Description

Cash shells with large tax losses. Minority oppression and the rights of preference shareholders. Chapter 11. If you are an expert in any of these fields I would really like to hear opinions on the best way forward. I am hoping someone has seen this movie before and can help unlock the substantial return that this opportunity presents. Thanks.

African Phoenix

African Phoenix (AXL.JSE) is a cash shell. Today you can buy the cash shell at a 20% discount to the cash on the balance sheet. You also get a very large tax loss. Adding in a very conservative value for the tax shield pushes the potential return to 40%.

But wait, there may be a 100% upside for investors who know their way around preference shares. Preference shareholders are currently taking legal action against AXL because they were prevented from voting on changes to the MOI. The following news report explains the essence of the dispute.

The price was also boosted by African Phoenix having more than R1.1bn in preference shareholder equity on its balance sheet, which is effectively interest-free capital for the time being, since these are noncumulative preference shares that have a right to a dividend only if a dividend is declared.

A group of preference shareholders are considering taking legal action, however, after they were denied a vote at the African Phoenix AGM where the company’s memorandum of incorporation (MOI) was changed from a bank-holding company to an investment-holding one.

The changes to the MOI should also have included changes to the terms of the preference shares such that they became cumulative in nature, meaning that any undeclared preference dividends would continue to accrue to preference shareholders, says Frédéric Bouchard, a fund manager at Florin Capital Management, who represented preference shareholders at the AGM.

But African Phoenix says that the provisions of the MOI did not in the opinion of the board require a separate preference share vote on the proposed changes, leaving the rights of preference shareholders unchanged.

While I am not a lawyer, I don’t think the legal action will succeed. Obviously, the lawyers charging the fees have a different view.

Personally, I would prefer to see high profile international investors getting involved. A few awkward questions on the next conference call may push management to review their fiduciary obligations to preference shareholders and reinstate the preference dividend.  

AXL is in a very strong financial position and can easily afford the preference dividend. It can be argued that withholding the dividend and treating preference shareholders as “free capital” is a form of minority oppression which does not square with the fiduciary responsibility the board owes to the preference shareholder.

Background

South Africa has only recently introduced a chapter 11 type bankruptcy process called “Business Rescue”. To date, all the business rescue attempts in the listed space have failed and African Phoenix is the first listed company to successfully emerge from the rescue process.

So, this is the first time that the South African market is dealing with this “animal” and there is a lot of confusion. As this is old-hat for American investors I think there is an opportunity to use this competive edge and profit from the opportunity.

African Phoenix used to be a bank holding company. The banking subsidiary went bankrupt dragging African Phoenix into business rescue. AXL emerged from business rescue with a large cash balance which it now wants to invest in order to take advantage of a very large tax loss.

AXL have been in talks to do a deal. These talks failed in April2017. Personally, because the tax loss dwarfs AXL’s asset base, I think it makes more sense for AXL to be acquired by an entity with a much larger asset base who can use the tax shield more effectively.

Valuation

Details of the ordinary and preference shares are shown below.

Market Cap

AXL (African Phoenix Ordinary Share)                      ZAR0.62

#shares                                                                                1 501mil

Mcap                                                                                    R931mil

AXL (African Phoenix Prefere Share)                    ZAR32.00

#shares                                                                                13.52mil

Mcap                                                                                    R433mil

Summing the ordinary and preference share market caps gives a total market cap of ZAR1 363mil.

Balance Sheet

The balance sheet as at 30Sep2016 is shown below.

I am going to roll forward the balance sheet to 31Mar2017 assuming the cash balance earns interest of 7% per annum. For now I will assume the interest is not taxed.

The following table compares the market caps to the book value of the equity on the March2017 balance sheet.

The ordinary equity trades at a 62% premium to the balance sheet nav and the preference shares trade at a 62% discount to the nav.

Overall, if one buys all the ordinary and preference shares one is effectively paying ZAR1 363mil for ZAR1 703mil of equity. This represents a 25% upside and is the base case return I am recommending in this write-up.

This return should be enhanced by a potential ZAR4bil tax shield. At the end of the write-up, I conservatively value the tax shield at ZAR200mil. Adding in the benefit of the tax shield increases the equity value to ZAR1 903mil boosting the potential return from 25% to 40%.

