Description

Executive Summary

• Had planned to write up the bonds, now like the stock
• Good business, bad balance sheet
• Management “took a bath” with restated financial statements and exited lower-margin businesses earlier this year
• They have raised a substantial amount of equity capital in 2021, significantly boosting their liquidity and enabling them to deleverage via debt buybacks
• The business started to inflect in 2Q21, and is projected to grow substantially in 2H21
• Assuming $212m EBITDA in 2022, the stock trades at 8.1x (bonds created at 4.7x)
• The largest shareholder and former Chairman was just named Executive Chairman and granted an aggressive equity compensation package, which suggests a positive outlook and potential multi-bagger return

I had originally planned on writing up Exela’s senior secured bonds due in 2023 (which are still attractively priced and a safer play than the stock). However, a recent development has me now more positive on the stock.

Warning: this is a highly speculative investment, with a very real possibility of going to $0. For those interested in the credit angle, I will also include my thoughts on the bonds.

Company Overview and History

Exela Technologies provides outsourced Business Process Management solutions to clients predominantly in the banking, insurance, healthcare and public sectors. Their main focus is in bill processing and payments soluitons, along with digital mail solutions. The company utilizes proprietary and licensed technology to help businesses transform inefficient, analog processes to efficient and scalable digital processes, hosted within a single, cloud-hosted platform. Exela, through its subsidiaries, offers a range of products on its seven-layer technology stack, starting with “Data Fabric” (think scanning paper invoices and insurance claims) to gathering and organizing data, automating business processes, integrating with other platforms, full-cycle process automation (including interfacing with counterparties), and high-value front-end software (B2B/B2C/SaaS).

Source: Company filings

The company serves over 4,000 customers globally across over 50 countries, including over 60 Fortune 100 companies. It has deep, long-established relationships, with more than 30 years of experience, and have served their top 15 clients for over 15 years. It has a substantial global workforce, employing 18,000 people. In their latest quarter, the company reported a 95% Annual Contract Value (ACV) renewal rate, in-line with historical trends prior to COVID-19 (renewal rates dropped to 81% in 2020). It estimates its total addressable market is greater than $200 billion, in a category that is secularly growing. Over the last twelve months, Exela has generated $1.2 billion in revenue and $107.4 million of EBITDA ($183.4 million “adjusted” EBITDA).

Exela has a complicated, and somewhat messy, history. It is the brainchild of its Executive Chairman, Par Chadha, who through his family office HandsOn Global Management (HGM) decided to start acquiring business process automation and technology companies 20 years ago. HGM acquired HOV Services LLC in 2007 and later combined it with other companies to form SourceHOV in 2011. SourceHOV acquired BancTec in 2014 and TransCentra in 2016. These transactions were funded with high-cost bank loans and mezzanine debt. SourceHOV merged with Apollo-backed Novitex in 2017 by way of a SPAC deal. Both companies rolled their equity interests, plus contributions from Quinpario, a SPAC entity that had been formed to find a merger opportunity, and PIPE investors. The deal was doomed from the beginning, and only closed after Chadha secured a loan to fund most of the PIPE, pledging his equity stake in SourceHOV as collateral in a new entity formed, called Ex-Sigma LLC. This was not the last time Chadha was involved with a related party transaction with the company. The deal closed in July 2017, with the newly created entity named Exela Technologies Inc. Since the deal closed, the stock has yet to trade back to trust value. Chadha remains its largest shareholder and Executive Chairman.

Over the next several years, Exela experienced myriad problems. Revenues declined in 2019 and 2020, and adjusted EBITDA fell from $276.2 million in 2018 to $173.5 million in 2020. And those adjusted EBITDA figures were grossly inflated with add-backs for optimization, restructuring, transaction, and integration costs that recurred every year. The company has never reported a full year of positive free cash flow, and had to restate its financial statements for 2017, 2018 and the first three quarters of 2019. It still does not have adequate internal controls to ensure its financial reporting is correct, which it is taking steps to remedy.

Exela has a leveraged balance sheet with very high-cost debt. The net leverage ratio is a moving target depending on what definitions of EBITDA and net debt are used. Pro Forma for subsequent debt buybacks and equity capital raised in 3Q, we estimate Exela’s total net debt sits at $1.4 billion. Using LTM “adjusted” EBITDA, net leverage is 7.7x. Its senior secured notes due in 2023 pay 10% and currently trade around 75 for a YTM of 30%. At 75, the creation multiple through the bonds is 5.4x using LTM EBITDA. The company needs to deleverage its balance sheet and grow EBITDA to have a shot at refinancing its debt next year.

