Description

Calamos is an equity and convertible bond asset manager with $30 billion AUM and $120mm in 2012 operating profit.  At the current market price, the asset management company is trading at an EV/EBIT of 1x. 

The main issue with the stock is investor skepticism/frustration as to when the significant excess cash and investments on the balance sheet will be returned to shareholders (if ever). (See finn’s writeup and the associated comments from a year and a half ago). Currently, cash and investments on the balance sheet add up to $8.60 per share, versus a current share price of $9.95. At an EV/EBIT of 8x, the asset management company is worth about $8.50 per share, which when added to the value of cash and investments on the balance sheet gives a target price of $17 on the stock.

Since the implied value of the operating business is almost zero at the current price, I will focus the writeup on why the skepticism on the cash is overdone. While I believe there likely won’t be a near term (say, in the next year or two) resolution, the stock pays a healthy dividend (4.5% yield) while you wait, and there will be a resolution if the asset manager continues to perform acceptably.

History and Corporate Structure

Calamos has been around since the early 70s, specializing in convertible debt, but really turned the corner in the early 00s when their big equity funds (Calamos Growth and Calamos Growth & Income) were outperforming. The firm went public in November 2004.

When the firm went public, it did so by selling a 23% stake in the LLC that controlled the asset manager to a newly formed C Corp (subsequently referred to here as CAM), which sold shares to the public. Doing preserved the tax-free status for Calamos family, who continued to own the other 77% of the LLC. It also created a $120 million tax asset for the new shareholders of CAM, earnable over 15 years. (The tax asset comes through something called a section 754 election, which allows an asset step-up in scenarios such as these; in my opinion this seems like a ridiculous loophole but the IRS has allowed it with asset managers). The structure was “unitized” – for every share of common stock outstanding, CAM owned one unit of the LLC. There were 23 million shares of stock, backed by 23 million units of the LLC plus the tax asset (the family owned the other 77 million LLC units).

By law, the tax asset can only accrue to shareholders of CAM, setting up a situation where CAM consistently has significant assets outside its holding in the LLC – the remainder of the tax asset, plus some accumulated cash (from the monetization of the tax asset, plus the difference between LLC distributions received and dividends paid). These are referred to in filings and in this writeup as Other Assets, and the present value of these assets were about $100 million, or $4.89 per share as of 9/30/12.

To make the corporate structure work, there are some unusual clauses. One is that RSUs and options issued to employees dilute the whole structure, not just CAM. When an RSU is exercised, CAM gets LLC units for free to offset the dilution. Repurchases work the opposite way – the LLC buys LLC units back from CAM, and CAM uses the cash from the sale to buy back CAM shares in the open market. The disclosure isn’t complete here, but as far as I can tell CAM has been getting credit (or charged) for its Other Assets when these transactions take place. This kept the structure “unitized” – for every CAM share that was issued or repurchased, an LLC unit was issued or repurchased.

The company was growing nicely through 2007. In 2007, the LLC borrowed $400 million, mostly seed new funds and partnerships as well as buy back some stock. In 2008, the market started to turn, and the LLC had to sell investments at a loss to raise cash to pay down and restructure the debt, since it was at risk of blowing the covenants. As part of the process to raise cash, the LLC sold units to CAM and to the Calamos family for cash and investments, “de-unitizing” the structure. Today, CAM owns more LLC units than it has shares outstanding thanks to this transaction.

Needless to say, this was probably something of a traumatic experience for management, and they got much more conservative with how the balance sheet was managed. They began hedging their investments and accumulating cash on the balance sheet. They also cut the dividend.  This was all much to the annoyance of shareholders, who have seen the share price languish even as the market (and the company) has recovered. Alpine Capital Research, a 6% shareholder, last year became vocal about demanding that cash be returned to shareholders. Today, even though dividend has been fully restored, but cash has been accumulating at the CAM level, reaching $64.7 million ($3.17/share) as of 9/30/12.

Why this will turn around (possibly soon):

The worry in cases like these, where management controls the company, is that management will somehow screw public shareholders. I would argue this is unlikely here because:

-       If you look at the history carefully, management does have a track record of returning cash to shareholders. They did repurchases in 2007 and 2008 (maybe not the best timing, but still) and have maintained a high payout ratio. Also, in 2008, they turned the cash at the CAM level into more LLC units at fair value (under some duress, but still).

