Hilltop Holdings $10.50

 

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. 

 

Company History

 

Hilltop Holdings (HTH) was formerly known as Affordable Residential Communities (ARC), and until recently the company operated manufactured home communities and ran a P&C insurance company based in Waco called NLASCO.  On July 31^st, 2007, ARC sold the manufactured homes business to Farallon for $1.8 billion and changed its name to Hilltop Holdings.  The company is now comprised of the profitable NLASCO business and a large cash balance.  Net cash excluding NLASCO comes out to $11.34 per share.  If you include NLASCO’s debt but not any of its cash or investments, net cash per share is still $10.43.        

 

Management intends to use the excess cash balance to make an acquisition in the financial services sector.  Hilltop has recently filed a 13-D on Downey Financial and has expressed interest in a possible business combination.  HTH is down 15% since the D was filed and has been downgraded by sell-side analysts who are hoping Ford will focus his sights on something a little less hairy.                     

 

Brief NLASCO Background

 

NLASCO provides fire and homeowner insurance for manufactured homes in Texas and several other states in the South.  The company was purchased by ARC early this year 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.  Over the 8 months HTH has owned NLASCO (8 months which have been tough for Texas home insurers), net income has been $7MM (annualizing that gets you $10.7MM).  As we will discuss below, at current prices, NLASCO is valued at only $3MM by the market.      

 

NLASCO’s former chairman and chief executive officer, Clif Robinson, is now on Hilltop’s Board of Directors.  He owns over 1.2mm shares of HTH.  It is worth noting that of NLASCO’s $181MM in cash and investments (note: none of this cash is included in the $850MM Hilltop cash balance), only $13.1MM are mortgage-backed securities.     

 

Valuation

 

At $10.50, Hilltop’s market cap is about $590MM.  Cash is $850MM, with debt and preferred stock of about $210MM.  The company also has taxes payable of $80MM and a deferred tax asset worth $28MM.  This would bring total TEV to $3MM.  If you want to be very conservative and include NLASCO’s debt of $51.5MM, TEV would still be only $54MM.       

 

Gerald Ford

 

As you can see from the valuation discussion above, buying Hilltop allows you to invest alongside Gerald Ford and get an insurance company worth probably $2.00 a share for free.  Another way to put this is that you get to buy into an unpromoted Gerald Ford SPAC at a 20% discount to cash.  Why is this a wonderful bargain? 

 

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.                       

 

Ford is Chairman of Hilltop’s board and owns about 17% of the stock.  Numerous sources confirm that HTH is his main priority right now.  When shareholders were voting on the company’s deal to sell its manufactured homes communities, Ford personally met with shareholders to discuss the benefits of the sale.  As he put it, “We’re getting out of something we don’t know much about and getting into something we know very well.”   

 

Ford’s Flirtation with Fremont

 

Gerald Ford is known as a tough negotiater.  A look at his 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 will 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. 

 

I don’t want to be harsh or disrespectful, but let’s compare this deal to a similar investment made by successful value investor Mohnish Pabrai.  If you do not know of him, Pabrai has built an incredible track record buying undervalued companies over the last 7 or so years.  Yet, his preferred investment in Delta Financial is evidence of how you can get burned investing in this space.  Pabrai’s preferred had no security, no structural seniority to any debt and is basically worthless in a bankruptcy.  Whether or not he is more correct or not on value is a different point, but I do wish to show how Ford’s sophisticated dealmaking adds value and should not be trading at a 20% discount.

 

Downey Financial

 

The market is apparantly in a panic about Gerald Ford’s 6.8% investment ($63MM) in Downey Financial (which is up from his purchase price) and the possbility of a merger.  One sell-side analyst who had upgraded the pile of HTH cash after the manufactured homes sale actually downloaded the pile of cash after the DSL 13-D because of “our ambivalence on an acquisition of this nature.”  Yet they upgraded the stock when Gerald Ford was telling everyone in the world he was going to make an acquisition in the financial services space and his specialty is thrifts and subprime lending. 

 

I have no great insight into the intrinsic value of DSL.  The company has been written up on VIC so I know there are members who have followed its saga more closely than I have and I would love for them to contribute to the discussion. The company has a valuable deposit franchise with owned branches and some analysts have estimated the true takover value of DSL to be well over $60.  It looks cheap on some superficial metrics, but I’ve often found that financials companies just don’t disclose enough information for me to make a good enough assessment of value myself.  Given Gerald Ford’s track record of success investing in this space, I have some faith that he will not lead HTH shareholders into a disastrous value-destroying deal.  Still, this the fundamental risk with this investment; we don’t really know what Ford is going to do.  If he negotiates a bad price for Downey, and if Downey’s franchise and balance sheet are damaged worse than Ford estimates, HTH shareholders could lose badly.  This is the risk you have to be comfortable with to make this investment.       

 

Conclusion

 

This is a very simple special situation that gives us an opportunity to invest alongside a proven investor at a discount to cash.  This is not the kind of stock you want to bet the ranch on, but HTH has many things going for it:

 

1) HTH trades at probably a 20% discount to cash value, given a fair value for NLASCO.

 

2)  Controlling shareholder Gerald Ford will make an acquisition in the financial services sector with that cash.

 

3) Ford has a proven track record generating value from buying underperforming lending companies.