Over the past few years, we have built a pretty solid track record on Seeking Alpha around identifying mispriced stocks that have had significant moves following our articles. Our eleven articles include short recommendations on six stocks that subsequently declined between 65% and 99% (including LPHI, JTX, HUSA, PCBC, REE, and HMPR). We like to think that our thorough analysis of facts has helped the investment community. We believe Harbinger Group Inc. (HRG), a holding company that currently has two significant assets, shares characteristics with many of the short ideas discussed in our previous work. It would appear that several promotional Seeking Alpha articles and a recent Barron's promotional interview may have contributed to the mis-valuation. We believe the stock is misunderstood by investors and overvalued on a fundamental basis by at least 23%. Given our view of significant risks with management and its largest shareholder, we believe investors could face between 35% to 50% downside from current levels.
By way of background, embattled hedge fund manager Phillip Falcone and his hedge fund, Harbinger Capital, acquired a shell company Zapata Corporation in July 2009 and renamed it Harbinger Group (sometimes referred to as "HGI" but we will reference it by its ticker "HRG" in this article). In the fall of 2010, the hedge fund, Harbinger Capital, contributed / sold its ownership in Spectrum Brands (SPB) to HRG for cash and shares. Phillip Falcone, the founder of Harbinger Capital, made a name for himself by shorting the subprime mortgage space in 2007. The firm's AUM peaked at $26 billion in 2008. However, following a series of bad investments and allegations of wrongdoing that resulted in the SEC charging Falcone and Harbinger Capital with fraud in June 2012, the firm's assets declined precipitously. According to industry articles, Harbinger Capital's assets were only $4 billion at the end of 2011, with the disastrous investment in LightSquared representing $3 billion of the remaining assets (marked down 59%). The Wall Street Journal reported that AUM was $3 billion at the end of March 2012, a few months before LightSquared's bankruptcy filing in May 2012. The public reports suggest AUM at Harbinger Capital has declined despite precluding investors from redeeming their interest in the funds.
Turning back to HRG, it should be a considerable part of any investment discussion to emphasize that the largest shareholder of HRG is Harbinger Capital. Despite his significant legal woes, Phillip Falcone not only runs the hedge fund, but he is also the CEO of HRG. If he is convicted of SEC charges, we do not believe he will be able to continue acting as an executive of the company. According to its 10K, HRG employed only nine people in September 2011 at the holding company. A more recent disclosure from June 2012 highlights 18 "officers and employees." We were only able to identify four employees and three board members who are not current, or former, employees of Harbinger Capital. After reading through numerous lawsuits, press reports and the SEC accusations, we do not believe the overlap with Harbinger Capital is a positive for HRG shareholders. Based on our analysis, we believe most HRG shareholders would be surprised to learn that HRG appears to be Harbinger Capital's last liquid investment (according to its 13F filing, which is somewhat confusing). If Harbinger or Falcone is convicted of SEC charges, or if Falcone is barred from the securities industry as part of a settlement or conviction, we have trouble conceiving a scenario where Harbinger Capital is not shut down, likely resulting in the sale or distribution of its HRG position. To demonstrate the extreme risk to HRG shareholders, we estimate it could take Harbinger over nine years to liquidate its HRG shares based on the trailing three-month trading volume.
In late June 2012, the SEC filed civil actions against Falcone and Harbinger Capital, accusing Falcone and the firm of fraud. Despite the possible negative implications, HRG's stock price has nearly doubled as investors appear to be completely unaware of the broad risks. The SEC's charges include three separate complaints:
1) According to the complaint, "Falcone and Harbinger engaged in two fraudulent schemes that disadvantaged investors and elevated Falcone and Harbinger's interests above the interests of the funds they advised." The SEC alleges that Falcone misappropriated $113 million from a Harbinger fund in order to pay a personal tax in April 2009. At the time, Falcone was renovating his $49 million Manhattan mansion, "traveled on a private jet, employed body guards and funded his wife Lisa's new career as a film producer." Falcone did not want to use his own assets (which included hockey team investments, a vacation home and art collection), but instead "borrowed cash from one of his Harbinger Capital Partners LLC funds, using his clients' money without their knowledge." In addition, the SEC alleged he provided certain of his large investors like Goldman Sachs with favorable redemption and liquidity terms that enabled him to "impose more stringent redemption restrictions" on other investors.
