Description

Last November I posted Hilltop Holdings (HTH) as a long idea with the following thesis:

“Hilltop Holdings is a special situation that allows you to invest at a *large discount to cash* alongside an investor, Gerald J. Ford, with a proven track-record generating value in the very corner of the market, subprime lending, that is getting most punished right now.”

In recent weeks we have received more information about how Hilltop will be investing its money and I think the situation warrants a new writeup. Despite being little more than a pile of cash, Hilltop Holdings has traded down 15% since I originally posted the idea. Thus, today you can invest alongside Mr. Ford at an even larger discount to cash. The Hilltop funds will be invested in a new bank, Ford Group Holdings, which several weeks ago was granted the first national shelf charter allowing it to buy failed banking assets directly from the FDIC. The charter gives the new bank access to the FDIC’s list of troubled banks and is another indication of Mr. Ford’s valuable relationship with regulators. Mr. Ford has raised a large private equity fund that will invest alongside Hilltop Holdings in Ford Group Holdings. In other words, sophisticated investors have lined up to pay hefty fees to Mr. Ford at a time when dry powder is very valuable. As investors in Hilltop, we are effectively being paid to invest alongside this high-fee money. Mr. Ford himself clearly views this as a silly valuation and he has bought large amounts of HTH preferred and common stock at prices above the current trading levels.

In short, since I posted this idea one year ago: 1) the discount to cash is larger, 2) insiders have bought large amounts of stock above current trading levels, and 3) we know exactly how Mr. Ford will use the money - to buy distressed banks. It is also worth pointing out that while many sophisticated financial services investors waded in early, Hilltop management has been very cautious and has mostly stayed on the sidelines. At the company’s shareholder meeting in July, CEO Larry Willard was very bearish and said the company was unlikely to wade into deals where it would have to take on balance sheet risks. 

A little company history

As I discussed in the previous writeup, Hilltop was formerly called Affordable Residential Communities (ARC) and operated manufactured home communities. In the middle of 2007, ARC sold its core operations to Farrallon for $1.8 billion and retained a medium-sized tax asset as well as a tiny P&C insurer called NLASCO that is based in Waco and has a small business insuring low-income dwellings. Upon completion of the sale, management stated it would use the cash balance to invest in the financial services sector. 

Before we discuss Hilltop’s actions over the past year, I think it’s worth understanding the valuation and what you own.

Valuation

Hilltop shares at $8.80 give us a market cap around $497mm. The company has net cash of $8.95 per share. This is a conservative estimate because it includes NLASCO debt in our calculation of net cash without including any of NLASCO’s cash and short-term investments. If we separate out NLASCO, HTH has about $9.70 in cash per share. The company will see some cash outflows from hurricane related losses ($14mm - which we will discuss below) but also has an income tax receivable of $27mm as well as a $16mm deferred tax asset. We will discuss below why it makes sense to exclude NLASCO from the calculation of net cash.

So the bottom line is for $8.80 a share, we are buying $9.70 per share in cash and we get a niche insurance company that has been historically profitable and as we will discuss below, was purchased for over $2 per HTH share. 

NLASCO

NLASCO provides fire and homeowner insurance for manufactured homes mostly in Texas. The company was purchased by ARC in early 2007 for a combination of cash and stock valued at around $120mm (over $2 per HTH share). The company has a history of dependable earnings – average net income from 2003 to 2006 was $16.5mm. For 2007, its first year as a part of Hilltop, NLASCO earned about $14mm in what was a tough year in the P&C industry. In 2008, NLASCO suffered through a very tough environment for insurers and was also hit by three named storms including the very destructive Hurricane Ike. The company had losses of $14mm related to the three named storms.         

The company is very conservative with its capital, has avoided large investment losses and reinsures against catastrophic risks. While the market has decided that NLASCO is worthless and cash in the hands of Gerald Ford is worth less than cash in our hands, we think NLASCO easily gives the company at least another $1 per share in value. $1 per share would value the company at about 5x the average of the last 6 years after-tax earnings, which includes this year’s small investment losses and the $14mm hurricane hit. If NLASCO is worth only $1 per share, then we are buying Hilltop cash at a 20% discount. Is that 20% discount fair? Let’s discuss Mr. Ford’s track record:                                          

Who is Gerald Ford and why should I give him $8.80 of my money to let him invest $9.70 for me?

Gerald J. Ford is a highly-successful Texas billionaire banker with a 30+ year history of buying and selling thrift banks, first in Texas and later in California. He is perhaps most famous for teaming up with Ron Perelman to buy five insolvent thrifts in Texas and Oklahoma in the late 1980s which he sold in the early 1990s at an estimated profit in the hundreds of millions. He and Perelman teamed up again in 1998 to buy into Golden State Bancorp via a reverse merger.    Ford was the chairman and CEO of the company, which he sold at a large profit to CITI in 2002 for $6B. It is worth noting that while Ford made a large amount of money on the Golden State deal, the stock plunged 44 percent in the first 8 months he owned it due to a tough economic climate for thrifts and investor wariness over Perelman. While his Perelman deals are the most famous, Gerald Ford perhaps had his most success rolling up Texas thrifts on his own starting in the mid-1970s. He sold most of these in a 1994 deal that grossed him $495MM.               

