Description

Pro Forma for an imminent refinancing, I think shares of HC2 Holdings are trading at a high-single-digit normalized FCF yield, ~60% of Net Asset Value and possess substantial optionality.  I also think the company has a thoughtful and determined capital allocator (Phil Falcone) at the helm. 

Two assets comprise the majority of the observable asset value today but will likely comprise a smaller percentage of the NAV in the future.  While somewhat cyclical, these assets generate substantial cash that Falcone can use to invest intelligently in other asymmetric opportunities.

In the near-term, I see two catalysts that should serve as a large positive for the equity:

• 1)      A global refinancing of the 11.0% Senior Secured Notes
• 2)      The market understanding the potential for asset management fees derived from managing the insurance subsidiary’s investment portfolio

The refinancing could potentially free up $16m of after-tax FCF and the asset management fees could deliver an incremental ~$8m of FCF.  Applying a 14x FCF multiple to the saved interest expense and a 10x multiple to the asset management earnings stream would lead to $297m of value.  On a $320m fully diluted market cap today (treating the convertible preferreds as if converted).

The company’s investor presentation does a decent job explaining the company’s complex portfolio (https://www.sec.gov/Archives/edgar/data/1006837/000100683718000105/hc2companyoverview2q2018.htm), so I’ll try to just briefly touch on the major drivers of value.

Construction - Schuff Steel Company (92.5% Ownership)

This segment did $663m in LTM Revenue, $57m in LTM EBITDA (8.7% Margin) and management is guiding to $60-$65m of EBITDA for 2018.  LTM CapEx/Revenue was 1.3%.  As of Q2, the Backlog was at $656m (1.0x Book-to-Bill).

Schuff is the largest structural steel fabricator and erector in the U.S.  In addition to fabrication and erection, it offers its customers building information modeling, cost-effective steel designs, budgeting tools and steel management.  While tied to the nonresidential construction cycle, competition is fairly limited in the market for highly complex superstructures (sports stadiums, convention centers, etc.).  It is a scale operator in a high-fragmented industry, possessing one of the highest fabrication capacities in the U.S. (annual fabrication capacity of ~318,000 tons) and growing through tuck-in acquisitions.  Contracts are generally fixed price, cost-plus or unit cost arrangements.  Revenue is recognized on a percentage-of-completion basis with most projects typically lasting from one to 12 months (though large/complex projects can last 2+ years).

Going forward, the company is attempting to target smaller projects that carry higher margins and less risk of large margin fluctuations (e.g. low-rise office buildings, healthcare facilities).

The one publicly-traded peer here, Canam, was taken private by a consortium of investors including CDP for C$830m in 2017 (12.0x EV / Trailing 5-Year Average EBITDA).

Global Marine Systems Limited (72.5% Ownership)

This segment did $194m in LTM Consolidated Revenue, $42m in Proportionate LTM EBITDA (including the Huawei Marine JV) and management is guiding to $45-$50m in Proportionate EBITDA in this segment for the full-year.  Global Marine finished Q2 with a backlog of $372m (1.9x book-to-bill) and the Huawei Marine JV finished Q2 with a backlog of $423m.

Global Marine is a provider of subsea cable installation and maintenance in telecom, offshore power and oil & gas.   The company has been around for a while, having laid the first subsea cable in the 1850s and the first transatlantic fiber optic cable in 1988.  Roughly half of the segment’s revenues are generated from long-term, recurring maintenance contracts.  In telecom they are the largest independent maintenance provider.  Maintenance services contracts are 5-7 years in length and the customer is typically a consortium of different cable owners.  Contracts are usually re-awarded to incumbent providers unless there are significant performance issues.  Installation business is project-based and contracts typically last one to five months.  The company’s 49% joint venture with Huawei is growing very quickly (+19% y/y in 2017), generating profits ($36m on $246m in Revenue in 2017) and has a large backlog ($423m as of Q2).

In the near-term, Global Marine should benefit as offshore oil & gas projects come back.  Over the past two years the company has seen margin compression because certain of their vessels previously involved in the energy space were redirected to telecom and offshore wind.  In the medium-term, Global Marine should benefit from the growing offshore wind market.  Prysmian projects European offshore wind projects growing at a 10% CAGR from 2017 to 2021 and Falcone has spoken repeatedly in the past about the attractiveness of the growth prospects here.

