HC2 Holdings (HCHC) is an investment holding company founded in 2014 by Philip Falcone. After publishing a string of positive news for the stock in October 2018 (the initiative to explore "strategic alternatives" for Global Marine, the acquisition of GrayWolf Industrial for the construction business subsidiary and the breakthrough-status device granted to MediBeacon), I recommended going long the stock. However, a sudden tightening in capital markets in November coincided with HC2's long-awaited debt refinancing, forcing the company to issue new debt at even higher costs and pushing the share price down, as investors were disenchanted with the prospects of holding longer a story that has been frustrating for the last four years. The increasing lack of coverage of the name at Seeking Alpha is, I think, testimony of the mood among investors.
Although undoubtedly Falcone's timing in restructuring the debt was poor (but it must not be forgotten that the bonds had a steep early-call provision at the time, so it was reasonable to wait a little longer to refinance the bonds), the operational performance of the different businesses has been really good, but the shares have been overwhelmed by the weight of a very high-cost capital structure, and they will not rebound unless investors see a material path to deleveraging.
In this article, I will refresh the investment case, the operational performance of the various subsidiaries, the main news over the last twelve months as well as providing an update of the sum-of-the-parts valuation of the company. The bottom line: the valuation I presented last year has barely changed (actually, it has increased mainly due to Continental Insurance and MediBeacon), because the value of the different businesses is either crystallizing (Global Marine) or becoming more obvious (Continental Insurance, Pansend). We may be near an inflection point in the story when (and if) the rest of the Global Marine business is sold (presumably, before the end of the year) to deleverage the capital structure.
Recent news and commentary
I will not go into the detail of HC2's different businesses - but a reader with insufficient background can check my previous article from a year ago. Rather, this article is an update of my previous thesis and so I will comment on the most important news of the last twelve months:
- Operational results YTD (November): operationally speaking, the results were good. The guidance for the construction segment was reaffirmed (it is the most relevant segment in terms of capacity to upstream cash to the holding company) and GrayWolf is almost integrated. In the broadcasting segment, the refinancing was completed at the subsidiary level (which will enable them to upgrade infrastructure technology and building some of the silent licenses and construction permits they have over the next 18 months). Finally, the insurance segment has positively surprised, being a strong cash contributor over the last nine months.
- Global Marine announces sale of Huawei Marine Networks JV (October): the most relevant news. Global Marine sells the 49% stake in the HMN JV to Hengtong Optic-Electric for $140M (total EV $285M). Global Marine will sell 30% of HMN to Hengtong at closing and retain a 19% interest in HMN under a two-year put option agreement at the greater of the same equity value ($285mm) or fair market value. Hengtong is also buying Huawei's stake in the JV. In total, HC2 will receive at closing $62M and an additional $39M under the put-option agreement. According to the 3Q'19 conference call, the remaining Global Marine business has a LTM EBITDA of $25M. Furthermore, Falcone mentioned in the call that "[w]e are now further along in the sales process for Global Marine and believe we will be approaching the culmination of the process as we move through the balance of the quarter", so it is not out of the cards that we see a complete divestment of the rest of Global Marine in the next few weeks - also, optically, the transaction would finally deconsolidate Global Marine's debt from HC2's balance sheet.
- MediBeacon announces $30 million investment from Huadong Medicine (July): as a reminder, MediBeacon was granted breakthrough device status from FDA in October '18, accelerating thus the path to potentially reach commercial stage. In July, HC2 entered into an agreement with Huadong Medicine, a Chinese company, to provide exclusive commercial rights to MediBeacon in Greater China. Also, Huadong Medicine will be responsible to fund the clinical trials, commercial and regulatory activities in 25 Asian countries. MediBeacon will receive an initial $15M at a pre-money valuation of $300M and a second $15M upon achieving US FDA approval for its TGFR Measurement System at a pre-money valuation of $400M. Given the breakthrough status mentioned above and Falcone being so vocal in the last few conference calls about a potential monetization of the device (and considering that Benevir was an absolute home run), I was expecting a clearer monetization to deleverage the balance sheet, but overall the news is good.
- Pansend enters into exclusive China/Asia-Pacific distribution agreement with Huadong Medicine for R2 Dermatology (June): Huadong receives exclusive distribution rights of R2's products in the China/Asia-Pacific market in exchange for an equity investment in R2. Neither the dollar amounts nor R2 valuation was disclosed.
- American Natural Gas acquires ampCNG (June): the acquisition brought 20 natural gas fueling stations for $41M. As a benchmark for the readers, in my valuation I had a fair price of $1.5-2M per station (slightly higher than the cost to build one from scratch), so from this point of view, the price HC2 paid was fair, but not a bargain. I cannot judge whether ANG would be worth much more now to an acquirer due to having a greater network of stations, but since ANG does not represent a large part of HC2's NAV, I see this transaction as largely irrelevant to HC2's future fortunes.
As I mentioned last year, it is worth remembering that Philip Falcone is an investor with longer time horizons than most other investors, so some of his ideas take time to materialize. This is the case with the recently formed broadcasting subsidiary, which in the last conference call Falcone mentioned that it will still take some time until they have a fully-fledged portfolio of stations ("we may look to acquire trade or sell stations in certain circumstances to optimize our geographic breadth and depth"), so some of HC2's businesses are still in the building phase. In some of these cases, a valuation is hard to come by, and Falcone is the best assurance that some of them will play out (bet on the jockey).
