Editor's note: Originally published on July 21, 2014
Over the last few months, I have been focusing a good portion of my screening activities searching for net operating loss (NOL) shells and it's something I would like to discuss today. I first became interested in the topic after reading a very interesting write up of a NOL shell. The main purpose of this post will be to talk about what NOL shells are, what to look for, and the benefits and risks of investing in these types of companies.
What are NOL shells?: So, first things first, what are NOL shells? A NOL shell is essentially a company that previously incurred substantial losses over an extended period of time and currently has no business activity. In the U.S., if a company generates a net loss in a period, it is allowed to "carryback" the loss two years (assuming it was profitable in the prior two years) and get a tax break or it can carry the losses forward for 20 years to offset future taxable income-hence the term "net operating loss carryforwards".
Net operating losses that are carried forward are recorded on the balance sheet as deferred tax assets (DTA). The DTA will allow profitable companies to offset future income against the DTA. So assuming the 35% corporate tax in the U.S., a $100 NOL will have a deferred tax asset value of $35, which will be able to offset future tax expense. Under U.S. GAAP, if it is unlikely that a DTA will be utilized (because there will be no future taxable income), then a portion or all of the DTA balance must be written down with a valuation allowance.
The most common type of companies that become NOL shells are biotech companies. These companies spend millions on R&D and rarely, if ever, profits. Many eventually give up on their R&D efforts and decide to liquidate. However, for savvy investors, these types of companies are exactly what you're looking for. These companies have often incurred millions of NOLs and trade for a fraction of the related DTA value. Just think about the implications of using a NOL shell as an acquisition vehicle and not having to pay taxes on your returns!-that's the basic gist of how NOL shells can be very attractive investments.
Rules limiting NOL "trafficking": Obviously, the IRS frowns upon such activity, so there are a few things to consider when investing in NOL shells. Section 382 of the Internal Revenue Code states that if a "change in ownership" occurs the NOL will subject to annual limitations. I won't discuss all of the details of the annual limitations as that would get complicated, but the short story is the limitations would significantly reduce the NOL value. A change in ownership occurs if one or more "5% shareholders" increase their ownership in the company by more than 50 percentage points over a three-year testing period. For instance, if a 10% shareholder increased his position in the Company to 70% (a 60 percentage point increase), the NOL would be subject to annual limitations.
Monetizing NOL shells: There are two main ways to win with NOL shells. The first is the most obvious; acquire a business with taxable income to offset your NOLs. The second is being acquired by another (private) company, in other words, a reverse merger. The two main reasons to go public through a reverse merger are that it is faster and cheaper than a traditional IPO. Both of these transactions should sufficiently compensate NOL shell shareholders.
Types of NOL shells: I like to classify NOL shells into several different categories as these companies generally evolve through three stages. The first stage is what I like to call the "SPAC" phase. Special Purpose Acquisition Companies (SPACs) essentially act as public PE firms to allow individual investors to gain exposure to private equity like transactions. SPACs raise capital through a combination of common shares and rights / units / warrants. The capital is utilized to acquire "undervalued" public companies -which is exactly what NOL shells are trying to do. A perfect example of this type of NOL shell is Myrexis (OTC:MYRX).
The third stage (skipping out of order here for a second) is what I like to call the "mature phase". These former NOL shells have acquired a business (or multiple businesses) and are essentially generating strong cash flow yields without paying taxes! A good example of this would be AMEN Properties (OTCPK:AMEN) (which I will eventually write about).
The second stage is something in between the SPAC phase and the mature phase; I call it the "developing NOL". This is a NOL shell that has developed a strategy for monetizing its NOLs, but is still in the process of implementing on its strategy. An example of a second stage NOL shell would be SWK Holdings (SWKH), which I have detailed in several posts. A common method of monetizing NOLs is acquiring drug royalties. These royalties are generally high margin and provide cash flows over an extended period of time, perfect for monetizing NOL shells, which is essentially what SWKH is doing.
Benefits and risks of NOL shells: There are three main reasons why I like NOL shells. The first reason is they are generally uncorrelated with the market. With overall equity valuations artificially inflated by central bank money printing, it would make sense to own assets that are uncorrelated with the broader market in the event of a correction. The second is that these companies are typically overlooked by most investors because the deferred tax assets associated with the NOLs are almost always fully reserved against with a valuation allowance. In other words, these assets are not present on the balance sheet. The final reason is that these types of investment typically do not take a long time to analyze and research. The process is very quick, simple, and relatively easy for the potential return you can hope to realize.
Investing in NOLs can also be risky, particularly if you're not the one in control of the Company's acquisition search. Most of the risks I will talk about will be in cases where you are not in control of the NOL shell. In these cases, you have to be very careful who you're in bed with.
Here are a few checklist items to consider with respect to the person in control of the NOL shell before you invest:
- Does this person have experience monetizing NOLs?-track record is everything when investing with someone trying to monetize a NOL shell.
- Does this person have extensive experience in M&A?-if the person doesn't have a track record of monetizing NOL shells, he/she better have extensive M&A experience to pull off a transaction like this.
- Will this person completely screw over minority shareholders? Has the person screwed over minority shareholders in past deals?
Often times the one of the biggest risks of investing in these companies is that the stock goes nowhere because the guy in charge cannot find a suitable acquisition. This is one of those worst case scenarios and should be avoided by only investing in managers who have extensive experience in prior transactions or M&A as I previously outlined.
One should also analyze at least a decade's worth of proxy statements and 13D/Gs to determine if a change in ownership has occurred, because that would automatically limit a substantial portion of the NOL usage. Often times companies will implement tax benefit preservation plans to help limit a change in ownership. These types of plans typically limit the amount of stock an individual/group can acquire (i.e. 4.99% of outstanding shares) so that a change in ownership is less likely to occur.
Overall thoughts: Overall, I think NOL shells can be good investments for people with the patience to deal with a stock that does not move very much. These companies are often overlooked by investors, despite having incredibly valuable assets. Of course, there are certainly risks with investing in NOL shells, but I believe the benefits often outweigh the costs of doing so.
Disclosure: No positions
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
