Description

HC2 Holdings (Ticker: HCHC), Phil Falcone’s permanent capital vehicle, was written up on VIC by dichotomy on 7/24/14.  The stock price then was $3.90, and dichotomy made a very timely “exit recommendation” just 7 months later on 3/26/15, when the stock closed at $13.09.  Today the stock is back down to $4.08 and has largely been forgotten in a market that has recently shunned many other leveraged roll-up investment vehicles.  A number of well-established investment vehicles, run by seasoned operators with long track records of success, have seen their stocks cut in half since their earlier highs (see IEP, PAH, DC/A CN, AGFS, NOMD, CG, etc.).  We believe HCHC is not your typical vehicle, nor does it have typical assets and upside.

HCHC is a similar situation to HRG Group (NYSE:HRG), formerly known as Harbinger Group, which Falcone previously headed and generated value/outsized returns for shareholders.  But HCHC is smaller and more leveraged, and is currently invested in cyclical businesses and smaller venture-capital-type holdings.  The risk is admittedly higher with HCHC.  But the reward in success should be higher, too.

HCHC currently operates three free cash flow generating businesses: Schuff (steel structure construction), Global Marine (undersea cable installation and maintenance), and Continental Insurance (LTC insurance in run-off) which pay dividends to the holding company (with the exception of the insurance co, which agreed not to pay dividends for three years as required for regulatory approval of that acquisition).  HCHC also invested in some non-cash flow generating investments in venture capital stage companies.  These investments seem exciting, however risky, and are a small portion of the current NAV and are being valued for our purposes at cost.  From its depressed price of $4.08 on 5/12/16, the upside to our current estimated NAV of $8.47 is 108%, although we see significant upside potential beyond that.

Background:

There’s no shortage of bad press on Falcone from his much discussed missteps that followed his multi-billion-dollar mortgage meltdown profit.  He made some risky bets in his hedge fund, the most publicized of which was the troubled wireless network LightSquared, which has since been renamed Ligado Networks.  But once Falcone entered the permanent capital, public market vehicle arena with HRG, he chose generally safer deals, with more established free cash flow generating businesses.  It appears that he has a strong desire to prove himself (and prove the naysayers wrong), and has since made a series of wise investments that set the stage for what we believe will be his most successful venture in HCHC.  Falcone has indicated that he intends to use this company as his primary vehicle for a lifetime of deal making.  He has also stated that future deals will be both larger, and cash flow generating.

When Falcone was running HRG, he acquired control of HCHC (then known as PTGi Holdings Inc.) via HRG.  PTGi was effectively a cash shell when Falcone got involved in early 2014.  When he stepped down from HRG in November 2014, he took the reins at HCHC and quickly began making deals.  The largest deals he made were Schuff (May 2014), one of the largest and most well-known steel fabricators in the world, and Global Marine (September 2014), a subsea cable construction and maintenance firm, which has since expanded into energy/wind farms (after the expiration of a non-compete).

Rather than rehash the entire story, we’ll focus on what has happened since dichotomy’s timely VIC write-up on HCHC.  And much has.

Let’s start with how the stock got so low (dropping from a high just above $13 to a low of $3.25).  Approximately a year ago the stock was hovering around $11.  HCHC attempted a failed, all-stock hostile bid to acquire MCGC, which was a large pile of cash and effectively a backdoor secondary.  MCGC had already agreed to be acquired by another firm (PFLT), so HCHC’s all stock offer, although higher, was met with skepticism by the board of MCGC (vs. PFLT's cash and stock offer).  A somewhat public war of words ensued, and shareholders were faced with a critical barrage about Falcone from the MCGC board, as well as the fear of a large amount of new stock hitting the market if the deal was successful.  Soon thereafter, HRG, who was then the largest HCHC shareholder with 5.7 million shares, sold over a million shares at prices ranging from $9.00 to $9.60.  This began a series of events that caused tremendous technical pressure on the stock, pressure we believe has only now begun to abate.  HRG’s remaining 4.7 million shares of HCHC were then sold in a block at $7.50 partially to Falcone himself, as well as a group of well-known and respected investors, including Leon Cooperman, Raging Capital, Mittleman Brothers, and Steel Partners.  Soon thereafter, HCHC did an approximately $58 million secondary at $7, with Jefferies as lead underwriter and also one of the lead investors along with Putnam.  During this time, the market began punishing businesses with a similar profile (leveraged investment vehicles), crushing Icahn’s IEP, and many others, in the range of 50% declines.  As this process continued, a few of HCHC’s largest holders, smaller funds who were beholden to their LP’s, began getting redemption notices from their investors.  As such, they were forced to liquidate millions of HCHC shares.  Other individual large holders were sold out due to margin calls, and this forced selling caused technical damage and fear.  And last but not least, over 2.7 million shares were shorted (most likely as hedges against preferred positions), adding additional pressure and overhang throughout this decline, pressure particularly painful to a relatively illiquid stock such as HCHC.