One of the problems for a company with such a high debt load is that it hinders its ability to bid on new projects. Exela lists one of its main risk factors that the business is subject to long selling cycles and implementation periods, which require significant upfront costs (e.g. hiring employees) that are not recovered until later periods once the project is finished and payments have been received. This is a main reason why Exela’s liquidity has historically been extremely tight, and why it needs to deleverage. The company has managed to survive thanks to scrappiness in securing new sources of liquidity, including asset sales, revolving credit facilities, related party loans, and receivables factoring and securitizations.

It looked like game over for the stock earlier this year, with liquidity running out and the bonds trading in the mid/high-30s. The bonds looked very cheap at this level, and in the event of restructuring we anticipated a recovery in the 50s or 60s. However, the company got a lifeline in 2021, as it raised $25.3 million net proceeds in March through a private placement. Since then, Exela has raised a $240.5 million in equity capital through At-the-money (ATM) equity offerings; its stock was swept up in the Reddit WallStreetBets chatroom craze, and used the opportunity to issue 103.7 million shares for an average net price of $2.32/sh. As of the most recent press release, the company has $200 million of liquidity and has also repurchased $94.6 million face value of its debt YTD. We estimate an average price paid of 74. Thus, the company has deleveraged its balance sheet by issuing equity and buying back debt in the open market. In its latest 10-Q, the company wrote [emphasis added] “substantial doubt no longer exists regarding the Company’s ability to meet its obligations as they become due within one year after the date that the financial statements are released.”

Turnaround

This stunning turn of events not only helps Exela’s liquidity management and capital structure; as mentioned, it also helps Exela’s fundamental business because they can better compete for market share and are viewed by the market as less of a risk of imminent bankruptcy. In addition, Exela fired its CFO following the AFS restatement disaster and replaced him with an internal promotion in May 2020. The company “took a bath,” recording a goodwill impairment charge in the fourth quarter of 2019, and exited lower-margin businesses that didn’t fit its long-term profile. It sold two assets in 2020 and recorded a net gain of $43.3 million. When the company recently reported its second quarter results, there were indicators the business had started to inflect positively. Revenues were down -4.8% y/y, a big sequential improvement from -17.9% in the first quarter. Gross margins expanded rapidly by 720bp, reaching close to 29%, and an adjusted EBITDA run rate of $200 million. For the full year 2021, management guided for $1.25 billion - $1.39 billion revenues; this implies a 2H21 growth rate between 6% and 29%. Gross profit margins are projected at 23-25%, and adjusted EBITDA margin of 16-17%.

The Coronavirus pandemic turbocharged the need for companies to undertake digital transformations and business process automations – with everyone working from home, going through mail, collecting physical invoices, or gathering HR paperwork is a challenge. Exela had already been developing a pipeline of WFH/WFA (“Work From Anywhere”) products pre-pandemic. Its higher-margin license Direct Mail Room (DMR) and DrySign products (competitor to DocuSign), which are sold to SMBs, represents a new business line and are now available in the US, UK, France, Germany, and India. These SMB products represented 8% of Exela’s LTM revenues, and grew 99% and 144% in the second quarter of 2021 respectively compared to the same period in 2020. In addition, the company identified $38 million of cost cuts to be realized in 2021; half of that has already shown in their SG&A expenses thanks to a reduction in employee headcounts and overhead.

2022 Projections

It is admittedly hard to predict what Exela’s 2022 results will look like. As mentioned, growth is starting to pickup both on the top and bottom lines, there are cyclical and secular tailwinds at the company’s back, and they have cut a significant amount of costs. Recent activity with company insiders (more on that below) suggests the outlook for 2022 has improved materially. My projections are as follows:

Revenues: $1.4 billion (+7%)

Gross profit: $395 million (28% gross margin)

EBITDA: $212 million (15% EBITDA margin, NOT adjusted)

Less:

$139 million cash interest

$0 cash taxes

$24 million CAPEX (Purchase of PP&E + capitalized software)

