Description

Signature Group Holdings, Inc. (SGGH), which is the reorganized Fremont General Corp., has a long and complicated history. However, present-day SGGH is relatively simple to analyze and value: cash, a good operating business, debt and sizable NOLs. I estimate SGGH is worth around $0.63-0.99 per share before the NOLs, which could be worth $0.51-1.31 per share. I regret not posting the idea sooner – the stock was around $0.60 at the beginning of June 2013 – but I believe there is considerable upside remaining as the path to valuation creation has improved.

Background

Fremont General, one of the largest subprime mortgage lenders, filed for bankruptcy in June 2008 and ultimately emerged from the highly-contested bankruptcy under the Signature/Noell plan two years later in June 2010. Since emerging from bankruptcy, there have been multiple proxy battles (McIntyre 2012, Charlestown/Bouchard 2013), significant board and management turnover, a legal battle over a rights agreement/poison pill, transition to internal management from external management and an unclear/shifting strategy. I suggest you visit the bankruptcy and EDGAR filings if you want to understand the history. The latest proxy fight was settled and as a result Craig Bouchard was named Chairman and CEO and a revised board slate is up for vote on 7/16/2013. Additionally, one of the key proxy proposals is to increase the number of common shares authorized for issuance from 190mm to 665mm, which the company expects to utilize if it pursues an acquisition funded by a rights offering to protect the NOLs (see discussion below).

I do not have any particular insight into Bouchard, the new Chairman and CEO effective 6/4/2013. From the proxy:

Mr. Bouchard is also Chairman of the Board and Chief Executive Officer of Cambelle-Inland, LLC, an entity created in 2013 through which Mr. Bouchard manages certain investment activities in China. Prior to founding Cambelle-Inland, LLC, in 2010, Mr. Bouchard founded Shale-Inland, a leading master distributor of stainless steel pipe, valves and fittings, and stamped and fabricated parts to the US energy industry with revenues approaching $1 billion. Mr. Bouchard served as the Chief Executive Officer and later as the Chairman of the Board of Shale-Inland through 2012. Before founding Shale-Inland, Mr. Bouchard was President and Vice Chairman of Esmark, Inc., a publicly traded company on the NASDAQ. Mr. Bouchard co-founded Esmark, Inc. in 2004. Mr. Bouchard was named a finalist for the 2005 Ernst & Young Entrepreneur of the Year Award in Illinois. His team later crafted the first and only hostile reverse tender merger on Wall Street, successfully replacing 9 directors of Wheeling Pittsburg Corporation in 2007. In doing so, Esmark became the nation’s fifth largest steel company. During Mr. Bouchard’s tenure, Esmark’s revenues grew from $4 million to over $3 billion. The company was one of the highest appreciating stocks on the NASDAQ or the NYSE for the full year 2008. The story was told in “America for Sale,” Copyright 2009, Craig T. Bouchard and James V. Koch (ABC-CLIO). From 1998-2003, Mr. Bouchard was the President and Chief Executive Officer of New York based NumeriX, a risk management software company commanding a leading market share on Wall Street. Mr. Bouchard holds a Bachelors degree from Illinois State University, a Masters Degree in Economics from Illinois State University, and an MBA from the University of Chicago. He has been a member of the Board of Trustees of Boston University and the Foundation of the University of Montana. He is currently a member of the Board of the Department of Athletics at Duke University. Mr. Bouchard holds United States Patent No. 4,212,168, Power Producing Dry-Type Cooling Systems, and has authored, with James V. Koch, the book “The Caterpillar Way. Lessons in Leadership, Growth and Stockholder Value,” Copyright 2013, (McGraw Hill, November 2013; www.craigbouchard.com).

Interestingly, Sam Zell entities (Zell Credit Opportunities Master Fund, Chair Trust Company) own 11.3mm SGGH shares and Phil Tinkler has a board seat. Tinkler is the COO/CFO of Sam Zell’s Equity Group Investments and also was the CFO at Covanta, which SGGH cites as a possible model (NOL, rights offerings). It’s important to note that the Zell stake is very small in relation to his net worth.

Valuation

Step 1: Value easy-to-value assets and liabilities. I arrive at a value of $0.27 per share after adjusting the most recent 10-Q for some recent asset sales ($18.9mm cash proceeds on 5/9/2013 and $8.6mm on 6/20/2013; see filings for details).

Step 2: Value SGGH’s main operating business, North American Breaker Co. (NABCO), which is a specialty industrial supply company. While there is not a significant amount of disclosure around NABCO, the company appears to be an attractive replacement-oriented distribution business with strong margins (37% gross, 25% EBITDA) and minimal capital expenditure requirements. From the company’s filings:

[NABCO] is based in Burbank, California and is one of the largest independent suppliers of circuit breakers in the country. We focus exclusively on the replacement circuit breakers market, particularly for commercial and industrial circuit breakers, where replacement time is extremely important, but we also supply residential circuit breakers. We operate from five warehouse locations across the United States, which enables us to improve customer delivery times, a key attribute of our service-oriented model.