2) The SEC charged Falcone and Harbinger with market manipulation related to an "illegal short squeeze." Harbinger Capital acquired 113% of distressed high yield bond issued by MAAX Holdings after Falcone discovered that his prime brokerage firm was short the bonds. The SEC claims he manipulated the securities price in order to maximize losses at his prime broker.
3) The SEC charged Falcone and Harbinger with Rule 105 violations. The SEC noted three instances where Harbinger actively shorted stocks within the restricted period before a public equity offering and covered the short with deal shares, a direct violation of Regulation M of Rule 105.
Describing the lawsuits, Robert Khuzami, director of the SEC's Division of Enforcement stated that: "Today's charges read like the final exam in a graduate school course in how to operate a hedge fund unlawfully." According to Forbes, Falcone "reportedly rejected a settlement offer that would have banned him from the securities industry, which would have prevented him from keeping position like being CEO of Harbinger Group." Despite the negative headlines associated with its CEO and largest shareholder, HRG has been one of the best performing stocks of 2012. Let's examine why we believe investors may be so misguided.
HRG's First Investment: Spectrum Brands
The largest asset at the holding company is the 29.7 million shares of Spectrum Brands, or nearly 58% of shares out. SPB is a roll-up that sells a range of products from small appliances to consumer batteries, shaving products, pet supplies, and lawn & garden and pest control products. Its brands include: Rayovac Batteries, George Foreman grills, Remington, Black & Decker, Russell Hobbs, Toastmaster, Varta, Farberware, Tetra, Marineland, Nature's Miracle, Dingo, 8-in-1, FURminator, Littermaid, Spectracide, Cutter, Repel, Hot Shot and Black Flag.
In December 2007, Harbinger Capital merged its ownership position in Applica Incorporated with Salton, Inc. (pink sheets: SFPI) and changed its name to Russell Hobbs. Harbinger controlled around 92% of the combined company after the reverse merger. In June 2010, Spectrum Brands and Russell Hobbs merged. Prior to the deal, Harbinger Capital owned 41% of Spectrum Brands and effectively all of Russell Hobbs. In the fall of 2010, HRG agreed to acquire 27.8 million shares of SPB from Harbinger Capital (again HRG's CEO is also the Portfolio Manager of the hedge fund from which it was buying HRG shares - not exactly arms length from our perspective). The transaction was consummated at what appeared to be a small discount to SPB's market price, when considering most transactions of that size would require a steep liquidity discount given the inability to sell that quantity of stock in the open market without price impairment. Nonetheless, we believe the transaction may have been used by Harbinger Capital to fund well publicized redemptions (a possible recurring theme). HRG funded the purchase from its CEO's hedge fund with $350 million of senior notes carrying a 10.625% coupon and 120 million shares of HRG stock. This transaction closed in January 2011. In October 2012, SPB announced the acquisition of Stanley Black & Decker's (SWK) Hardware & Home Improvement Business for $1.4 billion, with plans to fund the entire amount with debt. While the acquisition is accretive to SPB's earnings, the leverage of the combined entity will approach 5x EBITDA. We believe this amount of leverage adds significant risks to SPB, and by extension HRG. Today, HRG consolidates SPB's results on its financial statements, and reports a minority interest line items on its income statement and balance sheet. As we will show below, the holding company argument for valuing HRG has some major holes in it.
HRG's Sum-of-Parts Ropes in Investors
HRG provides a sum-of-parts slide in the investor presentation on its website. The diagram below is taken directly from management's presentation (slide 8) that depicts an "estimated value" of $10.07 per share.