= $49 million “simple” FCF

Working capital and other uses of cash: $9 million

= $40 million FCF

Recent Developments

As mentioned previously, Exela has netted $265 million of equity capital raised YTD, enhancing its liquidity and enabling them to deleverage. They have been buying back debt in the open markets at substantial discounts to par, which itself is usually a good sign of positive developments to come. Additionally, in an 8-K filed after hours last Thursday, the company announced the BOD has appointed its Chairman Par Chadha as Executive Chairman, with an annual salary of $1 million paid in cash. In addition, Chadha was granted a huge equity compensation package with aggressive hurdle rates: 8.5 million shares (i.e. 5% of total shares currently outstanding), with two tranches, one with a $10 strike price and 6/30/24 expiration and the second with a $20 strike and 6/30/25 expiration. We usually see this type of “spring-load” equity compensation package right before a positive catalyst takes place. The fact that the strike price is so high (stock needs to 5x just for the first tranche to land in the money) suggests that Chadha knows something that is not currently priced in, and he is taking advantage. Should both tranches vest, it would personally net him $127.5 million. This is not typically what we see when a company is about to file for bankruptcy, and is the reason why we are now more positive on the stock than the bonds.

How likely can Exela hit these share price targets? It’s difficult to find true public market comps, but Exela at its core is a software company with substantial IP and massive TAM. Most companies in this category trade at double-digit EBITDA mulitples. If Exela can grow EBITDA to $250 million in 2023, bringing net leverage down to 4.5x, it seems plausible for the TEV multiple to rerate to 11x, which would put the shares right around $10. $20/sh seems like more of a stretch, but perhaps Chadha knows something the market doesn’t.

Why Does This Opportunity Exist?

There are myriad reasons why investors would stay away from this company. It is littered with red flags, including Related Party transactions, restated AFS, a history of underperformance and burning cash, a leveraged balance sheet, limited capacity for incurring additional secured debt, and insufficient internal controls over financial reporting, to name just a few problems. In addition, Executive Chairman Chadha is a shady character. The company has an outstanding Appraisal Action liability due to former shareholders of SourceHOV stock, who successfully argued in court that the implied appraised value of SourceHOV at the time of the merger with Novitex was a fraction of its fair-market value. The full opinion is available online for those interested, as it gives a comprehensive history of the company and details about the SPAC deal. Chadha was found to have instructed Exela’s bankers to fraudulently prepare a “Backdated Valuation” for litigation purposes, after initially denying having done so during depositions (he later came clean on the eve of the trial). Thus, we believe most institutional investors have “given up” on Exela, which is certainly justifiable. It’s also reasonable that investors wouldn’t want to partner with a character like Chadha. Initially we liked the bonds, because if the company did have to restructure, bondholders could take control of the asset and deleverage its balance sheet. With the aggressive compensation package, we believe Chadha has an ace in the hole and is tipping his hand, which makes us comfortable betting alongside.

Additional Thoughts on the Bonds

The bonds are a $1 billion issue size. Exela Intermediate LLC is listed as Issuer and Exela Finance Inc as Co-Issuer. These entities are wholly-owned subsidiaries of Exela Intermediate Holdings LLC, which itself is a wholly-owned subsidiary of parent company Exela Technologies Inc. The bonds are first-priority lien senior secured notes, pari passu with the term loan and revolver. Pro forma for debt repurchases, we calculate a total of $1.376 billion of first lien senior secured debt. The only debt ahead of this class is the $145 million A/R securitization facility, which had $92 million outstanding as of June 30, and is more than covered by cash on the B/S. We believe the bonds would be the fulcrum in a chapter 11 scenario. Assuming $212 million of EBITDA in 2022, we are creating the bonds at 4.7x. Although this works somewhat counter to the equity thesis, additional equity capital raised via ATMs would facilitate a refinancing in 2022. At 75, bondholders realize a 13% cash return from interest payments alone over the next year, and a 50% return if they refinance at par in 2022. If our projections are wrong, and Exela is forced to restructure, we think the downside is limited. In a worst-case scenario, the bonds probably recover 60c on the dollar. So, 15pts of downside vs. 35pts of upside (10pts interest + 25pts to par value) is still a decent asymmetric bet.

Risks

The risks with this opportunity are substantial. The bonds go current in June 2022, so if there is no clear path to refinancing by then the company will have the restructure. The equity is likely a zero in that case. The bonds are less risky, and we believe the “good company / bad balance sheet” situation makes it attractive for a larger distressed manager to take control of the asset. But a potential five-bagger on the stock and the most informed person on this company in the world putting his chips in leads us to believe this is a bet worth taking.

Catalyst

Additional debt repurchases and refi