Insurance

In 2015, HC2 formed Continental Insurance Group (“CIG”) and acquired a long-term care and life insurance book from American Financial Group.  In late 2017, Continental Insurance Group signed a definitive agreement to acquire Humana’s long-term care insurance book for $0 and required Humana to make a $195m capital contribution before acquiring it.  The deal closed earlier this week.  Following the closing of this deal, HC2’s Continental Insurance Group will have $3.8 billion of cash and invested assets, PF statutory surplus of ~$155-$175m and total adjusted capital of $185-$205m.

Obviously a lot has been written recently about the problems with the long-term care insurance business.  G.E. earlier this year took a $9.5 billion charge to boost reserves, mostly for long-term care policies sold in the 1980s and 1990s.  They subsequently announced plans to more than double their reserves in the coming years to reflect adverse developments.  Life insurers are eager to get rid of their Long-Term Care books and reinsurers are hesitant to reinsure them.  In addition to low long-term interest rates, severity for long-term care has increased, driven by a longer duration of claims (especially in later claim durations) and higher benefit utilization in later claim durations.  To deal with the under-reserving (and to stay solvent), long-term care underwriters are asking state regulators for permission for substantial price increases (sometimes in the 50-150% range).  For CIG thus far, the price increases have been better than expected.

For HC2’s Continental Insurance Group, substantially all of the in-force long-term care policies were sold after 1995.  All individuals were individually underwritten with a maximum cap per policy ($300-$350k).  Per management, the book contains fewer policies with lifetime guarantees and products were sold on a guaranteed renewable basis, allowing the company to re-price in-force policies.

While acquiring these books of business sounds risky, the actual exposure to HC2 as the ParentCo should be fairly limited.  The company has not provided parent guarantees for any of the books.  On the initial American Financial Group long-term care acquisition, CIG is essentially required to fund any capital shortfall above $35m for 5 years following the transaction (so for 2.5 more years).  There is no such agreement with the Humana transaction.  But by not providing parent guarantees, if HC2 is unable to secure price increases and reserves are inadequate, they can essentially “put” the insurance subsidiaries back to the state regulators.

It's also worth noting that HC2 has put in place James P. Corcoran as Executive Chair of Continental Insurance Group.  Corcoran previously served as the Superintendent of Insurance of the State of New York.

On the potential upside from the transactions, there are two fairly simple paths to increasing the value of the businesses:

• 1)      Match the duration of the assets and the liabilities and improve the return on the investment portfolio
• 2)      Have the insurance business pay HC2 a management fee for managing their investment portfolio

On the first point, improving the average yield on the investment portfolio by 0.5% on $3.8bn of PF Cash & Investments could increase the Investment Income by $19m annually.

On the second point, there have been a number of Private Equity backed insurance companies charging asset management fees.  Fidelity Guarantee & Life (FG) is public again through a Blackstone-backed SPAC, with Blackstone charging them an Asset Management Fee of 0.30% of assets.  Athene (ATH) similarly pays an Apollo subsidiary 0.30% of assets under management.

For HC2, 0.30% of $3.8bn of Cash & Investments would be an incremental $11.4m of high-margin revenue that is possibly not contemplated by the market.

Broadcasting

Falcone has spent the past 12 months buying up 164 operational local broadcasting stations (102 of which are low-power stations), covering >130 markets with a footprint that covers over 60% of the population with depth (12-24 MHz of UHF spectrum [470-698 MHz band] per market).  He’s also bought licenses and permits to build out another ~400, with a goal of continuing to build until getting to >80% of the U.S. population.  The investment thesis is that he believes he has downside protection in the spectrum he is acquiring (pennies per Mhz/pop) and is ultimately attempting to capture upside through a new all-IP business model (utilizing the ~85% of owned spectrum not being used by the television group).  He believes content is becoming more abundant given non-traditional sources (Amazon, Youtube, etc.) and consumers would be willing to access content via new distribution methods, including over-the-air to your mobile device via an app.

While it’s certainly aggressive to spend $133 million of shareholder’s capital (13% of EV and 43% of FD Market Cap) on a start-up venture, I believe Falcone views the situation akin to a real estate development project where the price paid is secured by the increasing value of the underlying spectrum.  The strategy may be enhanced with the rollout of ATSC 3.0 in 2019/2020 (allowing for more throughput for Low Power TV channels, less interference, mobile compatibility and interoperability of channels).