We believe this disclosure is highly misleading and one of the primary drivers for the misplaced investor enthusiasm in the shares. For example, a recent Seeking Alpha article written by what appears to be a well-intentioned retail investor lays out a very similar sum-of-the-parts analysis (with $10.04 per share value). Another Seeking Alpha article published on August 31, 2012, included a similar implied range for Spectrum Brands and the indexed annuity business. That article helped drive HRG shares up 9% the day after it was published. Another HRG shareholder recently promoted his firm's investment in HRG during a Barron's interview, expressing the view that the net asset value of the company was $11.23. We think these arguments are dangerous and incorrect as discussed below.
Holes in the Sum-Of-Parts Evaluation: Book Value Does Not Equal Market Value
We believe the sum-of-parts presentation HRG's management has been using includes a few very aggressive assumptions that may have confused unassuming investors. For example, according to the small print footnotes in the presentation, the $10.07 per share value is based on 139.4 million shares outstanding. However, HRG has $400 million of convertible preferreds outstanding with an average conversion price of $6.64. Any economic analysis would adjust management's sum-of-parts above with shares issuable under the convert (and of course also take out face value of the preferreds from debt). This intellectually honest and economically accurate adjustment reduces the company's valuation by $1.14, or over 11%.
Yet the most aggressive assumption included in the sum-of-parts valuation is the nearly $900 million valuation for Fidelity & Guaranty Life ("FG&L') at "net book value." We will highlight why we believe this is an absurd valuation. FG&L is an indexed annuity provider that Harbinger acquired from Old Mutual in April 2011 for $350 million. According to management's presentation, this business has more than doubled in valuation during the last 18 months since the deal closed. To demonstrate how unlikely this assumption appears, the share price of FG&L's direct publicly traded competitor, American Equity Life (AEL), has actually DECLINED over that same time frame (while the S&P 500 (SPY) is up over 20%). AEL is down for a good reason, one which should also be depressing HRG's FG&L: the index annuity business faces significant regulatory and business risk due to the low interest rate environment. The issues that enabled Harbinger to get a "deal" on FG&L at a large discount to book value are not only still present, they have intensified. These issues are apparent in the valuation (and stock performance) of AEL.
AEL is the leader in the indexed annuity industry. Compared to FG&L, AEL appears to be more attractive on nearly every metric: market share, profitability, track record, return on equity and financial strength and credit ratings from S&P, Moody's and A.M. Best (see Table below for side-by-side compare). Despite relatively consistent results, AEL trades at a measly 39% of GAAP book value, 67% of book value excluding Accumulated Other Comprehensive Income ("AOCI"), and 42% of statutory capital.
AEL's management insists investors ignore AOCI (which makes up 41% of AEL's book value and 33% of FG&L's) and focus on book value excluding AOCI. Management of AEL has guided investors towards this approach DESPITE making the stock appear more expensive when utilizing this metric. In AEL's earnings releases, management goes so far as to calculate "total capitalization, total stockholders' equity and book value per share excluding AOCI" stating that "since AOCI fluctuates from quarter to quarter due to unrealized changes in the fair value of available for sale investments, we believe these non-GAAP financial measures provide useful supplemental information." In fact, in its earnings release, it ONLY provides book value on this basis (excluding AOCI). AOCI has increased substantially for spread based insurance companies as falling interest rates increase unrealized gains in investment portfolios. With long duration assets and liabilities of a spread business, there is little opportunity to realize these gains, so they are typically viewed by investors as temporary. HRG's FG&L is experiencing the EXACT same headwinds in its spread business!
Low interest rates make the indexed annuity businesses highly unattractive and are one of the main reasons they trade at large discounts today. Indexed annuity companies used to generate wide spreads by investing most of their investment portfolios in mortgages or mortgage securities insured by the US government. These carried little or no credit risk. With mortgage rates so low, indexed annuity providers have had to shift to much riskier investments to generate a spread and have limited ability to reduce crediting rates on the products (or demand will disappear). Today, indexed annuity companies are matching potentially very long dated liabilities with low yielding, but potentially risky investments. We believe investors are concerned that if and when rates rise, the reversal of AOCI and unrealized investment losses could result in realized losses for the non-surrender protection portion of their liabilities, potentially causing a "run of the bank."
