Value Investors Club / HILLTOP HOLDINGS INC (HTH)

Description

NOTE - Apparently the idea is too wide to fit the pdf version, although I am not being offered my good friend the blue line to resolve the width issue...

HTH has been written up on VIC three times prior to this submission, twice (11/2007 and 12/2008) recommending the common and once (04/2009)recommending the 8.25% cumulative preferred, which has since been redeemed. For an in depth review of the company, Gerald Ford, NLASCO, history, etc. please see the 11/2007 and 12/2008 ideas, both by oogum858, which do a far better job than I can in providing background. What follows has been kept intentionally brief, as I just revisited the company two days ago and gained awareness of the current valuation and recent SWS transaction. I am working on a never ending VIC submission, but thought I would provide this to fulfill my annual requirement and avoid having my membership revoked, in the event the other idea I am working on continues to be "elusive". Given my personal/professional history owning the cumulative preferred, and common on two separate occasions, I can state that I feel comfortable enough with the discount to book and "partnership" with Gerald Ford to propose the idea. This should not be construed as a recommendation to buy or sell HTH. I may buy or sell shares of HTH without providing notice to the VIC community. Do your own due diligence. However, if you own any of the big banks you may want to outsource that function.

Total assets (less goodwill, intangibles and loan origination costs aggregating $36,592), equal $910,860. Total Liabilities equal $305,999, which includes $138,350 notes payable, leaving tangible SE of $604,861. With roughly 56,499 shares outstanding at 08/04/2011, the resulting TBV/share equals roughly $10.71. Looking at the company's balance sheet per share, you get $2.82 per share in high-quality investments, $11.31 in cash and $1.99 in various other "assets". Note that reserve for losses equal $68,616 or $1.21 per share compared to the investments of $2.82 mentioned. Further note that EV in the heading excludes all investments ($159,234) and only incorporates cash balances (639,160), notes payable ($138,350) and market capitalization (using 56,499 x $7.50).

A simple reversion to TBV of $10.71 woud result in a gain of $3.21 per share or 42.8%. Cash and investments, net of total liabiliities, equals $8.72 per share. A simple reversion to net cash and investments would be a gain of $1.22 per share or 16.3%.

Note that $90,850 of outstanding debt can be exchanged for common shares. Given that the current exchange/conversion price is $13.52, I have not spent time looking further into the matter. Debt matures 2025 and yield 7.50%.

Insurance Ops

In the six months ended 06/30/2011, the business lost $11,823 - after $6,439 in income tax benefit. Note that total revenue expanded 10.33% compared to the prior 2010 period. Due to wind and hail losses in Texas, loss and loss adjustment expenses were $21,271, or 59.36% greater than that experienced in the same period 2010. It has been a bad year for insurance, even insuring low value dwwellings and manufactured homes in Texas. Assuming Loss and LAE returns to an H1 2010 level, at current revenue levels, the operations are roughly breakeven.

SWS Transaction

From 13-D (SWS = Issuer / HTH = Reporting Person):

Pursuant to the Funding Agreement (the "Funding Agreement"), dated as of March 20, 2011, between the Issuer, the Reporting Person and Oak Hill Capital Partners III, L.P. and Oak Hill Capital Management Partners III, L.P. ("Oak Hill"), on July 29, 2011, the parties entered into a credit agreement (the "Credit Agreement") under which the Reporting Person loaned the Issuer $50 million in the aggregate (the "Funding Amount"). In connection with the Funding Agreement and the loan made by the Reporting Person under the Credit Agreement, on July 29, 2011, the Issuer issued a warrant (the "Warrant") to the Reporting Person to acquire up to 8,695,652 shares of Common Stock of the Issuer (and, in some cases, the Issuer's non-voting preferred stock, par value $1.00 per share ("Series A Preferred Stock")). The Funding Amount was funded by working capital.

Debt is five year unsecured. 8% annual yield. Exercise price of warrants = $5.75.