Mr. Ford is chairman of the board and owns about 27% of Hilltop Holdings common stock. He has recently bought some Hilltop preferred stock (which yields about 13%) and he bought Farallon’s 10% block of Hilltop common at $9.75 per share. Over the past few months, Ford has bought a combined $63mm worth of Hilltop common and preferred stock for himself in negotiated transactions. This is another important point. Hilltop bears had pointed to Mr. Ford’s relatively small ownership stake in the company and the formation of his new private equity funds as evidence that Hilltop is not a high priority for him. Recent events have proven this to be untrue.        

Ford’s new bank, Ford Group Holdings, will be capitalized with about $1.4b, about half of which will come from Hilltop Holdings. The remaining funds will come from Mr. Ford’s recently-raised private equity funds.   

Two recent Ford negotiations:

Fremont General

Gerald Ford is known as a tough negotiater. A look at his 2007 negotiations with Fremont General is very instructive and will give you comfort that Ford is a great person to invest alongside with during this tough time for financials. As you may recall, Fremont negotiated a deal with Ford and then issued a misleading press release that stated Ford’s group “had agreed to buy preferred stock and warrants that would be exchangeable into common stock at $8.44” a share. A close reading of the 8-K revealed:

1) After the deal was to close, the conversion price would be reduced to 75% of tangible book value per share for the warrants and 85% of book for the preferred. The “tangible book value” at this reset date would be larger than it was at the closing date, because Fremond would increase its loss reserves. Additionally, the investor group would have the right to disapprove Fremont’s estimate of loss reserves if they “reasonably” disagree.

2) The conversion price would be reduced again on June 30^th, 2010 to reflect the company’s ACTUAL loan loss experience. By that time, Ford would have been in control of the company for several years, so he could take very aggressive reserves if he needed to.

3) After insurance litigation is resolved, conversion prices will be reduced yet again to reflect actual losses from litigation. 

In other words, Ford had negotiated a deal that gave him a conversion price equal to 75% of whatever tangible book value turns out to be after Fremont takes all its losses. On top of that, if Fremont turned out to be insolvent and its common stock worthless, Ford’s preferred stock was issued by the bank subsidiary, and thus senior to the debt of the holding company that has issued the common stock. Also, the deal included a very easy out for Ford should he end up not wanting to close on the deal later in the year. . .and this is what happened. After all was said and done, Ford ended up walking away from Fremont. 

 Downey Financial

 When I originally posted Hilltop as a VIC long idea, the company had just filed a 13-D in Downey Financial showing a $63mm equity investment in the company. As we all know, Downey has since turned into a zero. Mr. Ford was familiar with Downey and bought a 5% position to get himself to the negotiating table with hopes of merging the companies. Once Hilltop got a good look at DSL from the inside, they blew out of their stock position very quickly. It looks like the company sold the entire DSL position for a gain, though we cannot know the details for sure. 

Hilltop investment losses

While you are probably reading this thinking I must believe Gerald Ford is the second coming of the lord, it is important to point out that Hilltop has taken some lumps on passive equity investments in 2007 and 2008. In total, Hilltop has lost about $43mm in equity investments. We discussed these losses with management at July’s shareholders meeting and the company assured us that they were taking a much more conservative approach and were no longer making passive equity investments. We think this is an important data point for potential HTH investors. To a certain extent this is a “black box” investment, and by no means is Mr. Ford infallible. Still, we like what we have seen from the company to date. Hilltop quickly backed away from Downey and it has not chased its equity losses as the financial crisis has deepened.

Ford Bank

As Hilltop management predicted in July, the financial crisis has worsened significantly and we are now seeing large numbers of bank failures. This is exactly what the company has been waiting for and Mr. Ford has recently been given the first national bank charter that allows investment firms and public companies like Hilltop the ability to participate in bank deals. When the OCC decided to allow such banks to be formed by private equity funds, Gerald Ford was the FIRST person to be given the charter.             

http://www.occ.treas.gov/ftp/release/2008-137a.pdf

We expect that Ford Bank will be able to buy bank assets without taking on major liabilities, a similar situation to what happened in Texas in the early 1990s. 

Conclusion

 My conclusion here is essentially unchanged from the conclusion of my previous Hilltop writeup:

“Value investors seek to profit off of panic and fear. Until recently, 2007’s market panic was isolated to a specific market sector that is difficult to understand and analyse. Because it is so hard to value financial businesses, many value investors have been badly burned trying to capitalize off of the sector’s distress. I view Hilltop as a much safer way to invest in the distressed lending industry.”

Catalyst