The Dutchman Flies Again...
Special situations (including types of arbitrage and spin-off investing) often provide shrewd investors with significant returns not correlated with the performance of broader markets. In other words: this is the kind of stuff you need right now. In a period of low dividends, anemic fixed income yields, high equity prices and near term uncertainty - these types of situations can provide investors with insulation from volatility and a chance at realizing significant profit - if they are on the right side of the trade.
One such situation currently in the process of unfolding this month is a Dutch Tender by The Hackett Group (HCKT). I will briefly discuss the underlying business, what exactly a Dutch Auction (or in this case, a Tender) is, what options investors have when approaching this situation and how it could play out.
About the Business
Engaged in the Management Consulting industry, the Hackett group "provides advisory, benchmarking, and transformation consulting services, including shared services, offshoring and outsourcing advice. The Company operates in the business and technology consulting services segment." Unsurprisingly, as a firm with a focus towards outsourcing, the Hackett group serves the North American and European geographic regions in addition, "through its REL group, Hackett offers working capital solutions focused on delivering cash flow improvements. Through its enterprise resource planning solutions group (ERP Solutions), Hackett offers business application consulting services that help maximize returns on information technology (IT) investments." Quoted material is courtesy of Google Finance.
As you might have noticed, outsourcing has proliferated in the past several decades and thus demand for services related to the intracicies of outsourcing has grown considerably. IT systems consulting is a likewise advantageous position to occupy right now - as there has been an explosion in technological integration and business solution software. Hackett and its subsidiaries also provide services to streamline IT implimentation to maximize cash flow efficiency - an area which can often be a difficult field for companies to navigate on their own.
The Numbers on Hackett
This company is tiny, with a current market capitalization of slightly more than $200 million dollars. Currently priced at $6.51 with a book value of $3.17 per share, $10 million of cash on hand against $15 million of debt - investors are paying a premium for the company. Given the nature of the business (engaged in consulting and services and owning significant amounts of intangible, proprietary assets) - I believe that it is understandable to pay a premium for the stock given the unquantifiable nature of its assets. The company also comes at a reasonable P/E ratio of 14.34. The company also pays an annual dividend (recently instituted), currently yielding 1.51% - with a payout ratio of .21, a number that I believe indicates potential for future dividend increases - however with a high return on assets relative to risk free alternatives it is likewise acceptable for minority shareholders if the company maintains the level of current dividend payments. The companies free cash flow yield is also robust.
What going "Dutch" Means
"A Dutch auction offer specifies a price range within which the shares will ultimately be purchased. Shareholders are invited to tender their stock, if they desire, at any price within the stated range. The firm then compiles these responses, creating a supply curve for the stock. The purchase price is the lowest price that allows the firm to buy the number of shares sought in the offer, and the firm pays that price to all investors who tendered at or below that price."
The company has allotted $37.5 Million to repurchase shares at no higher than $6.50 per share and no lower than $5.75 per share. Dividing $6.50 into $37.5 Million indicates that at the highest price offered, the maximum amount of shares that the company can purchase is 5,769,230 or approximately 18.25% of the outstanding shares of the company.
How Might This Impact the Value?
Applying a 18.25% increase in share price to the amount of outstanding shares (as 18.25% of the outstanding float will become treasury stock, reducing the shares outstanding from 31.61 Million to 25.84 Million). If one multiplies 1.1825 by the price of the stock after retirement of shares into the treasury at around $6.50 per share, given the laws of supply and demand, the remaining shares will logically be worth 18.25% more than $6.50 - or approximately $7.69 per share. Assuming that the shares of the company are purchased at $6.50 per share, dividing the total dollar value of the transaction ($37,500,000) by the remaining outstanding shares (25,840,000) yields $1.45 per share of treasury stock. Adding this number to the purchase price of $6.50 per share equals a price of $7.95 after the tender offer has been concluded. These numbers, $7.69 and $7.95 are very similar.
If the tender goes through at a lower level, lets say at the midrange of the price offered - $6.125 - the company will be able to repurchase around 6.1 Million shares, leaving 25.5 million common shares outstanding and reducing the float by almost 20%. Multiplying 1.20 by the mid-range purchase price of $6.125 results in a price of $7.35 of the remaining common shares when adjusting for reduced float. Dividing $37,500,000 used for share repurchases into the outstanding shares in this scenario (25,500,000) indicates that $1.47 worth of treasury stock will be added to the shares of the company - Adding $1.47 to $6.125 equals $7.59 per share, a number which is again close to $7.35.
Wait a minute - Treasury Stock Isn't normally accounted for like that, right?
Correct. However, I am not pulling these numbers out of my hat and instead using them to illustrate a phenomenon I have previously observed - I am assigning these prices based on my observations of the company's stock after its Dutch Tender in 2012.
Can History Repeat?