On the positive side, this process resulted in a complete transformation of the top 10 holder list, transferring shares to a group of long-term oriented, value investors with strong track records.  It is worth noting that both Raging Capital and Mittleman Brothers, who participated in the block buy from HRG, both subsequently increased their positions to become top 5 holders.

From a compensation standpoint, Falcone only succeeds when the stock rises.  He takes $0 in cash salary, and currently owns over 10% of the stock on fully-diluted basis.  A couple of weeks ago something else quietly happened.  Falcone’s original employment agreement contained an anti-dilution clause that protected him from dilution of any kind, granting him options to offset any dilutive transaction.  In an 8K filed on 4/14/16, Falcone cancelled the terms of this anti-dilution agreement, and replaced it with one much more friendly to other shareholders.  In addition to his previous stake and option grants (mostly at significantly higher prices), Falcone is now paid with three tranches of 500,000 share options: at $7.50, $10.50 and $13.50.  So his interests are aligned with shareholders.  It’s also worth noting that he could have easily justified setting strike prices for these options much closer to the current stock price, but didn’t.  We believe that’s a testament to his confidence in the stock’s eventual performance, and his fairness to shareholders.

From a macro perspective, to break even on their secondary investment, and for Falcone to make any real money, these investors need the stock to double just to get them to the starting line.

So what has the market seen over the past year?  Large amounts of stock hitting the market, whether primary or secondary, selling into an illiquid market at a very unfavorable time; cash burning as the company continues to fund its various deals; silence in terms of new deals, as the company continues to grow its current holdings, which has been misconstrued as some form of lack of growth.  But Falcone appears focused on quality here, not quantity -- something we prefer as long-term investors.

What the market has seemingly ignored is that HCHC’s cash, and Falcone, have been hard at work.  While showing approximately $40 million of cash at the holding company level, the holding company owns an additional $7 million share of (approx.) $50 million investment in public securities last quarter in addition to that $40 million.  So at the holding company level, there is really $47 million in cash and liquid investments, plus HC2’s ownership of Novatel Wireless (NASDAQ: MIFI) is freely tradeable, which is another $20 million or so they could raise if needed, plus their ownership of the Canadian publicly-traded Gaming Nation, a stake presently worth $5.1 million.  This brings parent company cash and securities up to around $72 million.  Adding in the approximate $30 million in dividends (using last year’s #’s) likely to be received by the holding company from Schuff and Global Marine, there should be more than adequate liquidity.

Each subsidiary has about $20 million in cash on their books, offset by similar sized amounts of debt and/or pension liability, but the subs remain largely unlevered.  And for those watching the debt covenants, the debt requires one year of interest payments to remain on the books in cash (approx. $40 million). However, when asset coverage is over 2x (which it is), that requirement drops to 6 months’ worth, or approximately $20 million.  To be in compliance with the covenants, HCHC only needs approximately $20 million in cash at the parent level.  Looking at the whole picture, and taking into account typical upcoming dividends from the subs, the covenants should be well covered.

Last but not least, after acquiring the insurance company (Continental Insurance), the company has access to its $1.3 billion float as investment capital.  This capital can be invested and/or reinvested in various ways, subject to certain limitations by the state regulators.  Our understanding is that approximately 20% of the float ($260 million) can be used by Falcone to invest how he pleases.  This is a valuable source of additional liquidity and firepower that can be used to make bolt-on acquisitions to existing platforms or to create new platforms altogether.  With regards to the rest of the float, we believe a seasoned investor with Falcone’s background in fixed income will carefully choose investments that will be more beneficial to the bottom line than investments made by the predecessor owner.  Even a slight uptick in the yield on this portfolio would bring a significant amount of money to the bottom line.