In this section, I provide an update of the valuation I undertook last year. The numbers are updated as of the end of 3Q'19 but adjusted for the sale of HMN. As I indicated last year, SoTP valuations have some drawbacks, such as: i) uncertainty about value realization, ii) lack of disclosure and relevant financials to correctly value some of the subsidiaries and iii) under the bearish and the bullish scenarios, you end up piling up pessimistic and optimistic assumptions, one on top of the other, so the NAV is distorted. Here I will take the base case scenario as a target price and will apply a 20% discount to reflect the uncertain timing of the deleveraging.
Some comments to the valuation update:
- DBM Global: I have assumed the mid-point '19 EBITDA guidance and have kept the same multiple (8.0x for the base case). It is worth remembering that DBM paid around $135M for GrayWolf, for an adjusted EBITDA of $20M, a multiple of slightly less than 7x - a number before the G&A and commercial synergies.
- Global Marine: I have subtracted the HMN value from Global Marine and assume it to be cash (under the EV line). For the rest of the business, I have assumed a 7x multiple (slightly less than last year assumption, considering that HMN is now out of the perimeter of the remainder business) for an EBITDA of $25.4M (as per the conference call). The pension deficit is not quarterly disclosed, so I have kept the 4Q'18 number.
- Continental Insurance: Total adjusted capital increased to $334M, reflecting the good performance of the business. I have also raised the P/BV multiple from 0.5x (distressed valuation) to 0.7x, which I think is still conservative, a multiple that reflects such a performance and the fact that they will seek to raise the pricing of some polices.
- Pansend: I have fine-tuned a couple of assumptions. First, I have discounted (at 10%) back in time Benevir future payments (both the country approvals and the sales milestones) in order to take into account the delayed timing of such payments. Second, I have updated MediBeacon's valuation in order to reflect the pre-money valuation reached in the Huandong deal ($300M).
- Broadcasting: investment cost as of 1Q'19 (per the 1Q'19 Conference Call).
- ANG: I have adjusted the number of stations for the acquisition of ampCNG, but in terms of valuation per station I have kept the same assumptions (replacement cost of building a station, between $1M and $1.5M). Given the higher level of debt at the subsidiary level, the contribution of ANG to HC2's NAV has remained roughly the same.
- Corporate expenses: a multiple of 5X on LTM corporate expenses. Corporate costs have been slightly trending down lately and probably with the complete sale of GMS they may go even lower, but I do not have any special insight on this.
I arrive at a valuation of $12.8 per share, a number very much in line with the one I reached a year ago (after the 20% discount mentioned above the target price would be roughly $10 per share). In other words, the NAV has not changed much over the last year, but I would argue that its quality has: i) the integration of GrayWolf so far has been smooth, ii) the value of Global Marine has been partially crystallized and with more to come, and iii) the insurance business has proven to be a positive contributor to the results (at least so far).
The valuation is as follows:
After the full sale of Global Marine, HC2 will begin to dent its heavy capital structure, and that may be the trigger the share price needs in order to reflect the current reality of HC2's subsidiaries' performance. Even if only the $100M raised with the sale of HMN (and not additional proceeds from the full GMS sale are assumed) is applied to reducing the 1st liens, around $95M of debt will be reduced (there is an early call provision until June '20 at 104.5), implying a reduction in interest payments of $11M. The full sale of GMS would bring interest payment savings even higher. And, as pointed in the 3Q'19 Conference Call, some creative partial monetization (i.e. releasing excess capital) of Continental Insurance cannot be ruled out.
It is important to note, however, that capital markets for distressed debt remain somehow shaky, so the sooner HC2 tackles the balance sheet the better in order not to repeat the missteps of 2018. Falcone is a savvy investor and is well aware of the problem, but so far, the task has been proven to be elusive. Nonetheless, I am optimistic that 2020 may finally be the year where all the pieces of HC2's balance sheet puzzle come finally together.
- The sale of the rest of Global Marine may not be completed or may not be achieved at attractive multiples (unlikely, given what Falcone mentioned in the 3Q'19 Conference Call).
- The main business in terms of cash generation, DBM Global, is a cyclical one, and the recent slowdown of the global (and US) economy may hinder the cash that DBM can upstream to the holding company.
- The strategy at the Broadcasting subsidiary takes longer to deliver or does not deliver at all.
- Additional deals that take time to deliver and delay the unlocking of value (which for some investors can be considered a positive, given Falcone's track-record).
- Turbulences in the capital markets.
- The rest of the Global Marine business is monetized at an attractive valuation and is used to target the debt at the HoldCo level (Falcone has been quite vocal about the use of proceeds to target HoldCo debt).
- Additional progress with MediBeacon or R2 Dermatology is achieved (e.g. MediBeacon is approved by the FDA).
- Benevir achieves regulatory approval in the US and/or in Europe and/or in Japan.
- ANG is sold and/or some television stations are monetized at attractive multiples.
- Continental Insurance upstreams more cash to HC2 than originally anticipated.