The rate environment is not the only reason indexed annuity providers trade at massive discounts. There continues to be significant regulatory risk in this business. Indexed annuities are a product group that is typically aggressively sold with extremely high commissions for agents. A strong majority of indexed annuities are sold through lightly regulated independent agents. The main issues consumer advocates have with the product revolve around suitability issues and very high costs related to commission and gimmicks. The typical buyer of indexed annuity products is retirement age and indexed annuities can carry very large surrender charges that lock up funds for up to 15 years. Some industry observers speculate that surrender fees drive a large piece of the economics for indexed annuity providers. Given the myriad of concerns, multiple regulators, including the SEC, have considered regulating indexed annuities as investment securities rather than insurance. If this would happen, only registered investment advisors would be able to sell the product (unregistered agents make up a strong majority of indexed annuity sales today). Our research suggests that registered reps despise indexed annuities given the suitability and surrender fee profile of the product. As a result, if indexed annuities were regulated as investment securities, sales would likely dry up. For a more detailed view on the negative aspects of indexed annuity industry, we suggest reading the Reuters article "Don't Buy Indexed Annuities," where the author states there "are at least three scandalous aspects to the index annuity racket."
If management, and the misinformed bulls on HRG, valued FG&L more inline with its closest comp (accounting for the myriad of issues), then the bullish valuation argument would evaporate. Applying AEL's valuation metrics to FG&L, we arrive at roughly a $350 million valuation (see table below), which is the same price HRG paid in April 2011. Over this same time period, AEL's stock price has actually declined. Thus we could argue that this flat valuation is overly generous given FG&L metrics are inferior to AEL. What is perhaps most ironic about the bullish argument is that an investor can recreate the HRG assets by directly buying AEL shares and shares of Spectrum Brands (80% of company's valuation tied to Spectrum and F&G Holdings) without the liquidity or shareholder risk that accompany HRG shares. Any HRG investor would have a hard time justifying the liquidity premium they are paying to own HRG versus a proxy for the nearly identical assets.
source: company filings.
What is Left at the Harbinger Hedge Funds?
It is difficult to find reliable information on the current status of Harbinger Funds. Aside from hedge fund media reports, the best source of information appears to be the company's 13F filings with the SEC. However, Harbinger's 13F is difficult to evaluate at first glance since HRG's positions are also included in the filing. After reorganizing the positions by their entity, we believe it is clear that HRG may be the only listed equity at the two embattled hedge funds (see table below). The 13F seems to support the view that all other publicly traded equities at the hedge funds were liquidated earlier in 2012. We believe this would be a surprise to most HRG shareholders investors and may foreshadow a problem for HRG stock holders. If Harbinger funds need liquidity to meet redemptions or lawsuit claims, HRG shares may be one of the only sources for liquidity. If Harbinger or Falcone is convicted of SEC charges, or if Falcone is barred from the securities industry as part of a settlement or conviction, we have trouble conceiving a scenario where Harbinger Capital is not shut down, likely resulting in the sale or distribution of its entire HRG position.
Given the limited liquidity of HRG trading volume, a small float and very little institutional sponsorship, we believe a share sale or distribution by Harbinger could crush the stock. As a reference, if we assumed Harbinger was able to utilize 50% of the three-month average daily volume of 109,000 shares to sell its shares, it would take Harbinger nine-and-a-half years (based on 250 trading days per year) to liquidate its HRG position. While this is probably an unrealistic scenario, we believe shares would need to trade at a massive liquidity discount relative to current prices to attract volume buyers.
After Falcone received a Wells notice from the SEC in December 2011 informing him of their plan to bring an enforcement action, the New York Times' DealBook declared that starting December 30th, "Harbinger will bar investors from withdrawing money from four of its funds." If in fact Harbinger Capital investors are still gated, it could have terrible consequences for HRG shares.
