By SA PRO Editors :
Dane Capital Management, LLC is an investment manager focused on value/special situations and a long-time Seeking Alpha contributor. Notable calls include Limbach Holdings ( LMB ) - see here and Hostess Brands ( TWNK ) - see here . We emailed with Dane Capital about avoiding the crowd, the extensive and selective idea gen process and the potential impact of tax law changes on micro/small caps.
Seeking Alpha: You've had a lot of success with SPACs - why focus on them?
Dane Capital Management: Dane's goal is to find mispriced securities where we believe there's an asymmetric risk/return profile. Obviously, there are thousands of investment alternatives, and a finite number of hours in the day. As a result, we spend a disproportionate amount of time looking at situations that lend themselves to mispricing. One could probably use Joel Greenblatt's You Can be a Stock Market Genius as a bible for identifying such opportunities, which include spin-offs, restructurings, bankruptcy emergences, rights offerings and other special situations. We spend a lot of time in these areas, but so do many other value-oriented investment funds.
We don't focus on SPACs, per se, but we have found them to be systematically inefficient, and frequently, exceptionally mispriced. In addition, it's an area in special situations investing that is far less crowded than spin-offs or merger arb, for example.
What we've found, and continue to find fascinating about SPACs is that they represent IPOs turned upside down.
What we mean by that is if an underwriter were pricing an IPO, they'd use all existing facts to come up with an IPO price range. Then they'd have the company go on an institutional roadshow, and at the end of it, the company's stock would be priced based on what the market determines. This price could vary from what truly is the company's intrinsic value. However, at least in theory, this is a market determined efficient price.
This stands in stark contrast to SPACs, which all start out priced at $10. When a sponsor announces a merger, the fair value could be $2 and it could be $18 (or something in between). Sponsors have a motive to find a deal, any deal, to receive their "promote" and expense reimbursement. This frequently results in a cynical investor community, likely to dismiss, or not even look at, a transaction.
Given the track record of SPACs, which is -11% on average according to spacanalytics.com, this negative view is well deserved. However, this is an average. There are winners. More importantly, the starting $10 price can be, and often is, completely disconnected from what would be a reasonable market determined price.
When we assess SPACs, assuming we're comfortable with the sponsors, deal dynamics, and several other questions on our checklist, we ask ourselves, "If this wasn't a SPAC, and we didn't know the price, what would the price be?" This seems like an obvious question. In our view, it is THE question.
Last year, of the multiple SPACs that successfully completed mergers, Dane Capital invested in two, Hostess Brands and Limbach Holdings - the two best-performing SPACs of 2016. When we made our initial investment in each, we performed the "what would the price be" exercise and believed shares of each were worth over $15, and thought they would be priced in that range via a traditional IPO. In neither case were we reliant on margin expansion, divestitures of a division, or an asset sale, or any other fundamental/strategic improvement to achieve fair value. We merely needed the SPAC arbs to exit, and fundamental buyers to accumulate shares, with shares moving to intrinsic/fair value.
As long as SPACs continue to be structured as they currently are, and SPAC arbs remain willing to exit at non-fundamental prices, we think the opportunity will remain attractive… albeit, potentially with more losers than winners, so selectivity is important.
SA: How is due diligence different than "normal" stocks?
DCM: Appropriate diligence on SPACs is essential, although we believe that's true for any investment. Given the significant promote that SPAC sponsors receive, they can find a poor deal, which ultimately trades down significantly, and still come out ahead if they are able to complete a transaction.
SPACs are fairly unique in that proxies provide much more information than a typical IPO prospectus - and they are almost always far lengthier (a good cure for insomnia). They discuss the phone calls, meetings, and other due diligence between the sponsor and merger partner in far greater detail than any S-1.
Given the incentives for sponsors to get a deal done, we spend an inordinate amount of time getting to know the sponsor, the merger partner and the industry. We look closely at investor and management alignment. A current case in point would be Hennessy Capital's ( HCAC ) pending merger with Daseke. Hennessy's first SPAC - now BlueBird ( BLBD ) - has returned 60%+ in less than 2 years. Hennessy is focused on the industrial space and has a strong track record in that segment (including BlueBird), so Daseke is clearly in their wheelhouse.
And perhaps, most importantly, Daseke is taking 100% stock and no cash in the transaction, with 77 year-old Don Daseke agreeing to a 3-year lock up. There's potential for additional share earnouts, but that requires both significant growth and share price appreciation. This appears to be a highly aligned and thoughtful transaction.
