BKF Capital (BKFG) is a microcap holding company with significant cash and NOL tax assets, which now looks poised to benefit from an ongoing turnaround at its recently-controlled operating subsidiary.

Undervalued cash-and-NOL shells are becoming difficult to find in the current market, but if chosen wisely can provide an attractive substitute for cash that creates additional upside optionality through realization of tax assets. Footstar/Xtelos (FTAR), SWKH Holdings (SWKH), and more recently Myrexis (MYRX) are several previous VIC selections in this category that have created (or hopefully will create) significant value for shareholders. As an intriguing counterexample, 2003 VIC favorite Cadus Corporation (KDUS) sat on its unused cash for 11 years while allowing NOLs to expire, and is now executing a rights offering so that Carl Icahn's son-in-law can buy and renovate residential properties in Florida. The moral of the story is that the ROI from deep value investing in NOL-rich shells is at its best when combined with the catalysts of highly incentivized and value-oriented management and tangible progress on an existing plan to create shareholder value.

BKFG may now represent an interesting opportunity to invest in a value-oriented activist entity taking tangible steps toward value creation, while paying very reasonable prices compared to its substantial net cash holdings, sizable net operating loss tax carryforwards, and its significant investment in a recently controlled company which may now be beginning an operating turnaround under BKFG’s guidance.


Summary

BKFG is a holding company controlled by Steven N Bronson, an investment banker with 16 years of prior experience in several successful turnarounds of underperforming microcap electronics firms, who is also a self-described value investor. BKFG had net cash and equivalents of $5.9 million as of the latest 10-K, and has additionally accumulated a 2.6 million share stake in Qualstar Corporation (QBAK), a NASDAQ-listed supplier of data storage systems and specialty power converters which has begun to show significant revenue growth and margin improvement following BKFG's replacement of its former management. A direct investment in BKFG may allow value investors to participate in a QBAK turnaround on especially attractive terms after considering BKF’s additional cash and NOL tax assets.


Assets and NOLs

With $5.9 million of net cash and a current market cap of $8.2 million near $1.13 per share, BKFG’s $2.3 million enterprise value represents a more than 40% discount to the $3.9 million market value of its 2.6 million share stake in Qualstar, while also assigning no value to substantial NOL tax assets on the balance sheets of both firms.

Interestingly, this is the same BKF Capital that was formerly a large HF/instutional asset manager led by John Levin, which subsequently lost most of its AUM and wound down operations following Levin's departure, resulting in sizable NOLs in addition to its cash holdings. (http://nypost.com/2005/08/13/bkfs-levin-out-as-ceo/) BKFG has federal tax NOLs of approximately $11.9 million and state tax loss carryforwards of $4.9 million, resulting in a deferred tax asset valued at $4.6 million which is currently entirely excluded from the balance sheet under a valuation reserve. Although harvesting of carryforwards will be limited to a rate of $344,000 per year based on Section 382 limitations arising from its prior change in ownership, the majority of these NOLs will only begin to expire in 2025 through 2028, and may eventually create a significant source of value relative to the current $2.3 million EV.

Qualstar also has a strong balance sheet including over $9 million of cash and marketable securities (mostly investment-grade bonds). QBAK itself has more than $23.4 million in federal NOLs which will begin to expire in 2025, in addition to $16.7 million in state NOLs which begin to expire this year. With revenues and margins at QBAK now beginning to improve substantially following the change in control, the market may greatly underestimate the potential value that could be created with a successful turnaround at Qualstar, or unlocked through a divestiture of its chronically underperforming tape storage business.


QBAK operations and turnaround

While under the control of former CEO Lawrence Firestone, QBAK experienced stagnating revenues and excessive levels of management compensation and SG&A expense, including the costly and unwarranted opening of a new office in Firestone's home base of Boulder Colorado, over which BKFG is now suing Firestone for breach of fiduciary duty. After BKFG accumulated a large QBAK stake and gained control of Qualstar through a successful proxy contest last July, BKFG CEO Steven Bronson began a series of cost reductions projected to generate savings of $1 million per year from upper management salary alone, and has brought on experienced industry sales executives to engineer a turnaround.

http://www.sec.gov/Archives/edgar/data/758938/000143774913008836/qbak20130715_8kex99-1.htm

In the latest 10-Q released this February, QBAK reported revenue grew by 57% to $3.4 million from $2.2 million in the previous quarter (approximately +64% YoY). Gross margin increased 22.9% to 43.9% on 93% top-line growth in the higher-margin power supply business. Total operating expenses decreased $1.2 million or 41% to $1.8 million from $3.0 million. Although the company has not yet reached profitability, this already represents the best revenue and margin figures achieved since mid-2007, when QBAK stock was at roughly double current levels.

Importantly, Qualstar’s power conversion business has been profitable in each of the past five fiscal years, with its results obscured by losses in the unrelated and highly competitive tape storage business, and generated net income of $944,000 in FY2011 on a standalone basis. Unlike prior management, Bronson will be highly motivated to realize value for shareholders, and QBAK’s solid balance sheet should provide ample runway to stabilize the business and prepare either the storage division or the company itself for sale to a strategic buyer if a turnaround proves difficult to achieve.


Management incentives and track record, insider buying

CEO Stephen Bronson owns 57.8% of BKFG’s common stock, strongly aligning his interests with shareholders, and has been a consistent buyer of additional shares on the open market, with Bronson and BKFG director Leonard Hagen purchasing over 595,000 shares since last April, including 48,000 shares last month at higher prices. BKFG added to its QBAK position at attractive levels during late 2013, and the successful microcap value investor Lloyd Miller independently purchased over 300,000 QBAK shares this February.

As Chairman of Mikron Infrared Instruments from 1996-2000, Bronson replaced management and successfully grew revenues by 500%, leading to an eventual sale of the company in April 2007. After taking control of Interlink Electronics (LINK), another struggling Los Angeles-based electronics firm generating over $1 million in annual losses, Bronson successfully returned the firm to profitability within two years before handing operating control to LINK President Dr. Howard Goldberg. With Bronson having now heavily invested in BKFG and QBAK, and continuing to personally accumulate further BKFG shares while Qualstar has shown substantial progress in revenues and margins, BKFG shares should make a timely addition to a microcap value portfolio.


Risks and catalysts

Risks include the uncertainty of a successful turnaround at Qualstar, somewhat mitigated by the strong balance sheets of both firms. There is also an outstanding infringement suit against QBAK's tape storage business by troubled competitor Overland Storage (OVRL), which management believes is without merit and will not result in material liability. OVRL simultaneously filed suits against seven storage companies (http://www.storagenewsletter.com/rubriques/tapes/overland-pursues-patent-infringement-lawsuits/ ), including a German competitor Tandberg Data which OVRL subsequently issued stock to acquire. If QBAK is able to use a similar strategy to dispose of its underperforming tape business, this could help to unmask the historically greater profitability of the higher-margin power supply business going forward.

In conjunction with a value-oriented and strongly incentivized manager, the strong balance sheets and additional NOL tax assets of BKFG and QBAK provide a reasonable margin of safety combined with asymmetric upside optionality from an ongoing turnaround at Qualstar and the potential for further value-creating acquisitions. If management is even modestly successful at beginning to deploy its controlled capital for shareholders’ benefit, BKFG shareholders may stand to benefit substantially over the longer term from the substantial tax assets at each firm.

continued revenue and margin turnaround at Qualstar

turnaround, sale, or closure of underperforming tape storage business

eventual realization of NOL

further value-creating acquisitions by incentivized and value-oriented owner/manager