Earlier in 2012, HRG filed a shelf for the registration of primary and 25 million secondary shares owned by Harbinger Capital's hedge funds. This may be an ominous sign for HRG investors, as it could allow Falcone to sell HRG shares to raise cash, or allow him to distribute registered HRG shares directly to Harbinger Capital's limited partners to fulfill redemption requests. There is precedent for this type of redemption from Harbinger Capital. According to Absolute Return, in June 2011 Harbinger paid redemption requests with "in-kind payments of the firm's illiquid holding in broadband wireless company LightSquared." According to the investor letter, Falcone stated that, "while we have had opportunities to monetize a portion of our LightSquared position in recent months, I feel strongly that any sale by our funds of an interest in LightSquared would have been premature and would not only have jeopardized the ability to join forces with a strategic partner, but also would have limited the substantial upside that I am convinced will come to all of our investors as our plan is executed." Less than a year later, LightSquared filed for bankruptcy.
source: company filings.
The LightSquared bankruptcy could provide further pain for Harbinger Capital, and by extension, HRG shares. According to the Wall Street Journal, LightSquared's lenders are attempting to recover over $260 million from Harbinger Capital for a 2011 "loan" to LightSquared that they believe was actually an "equity infusion." If the courts ruled in the creditors' favor, Harbinger Capital would likely need to generate liquidity, and our analysis suggests a large sale or distribution of HRG shares may be one of the only options.
Harbinger appears to be taking desperate actions to get liquidity for the remaining investments at the hedge fund. Falcone attempted to launch an HRG look alike with a blank check SPAC called Australia Acquisition Corp (ticker AACP). Under the proposed transaction, Harbinger Capital planned to contribute three investments that it claimed were worth $350 million in exchange for 83% to 96% ownership stake in AACP. Falcone planned to rename the company Harbinger Global Corp. The illiquid investments (thus not included in its 13F filing) included a casino development project in Vietnam and a minority interest in an iron ore producer in Brazil. It appeared to us that Falcone was again attempting to liquidate otherwise illiquid assets through a controlled vehicle. As of early November 2012, the transaction was delayed due to an extended review by the SEC. Then, on November 16, 2012, Australian Acquisition and Harbinger Capital announced the abrupt termination of the transaction, citing "time constraints and additional funding requirements, as well as other considerations, make attempting to proceed with the proposed transaction no longer, at this time, in the best interests of AAC and its shareholders, or HCP and its various funds' investors." With limited ability to turn these three Harbinger Capital investments into a liquid investment in the short term, it may expedite the need for Harbinger Capital to seek liquidly in HRG shares.
Harbinger Capital May Not Be Only Seller
On January 31, 2012, Harbinger Capital and Phil Falcone took out a $190 million loan from Jefferies (JEF) at a highly distressed effective interest rate of 24%. On June 14th, 2012, it paid off the balance of the loan with a new credit agreement with MSD Capital, the money-management arm of Michael Dell. Under the agreement, MSD can swap $50 million of the loan extended to Harbinger Capital for HRG shares at $6.50 per share before June 2013, or $7 per share after that date. Today, MSD can convert its loan in exchange for 7.7 million HRG shares. These loans provide additional questions and concerns about Harbinger. For example, it remains unclear if the loan is to the fund or to Harbinger Capital… and if it is to the Company, why can a possible loan to a hedge fund company be paid off with investments from a fund (which presumably are partially owned by outside limited partners). If MSD believes it can liquidate HRG shares for more than $6.50 per share, it would seem to make sense for MSD to convert its shares, especially before Harbinger Capital distributes or sells shares.
What is HRG worth?
Adjusting management's sum-of-parts analysis for the convertible preferred stock (so roughly 202 million shares out with a subsequent reduction in debt), a tax effected stock price of SPB (which brings the value below $5.50 per share at recent prices), and a more reasonable valuation of the indexed annuity business of $1.75 per share (the same $350 million that was paid prior to the industry risks accelerating and the closest comp declining 20%), and roughly $0.50 per share of remaining debt net of cash and other investments, we arrive at a fundamental value of less than $6.75 per share. This equates to over 23% downside from current levels. Our analysis is not impacted by HRG's recent announcement to acquire natural gas fields from Exco Resources (XCO) (as it replaces cash with this investment at market value). If we apply a reasonable and prudent liquidity and risk discount of 20% associated with: HRG's ownership structure, concentrated ownership by a hedge fund that has been charged with fraud, and material future risk of significant share sales/distributions, we arrive at a $5.35 price target, or 39% downside.