Operationally, Falcone knows insurance.  One of his biggest successes at HRG was the acquisition of an insurance company, Fidelity & Guaranty (FGL), under similar circumstances.  FGL was sold to HRG by Old Mutual PLC in 2010 while under pressure to raise capital following the financial crisis.  In HCHC’s case, they acquired Continental Insurance at a very low price (including 1 million shares of HCHC and 2 million options around $7) from a company that realized an immediate, significant cash savings from a tax loss by doing so.  The seller was also under tremendous shareholder pressure to exit a business (long-term care insurance) that at the time was in the headlines for the seemingly endless losses it was creating (from actuarial errors now known to us before buying).  So, Falcone bought a book of business from them of mostly short-term policies (the most profitable and least risky), at an extremely low price, and now has access to both the profits likely to flow from those policies and the large rate increases now being allowed by regulators.  In addition, there’s the income from deploying the large float into wiser investments paired against the shorter duration of the policies.  And Falcone has repeatedly stated that this is a platform for future, similar acquisitions, so we expect more to come.  Falcone has been explicit in his plan for Continental.  Along with buying the book of business, he also acquired infrastructure to handle policies.  Additional books can be layered on top of this administrative infrastructure, spreading out costs and increasing earnings.

THE VENTURE CAPITAL SIDE OF HCHC:  

This is the most underappreciated, undervalued, and least understood part of HCHC.  Over $70 million in cash has been invested in deals that no one is paying attention to, or may not even know about.  In the Pansend LLC life sciences venture capital segment, which is run by an outstanding management team, the company is excited about R2 Dermatology (http://www.r2derm.com/new-page/) a skin-lightening medical device they hope to begin selling in Asia this year.  HCHC paid $9.9 million for 61% of R2, and has the right to increase ownership to 70% for an additional $9 million payment. R2 intends to file for FDA approval in the US this year, which is a streamlined process, as it is a medical device and not a drug.  Japan and China combined represent a multi-billion market opportunity according to their Chinese partner.

In subsequent events in the latest 10Q, HCHC noted that they recently paid an additional $9.3 million ($6 million had been in escrow subject to milestones, so this payment only depleted their existing cash post-Q by $3.3 million) to increase their stake in another subsidiary, Medibeacon, which makes what is purported to be the first non-invasive way to measure kidney function, and has been developed over many years with a tremendous amount of money invested in it before HCHC got involved.  If this works (and they believe it does), it is another multi-billion dollar market opportunity.

Within Pansend LLC, HCHC also has a stake in Benavir, a drug company working on a cancer drug for melanoma.  A comparable drug was sold to Amgen for $1 billion a year ago.  In early stage research, Benavir’s drug has demonstrated more efficacy (and is patented) than Amgen’s, and the inventor of this drug was co-inventor of the drug that sold to Amgen.  HCHC made their deal before that deal was announced with Amgen, and HCHC owns 49% of the company for $2 million.

CYCLICAL RISK:

On the cyclical risk involved with a business like Schuff, as of the most recent conference call on May 9th, Falcone stated that he is seeing “no signs whatsoever” of that business slowing down.  In fact, the backlog has been growing and margins are improving.   With a backlog of over $400 million (which on the May 9 call Falcone indicated is likely to grow significantly in the near term), and many of their “marquee” projects from major firms, Schuff is well positioned to continue to grow for the foreseeable future.

Global Marine also has a strong backlog of over $270 million, but had a weak Q1 (Q1 has historically been GM’s seasonally worst quarter).  The company also endured a $5.8 million non-cash write-down from a delayed Russian telecom project due to weather, effectively wiping out its EBITDA contribution for the quarter.  However, GM looks to be set up for an excellent year.  With a non-compete in the sector having just expired, GM is now allowed to reenter the power/wind farm space, a space that had previously accounted for approximately 30% of their EBITDA.  When the non-compete expired, HCHC quickly announced an acquisition in that sector (C-Wind), and look to be focused on ramping up those efforts.  It’s also worth noting that approximately 50% of GM’s EBITDA comes from maintenance contracts.  These are recurring contracts, unlikely to be cancelled in any economic environment.  The cyclicality at GM is mitigated from the strong undercurrent of recurring revenue maintenance contracts.