Because circuit breakers are critical components of most electrical systems, they must be replaced immediately when damaged. Our primary focus is on the replacement market, particularly for commercial and industrial circuit breakers where replacement time is extremely important. We believe the replacement market niche has fewer large competitors and is less dependent on macroeconomic trends than serving the new construction market. Circuit breakers are manufacturer specific and generally not interchangeable, so product availability and knowledge in the replacement niche is very important. Accordingly, we maintain a significant depth of certified, new product inventory from all the major manufacturers, as well as a considerable investment in discontinued, end of life inventory that is no longer widely available. We do not manage our operations in terms of inventory turns or other traditional operating inventory metrics; rather, our inventory levels may increase in a declining sales environment if valuable purchase opportunities present themselves as there is minimal risk of obsolescence for these products.

We are a national supplier selling exclusively to wholesale electrical distributors and operate from five warehouse locations across the country. This national presence allows us to service a broad section of our customer base with next day ground shipping, providing a competitive advantage for the mission critical components we supply. In 2012, we served approximately 600 customers, shipped approximately 5,500 SKUs to over 3,000 customer locations nationwide. Our customer base includes many of the largest wholesale electrical distribution companies in the nation, who find it impracticable to stock more than a limited amount of circuit breaker inventory, given the broad number of SKUs and infrequent demand, and prefer the convenience we offer as a just-in-time supplier. By providing industry-leading customer service, maintaining an extensive inventory, and offering same day shipping, we have become a preferred supplier for many of our large wholesale electrical distributor customers. Customers for whom we are a preferred supplier represented 51.1% of Industrial Supply net sales in 2012.

Other pertinent business factors include:

• our business is seasonal with higher sales volume occurring during the summer months as weather conditions drive increased electrical usage;
• our business operates in a highly fragmented market with hundreds of competitors, although few have our depth of inventory or national presence; and
• we do not sell used circuit breakers, nor do we refurbish circuit breakers.

NABCO generated $9mm of adjusted EBITDA on $36.2mm in sales in 2012, which is an increase from $8.3mm of adjusted EBITDA on $32.1mm in sales in 2011. SGGH disclosed in the 2012 10-K that NABCO revenue and EBITDA are tracking 11.8% and 45.4% higher than original estimates (related to goodwill impairment test). I value NABCO at 5-10x 2012 EBITDA or $0.36-0.72 per share. It is worth noting Signature paid around 4.5x EBITDA but larger wholesale distributors (MSM, GWW, DXPE, AIT) trade around 10-11x 2013 EBITDA.

Step 3: Value NOLs. SGGH had $886.9mm of net operating loss carryforwards (NOLs) as of year-end 2012 and the NOLs begin to expire in 2027. Ultimately, the value of the NOL will be determined by the company’s success in acquiring cash flow generative businesses because NABCO, the main operating business, only generates around $9mm of EBITDA per year. I estimate the NPV of the NOL is worth around $64-164mm which is 7-18% of undiscounted NOL based on a range of various acquisition scenarios. For a point of comparison, both McIntyre and Charlestown estimated the NOLs at $90-180mm during the 2012 and 2013 proxy fights.

The acquisition strategy and timing is still uncertain, however, a recent 8-K (6/12/2013) included some hints:

In expressing enthusiasm for the potential of the Company, Mr. Bouchard reported a desire for the Company to pursue a focused strategy of growth through acquisitions, with a goal of each transaction being accretive. He stated that the Company would continue to pursue additional acquisitions and indicated an anticipated preference for transactions in the $100 – 400 million EBITDA range.

Mr. Bouchard, Mr. Tinkler and Mr. Manderson discussed generally that the Company would seek to utilize rights offerings, as discussed in the Company’s definitive proxy statement filed with the SEC on June 10, 2013, as a way to support and pursue acquisition activity. They added that recent improvements in the Company’s share price caused the Company’s market capitalization to exceed the $75 million threshold for eligibility to use a Form S-3 registration statement, enabling the Company to register securities on Form S-3 as long as it remains current in its SEC filings. Therefore, the Company could also consider utilizing a shelf registration statement on Form S-3 to register stock for rights offerings, potential acquisitions and other business purposes.

Furthermore, during the proxy process, SGGH cited the Covanta (CVA) model, which made acquisitions funded by pro-rata rights to protect the NOL. It’s important to note that one existing and one proposed board member have experience at Covanta (Bynoe, Tinkler). 

Other considerations: my valuation (1) assigns no/minimal value to Cosmed, which the company acquired for $2.6mm in 2011 and is currently in discontinued operations, (2) deducts the full $7.25mm repurchase reserve (related to subprime mortgages) from the NAV and (3) may understate certain other assets based on the company’s fair value disclosures.

I use 125mm diluted shares to calculate NAV, but note that SGGH has 122mm common shares, 15mm shares related to warrants ($0.66-0.69 exercise price, June 2020 expiry) and around 2mm options outstanding.

Key risks

• Cash burn related to corporate overhead
• Dilution related to board/executive compensation
• Expensive/bad acquisitions
• Slow monetization of NOLs
• Legacy issues – repurchase reserve ($7.25mm as of last 10-Q), unpaid claims ($5.1mm as of last 10-Q)

Catalyst