The broadcasting group is currently burning cash but Falcone has hired a number of veteran managers and is guiding to breakeven over the next few quarters (prior to the all-IP business model being put in place)

Subsequent to quarter-end, the Broadcasting subsidiary, HC2 Station Group, borrowed $35m from certain Institutional Investors (at 8.5%) and sold a 2.0% equity stake to the same investors for $3.1m (i.e. implying a $155 million equity value for the subsidiary).

American Natural Gas (ANG, 67.7% Ownership)

ANG designs, builds, owns, operates and maintains compressed natural gas commercial fueling stations for transportation.  The goal here is to build a nationwide network of publicly accessible heavy-duty CNG fueling stations throughout the U.S. designed and located to service fleet customers.  They currently have 42 stations owned or operated in 15 states across the U.S.  Per the Department of Energy, as of December 2017 there were ~1,672 CNG fueling stations in the U.S. and over 150,000 natural gas vehicles on American roads, including 39,500 heavy-duty vehicles, 25,800 medium-duty vehicles and 87,000 light-duty vehicles.

At the moment natural gas is an attractive alternative to gasoline and diesel, as it reduces emissions, extends a truck’s life and reduces fuel cost.  Roughly 65% of ANG’s revenues come from customers with multi-year contracts based on committed fueling volumes (with pricing determined on a cost-plus basis).  This segment generated $16m in revenue in 2017 and $4.3m of LTM EBITDA, but is not yet generating positive FCF.

Interestingly, earlier this year Total S.A. acquired a 25% stake in Clean Energy Fuels Corp (Ticker: CLNE) for $83 million (https://bioenergyinternational.com/biogas/total-acquire-25-stake-clean-energy-fuels-corp)

Life Sciences (Pansend)

While I’ve done a little bit of scuttlebutt on some of the assets in HC2 Pansend portfolio, I am still not sure exactly how to value them.  Nevertheless, I don’t think you are paying for any of these investments at today’s prices and can view them as a free option.

HC2’s recent monetization of BeneVir illustrates the potential value here.  BeneVir is a development stage company focused on the development of a patent-protected oncolytic virus for the treatment of solid cancer tumors.  HC2 invested a total of $8m for its 75.9% stake in BeneVir.  On June 8^th Pansend closed on its sale to Jansen Biotech, received a $106.7m upfront payment and is eligible to receive ~$683m of milestone payments in the coming years (of these HC2 is eligible to receive up to $512m).  Management is certainly more optimistic on the potential to receive some of these milestone payments than the market is.

I think this transaction provides HC2 management with a lot of credibility (they had been talking up BeneVir’s potential).  The other two assets management hints may be monetizable in the near-term are R2 Dermatology and MediBeacon.  Pansend owns 74% of R2, whose cryosurgical R2 Dermal Cooling system is used to lighten and brighten skin.  It has behind it some of the same doctors at Mass General that developed the fat-freezing fat reduction procedure, “CoolSculpting” (Zeltiq).  Pansend owns 50% of MediBeacon (http://www.medibeacon.com/) which is developing a proprietary non-invasive real-time monitoring system for the evaluation of kidney function.  It’s the first and only non-invasive system to enable real-time, direct monitoring of renal function at point-of-care (i.e. it enables monitoring the kidney without having to take blood). 

Capital Structure / Refinancing

HC2 has a messy capital structure.  Pro Forma for the recent debt-raise at the Broadcasting sub, there is over $700 million of Total Debt ($271m Market Cap).  $510 million of this is in the 11.0% HC2 Senior Secured Notes due 2019.   These notes are secured by substantially all of HC2’s assets and the indenture contains certain restrictive covenants.  The notes can be called at 105.50 prior to November 30, 2018 and at 100 thereafter (trading at 101.31 today).  At the B. Riley FBR Conference in late May of this year, Falcone alluded to his expectation that the Notes could potentially get refinanced in the 7.0-7.5% range.  On the Q2 call, it sounded like management may be waiting for one more monetization event at Pansend before refinancing and noted they looked forward to “sharing additional updates on this and other key initiatives in short order over the next couple of months”.

In addition to the debt, there’s $27 million of Convertible Preferred Shares carrying a 7.5% dividend.  The company has been slowly repurchasing some of the convertible preferreds over time and management understands that this is an overhang for the common.

Net Asset Value

I believe the Net Asset Value presented below is fairly conservative and think there is likely potential upside to where I’m carrying Pansend and ANG.

Key Risks

• Nonresidential construction cycle
• High-Yield Market
• Rising interest rates

Catalyst

• Global Refinancing the 11.0% Notes
• Market better understanding Insurance and Broadcasting businesses
• Monetization event in Pansend