While I am sure many are familiar with private equity firm Oak Hill Capital, note that it is operated by Robert M. Bass, a DFW native. Gerald Ford and HTH office in the Crescent Court. SWS Group, Inc. is headquartered right down the street. My insinuation is just that, but you have a ton of very well-informed and well-capitalized individuals very, very close. I cannot think the two parties entered into the deal hoping to invest $100MM at 8% and perhaps get a couple of bucks from warrant exercise, with the other side of the transaction being 100% capital loss. My guess would be that, if necessary, you will see the combined group recapitalize the entity. Again, I know very little about SWS (other than their television commercials are poor) or future capital needs. The SWS banking sub was on a cease and desist from the OTS earlier in the year. While not going into additional analysis may seem analytically lacking, it is a $50MM exposure or less than $1 per HTH share. The mention is rather to note the combined interest in SWS.

From SWS Press Release:

Completion of Capital Raise

On July 29, 2011, SWS Group completed its previously announced $100 million capital raise with Hilltop Holdings Inc. ("Hilltop") and Oak Hill Capital Partners ("Oak Hill Capital"). The capital will be used to address asset quality issues at the Bank and for other corporate purposes, including growth opportunities for SWS Group's broker-dealer. Pursuant to the transaction, Hilltop and Oak Hill Capital each made a $50 million loan to SWS Group, and SWS Group issued each of Hilltop and Oak Hill Capital a warrant to purchase shares of common stock of SWS Group at an exercise price of $5.75 per share. Upon full exercise of the warrants, Hilltop and Oak Hill Capital would each own approximately 17 percent of the Company.

The Company also announced that Gerald J. Ford, Chairman of the Board of Hilltop, and J. Taylor Crandall, Managing Partner of Oak Hill Capital, have joined the Board of Directors of SWS Group in connection with the closing of the transaction. [emphasis added] In addition, Hilltop and Oak Hill Capital each appointed a non-voting observer to the Company's Board of Directors.

Preferred redemption
While the announcement ruined my day in Q3 2010 given ownership of the 8.25% cumulative preferred (with a cost basis of roughly $18 for >11.44% annual yield), as owner (now) of the common the transaction freed up $10,312.5 in annual DSR.

Why Now?

This idea has not worked thus far. It is my belief that had the FRB, government et al. not interceded into the banking system that you would have seen HTH in an enviable position capitalizing upon the weakness. It appears to me that financials are again getting cheap, some for good reason and some are just getting thrown in with the group. While this time may not be different, I sincerely doubt you will see anything which resembles TARP. For the discriminating, well-connected, well-capitalized prospective buyer of financial institutions, I think the next few years may be immensely profitable. We shall see. Regardless, the situation, without significant cash burn appears extremely asymmetric.

Fair Value

I am unsure what fair value is, although it is at least at a slight premium to net cash and investments. Should further deterioration in the economy and banking system occur - which I expect - the upside could be considerable, assuming capital can be deployed. Given a very long time to look at potential targets, the operating environment, regulatory response, etc., the probability of any acquisition being successful has improved - not that it was low to begin with given Ford's history in the space.

Noted Risks:

- Lack of acquisitive behavior leads to hope of discounted transaction vanishing...further. In such a scenario, discount to TBV may not revert. Partially mitigated by indication provided by recent SWS transaction. Further mitigated by weakening in financial services broadly, which should provide additional opportunity to allocate HTH capital.

- Relative illiquidity of shares.

Catalyst

- For a third time on VIC, discounted acquisition in the financial services space.

- Reversion to historic discount to TBV.

- Supplemental earnings provided by Q3 2010 redemption of 8.25% cumulative preferred and 8% yield on $50MM SWS debt. The net earnings retention should improve, relatively to previous years, by $14,313 ($4,000 from SWS debt + $10,313 from Preferred no longer being paid).

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			2011	2012
Price:	7.50	EPS	$0.00	$0.00
Shares Out. (in M):	56,499	P/E	0.0x	0.0x
Market Cap (in $M):	424	P/FCF	0.0x	0.0x
Net Debt (in $M):	-501	EBIT	0	0
TEV (in $M):	-77	TEV/EBIT	0.0x	0.0x