-       In 2009, they voluntarily codified the value of the Other Assets by amending the company’s Certificate of Incorporation so that any exchange of LLC units into common stock would be required to account for them. (Although, in any case, the family would be unlikely to convert LLC units into shares anytime soon anyway because doing so would dramatically hike their tax bill by subjecting their ownership to corporate income tax).

-       One thing to note is that all of the employees, including non-family executive management and the directors, only own shares, or RSUs and options that convert into shares. Screwing over shareholders to benefit the family would not be good for employee morale.

-       The family owns 78% of a company that’s probably worth $1 billion or more. They don’t have much to gain by going after the shareholders of that own the other 22%. At the same time, the CLMS share price is a public indicator of how the company is doing, so they have some incentive to get it up. Usually (but not always!) when you see an abusive management, it’s when management has a minority economic interest and thus more incentive for abuse.

-       There’s also no legal way for them to get at the assets held at the CAM level without giving fair value from the LLC back to CAM (as they did in 2008, when they sold LLC units to CAM). Thus, they don’t have a ton to gain by accumulating CAM cash when the stock is trading at a level this low, the family would massively dilute themselves by downstreaming cash to the LLC.

The big issue here is timing. Now would be a great time for a repurchase or a self-tender, with the stock trading so cheaply. They could do this in a way that benefited both the family and public shareholders (if they used LLC cash and investments) or just public shareholders (if they used CAM cash). I don’t think this can be ruled out – they declined to do a special dividend at the end of 2012 (surprising for a company with excess cash) and the last time they did a repurchase, they gave no indication they would do so beforehand, stating at one point they didn’t want to tip their hand if they were considering one.

On the other hand, management does seem a bit scarred from their 2008 experience. Note below that the LLC itself is still in a net debt position. Also, there is a $46 million chunk of debt due in the middle of 2014. If they were to return cash to shareholders, they would have to liquidate some of their investments, something management is probably loath to do. So, a return of cash to shareholders isn’t exactly a slam dunk right here. However, I think it is likely to happen in the next three years or so if the stock price stays low, as the company pays down debt and accumulates cash. 

Valuation of the cash and liquid securities: 

One wild card here is the tax asset. It still has 7 years to run (through 2019) but it only has value as long as CAM has $8 million a year of federal taxes to cover.  If LLC profits slip or corporate tax rates are cut, this might be impaired somewhat, though I think a 12% discount rate compensates for the risk (the gross value is $56 million). Also, the value of the LLC investments will go up and down with the market (over half is in equities, the rest is in traditional fixed income and converts), so that’s something to keep an eye on too.

Valuation of the Operating Company 

I think the operating company is worth maybe 8x pretax income, or about $800 million. CAM’s 22.1% stake would be worth about $175 million, or $8.50 per share given 20 million shares outstanding. It’s not the highest multiple in the world, but I think there is some risk that assets under management continue to decline, as performance has been weak. 

The biggest open-end fund, Calamos Growth, accounts for $5.8 billion of AUM, or 19% of total AUM. Thanks to recent underperformance, it is now a 1 star rated fund. It accounted for a lot of the AUM growth in the earlier years; at its peak it was a 5 star fund and had $17 billion AUM. (Which goes to show how useful Morningstar’s rating system is). The second biggest fund is Calamos Growth & Income, at $4 billion AUM (13% of the total), and is now 2 star rated. Of course ratings can change quickly based on future performance.

The remainder of AUM is more secure, including open-end funds that aren’t doing that badly ($7 billion), closed-end funds ($6 billion), institutional accounts ($6 billion), and managed accounts ($2 billion).

One interesting thing to note here is that they just acqui-hired a co-CIO from outside the family, Gary Black, who in the past has led GSAM and Janus. This might help a bit in landing more institutional money.

Risks

-       Management refuses to let go of the cash

-       Management does something to screw over public shareholders

-       Declining equity markets

-       Continued underperformance of managed funds

Catalyst