Signature Group Holdings (OTCQX:SGGH) trades at a discount to intrinsic value despite a successful restructuring, hidden asset in its circuit breaker business and significant tax assets valued at a fraction of their true worth.
SGGH.PK is the successor company to Fremont General, a financial services company that offered retail banking products as well as commercial and residential mortgages. Fremont filed for Chapter 11 bankruptcy in June 2008 and emerged in June 2010 as Signature Group Holdings with a new board and management team. SGGH.PK acquired specialty industrial supply company North American Breaker (NABCO) in July 2011.
SGGH.PK has two primary businesses.
NABCO supplies circuit breakers used in commercial, industrial and residential structures in the U.S. with a focus on the replacement market. NABCO operates seven warehouse locations and expects to open two additional distribution centers this year.
Signature Special Situations acquires sub-performing and nonperforming commercial and industrial loans, leases, mortgages, corporate and structured debt, typically at a discount. Signature also originates secured debt financing to middle market companies.
Although SGGH.PK exited from bankruptcy over three years ago, it still qualifies as a post-bankruptcy play given that the main value catalyst is the significant NOLs received after its exit. Before any discussion of valuation, the tripling of the stock YTD should be addressed.
While this price appreciation certainly is based on the expectation that the NOLs will eventually be used, it fails to properly account for the full value, the successful ongoing restructuring or the strong circuit breaker business (in-depth discussion below).
Investors should be less concerned with missing the previous move in the stock and more concerned with the following:
First, the current valuation should be compared to the intrinsic value. If the former is significantly smaller than the latter then an attractive value opportunity exists, regardless of past price movement. Many investors miss out on future gains by focusing solely on past gains and placing a mental ceiling on the stock (e.g. Apple (AAPL) from April 2009 to September 2012).
Second, the ability to manage risk should be considered. More often than not, stocks that have risen significantly in a short time frame do not allow for a low risk entry due to the high probability of a pullback. However, SGGH.PK recently consolidated into a tight range and provides investors with the opportunity to reduce risk by placing a tight stop loss. Furthermore, the consolidation is a positive sign as many stocks that have gone parabolic often retrace a significant portion (e.g. a third to a half) of their gains in a short time period. This is not the case with SGGH.PK.
Disconnect between implied and true value for NOLs won't last forever
SGGH.PK has ~$886.9 million of federal NOLs (20-year life and begin to expire in 2027) and $980 million of California NOLs (either a 10 or 20-year life and begin to expire in 2017). SGGH.PK created a tax benefit preservation plan in order to preserve these NOLs.
The current valuation places a significant discount on the value of these NOLs due to the fact that management has not yet acquired a large and profitable company that would allow it to fully use the NOLs. Even SGGH.PK places a full valuation allowance on its deferred tax assets.
The implied value for the NOLs decreases as more time goes by without an acquisition announcement. However, there are five key points to consider.
First, this delay should be viewed as a positive as management is clearly focusing on the long-term best interest of the company by not overpaying and/or acquiring a small company (without a sufficient level of profitability to fully use the NOLs) merely to please short-term oriented investors. In this instance, action does not equal progress. Moreover, the new board has access to higher quality deal flow and increases the possibility of consummating a large and accretive acquisition.
Second, the disconnect between implied and true value should rapidly narrow after an acquisition is announced.
Third, the significant stock price appreciation is actually a positive (even for current investors) as this means the company should be able to issue fewer shares to pay for an acquisition*, which reduces the potential dilutive impact. Furthermore, management intends to raise capital through a rights offering, which is significantly less dilutive than traditional equity raises and preserves the right to use the NOLs.
Fourth, management intends to use Covanta (CVA) as the model for its rights offering. The fact that legendary investor Sam Zell was a board member of CVA and owns 9.3% of SGGH.PK is a significant positive factor. Another interesting parallel is that CVA rose from ~1.5 to ~10 in the four months prior to emerging from bankruptcy in March 2004 and then steadily rose to ~30 by 2008.
Fifth, SGGH.PK intends to list on the NASDAQ (click on FAQ), which should be a significant value catalyst, as this will exponentially increase the potential shareholder base as many investors ignore OTC listed stocks.
*At the annual shareholder meeting shareholders approved an increase in the number of authorized shares from 190 million to 665 million. In September 2013, SGGH.PK filed a shelf registration statement, which would allow it to raise up to $300 million through the sale of securities.
Successful ongoing restructuring
SGGH.PK has made significant progress since emerging from bankruptcy. The complicated nature of the ongoing restructuring results in a valuation ceiling being placed on the stock, which should be raised (and eventually eliminated) after the market begins to price in the following improvements:
Sale of non-core and legacy assets. SGGH.PK intends to sell Cosmed (anti-aging skin care subsidiary) after classifying it as discontinued in 4Q12 and receiving an unsolicited offer for its intellectual property and other assets. SGGH.PK continues to take advantage of favorable market conditions to dispose of the legacy assets and liabilities of its former business (Fremont) including subprime residential real estate mortgages as well as residential and commercial real estate.
