Description

“Does anyone remember laughter?” – Led Zeppelin

“Does anyone remember equity accounting?” – VIC member

Safeguard Scientifics (SFE) has announced plans to liquidate and may be under imminent pressure from an activist fund (who already has 2 of 5 Board seats) to accelerate the liquidation timetable and further reduce operating costs.  After 2 recent asset sales, SFE has 19 venture investments in the healthcare, digital media and financial services businesses.   In general, initial investments range from $5-10 million and SFE is the lead financial sponsor and gets board representation in exchange for ownership of 20-50%.   The key to understanding the stock (and one of the reasons it doesn’t screen well) is that SFE uses equity accounting for its investments which likely dramatically undervalues the assets.  As an example, at the end of 2018, SFE’s investments which had a cost of $264 million were listed on the books for only $90 mm due to the use of equity accounting.

Equity market cap/book value of investments            2.6x

Equity market cap/cost of investments                       0.9x

SFE invests in venture portfolio companies, all of which lose money or have lost money in the past (not because they are bad companies but because they are early stage companies).  As a reminder, under equity accounting when one of its portfolio companies reports a net loss, SFE records its share of the loss as a loss on investment, which decreases the carrying value of the investment. Using the equity method, SFE reports the carrying value of its investment independent of any fair value change in the market value. 

An illustration of the difference between the fair value and book value can be seen in several of SFE’s recent exits:

Investment      Date sold         Sale Price        Book value      Gain    Sales Price/cost of inv

Media Math    July 2019         $45mm            $0                    $45                  4X

Propeller          Jan 2019          $41mm            $9                    $32                  3X      

Additionally, the buyer who purchased some of SFE’s Media Math shares listed above also has a right to purchase SFE’s remaining shares (which have a $0 book value, even though SFE recently sold the exact same share class at a huge premium) for $13 mm.  SFE is a venture portfolio so in addition to the gains listed above SFE has some (much smaller) losers.  A big catalyst could be the outcome from the reported Barclays-lead sale of Transactis, an e-billing company SFE invested $15 million in 2014/16 and has a book value of $7.7 million.  Finally, SFE has a large $300 million NOL which should minimize the cash taxes on any asset sale.

SFE’s 19 investments were made on average about 5 years ago and are in companies that can be classified by revenue stage as:

            -Revenue up to $1mm             2 investments

            -Revenue  $1mm - $5mm        5 investments

            -Revenue $5mm- $10mm        4 investments

            -Revenue $10mm +                 8 investments

The companies are projected to do $435mm of revenue in 2019 which would be an increase of 15% over last year.

The investor presentation on SFE’s website and the latest earning release give more detail about the portfolio companies.

In January 2018, SFE announced a change in its business strategy and operations to increase shareholder value.  SFE said it would not invest in any new companies and would focus on supporting existing partner companies and maximizing monetization opportunities for partner company interests to enable distributions of net proceeds to shareholders.

In April 2018, Horton Capital lead an activist group to make changes at the company.  While this group owned only 5% of the company, we believe the group had support of other large holders.  As a result of the activism, the CEO and CFO departed and a settlement agreement resulted in the board being dramatically reconfigured and Horton got 2 of 5 board seats.  The standstill of the settlement agreement has recently expired and we believe we may see additional changes or activism that may lead to increased shareholder value as the nomination window is now open for a short period of time.

In February 2019 SFE hired Evercore to assist in exploring strategic alternatives which we view as a shareholder friendly move.

Some of the issues an activist may focus on:

1)      1) How quickly should the company liquidate?  Management’s incentives may not be aligned with all shareholders on this topic as management owns little stock but does receive a pretty nice annual compensation package.  Although there is an undisclosed bonus pool for management based on dollar value of asset sales, activists may wish to make sure asset sales are being done in the time manner most beneficial to shareholders.  Management has indicated it may take 4 years to liquidate the portfolio, we would bet on the under. 

2)    2)   How much should the company spend during the liquidation period?  Management appears pleased that is has brought down its annual operating expenses to approximately $8 - $9 million.  This figure seems incredibly high to me considering the company has no operations (besides its investments) and only 13 employees.  Activists may wish to understand how operating costs can be further reduced perhaps by reducing the $800k annual audit fee paid to KPMG (why does this company need to use KPMG??) or reducing rent ($0.6 million annual for 13 people in Radnor, PA), etc.

3)    3)   Previous management entered into a ridiculous debt deal whereby the company must make mandatory repayments based on a formula of asset sales AND pay full interest until maturity assuming the prepayment hadn’t been made.  So even though the company has no net debt and shouldn’t in the future, it must still pay cash interest until the debt matures in May 2020 and lets say its paying L+8.50.  In other words, the company doesn’t get any benefit from prepaying debt. Stock buybacks are prohibited under the terms of the debt.

The activist fund is Horton Capital which is run by Joe Manko, Jr. whose bio follow: Joe has over 20 years of investment experience, predominately in the asset management, investment banking, private equity and corporate securities markets. From 2005-2010 Mr. Manko was a Partner and Chief Executive Officer of Switzerland-based BZ Fund Management Limited, where he was responsible for corporate finance, private equity investments, three public equity funds and the firm’s Special Situations and Event-Driven strategies. Prior to that Mr. Manko was a Managing Director with Deutsche Bank in London where he was head of their European and Asian Equity Capital Markets business. He began his investment banking career at Merrill Lynch as a Vice President in Hong Kong.  Before beginning his investment banking career, Mr. Manko was a corporate finance attorney at Skadden, Arps, Slate, Meagher & Flom. Mr. Manko has served on the board of several European companies, participated in numerous successful shareholder value creation strategies and helped companies raise substantial amounts of growth capital. Mr. Manko earned both his B.A. and Juris Doctorate from the University of Pennsylvania.

Horton filed its first 13D in Jan 2019 disclosing an approximate 5% stake with an average cost of approximately $12.10 so they remain underwater

Valuation:

This is a very back of the envelope analysis.  The key is how much they will be able to monetize their assets for. 

Remaining interest expense                $(15)    $10mm for 1.5 years

Remaining operating costs                  $(21)    3 years at $7mm annually (should be less)

Taxes                                                   $0       

Net Debt                                             $0        (pro forma Propeller asset sale in q1 2019)

            Total remaining liab                $36 million

So, what is the value of the 19 remaining investments which have a book value of $80mm and cost of $244mm.?

Cost of investments                244                  244                  244

Sale multiple                           1.0x                 2.0x                 3.0x

Implied EV                             244                  488                  732

Less: Liabilities                       36                    36                    36

Implied Equity Value             208                  452                  696

This stock has done poorly over 1,3,and 5 year time periods.  Investor fatigue has set it.  It doesn't screen well and isn't easy to understand.  There’s a 16 day to cover short interest ….what happens when the company announces more assets sales (as management has promised) and begins buying back stock?

Catalyst

additional shareholder activism, asset sale, increased investor awareness, stock buybacks