The Private Market Value Strategy: Part 3 - Leveraged Companies

| About: Aemetis, Inc. (AMTX)
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The private market strategy seeks to capture the value that a private investor (including a corporation making an acquisition) would attribute to an entire company.

Leveraged companies can contain hidden value which would be attractive to a private investor.

Leveraged companies have to be analyzed carefully to isolate cash flow, debt terms, and valuation and to determine actual private market value.

In a sluggish economy, leveraged companies offer one of the rare opportunities to generate earnings growth as debt is retired and interest expense declines.

The two companies which I have written about using this strategy have both been acquired by larger companies; the third - Aemetis (AMTX) is one of my highest conviction holdings.

I have written about the private market strategy previously. In the first article I discussed companies selling well below net asset value and in the second article I discussed situations in which investors could acquire cash flow at a bargain price. This article will deal with "leveraged companies" which I will define as companies with a considerable amount of gross and net debt. These companies are generally structured so that the debt is not "stable" but is in the process of being aggressively retired. Thus, from quarter to quarter, an investor can track the "pay down" of the debt. Of course, as the debt is retired, interest expense declines and this creates a powerful earnings tailwind.

Pro Forma Analysis - To better understand the financial mechanics I am going to set forth a simple pro forma for a leveraged company. The table below sets forth data at the start of (and, where relevant, during) two consecutive fiscal years for a typical leveraged company.

  Year One Year Two
Debt $100 million $67 million
Interest $15 million $10 million
Depreciation $12.5 million $12.5 million
Amortization $12.5 million $12.5 million
Tax $2 million $3.6 million
Earnings $8 million $11.4 million
EBITDA $50 million $50 million
Debt Pay Down $33 million  
Market Cap $112 million  
Enterprise Value $212 million $212 million
Market Cap - EV Method   $145 million
Market Cap - PE Method   $160 million

The interest expense is as of the beginning of each year and declines through the year and is based on a 15% interest rate (not unusual for a leveraged company). The market cap (share value times number of shares) is based upon 14 times earnings assuming that a conservative valuation is given to the company due to the debt load. In calculating year two market cap, I have used two methods. The first method is to assume that enterprise value (market cap plus debt) stays the same and that the market cap increases as the debt declines. The second method assumes that the market cap is based on 14 times year two earnings. Using the first method, share price would increase 27.5% in one year; using the second method, it would increase 42%.

This is a grossly simplified analysis and there are other relevant considerations. Of course, operating results can change from year to year. The analysis assumes constant EBITDA and results can be better or worse if EBITDA changes. Share count can also change and leveraged companies are almost never engaged in share repurchases so that it is not unreasonable to assume that these results will be diminished by a higher share count. I have also assumed no capital expenditures; in fact, there are bound to be some but leveraged companies tend to be very stingy. On the positive side, it is likely that, as debt is paid down, the price earnings ratio will increase due to a perception of less risk. In addition, while many leveraged companies pay a high average interest rate, they often have a variety of debt obligations and the highest interest rate obligations will tend to be paid down first so that average interest rates may decline as debt is paid down. It is also possible that as debt is paid down, the company will be able to negotiate new terms or find a new creditor to replace high interest rate debt with debt on more reasonable terms. It is also sometimes (but not always) the case that companies in this situation have large tax loss carry forwards and so do not make income tax payments.

Taking all of these caveats into account, we still have produced a mechanism for steadily increasing earnings as long as debt is being retired. This mechanism works if: 1. cash flow is much greater than earnings due to high depreciation and amortization, 2. interest rates are relatively high so that interest expense declines quickly, 3. EBITDA is, at least, relatively steady, and 4. management is committed to using cash flow to pay down debt.

The beauty of this situation is that earnings growth can be achieved without top line revenue growth. Simply by using cash flow to pay down debt, management can cause earnings to grow "automatically." An investor in this situation does not really have to worry about how management is going to use cash flow and fret about ill-conceived acquisitions. In this situation, it is virtually inevitable how cash flow will be utilized (to get rid of 15% debt!).

Some Leveraged Situations - I have written about three companies in this situation. The first two - Digitial Cinema Destinations (NASDAQ:DCIN) and EasyLink (NASDAQ:ESIC) - were acquired within a fairly short time after my articles. Both of these companies had borrowed heavily to make acquisitions and were using the cash flow from the acquisitions to pay down the debt. EasyLink had relatively low cost debt: Digital was carrying relatively high interest rate debt. I first wrote about EasyLink here in June 2011 when it was trading at $4.73; I discussed the implications of its takeover in May 2012 at $7.25 in this article. I first wrote about DCIN here and it was taken over shortly thereafter, although not at a particularly attractive price. In each case, I was somewhat disappointed by the fact that they company was acquired because I thought that, as debt was paid down, share value would increase to levels well beyond the price paid for the acquisition.

The third company in this category is Aemetis (NASDAQ:AMTX) which I have written about here and here recently. It has very high interest rate debt, strong cash flow and large depreciation and amortization deductions. It is paying off debt rapidly and fits the model very nicely.

The fact that two of the companies identified as fitting this strategy were promptly acquired suggests that it is, in fact, a legitimate private market strategy. It appears that buy out targets are being identified on this basis. The strategy is also somewhat comparable to the private equity strategy of buying a company out and then loading it up with debt. If successful, the strategy plays out nicely as the debt is paid off and the company emerges with lower debt and a higher market cap.

With a sluggish economy and slow growth, this strategy has the enormous advantage of identifying a path to much higher earnings while assuming no growth at all in net revenue. I will continue to be on the look out for companies which appear to fit the model.

Disclosure: The author is long AMTX.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.