One other important thing to note: GM owns 49% of a joint venture with Huawei Marine Networks (a division of Huawei, a billion dollar Chinese firm) classified under “other investment assets” on the balance sheet. This joint venture generated over $190 million in revenues last year (up over 150% from the prior year) and did $14 million in net income last year, up 10-fold (in the 10q, these appear as “income from equity investments.”  The JV had $26 million in cash as of year-end 2015.  This piece of GM is being valued on the books at $14.3 million, but is likely worth much more.  We value this stake at approximately $70 million, using a conservative PE of 10x on this fast growing portion of their business.

In spite of the aforementioned write-down, Falcone confirmed on the May 9th earnings call that GM would still make its numbers for the year, with some presumed upside from there.

The future looks bright for these key components of HCHC.

CORPORATE EXPENSES:

Corporate expenses are an area of concern, in that the numbers are too high to sustain long term.    On a normalized basis, the overhead should be much lower.  In 2015, the numbers were largely inflated by non-cash pass through losses from many of the subsidiaries, non-recurring deal expenses, as well as cash funding to some of the Pansend companies that is classified as Corporate Expense.

Following is a breakdown of last quarter’s total corporate expense, cash vs. noncash:

Actual cash corporate expense came in at $5.7 million ($900,000 of that was bonus accruals, which is a variable amount based on the previous year’s performance.  So we are looking at a quarterly corporate expense burn rate of $4.7 million, which consists mostly of legal, consulting and accounting expenses.  Non-cash charges included in the corporate expense number is stock compensation (an additional $2.4 million), and non-operating corporate and other which passes through another non-cash $4 million, half of which comes from MIFI.  The company has stated that they are focused on reducing these cash costs.  But we also recognize that this entity is built for future large acquisitions.  So one deal can transform this number into a much smaller issue.

RING FENCED:  

Some investors may fear that Falcone could get too aggressive.  What happens if he loses $500 million of the float and wipes out HCHC?  Or what if there’s a big cyclical slowdown and Schuff goes bankrupt?  It’s worth noting that in 2008-2009, the worst time in history for Schuff’s business, the company still generated free cash flow (primarily by making working capital adjustments).  This is not a big fixed-cost business.  Aside from that, it’s important to note that all of HCHC’s businesses are ring fenced from one another.  If the insurance company was entirely wiped out, HCHC would only lose its equity investment and loan guarantee to the seller.  If GM went bankrupt, only HCHC’s equity investment would be lost.  This vehicle has a diverse portfolio of options for liquidity raising, liquidity events, and borrowing needs.  The bond covenants are non-restrictive and allow effectively unlimited debt raises.  And they aren’t due until 12/1/2019.

So what are the real risks here?

HCHC runs out of cash.  Possible, but we believe it’s highly unlikely.  If there’s anything Falcone has proven, it’s the ability to raise money.  He could raise more preferred stock.  He could borrow money at the relatively unlevered subsidiaries and dividend it up.  He could sell something (like MIFI, for starters, which is publically traded, as is Gaming Nation).  And obviously as a last resort, equity.  Falcone has more options than he needs to keep this venture funded.

We have another 2008 like recession.  Schuff’s EBITDA would decline, but the business would still continue to generate cash as it did in 2008 and 2009.   At Global Marine, they’d still have a strong base of recurring maintenance income.  In this “worst case” scenario, it wouldn’t be pleasant, but the parent would likely survive by pruning their capital commitments, and raising enough capital to carry the bond payments through that period.

CONCLUSION:

We believe HCHC represents a timely way to piggyback the proven abilities of an investor such as Phil Falcone, at a severely discounted price, after a large pullback, when the most exciting prospects lie both in the current portfolio and the likely long stream of future cash generative deals.

General breakdown of the NAV below.   

We are long HCHC and may buy or sell additional shares at any time. This is not a recommendation to buy or sell securities. Please do your own research and reach your own conclusion.

We do not hold a position with the issuer such as employment, directorship, or consultancy.

Catalyst

-Recovery to minimum fair value/NAV

-Continued deal generation

-Potential liquidity events in the non-public ventures