.25and
thepreferredsultimatelyconverttocommon)plustheirSHFKstakeplusthevalueoftheNOLsdividedbytheirshares
outstanding(23.3mwithoutpreferredconversionandafteradjustingforthewarrants30.4mifpreferredsconvert).Afew
samplescenariosarelistedbelow.AllofthesescenariosassumethatHCHCmanagestopurchaseSHFKinorderto
utilizetheirNOLsandignoresany"gainonbargainpurchase"oftheminoritystakeinstead,itonlyseekstovalue
HCHC'scurrentstake(inotherwords,ifSHFKisactuallyworth$50ashare,itassumesHCHC'sstakeisworth$50a
shareandthattheypayminorityshareholders$50ashare.ThemathlooksevenbetterifSHFKisworth$50andHCHC
buystherestofminorityshareholdersoutforonly$31.50.ThemathobviouslylooksmuchworseifyouthinkSHFKis
worthlessthan$31.50ashareandtheybuySHFKfor$31.50).
SHFKsharesarefairlypricedat$31.50,andSHFKearns$20minoperatingincomeperyear.Inthiscase,
HCHC'sstakeisworth$85m,andtheNOLswillshieldaround$7mintaxpaymentperyear.TheNPVofthosetax
shieldswouldbeworthabout$50m,andHCHCoverallwouldbeworthjustabout$4.75pershare(+$10mvalue
fromdebtandcashexcludingpreferredsplus$85mplus$50mdividedby30.4msharesout).
IfSHFKisactuallyworth$42.50pershare,thenitwoulddo~$30minoperatingincomeperyear.Inthiscase,
HCHC'sstakeisworth$115mandtheNOLsareworth$65m.Totalvaluepersharecomeoutto$6.25.
IfSHFKcould,onaverage,earn$50minoperatingincomeperyearandwasworth6xoperatingincome,the
shareswouldbeworthover$70andHCHC'sstakewouldbeworth$200m.TheNPVofthetaxshieldwouldbe
veryhigh(around$85m),astheywouldallbeusedwithinthenext7yearsorso,andHCHCsharesareworth
around$9.50pershare.
Again,noneofthisistosuggestwhatSHFKactuallyisorisnotworth.It'sjusttoshowthatthevalueofHCHC'sNOLs
putshareholdersinauniquesituation:iftheyareacquiringSHFKforroughlyfairvalue,thenHCHCsharesarefairly
valuedorperhapsslightlyundervalued.IfthecyclecontinuestoturnfavorablyandHCHCacquiredSHFKcheaply,then
theNOLsandleverageHCHCusedtoacquireSHFKwillresultinamassivehomerun.
There'sonefinalcatalystworthmentioning.Theinterestrateonthecompany'spreferredstockwillincreasesignificantly
ifthecommonstockisnotlistedonanationalexchangewithinoneyear,soHCHCwilllikelybelookingto"uplist"toa
largerexchange,whichshouldresultinincreasedvolumesandthepotentialforincreasedinstitutionalownershipjustas
HCHCapproachestheoneyearmarkontheirownershipofSchuffandtheirfinancialstatementsstarttonormalize.This
uplistingcouldserveasastrongcatalysttodriveshareshigher.
Therearecertainlysomeriskshere.Obviouslythere'stheriskthatweenteranotherhugerecessionandSHFK'sresults
falloffthecliffjustlikeintheGreatRecession,inwhichcasealloftheleverageHCHCusedtobuySchuffwillbeahuge
chokeonthem.Leveragecutsbothways:theinterestpaymentswillconsumeallofthecashandmakeHCHC'sNOLs
useless,andthedebtwillmagnifyHCHC'slossesifitturnsouttheyoverpaidforSchuff.Andthereisofcoursetherisk
thatHCHChasoverpaidforSHFK,inwhichcasetheleveragewould(again)beverynegativefortheequityholders.
Otherthanthat,thebiggestriskismajoritycontrol.PhilFalconecontrols~40%ofthestockthroughHarbinger,sofor
betterorworse,investorsaretiedtohimandwhathedoeswithHC2.Falconeisobviouslyaverycontroversialfigure,
andthecontroversyaroundhimisquitepublic(hisWikipediapageisagreatstart)sothere'snotmuchofaneedto
recountithere.It'ssomethingapotentialinvestorneedstogetcomfortablewith,andI'vedonesobyreviewingthetrack
recordsofcompaniesthathe'stakencontroloreffectivecontrolof.Ingeneral,minorityshareholdersofcompanies
Harbingerhastakencontrolofhavedoneverywell.Forexample,HarbingertookmajoritycontrolofSpectrumBrandsin
September2010belowishowthecompany'sshareshaveperformedsincethen.
(clicktoenlarge)
Obviouslyeverysituationisunique,andpastresultsatadifferentcontrolledcompanydon'tmeanthesamethingwill
happenhere.However,itdoesshowminorityshareholderscandoverywellunderHarbinger,andifHCHCfollows
anythingclosetoasimilarpattern,investorsattoday'spriceswillobviouslybeveryhappy.Inadditiontopasthistory,
execsatHCHCarerewardedsignificantlyiftheyincreasevalueatHCHCpertheirnewemploymentagreement,they'll
capture12%ofanygainsinassetvalueover7%annually,somanagementwillbehighlyincentedtocontinuemaking
accretivedeals.
Finally,there'stheriskthattheSchuffdealdoesn'tgothroughsoHCHCcan'tutilizetheirNOLs.Inadditiontothe
criticismfrominvestors,thedealhasattractedheatfromtheNewYorkPost.Whilethedealfailingtocloseisdefinitelya
risk,Ithinkit'sasmallone.HCHCalreadycontrols70%ofSHFK,soI'msuretheycanfigureoutsomethingtomakean
acquisitionwork.Ifnot,therearealwaysotherpotentialacquisitions,andHCHCcanborrowagainsttheirSchuffstake
(oroutrightsellSchuffataprofit!)inordertofundthefullpurchaseofabusinessthattheycanconsolidate.
Insum,whiletherearecertainlyrisksandcontroversiesaroundHCHC,thecompanyhasauniquesetofassetsanda
clearpathtowardsvaluecreation.IfSHFKinvestorsarerightandHCHC'sproposalundervaluesSHFK,thenHCHC's
70%ownershipimpliesanunderlyingvaluesignificantlyhigherthantoday'sprices.IfSHFKshareholdersarewrongand
HCHC'sofferfairlyvaluesSHFK,thentheNOLsandcontinuedpotentialfordealmakingimplythatHCHCisstillslightly
undervalued.Eitherway,investorsattoday'spricesshoulddowell.
Editor'sNote:Thisarticlecoversastocktradingatlessthan$1pershareand/orwithlessthana$100millionmarket
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