For us to invest in a SPAC, our due diligence needs to make us very comfortable with management, the business, the industry, incentives/alignment, and the deal structure.
SA: What's your outlook for the SPAC market in general? Where do you see SPAC volume in 2017? Do you think SPACs will ever drop their negative reputation among investors or will the space be "permanently inefficient"?
DCM: In each of the last two years, SPACs have raised about $4bn in new issuances. We expect that to grow 25-50% in 2017.
We suspect that with a larger set of higher quality sponsors leading SPACs, including Haim Saban ( SCAC ), William Green/Joseph Tucci (GTYH), former CEOs of Accenture (ACN) and (EMC) respectively, and Chinh Chu ((CFCO)), formerly of Blackstone, there are better prospects for superior deal quality and stock performance. We've also seen increased participation from experienced and well capitalized major private equity players like Gores Holdings (now on its second SPAC, following Hostess last year), and TPG (PACE) with its recently announced merger (yet to close) with Playa.
We believe the historic idea that SPACs are a dirty word or a last resort for a company that can't IPO or be sold may change. That said, each needs to be evaluated on its own merits. But that only answers part of your question. While we think deal quality is likely to improve as sellers become more comfortable with the SPAC process, until the SPAC structure changes, there should be ongoing inefficiency and opportunity for investors willing to dig in.
SA: Speaking of inefficiency, you also focus on the micro/small cap space - given the vast number of opportunities yet relatively little coverage by Wall Street, can you walk us through your idea gen process?
DCM: Dane frequently invests in micro/small caps, not because we have a specific bias or mandate to invest there, but because when we make any investment, we want to be able to answer the question "why does this opportunity exist?" Or, to put it another way, "What do we understand, or think we understand, that our counterparty is missing?" If we thought that Apple's (AAPL) iPhone 8 was going to be materially more successful than baked into estimates, or that the potential for repatriation of overseas capital wasn't reflected in its shares, we'd have no problem owning Apple.
We want to have a unique or variant view. As it turns out, it's typically easier to have a variant view in micro/smaller cap stocks, simply because, in general, there's limited research, no consensus view, and a small following of institutional investors.
The idea generation process is a lot of heavy lifting. We run screens typically based on corporate actions and news events - insider buying, stock repurchases, divestitures, restructurings, etc. We read tons of press releases and SEC filings to find corporate change situations that might lead to mispricings - and, unfortunately, we go on numerous wild goose chases. We don't need to own 100 stocks. If we find several material mispricings per year, we'll do very well. As a result, since we're looking for only a few great ideas, that means most days, we spend a lot of time on research and far less on buying or selling.
SA: Can you discuss the importance of (and opportunities in) not being limited to one part of the capital structure? A case in point would be your thesis on Hostess Brands.
DCM: We're willing and able to invest in any portion of the capital structure, but we are, by and large, a long/short equity fund. Last August, we bought shares of Hostess Brands and their warrants (which in our view is essentially a leveraged equity). Our rationale for buying warrants was not because we wanted leverage, but because the warrants appeared materially mispriced relative to our view of their fair value based on options pricing theory.
Our thesis was that while 25mn shares of Hostess (then Gores) had traded, only 13mn warrants had traded, with SPAC arbs selling both shares and warrants with prices that were disconnected from their fundamental value. Our view was that both share and warrant inventory would eventually clear, and each would move towards their intrinsic value.
In the case of the warrants, our view was that the slower trading pace was causing warrants to be unfairly discounted versus the pricing implied by Black-Scholes. By our calculations, given the price of the underlying equity, warrants should have been trading 40-60% higher. Since then shares are up ~35% and warrants ~130%.
SA: What are some of the categories of special situations (besides SPACs) you focus on? Where do you see the most opportunity currently?
DCM: We spend a good deal of time on spin-offs and more recently have spent more time on potential micro/small-cap beneficiaries of tax law changes.
Clearly, the role of activists on Wall Street has only accelerated the pace of spin-offs and other value-creating activities. Spin-offs frequently change management incentives, a company's shareholder base, and have other effects that result in mispricings, and ultimately, repricing of a security. At this point, the secret is out on spins, and it has become a fairly popular segment among value investors, although significant pockets of opportunity still exist.
Another area where we've been spending more time recently is analyzing the impact of potential tax law changes on micro and small cap companies. We believe a reduction in corporate tax rates will significantly benefit share prices of full tax payers to an extent not yet adequately reflected in share prices. We're working on an analysis of a number of potential beneficiaries, but, among our holdings, we think Limbach, which also stands to benefit from increased infrastructure build, would particularly benefit from a reduction in rates from 37-38% to something in the low 20s.
