Dissecting The Washington Mutual KKR Deal

| About: WMIH Corp. (WMIH)

On December 9, shares in the reincarnated Washington Mutual (NASDAQ:WMIH) surged some 50% after the company's board of directors announced a commitment for strategic investment with KKR & Co. L.P. (NYSE:KKR), which instantaneously added 70% the company's market value. The announcement caught most unaware, a positive shock to the few holdout retail shareholders who have remained deeply involved with the former banking giant since its FDIC forced seizure and following bankruptcy in September 2008. Many were not expecting any significant news announcements by WaMu until after the company's two-year post-bankruptcy anniversary in March because of IRS Section 382 limitations regarding the carry forward the company's NOL tax assets.

The Deal

Under the terms of the agreement, and pending final approval, KKR has agreed to purchase $10.55M in WMIH convertible preferred stock, exchangeable into 9.6M shares of common equity. In addition, KKR will commit to purchase up to $150M in yet to be issued WMIH subordinated 7.5% PIK notes. Combined with its previous credit line of $125M at 7% obtained during bankruptcy negotiations, WaMu now has the ability to obtain $275M in immediate financing towards a leveraged buy out that allows it to best utilize its current NOL tax assets. The deal also grants KKR five year warrants in WaMu, allowing it to acquire 61.4M shares at a blended rate of $1.38/share.

While the deal adds 71M shares to the company's current issuance, or a 26% dilution for a $95M capital injection, it does immediately raise the company's bottom line market value to $365M from its previous bankruptcy court appointed value of $210M. Shares closed up over 45% on the news, setting an intraday high of $1.81/share that matched the $365M market value based on 202M current shares, before settling down some. The agreement creates a new point of resistance against short sellers by establishing a true floor price for the company, which some online message boards pushed heavily as having no real floor at all; right up until the news was released. While the dilution does decrease WMIH's upside some, it significantly decreases the downside risk.

Seat at the Table

While the deal injects needed capital into WaMu to pursue future M&A activities, what is more important is that WaMu now has a seat at the big table, so to speak. All too often, the best deals on Wall Street are based on whom you know. Even though the agreement does subject current shareholders to a 26% dilution, it partners them with a leading global investment firm that would not be dealing unless they saw significant money to be made. With $90.2B of assets under management, and a market cap of $7.2B on the open market, KKR should be able to shop WaMu's NOLs out and close a deal in short order. It should be noted that publicly traded KKR shares represent only 30% of the firm's actual ownership equity, with the remainder held by the firm's partners. This raises KKR's true market power $24B. Consequently, KKR should have no problem harvesting all of WaMu's $5.97B in NOLs before their expiration date.

Upwards Spiral

The NOLs, estimated to be $5.97B, is WaMu's most significant asset. At a 35% corporate tax rate the short answer is that the NOLs could be worth up to $2.1B in cash from future tax savings. The long answer is that it is much more complicated than that. As testified in court, the NOLs would likely be discounted by 25% to 35% for transaction risk if WaMu merged in an all-stock transaction with another entity. Further reduction would come in the form of discounted cash flow, namely a reduction of the NOLs value based upon how long it would take to use them up. Consequently a value of $1.05B seems a much more reasonable and lower risk valuation, though the court assigned the NOLs a value of just $51M based in part on a "worst case" ongoing operations only situation. With KKR's pairing however the "worst case" is now off the table. As shares in WaMu continue to rise, its ability to use its NOL assets increases proportionally, given how they hinge heavily upon M&A activities and further capitalization, both of which are strongly dictated by market cap. Consequently the higher its stock moves the easier it becomes for WaMu to "cash in" on its NOLs, thereby making them worth more, which in turn increases share price, resulting in a positive loop.

It's Called Synergy

KKR's agreement with WaMu has not been a one sided affair. KKR shares have risen some 7% since the announcement, in part because its warrants and convertible preferred stock in WMIH have already added $56.3M to the company's bottom line, even before the ink has dried on the deal. The $56.3M in paper profits represents a 60% return for KKR on its investment in just five trading days. Furthermore, in a somewhat more ambiguous yet encouraging forecast, KKR has wrangled the additional right to participate in future WMIH equity offerings, up to an aggregate of $1B and including a cap in ownership by KKR of 42.5% of WMIH's common shares, for the next three years. This forecast gives WMIH a greatly improved market value. Based on the $1B for 42.5% ownership valuation, WMIH's market cap would weigh in at $2.36B. Under this evaluation, KKR's 26% interest in WMIH for $95M would reap $620M for KKR's equity, a tidy 650% return. Meanwhile WaMu's shareholders would retain $1.36B in value from such a deal.

An Exceptionally High Alpha

Based upon 202M current shares, and $1.36B in value, WMIH's shares appear to have the ability to ring in at $6.73/share, pending no further third party dilution than the additional 16.5% detailed above. At its current trading price of $2.13/share, this represents an upside of 315%, against an established floor of $1.81, a 15% loss. The time frame to reach such a price is somewhere between March 2014 and December 2016, based upon WaMu's soon to be expiring 2 year IRS Section 382 limitations and KKR's three year equity offering rights, or a 105% yearly return, assuming three. While such price appreciation may appear overly rosy, shares based purely on the company's NOL cash estimated value of $1.05B, and a 57.5% ownership retention of such, still returns a comfortable $2.99/share. That works out to a decent 40% return for simply purchasing "cash" and no ongoing activities. Buying cash alone should not be a major concern as WaMu is highly likely to become an ongoing company in order to best use its NOLs.

Disclosure: I am long WMIH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.