In 2Q13, SGGH.PK sold a majority of its Signature Special Situation group assets (portfolio of residential real estate loans) for ~$27.1 million, which resulted in a gain of $5 million. Subsequent to the closing of 2Q13, SGGH.PK redeemed FHLB stock (required to be held in order to maintain a borrowing relationship) in July for $2.1 million. At the end of 2Q13, no residential real estate loans were in nonaccrual status compared to 10.1% at the end of FY12.
SGGH.PK deserves a higher multiple for these disposals for two reasons. First, the significant balance sheet uncertainty is virtually eliminated, which should not be taken for granted, especially for a bank that emerged from bankruptcy. Second, the gain on the sale of the disposals, as well as the high credit quality of the remaining assets, most likely exceeded expectations. As a result, the strong net cash position should help finance an acquisition and reduce the size of a rights offering.
Reduced cost structure. Income from NABCO and any future acquisition should drop straight to the bottom line given the significantly lower cost structure and elimination of multiple one-off charges including the following:
- Reduced workforce by 25% in FY12.
- No more proxy contest expenses ($1.8 million in 2Q13).
- The settlement of a substantial number of legacy legal actions, which should significantly reduce litigation expenses going forward.
- No plans to renew sublease (in April 2014) for corporate headquarters as it is "larger and more elaborate than present needs" (SGGH.PK will look for a smaller space).
- Reduced assets of discontinued operations from ~$22.6 million at the end of FY11 to ~$3.4 million at the end of the mrq.
- Sale of IT systems related to Fremont business.
- Reorganization expenses reduced to virtually zero ($0.1 million in FY12).
- Expected refinancing of 9% notes for significant interest savings
- Reduced repurchase reserve liability (see Risks section below).
NABCO is a hidden asset
NABCO is one of the largest independent suppliers of circuit breakers for the replacement market. Its broad geographic footprint provides 'just in time" delivery and a significant competitive advantage.
The demand for this critical safety device* (which must be replaced immediately when damaged) used in virtually every structure should only grow due to the aging electrical infrastructure. According to a Georgia Institute of Technology study, the majority of equipment in the U.S. electrical grid is at least 40 years old. The replacement market is characterized by the following positive traits:
- Fewer large competitors.
- Less dependent on the more volatile new construction market.
- Minimal risk of product obsolescence, which significantly reduces the risk of a large inventory write-down.
In the mrq, revenue rose 4.3% driven by new customers. Adjusted EBITDA rose 9% to $2.4 million. Net earnings rose 38.3% while the profit margin rose 260 basis points to 10.8%.
*A circuit breaker will automatically shut off an electrical circuit when the flow of electricity increases above a safe level in order to prevent serious damage including fire.
NOLs. SGGH.PK will need to acquire a sufficiently large and profitable company in order to use its NOLs.
Potential dilution. As discussed above, SGGH.PK expects to conduct a rights offering in order to fund an acquisition, which may result in dilution.
Repurchase liabilities. SGGH.PK maintains a reserve that represents estimated losses from repurchase claims based on breaches of certain representations and warranties provided by Fremont Investment & Loan (FIL) to counterparties that purchased residential real estate loans originated from 2002-1Q07. As of the mrq, there were $101.7 million of total outstanding repurchase claims.
This risk is mitigated by several factors. First, the repurchase reserve liability decreased $0.5 million to $7 million in 1H13 (and from $8.5 million at FY11) as no repurchase claims were received or settled during this time frame. Second, of the outstanding claims, there has been no communication or other action from the claimants:
- for more than 60 months for $61.6 million in claims
- for more than 36 months but less than 60 months for $11.4 million in claims
- for more than 24 months but less than 36 months for $28.7 million in claims
Bankruptcy claims. SGGH.PK has $5.1 million in remaining unpaid claims filed with the U.S. Bankruptcy Court.
Outstanding lawsuit. SGGH.PK has a $1.8 million litigation reserve for the full amount of a judgment relating to a lawsuit brought by a former Fremont employee.
Customer concentration. Three industrial supply customers accounted for 40.3% of total operating revenue in FY12.
The target price of 1.37 is based on the sum of the parts analysis. This is extremely conservative given the assumptions used in the model and represents a shorter-term price target (e.g. 6-12 months). A stop should be placed no more than 5% below support at 1.15.
A more aggressive and longer-term (e.g. 12-24 months) price target is realistic however the range for this price target is wide given the significant uncertainty regarding an expected transformative acquisition (e.g. industry and EBITDA level unknown). In this instance, conservative investors could enter on strength above the recent high of 1.30 while more aggressive investors could enter at current levels with a tighter stop.