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Summary

  • SWK Holdings Corporation is a publicly traded, specialty finance company with a focus on the global healthcare sector.
  • On August 18, 2014, it announced an equity financing of up to USD115 million including a deeply discounted USD12.5 million non-transferable rights offering.
  • This financing transforms its prospects, creating a company with much greater scale and ability to execute on its strategy.
  • However, post-announcement, its share price jumped about 27%. We estimate its current share price implies a slight premium to book value post-financing.
  • In the months leading up to the announcement, we considered SWKH an attractive prospect with near-term catalysts. Post-announcement, the trade is no longer as compelling.

Background

Until December 2009, SWK Holdings Corporation (OTCQB:SWKH) was known as KANA Software, Inc. ("KANA"). Incorporated in 1996, KANA engaged in the development, marketing and support of customer communications software products. In December 2009, KANA sold substantially all of its assets for approximately USD40.6 million in consideration. At the closing of the asset sale, KANA changed its name to SWKH. Its goal was to redeploy its cash in businesses with taxable income that could be offset by use of its net operating loss carry forwards ("NOLs"). As of June 30, 2014, SWKH had NOLs of approximately USD433 million that will expire by 2032, with the majority of such NOLs expiring by 2021. SWKH has also adopted a Rights Plan to preserve the NOLs as described here.

In May 2012, SWKH announced that it hired Brett Pope and Winston Black as its CEO and Managing Director, respectively, to build a specialty finance and asset management business. They were the co-founders of PBS Capital Management, a firm established in 2009 to deploy capital in the health care and pharmaceutical royalty market. Prior to founding PBS Capital, they were employed at Highland Capital Management in Dallas. SWKH estimates that the current addressable market for commercialized life science product monetizations is in excess of USD40 billion globally. In 2011, the value of the publicly announced pharmaceutical royalty monetizations was estimated to be in excess of USD2 billion.

Its strategy is to be a healthcare capital provider by offering customized financing solutions to life science companies, institutions and inventors. SWKH intends to fill the sub-USD50 million niche transaction size. Its returns are generated primarily from owning or financing through debt investments, royalties generated by the sales of life science products and related intellectual property; receiving interest and other income by advancing capital in the form of secured debt to companies in the life science sector; and to a lesser extent, realizing capital appreciation from equity-related investments in the life science sector.

In addition, through its wholly-owned subsidiary, SWK Advisors LLC, it provides non-discretionary investment advisory services to institutional clients in separately managed accounts to similarly invest in life science finance sometimes alongside its own investments. SWKH does not anticipate providing capital in situations prior to the commercialization of a product and it generally funds the full amount of transactions up to USD10 million through its working capital. In circumstances where a transaction is greater than USD10 million, SWKH seeks to syndicate amounts in excess of USD10 million to its investment advisory clients and/or other investors.

This transformation from cash shell to specialty finance company was essentially orchestrated by Carlson Capital, L.P. ("Carlson") who has been SWKH's largest shareholder since the fourth quarter of 2009. It owned around 28% of SWKH in July 2014. In September 2013, SWKH obtained a USD30 million four-year financing from a fund affiliated with Carlson. In conjunction with the credit facility, Carlson received a seven-year warrant, for 1,000,000 shares of SWKH's common stock at a strike price of USD1.3875. On May 16, 2014, Carlson made a non-binding offer to acquire 80 million shares of SWKH for USD1.20 per share. This quickly escalated into a potential proxy fight with SWKH's special committee. On July 15, 2014, Carlson proposed changes to SWKH's board to attempt to resolve the roadblocks. The issues have been resolved as expanded on below.

New equity financing agreement

On August 18, 2014, SWKH announced that it had entered into an agreement with Carlson whereby it will purchase new shares in SWKH such that its ownership increases to 69%. Per the press release, the issuance of shares will be staged as follows:

  • First, SWKH conducted an initial share issuance of 55,908,000 shares to Carlson at USD1.37 per share.
  • Then, as promptly as reasonably practicable, SWKH will undertake a separate USD12.5 million rights offering based on a price of USD0.86 per share. Existing stockholders, including Carlson based on its just over 28% pro rata basic participation rights, may elect to participate on a pro rata basis.
  • Lastly, a subsequent share issuance at USD1.37 per share of a to-be-determined number of shares will occur such that Carlson will have a voting 69.0% ownership interest in SKWH.

In total, SWKH expects to raise at least approximately USD89.1 million and up to approximately USD115 million in equity proceeds, based on non-Carlson stockholder participation in the rights offering of zero and 100%, respectively. In addition, three members of SWKH's board (including the two members of SWKH's special committee) were replaced with three Carlson nominees.

(click to enlarge)

(Sources: Company filings and author's estimates)

The impact of the equity financing on SWKH's capital structure is shown above. As at June 30, 2014, SWKH had a share price of about USD1.17 and a market capitalization of USD50.5 million. Assuming 100% non-Carlson participation in the rights offering, SWKH raises about USD115 million in new equity financing bringing its market capitalization to around USD165 million or USD1.25 per share. This is in line with our estimate of SWKH's post-equity financing book value per share of around USD1.26.

