Sycamore Networks (NASDAQ:SCMR) is currently set up as an NOL vehicle for activist hedge funds (Sparta Group, General Holdings, Farallon Capital). Erymanthos provided a good discussion about the background and current situation of the Company (seekingalpha.com/article/3695896-activists-circling-sycamore-upside-outweighs-downside-liquidation-risk), so I will not repeat what was said. Instead, I will attempt to analyze the possible paths forward for the Company and see why its valuation could change drastically in the coming months through a different mechanism that Erymanthos described).
The Company has a liquidation value of approximately $0.35 per share as of October 31, 2015 per Management's analysis.
However, there are three assets that are not included in the above analysis:
- SCMR's $2.2mm investment in Tejas Networks India (representing 5% ownership in Tejas)
- Federal and state NOL carryforwards of $857.8mm and $36.2mm, respectively, expiring at various dates through 2034
- Federal and state R&D credit carryforwards of approximately $11.3mm and $10.0mm, expiring starting in 2020 and 2016, respectively
Per Section 382 rules, it is difficult sell an NOL vehicle as the buyer would lose significant value locked up in the NOL carry forward. The amount of the carry forward that can be used in any given year is equal to the TEV (as determined by the acquisition) multiplied by ~2.65% (the Applicable Federal Tax-exempt Rate as of January 2016). The annual dollar value of the carry forward is therefore TEV x 2.65% x Tax Rate. Clearly a small amount in the case of SCMR.
The much more interesting path forward, therefore, is to use SCMR as an acquisition vehicle and acquire another company instead. This would allow for potentially the full use of its substantial carry forward. I've listed several valuable characteristics of this potential acquisition:
- Predictable cash flows from the target to efficiently use the tax assets
- Moderate leverage to reduce the tax shield effect from the debt, thus burning as much NOL as possible in the upfront years
- The activist investor will likely need to recapitalize the vehicle with additional capital in order to make a substantial acquisition. In order to not trigger the 382 ownership change. This capital will likely come in the form of non-voting preferred equity (with lower interest expense to maximize cash flow and consequently burn up NOL)
- Tax savings from NOL carry forward will help with cash flow, thus paying down the debt faster than a normal company can
- The activist investor will be incentivized to maximize near term cash flows. E.g. through efficient cost cutting and capital allocation. Thus creating a lean and efficient enterprise
In conclusion, it is very difficult to value SCMR's NOL carry forward today as the value would come from an activist investor's usage. However, the limited downside as provided by management's liquidation analysis and potential large upside makes SCMR an interesting bet.
Disclosure: I am/we are long SCMR.