During this Dutch Tender, the company tendered to purchase 11,000,000 shares of its common stock at a price between $4.25 and $5. After being announced on February 21st 2012 shares increased from $3.89 to approximately $4.8 - leaving a considerable spread between the upper limit of the tender range ($5) and the price of the stock at market ($4.8) - especially considering the fact that the tender offer expired one month after being initiated.
On March 22, the company announced that the offer was fully subscribed (in fact, slightly over subscribed) and elected to purchase slightly over 11,000,000 shares for $5 each - the maximum amount stipulated in the terms of the agreement. For many investors who purchased shares after the announcement simply to tender immediately, the successful conclusion of the offer at the highest price level was the end of the story, as the annualized returns - even for those late to the party - were significant enough to constitute an attractive arbitrage operation given the one month commitment.
For those who did not tender and held on after the expiry, the rewards were great. Something very interesting happened as the offer concluded: the price of the company appreciated significantly above $5 and did so quickly - hitting $6.41 on April 5th, less than three weeks after the conclusion of the tender. $6.41 represents 28% over the highest tender price offered by the company during the 2012 offering - a number that is very close to the 27% of the common shares the company decided to repurchase (reducing the total share float by 27% - thus increasing the price of all the outstanding shares by that number).
This Just Might Happen Again
I believe that history stands a very good chance of repeating itself - and that investors will once again find themselves witnessing a sharp appreciation in the price of the company's shares in the aftermath of it's tender offer, should it be successfully concluded. This situation does bear marked differences however, as the spread between the ceiling of the tender offer and the current stock price is much more narrow (and on some days is actually at a premium to the maximum tender price). I believe that investors who can purchase shares at or below $6.50 (ideally around $6.30) as the tender offer progresses and who hold or purchase their shares after the tender offer expires will realize significant gains of approximately 18%-20% (corresponding with the amount of shares to be retired) in a short period. In order to better assess the situation, I will be intently watching the progress of the tender offer - especially the price point at which the company purchases shares and the total amount purchased.
The Timeline is Important
If history is to be our guidepost as we venture into the unknown, the price action of the stock one month after the conclusion of the tender will provide the necessary proving ground with which to test my assumptions. Hackett's tender offer expires September 26, 2013 and using the past as a guide - I believe there is a one month window for significant price movement. If the price of the stock appreciates by roughly 18% (the amount of the float which will be removed should shares be purchased at the price of $6.50), from investors stand to reap an annualized pre-tax return of 216% if the price of the stock revises upwards in a similar manner as it did in 2012 - an extremely efficient manner with which to utilize capital.
Risks to be Aware Of
As with any special situation, there are potential risks to be had. The first is overpaying for shares of the stock relative to the final price at which the tender offer will be executed. Since we will not know the precise terms of the tender offer until it expires later this month - investors are faced with some uncertainty risk during this period, particularly since shares have recently increased in price beyond the high point of the tender offer - potentially indicating that the trade has already become crowded.
In spite of the risks attached to the tender offer, investors also have the option of purchasing shares immediately AFTER the results of the tender offer are announced in order to protect themselves further and utilize more complete information. I would advocate purchasing a fractional position with a limit order somewhere below $6.50 before expiry - and depending on the development of the terms, purchasing more shares after the preliminary results of the offer are announced by the company.
Something that makes this special situation appealing in my eyes is the fact that investors are able to corral their risk - as the company has, in theory, established a variable floor ($5.75~$6.50) for the price of the stock based upon repurchases in the near term. For investors seeking to purchase shares with the express purpose of tendering, opportunities have begun to dry up - however investors willing to wager upon the dynamics of supply and demand are well situated and have the luxury of observing the results of the company's 2012 tender offer.
Another risk that I believe investors ought to be appraised of is the participation of insiders in the tender offer - as during the 2012 tender several major holders of the company participated.
Heavy insider participation in this operation (depending on the amount of stock tendered against total share ownership) could represent a red flag about the long term prospects of the company, while a lack of participation or buying by insiders would be considered a positive in my mind - indicating an expectation that the company's stock will appreciate significantly in the future.
I believe that this is very possible given the aggressive buybacks that have been conducted (11M shares in 2012 and 5.5M or more shares in 2013), the low cost of borrowing given in the current interest rate environment and the ample free cash flow generated by the business
I believe that this situation offers investors a chance to realize significant returns that are insulated from broader market conditions. For investors willing to pay close attention in the next several months, there is a significant potential to profit from price appreciation after the tender offer is concluded.
Since I was late to the party, I have a limit order open for a fractional position in Hackett shares in the mid range of the tender offer price and am planning future purchases based upon the published results of the tender. Over the next three weeks - investors interested in participating will be provided with a more complete framework of information upon which decisions can be made. Though this situation does require more due diligence - it is a very attractive mispriced gamble in my mind.
Additional disclosure: I currently have an open limit order for HCKT shares until the expiration of the tender period.