Carlson ends up with a 69% shareholding at an estimated average cost per share of around USD1.29. Based on SWKH's current share price of USD1.44, we calculate non-Carlson shareholders who acquire SWKH's shares post-announcement are able to participate at around the same average cost as Carlson. This assumes that the record date for the rights offering is set sometime in the future and not pre-August 18, 2014. It also assumes shareholders participate fully in the rights offering. It is highly unlikely there will be zero non-Carlson participation given the dilutive effects of the deeply discounted rights offering. Shareholders will not be able to transfer their subscription rights to anyone and payments can only be made from a personal or certified check drawn on a U.S. bank.

We think this is a game-changing catalyst for SWKH. The equity financing enables it to substantially expand its operations and capture more of the economics of its royalty securitization business. It enables SWKH to diversify its portfolio lowering its exposure to any single investment. It should be able to access more attractive debt financing in the future and more effectively compete for business that requires a demonstration of substantial capital resources. With the majority of its NOLs expiring in 2021, this should enable it to maximize the potential benefits of this important asset class. Finally, it also provided the opportunity to enter into new employment agreements with Brett Pope and Winston Black extending their employment through December 31, 2018.

Growth strategy

In the August 18, 2014, press release, Brett Pope revealed a key component of how SWKH intends to generate shareholder returns: "With the proceeds from this transaction, SWK[H] is now well positioned to aggressively pursue this compelling market opportunity in order to generate significant cash flow and compound book value."

SWKH is a specialty finance company and it seems to operate very much like a business development company ("BDC"). BDCs are publicly traded closed-end funds that enable investors to participate in high yielding private market investing while maintaining daily liquidity. BDCs are tax advantaged and are normally classed as regulated investment companies ("RIC"). Like real estate investment trusts, as long as the RIC meets certain income, diversity, and distribution requirements, the company pays little or no corporate income tax. As a pass-through tax structure, RICs must distribute at least 90 percent of taxable income as dividends to investors. This creates a structure that pays out generous dividends whilst NAV per share remains relatively flat or grows at a more modest pace.

American Capital (NASDAQ:ACAS) is one well-known BDC that elected to become a taxable subchapter C corporation in 2011 to allow it to recognize its NOLs. Freed from the obligation to pay dividends as a former RIC, the company then concentrated on growing its book value. Its ability to grow its book value at an average annual rate of 23% from 2009 to 2013 appears impressive. Its share price rose 500% over the same period but this is off a very low base as ACAS had a near death experience during the Great Recession. Since 2008, its shares have consistently traded at a discount to book value despite an aggressive share buyback programme initiated in the last few years. This has yet to narrow the gap sufficiently and it still trades at around 0.76x book value. The point here is that trying to compound book value, rather than pay dividends, may not be rewarded by the market with a significant premium to NAV. Another serial book value compounder that we wrote about previously, Kennedy Wilson (NYSE:KW), suffers from a similar issue even though it really benefited from the Great Recession.

Risks

The main concern we have is the potential actions of the controlling shareholder. With a 69% shareholding, its nominees on the board, approval rights granted in the latest stockholders' agreement and an affiliate providing credit facility financing to the company, this is very much a Carlson dominated company. However, we think there are a number of factors that limit Carlson's ability to consolidate its holdings any further. Access to the equity market for financing is an essential part of a specialty financing company's operating model. Repeated abuse of minority shareholders will limit SWKH's ability to raise new, third-party, equity financing or at least make it very expensive to do so. In the August 18, 2014 shareholders' agreement, Carlson has agreed that it will not increase its voting percentage to greater than 76% for a five year period. We also note that Carlson has articulated its sensitivity to minority shareholder rights in the past and it subscribed to new shares at a substantial premium to SWKH's pre-August 18, 2014 share price. As a former minority shareholder, we have benefited greatly from Carlson's drive to transform SWKH, so we applaud their efforts to date.

As a recently formed company, SWKH has a limited operating history. Its portfolio is concentrated, making it more susceptible to default risk. It is heavily reliant on two key people, Brett Pope and Winston Black. If their relationship with each other or even Carlson frays it will have a disproportionate impact on the business. Many specialty financing companies, such as ACAS, really struggled during the Great Recession to raise capital and suffered large write-downs in their loan portfolios. We think SWKH may be a bit more resilient due to its unique focus on life science revenue streams. Finally, we are concerned about the record date of the rights offering. One simple way of limiting Carlson's participation is to back-date the record date to pre-August 18, 2014. This means anyone investing at present may not be able to participate and they are buying into SWKH at a significant premium to book value.

Conclusion

For us, in addition to the standard operating model of a specialty finance company, there has to be something more to make it a compelling investment opportunity. We anticipated what unfolded last week for months and we are glad an investment thesis played out. But based on SWKH's current share price, we calculate the discount to NAV is gone. There are a whole range of specialty finance companies to choose from. A few like Main Street Capital Corporation (NYSE:MAIN) and Triangle Capital Corporation (NYSE:TCAP) trade at a premium to book, but most trade in line with their book values. The main example of a financing company focusing on growing book value over dividends is ACAP. However, it is trading at a significant discount to NAV despite trying to eliminate this gap for years. We do not doubt SWKH's prospects have been transformed, we like the company, business model and management. It may well trade at a significant premium to NAV overtime. We just cannot construct a thesis backed by compelling evidence to support this view right now. We have exited the trade and will continue to monitor SWKH to see if another lucrative entry point presents itself in the future.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Editor's Note: This article covers a stock trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

Source: SWK Holdings: New Equity Financing Is A Game-Changer, But Current Entry Price Is Not Compelling
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