Rand Capital Trades At A Significant Discount To Its Growing Book Value

| About: Rand Capital (RAND)
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Summary

Rand Capital is undervalued on an absolute and relative basis despite steady book value growth over the last three years.

A recent large gain on the sale of a portfolio investment more than doubled the cash balance (35% of book value), which should fund accelerated share repurchases.

The market is unjustifiably valuing its largest investment at cost instead of true market value, which could result in its sale in order to capture the significant unrealized gains.

Company overview

Rand Capital (NASDAQ:RAND) is a business development company (NYSE:BDC) that provides venture capital funding and managerial assistance to small and medium-sized companies headquartered in the Western and Upstate New York region. The typical initial investment is $0.5-1 million through equity, debt or both.

An opportunity to buy a (growing) $1 for $0.74

The fact that a vast majority of VC alpha is captured by the top quartile funds results in investors searching for "alternative alternatives" given that many of these funds are closed to new investors. Buying a BDC trading at a significant discount to book value such as RAND is an attractive alternative, especially compared to others such as buying shares on private markets (which are in decline for multiple reasons).

RAND trades at only 0.74x book value, which increased 12% in the mrq after the sale of one of its investments (Liazon, a provider of private exchange online benefit solutions) generated a $6.3 million gain (on a $1.1 million investment), which resulted in the largest net realized gain in more than a decade.

This gain is largely responsible for the more than doubling of the cash balance to $9.8 million, which now accounts for ~35% of net assets compared to 16% in 2012. Moreover, this cash excludes the $1.3 million held in escrow from the sale of Liazon and Ultra-Scan (another investment), which should be received by 2015.

RAND has two key advantages over other BDCs and VC firms, which further highlight the attractive valuation. First, it is able to borrow at low, fixed rates from the Small Business Administration (SBA) while the nearest maturity is not until 2022. Moreover, during 2011 and 2012 RAND repaid $9.1 million of SBA leverage and drew down $4 million at lower interest rates, which resulted in a 65% decrease in interest expense since 2011.

Second, by using a mix of loans/debt and equity, RAND is able to generate a meaningful amount of investment income (~$2.5 million in 2013), which effectively offsets operating expenses and enables greater book value growth. Moreover, it earns an attractive spread due to the previously mentioned low borrowing rates (e.g. borrow at ~2.3-3.6% + annual charge of ~0.8% and charged 8-15% on debt originated during the past 18 months).

Peer comp and catalysts

Despite all of the above, RAND still trades at a significant discount to its book value and peer group as shown in the chart below.

RAND continues to take advantage of this mispricing by making significant share repurchases. During the last two years it repurchased ~407,000 shares, including ~198,000 last year at an average price of only $2.96. These repurchases should continue as the stock still trades at a discount to book value, especially as there are still >500,000 shares available to be repurchased under the expanded 1 million share program. Moreover, the board will only repurchase shares at book value or less, as opposed to other companies that "reward" shareholders by repurchasing shares at inflated valuations*.

The fact that the P/B multiple remains well below 1x despite the consistent book value growth (shown in the chart below) may support placing the portfolio in run-off mode (if the discount does not narrow over the next year), in which portfolio gains are harvested and returned to shareholders in the form of special dividends or by continuing to repurchase shares.

Although management and the board are not to blame for this discount (actually they deserve credit for the strong operating performance), it does not change the fact that the current valuation disconnect is unsustainable.

For example, of the total portfolio value of $28.3 million, $8.4 million is net unrealized gains or ~30% of the total (similar in size to the discount to overall book value), which means the market is implying these unrealized gains will never be realized. However, this implication is in direct contrast to the recent conversion of significant unrealized gains to the realized category (e.g. Liazon).

This discount may be due to the fact that one investment accounts for almost all of the unrealized gains. Gemcor (a supplier of automatic riveting machines used in the assembly of aircraft components) has a cost basis of $1.5 million and a fair value of $10.2 million. However, these gains are more "real" than implied by the valuation for two reasons.

First, increasing global aircraft production provides stable demand and results in greater revenue visibility. Second, in 2013 and 2012 Gemcor paid RAND dividends of $1.5 million and $1.7 million, respectively. This means the market values Gemcor at cost of $1.5 million, the same amount of the dividend received in 2013 alone. The quickest way for this discount to be eliminated is to sell the entire holding at the earliest possible opportunity.

Management is already halfway to implementing this strategy as it said in the 2013 10-K that it is "evaluating potential exits from portfolio companies to increase the amount of liquidity available". Although they were primarily referring to using the funds for new investments and operations, they also mentioned repaying SBA leverage. However, the latter could be done immediately (no prepayment penalties!) given the $9.8 million of cash and leverage of $7 million.

Moreover, one of its investments (Synacor) is publicly traded and its remaining shares could be sold immediately for ~$1 million at the current price of $2.55 (also for a large gain). Furthermore, by repaying leverage and going into run-off, RAND could significantly reduce the non-interest expense run rate of ~$1.1 million (average over the past five years excluding bonus/profit and bad debt expenses). Given the concentrated ownership (e.g. four 5%+ holders own ~46% of the stock), it should not be difficult for one of these holders (or a new one) to recommend this strategy to the board.

After selling Gemcor and Synacor, RAND would still own an attractive portfolio of investments in companies involved in such fast-growing areas such as gesture recognition, social networking and next-generation semiconductor lasers.

*This is why so many investors prefer dividends to repurchases. In a perfect world (which only seems to exist in college corporate finance textbooks), dividends are an inefficient way to reward shareholders given the double taxation. However, receiving an after-tax dividend is still better than a company buying its stock at 40 only to watch it fall to 20 six months later.

Risks

The following are the primary risks to the investment thesis, in order of importance:

  • Given that 96% of its investments are not publicly traded, actual market value may be less than stated fair value. Moreover, this results in a lower level of liquidity.
  • There is inherent risk in investing in small and medium-sized private companies given that the new technologies may not find market acceptance, especially given the competitive threat posed by larger companies with significantly greater resources. For example, in 2013 RAND realized a loss of ~$1 million on its investment in Mid-America Brick after it filed for bankruptcy.
  • The portfolio is relatively concentrated as the top five investments account for 45% of total assets (although down from 58% in 2012) with one investment (Gemcor) accounting for 26% alone.

Conclusion

The market should reward RAND with a P/B multiple of at least 0.90x over the next 12-18 months, which would represent a price of ~$3.94 and a gain of ~20%. A 5% stop loss should be placed below the 50 DMA ~2% below the current price.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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