While buying a combination of the ordinary and preference shares is the base case I think it is instructive to work through a few scenarios in order to get a better feel for the range of potential outcomes. The scenarios I will work through include

• ·         The Liquidation Option
• ·         Commitment to a Preference  dividend
• ·         Act in the ordinary shareholder’s best interests
• ·         Meet in the middle

Liquidation Scenario

It is worth exploring the liquidation option as it highlights some of the trade-offs and complications various scenarios will present.

If the company is liquidated the preference shareholders will be paid ZAR1 130mil for a holding which can currently be bought for ZAR433mil. This represents a 160% return.

Unfortunately, ordinary shareholders will lose money and they have the votes, 1 501mil shares versus 13.5mil shares. Clearly, the liquidation option will probably not fly.

Commitment to a Preference Dividend

The preference shares pay a dividend at 69% of prime. Prime is currently 10.5%. If management declare the preference dividend it would amount to ZAR7.24 per share (69% * 10.5% * ZAR100). This implies a 22.6% yield on the current ZAR32 share price.

Listed non-cumulative preference shares trade between 8% and 12% in South Africa. If management can be convinced to commit to a dividend as originally intended then the preference share could easily double in value. If, however, management shirk their fiduciary duties and decide to use preference shareholders as interest-free capital then the preference shareholders could be in deep trouble.

While the preference shareholders are using the law to challenge the not cumulative nature of the preference shareholders, I think the moral argument has a better chance of success. “Widows and orphans bought these shares for the dividend stream and there is more than enough resources and income to declare the dividend.”

Ordinary Shareholder’s Best Interest

The ordinary shareholders would prefer not to pay the preference dividends and to invest the full cash balance.

The balance sheet below assumes that the full cash balance is used to buy an investment which doubles in value.

In this scenario the value of the ordinary equity jumps from ZAR573mil to ZAR2 447mil, a 327% increase. At the same time the preference share NAV remains the same.

Giving all the benefit to the ordinary shareholders does not seem very fair to me and is difficult to reconcile with the fiduciary duties owed to the preference shareholders.

Meet in the Middle

An interesting idea would be to buy-back the preference shares at ZAR50, a 56% premium.

The amount required would be ZAR676mil and following the buy-back the balance sheet will look like this.

In this scenario the value of the ordinary equity increases from ZAR573mil to ZAR1 027mil, an 83% increase. In addition, the conflicting fiduciary duties are resolved and the company can move forward with a clean slate.

Tax Shield

AXL emerged from business rescue with a ZAR18bil tax loss. This loss can only be used to offset capital gains, not income, and will provide an effective ZAR4bil tax shield.

Assuming AXL invest the R1.5bil which grows at 10% a year. If the R150mil gain is realized, the tax on the gain will be ZAR33.6mil.

Assuming ZAR33.6mil in taxes is saved for 10 years. This translates into a PV tax shield of ZAR200mil using a 10% discount rate. (PV(10%,10,33.6)

The ZAR200mil is a fraction of the potential ZAR4bil tax saving. It makes much more sense to sell AXL to an entity with a much larger asset base who can use the tax shield more effectively instead of pottering around trying to become an investment holding company.

Hidden Asset

AXL did retain a small insurance operation which is profitable. I am assigning no value to the operation as it does not have scale. However, I plan to review the value following the publication of the March2017 results. Estimates are that it can be worth ZAR100mil.

Activism

I am aware that some preference shareholders have bought approximately 20% of the ordinary shares in order to protect their rights.

I am pretty sure that this group of shareholders will have sufficient voting power to block special resolutions and to frustrate the management of the company.  Sooner or later management will have to address their issues and resolve the dispute with the preference shareholders. The next set of results and the AGM on 19July2017 are going to be interesting events.

One last thing. The board seems incredibly weak to me and there is no evidence that they have the necessary experience to run an investment holding company. Most of the board is up for re-election and I would not be surprised to see nominations from "the ordinary shareholder voting pool" seeking to protect the value of their preference shares.

Conclusion

I still maintain that the South African market is not quite sure how to deal with this animal that has emerged from business rescue. This confusion extends to management and to potential acquirers of AXL.

In addition to this, the preference share create even more confusion. Because of all this uncertainty investors and fund managers just stay away.

There is potential to make very good money here and I am hoping to hear comments from experts on VIC who may have a view on these matters. Further, I think management would be more sensitive to the views of international shareholders and I hope this write-up will encourage some members to invest and make their voices heard. AGM 19July2017

Catalyst

AGM 19July2017 and immenent release of results