SA: What's one of your highest conviction ideas now?
DCM: In keeping with the theme of SPACs, and there are several right now that we find interesting, we like Pace Holdings (PACE) which is merging with Playa Resorts. Pace is sponsored by Texas Pacific Group, among the most well-known and successful private equity firms. Playa is an all-inclusive owner-operator of resorts in Mexico and the Caribbean. Management has outlined a plan to increase margins through changes in marketing, distribution and facility ownership (i.e. bringing property management in house). We think it has strong business momentum, plays into an expanding economy, and should benefit from public currency and a solid balance sheet.
While Dane doesn't typically pay 9.7x EBITDA for anything, this represents a discount versus peers. Moreover, the 9.7x multiple reflects a Peso/US$ of 18.25 versus today's 21.95 - a 20% move. By our calculations, the merger is now priced below 8.5x. A move back to 9.7x (and we expect a higher multiple) would suggest a $12+ share price today.
Given public currency, an all-star management and board, and a much improved balance sheet, we think incremental growth opportunities for Playa are significant. Importantly, share dilution due to warrants should be much less than for many other SPACs since, as part of the initial IPO, unit holders only received 1/3 warrants which are redeemable at $18.
In our view, this is clearly a deal that gets done, based on current trading activity that is well above redemption price. We think this will be a strong growth story at a reasonable price - and certainly should benefit from a y/y, which is far less/not impacted by Zika in 2017 as it was in 2016. Much like Gores/Hostess, which we mentioned earlier, we also believe warrants trade at a material discount to the value implied by Black-Scholes.
Thanks to Dane Capital for the interview. If you'd like to check out or follow their work, you can find the profile here .
PRO idea playing out
ING (ING) is up ~50% since buysider Renaissance Research called the bottom with their contrarian and bullish call in July 2016. Renaissance took advantage of the Brexit sell-off as ING traded at a slight discount to peers despite superior profitability, loan growth, a stronger balance sheet, little direct exposure to the UK and a high single-digit yield. The strong financial performance continued in 3Q16 as ING reported a 22% increase in net income, 11.3% ROE on a YTD basis, 3.6 billion EUR net core lending growth and increase in the fully-loaded CET1 ratio to 13.5%. In a follow-up article earlier this month, Renaissance said ING was still one of its top picks in the European banking space though cited the upcoming Dutch elections as a risk factor to monitor.
Call from the archive - SUNW
Although Sunworks (SUNW) quickly jumped ~30% after Jaret Wilson published his bullish thesis in July 2016, it has since pulled back, likely due to the slightly lowered revenue guidance for FY16 and the election of Trump (who is generally seen as less enthusiastic about alternative energy). However, the secular trend towards solar remains unchanged and from a company standpoint, SUNW continues to post strong top line (+87% on a YTD basis) and backlog (+31%) growth. As the original price target would provide 100%+ upside from the current price, it may be worthwhile to take another look at this name.
Noteworthy PRO articles
In addition to the 2 top ideas we published this week, we wanted to highlight a few of our PRO editors' favorite PRO ideas this week:
PRO Managing Editor Daniel Shvartsman : Black Mamba makes a strong case for why Impinj's (PI) recent jump - 25% from early December prices after being up as much as 50% - is unjustified, as the Amazon Go hype won't translate into earnings. With too much hope priced into the stock and insiders selling, PI seems ripe for a short according to the author.
SA Editor John Leonard, CFA : The Game Changer discusses why Argos Therapeutics (ARGS) is significantly undervalued with 100%+ upside using conservative assumptions as its lead drug candidate in Phase III trials (which already demonstrated higher clinical benefit/efficacy in a Phase II trial) could become the standard of care in a combination therapy setting for mRCC; upcoming catalysts include Independent Data Monitoring Committee review in February 2017 and Phase III data readout by or during June 2017; high insider ownership and high short interest could fuel additional upside.
SA Editor Jeffrey Fischer : One of Ian Bezek's favorite investment sectors is in play, as Trump fears have weighed on Grupo Aeroportuario del Pacifico (PAC), one of Mexico's leading airport operators. Bezek sees development and growth, as well as a strong dividend policy.
SA Editor Marc Pentacoff : Simeon Rusanov argues the market is pricing in a soft Brexit for London home builder Berkeley Group (BKGFY). A harder exit or weaker London market would have a disproportionate effect.
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See also Sustainable Investing In 2017: Getting Interesting, In A Good Way on seekingalpha.com
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