The NOL Newsletter: What Types Of Companies Are We Interested In?

by: Arquitos Capital Management


We're looking for companies with very specific characteristics.

Attractive investments in this niche must be analyzed qualitatively.

Potential investments often are creatively funded, utilizing rights offerings or debt provided with below-market interest rates.

This article first appeared in The NOL Newsletter, a premium service provided by Arquitos Capital Management and The Benval Group.

The NOL Newsletter is focused on a specific type of investment. We highlight and cover companies that have significant Net Operating Losses (NOLs) where the company is attempting to monetize those NOLs.

There are a lot of companies who have acquired NOLs. The vast majority are not potential investments. After all, they must have lost a considerable amount of money in the first place to acquire the "asset." We're not interested in companies that have NOLs that are doing the same thing they've done in the past. We're interested when some "break" has occurred. Common situations are when an activist has gotten involved. Sometimes a divestiture has occurred, or perhaps there has been a transformative acquisition. Other times a new operator has been put in charge or some other significant change has occurred.

Out of the 8,000 or 9,000 potential investments in the United States, we're focused on perhaps 30. Most of these companies are small and have limited or no analyst coverage. A company considered large in this world may be a WMIH (WMIH), with a market cap of $600 million. Or a Signature Group (NASDAQ:RELY) with a market cap of $300 million. Or a Steel Partners Holdings (NYSE:SPLP), which clocks in at $500 million. On the other end of the spectrum, you have ATRM Holdings (NASDAQ:ATRM) with a market cap of $3 million. Or a Sycamore Networks (NASDAQ:SCMR), which is liquidating, and currently has a market cap of $11 million. We'll highlight a group of NOL shells in the sub-$5 million range, and we ask for your help to identify others like this that may be interesting.

At one time or another many of these NOL companies were shells and had limited operations during the time of their transition. Some were recently bankrupt. Most are obscure, and that's where investors are able to gain an advantage. Very few of these companies have analyst coverage, and when they do, that coverage only comes after an acquisition and a considerable run-up in its stock price.

The NOL is certainly an asset, shielding future income up to 35% at the federal level. However, the companies we're most interested in are the ones who have attracted investors and operators who are effective capital allocators. Companies with significant NOLs often attract these types of investors. These investors understand the asset, and also tend to understand the best ways to utilize the asset.

Companies with significant NOLs that are run by effective capital allocators understand that we want predictable free cash flow. They understand that a strict focus on ROIC is important. They tend not to be interested in speculative uses for company resources. Compensation at the executive level should also be fairer and better focused on incentivizing the executive to more safely grow the company.

Another element that is attractive to us as investors is that in order to preserve the NOLs, companies often need to be creative with their financing. We'll often see rights offerings involved as part of an NOL company making an acquisition or expanding their operations. That's great for us as investors because we get access to additional shares at a discount and we typically have the opportunity to participate in an oversubscription. Recent examples of this are the rights offering in 2014 for SWK Holdings (OTCQB:SWKH) at $0.86, and the rights offering earlier this year for Signature Group Holdings (now RELY, then SGRH) at $5.64. Since those rights offerings, shares for those two companies are 80% and 101% higher respectively from the price of the rights offering.

In other instances the largest shareholder may provide debt to the company at a below market interest rate. This happened with ALJ Regional Holdings (NASDAQ:ALJJ) when it acquired subsidiaries Faneuil and Carpets N' More. Why would a large shareholder do this? They understand the value in maximizing free cash flow and taxable income, which would then be offset by the NOLs.

These characteristics provide safety on the downside, as well as potential for significant gains on the upside. When these companies succeed, their shares don't rise 20%. Their shares typically rise exponentially.

Because we rely heavily on these qualitative characteristics, the companies we're interested don't show up on screens. That's good, and gives investors like you who are interested in this niche a tremendous advantage.

Disclosure: The author is long ALJJ, SWKH, WMIH, RELY.

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.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.