By Bradd Kern :
The purpose of this write-up is to update key assumptions from the October 2nd sum of the parts (SOTP) valuation analysis and provide some qualitative thoughts on Falcone's strategy with HC2 ( HCHC ). See the original article, Ready to Deal: Deep Value in HC2 for background. The net impact of the changes is a lower SOTP fair value for HC2 relative to our previous analysis, but further clarity on HC2's path to value creation above and beyond current SOTP fair value.
The biggest impact on our fair value comes from re-calculation of HC2's complex capital structure's share count to include higher share count, which we analyze in greater detail below with a table. Other key impacts to fair value are a reduction in assumed ownership percentage of ANG due to a more conservative interpretation of the language "majority ownership" in the press release, as well as a positive impact to fair value from using Schuff 2014E EBITDA rather than 2013.
Our new mid case SOTP analysis suggests a fair value of $5.69 per share (+3%), with upside to $7.43 per share (+35%), and downside to $3.96 per share (-28%) .
We favor the mid and high-range scenarios for reasons we explain later in the write-up, where we share some qualitative thoughts on HC2 regarding catalysts and value creation going forward.
The major updates in this analysis are as follows:
We now assume a share count of 33.4 million (see below for calculation), assuming conversion of all preferred stock, which adds 10.1 million shares to the share count at 7/31/14, per the second quarter 10-Q. This number of 33.4M is higher than the previously assumed amount of 26.8M shares.
Since the end of the year is only 3 months away, we will use 2014 estimated EBITDA for Schuff of $34M (a 21% increase from $28M in 2013 based on both higher revenues and margins) while maintaining a 5x to 6x multiple. Halfway through the year (on May 30th), HC2 bought Schuff ( SHFK ) at 5.1x 2013 EBITDA, and 4.2x 2014E EBITDA using our estimate. There is a well understood arbitrage in buying private companies sourced through proprietary deal flow (as opposed to through an auction process run by an investment bank) at a discount to publicly traded comps, which may be at the heart of HC2's strategy (we discuss this more later in the write-up). Although Schuff was public, it was controlled by one family and was extremely illiquid. Therefore, with Schuff soon to be a wholly owned subsidiary of a "more normal" public company, if the tender succeeds (we think it will), 5.0x-6.0x continues to be a fair multiple range.
Of course, everyone should make his or her own assumptions. We are aware of one Schuff investor with a 2014 EBITDA estimate of $60M , but are taking a more conservative stance towards growth assumptions until we see 2014 financial results.
Novatel ( NVTL ) is trading at $3.55/share, in relation to 5-year warrants with an exercise at $2.26/share and Series C convertible preferred stock with a conversion price of $1.75 per share . If HC2 would like to raise its ownership to 25%, it will have to pay $2.26 per share for 4.1 million shares-we therefore deduct $9.3M in cash from the EV. These are 5-year warrants, so in reality, HC2 probably does not actually exercise them for a long time ( never exercise an option early! ), which means the cash outlay should be discounted on a present value basis. However, that means the additional NVTL 7% equity ownership value would need to be discounted as well. Rather than making this too complex, let's keep things simple and not discount either. We'll assume 25% NVTL ownership with the $9M outlay subtracted from EV.
American Natural Gas
Previously, we were assuming 100% ownership, which was not conservative relative to the language from the press release of HC2 having taken a "majority" interest. Therefore, we are going to assume only 51% ownership in ANG. We may later learn that the ownership is higher. For now, we are only going to give HC2 credit for 51% of ANG's value. We remain comfortable with our multiple comps for now, regardless of what price HC2 may have paid for the stake (say it with me again…proprietary deal flow). Again, investors can and should make their own assumptions.
We now assign corporate expense a multiple of 4.5x. Although common practice when doing a SOTP analysis for a mature company is to assign a blended multiple for corporate expense, HC2 could not be further away from a mature company! We think the value of the various holding companies and investments will grow at a much faster rate than corporate expense. In other words, there will be a dynamic akin to fixed cost leverage within the SOTP valuation at the corporate expense level, as HC2 adds businesses with smaller rates of growth in corporate expense. Therefore, we keep the same 4.5x multiple across the low, mid, and high range to reflect this view.
SOTP Analysis v2.0
While we've provided a valuation framework for HC2 using conservative operating statistics and multiples, investors can and should make their own assumptions. Based only on today's composition of HC2 (it will certainly change), our new mid case SOTP analysis suggests a fair value of $5.69 per share (+3%), with upside to $7.43 per share (+35%), and downside to $3.96 per share (-28%) . Looking ahead, the high end of this range makes a lot more sense to us than the low end for reasons we explain in the next two sections.
Value Creation in HC2 Going Forward
SOTP is an attempt to understand what the company is worth today, in a static state with respect to the composition of assets. HC2's assets and complex capital structure are evolving at a rapid rate . It wasn't worth $5.69 per share a few months ago-it was worth less before this flurry of deal activity. And HC2 probably won't be worth $5.69 a few months from now, depending on what kind of deals Falcone assembles, and the performance of existing assets. In addition, there may be synergies between some combination of current and future operating subsidiaries that we have not considered. In other words, the SOTP gets us to today's value. Ongoing deals are likely to continue to improve it though, as management is explicitly incentivized to grow net asset value per share each fiscal year.
Near-term catalysts to watch include (1) new deals; (2) further updates on the success of HC2's tender for the rest of Schuff (last update was that HC2 would own 88.6% upon consummation of the tender); and (3) an eventual graduation from the pink sheets to an exchange. All of these should be positive for HC2 and its shareholders.
Proprietary Deal Flow and the Private to Public Arbitrage
Allow us to offer a final word on how to think about the valuation at which HC2 buys an asset versus how that asset should be valued once tucked into HC2. The private equity deal sourcing world largely relies on a concept called "proprietary deal flow," which means that a buyer is advantaged in the price they pay versus public market comps because they may be the only ones even bidding on it, as opposed to an auction. There is an arbitrage when Falcone buys a private market business and then puts it into HC2's public company holdco. Another term for this strategy is "multiple arbitrage."
Examine recent private equity transactions and you will notice they are predominantly private market companies (Warren Buffett's last deal for Van Tuyl Group being another good example). There are few LBOs of public companies these days despite cheap debt, because valuations in private market are lower than in the public market. The WSJ noted on July 30th of this year that public companies have only been 3.5% of the $89 billion of U.S. leveraged buyouts in the first half of 2014, versus 68% buy dollar volume in the first half of 2008 (see graph below)! Falcone is taking notice of lower valuations in private markets versus public markets, to the benefit of HC2 shareholders.
Furthermore, what kinds of companies are receiving the highest valuations in public markets? Startups. Isn't it interesting that so many deals in HC2 so far have been of this growthy ilk? Venture capital investors have been known to rely on the private to public multiple arbitrage as well. As we said earlier with respect to Schuff, this private to public arbitrage, whether for cyclical or growth companies, may be one of the keys to Falcone's strategy for value creation in HC2.
Disclosure: The author is long HCHC. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Armored Wolf is currently long HCHC on behalf of its clients. In addition, the author owns shares of HCHC in his personal accounts.