Description

SWK was most recently written by Banjo in mid-2013.  Since then, I believe there was been enough business development to warrant a follow up to the analysis.  Since prior write ups have discussed the corporate history, I will not delve into that area.  The core of my thesis is relatively short and simple, but I have also included a section on various notes on the Company’s investment portfolio.  

Key investment highlights include:

• Stock is cheap:  Stock trades at 1.11x BV and 13.9x LTM P/E. (excluding tax benefits)    

• Extremely valuable NOL asset:  The Company has $421 million of federal net operating loss (NOL) carryforwards.  The NOLs will expire between 2021 and 2032.  A large portion of the NOLs will expire on 2021, but the Company will still have ~$100 million after that.    

• Strong IRR on investment portfolio:  Company targets investments with mid-teen IRRs.  Actual performance has been high-teens to low-twenties IRR.  

• Low overhead, highly scalable model:  The Company only has three employees on the investment team with two employees in back office (one of which is part-time).  In FY 14, the Company operated on $3.3 million of G&A.  Company operates out of a 2,400 square foot office in Dallas.  

• Management and Carlson’s interest aligned with shareholders:  Carlson Capital owns 91.1 million shares or 69.0% of the Company.  Both the CEO and Managing Director own 1,750,000 options, part of which only vests if the stock hits certain price levels.  Management is compensated based on a percentage of pre-tax profit and ROE, incentivizing them to maximize profit.

• Opportunity to gain exposure to a diversified stream of healthcare/biotech cash flows:  An investment in the Company offers investors broad exposure to the health care sector from dental products to cyclotrons to artificial hearts.

• No analyst coverage:  The Company is completely underfollowed with no analyst coverage.  I was the only shareholder that made it to the annual meeting this year.

Strategy:  SWK was formerly a NOL shell.  Over the past two years, the Company has really come a long way in its financing strategy.  SWK’s strategy is to focus on investing in the life sciences industry, which includes biotech, medical device/diagnostic, animal health, and pharmaceutical companies.  The Company’s investments typically fall under three categories: (1) royalties, (2) debt structured as synthetic royalties, and (3) equity (common shares, preferred shares, and/or warrants).  The Company intends to focus on sub-$50 million transactions.  Through May 2015, the Company deployed $134.6 million of capital through 16 transactions (two of which were prepaid early).

Strong results:  Since SWK began its new strategy two years ago, results have been very impressive.  The Company generated 2014 revenue of $17.4 million and profit of $13.3 million (before tax benefits).  In addition, the Company generated 2014 adjusted cash from operations of $8.3 million.  The trend continued in Q1 15 where SWK generated revenue of $5.8 million, profit of $4.6 million, and adjusted cash from operations of $4.2 million.  In Q1 15, the investment portfolio generated a weighted average annualized return of 17.8% as outlined below:  

Despite the strong operational performance since inception, SWK only trades at a slight premium to book value and 13.9x LTM earnings.  Given the strong performance in 2014 and an annualized 17.8% portfolio return in Q1 15, I believe SWK will be able to continue to grow book value in the mid-teens rate over the next few years.  

Management and directors incentives aligned with shareholders:  I would also like to take some time in the write up to discuss management incentives.  SWK is led by CEO Brett Pope, Winston Black as Managing Director, and Quinn Mellette as Senior Analyst.  All three members of the management team have worked together at one point in the past:

Both Brett and Winston are compensated through a percentage of pre-tax profit (11.0% for 2015) and return on equity.  In addition, Both Brett and Winston each hold 1,750,000 options, split into two tranches (750,000 and 1,000,000).  The 750,000 tranche will vest in 25% increments based on the Company’s 60-day average stock price performance between $1.24 and $2.49 prior to 12/31/18.  For the 1,000,000 option tranche, 50% will vest over four years beginning on 12/31/15.  The remaining 50% will vest if the 30-day average closing stock price exceeds $2.06 prior to 12/31/18.  Given the compensation scheme (profits, ROE, and stock price performance), I believe management’s incentives are well aligned with shareholders.  

In addition, the controlling shareholder, Carlson Capital, owns 91.1 million shares representing 69.0% of the Company.  Overall, I feel comfortable leaving Carlson in charge here for a few reasons.  First, in August of 2014, Carlson bought 73.3 million shares of SWK in a private transaction for $1.37 to provide it with capital to grow the business.  The price represented a premium of over 20% from the prior trading day.  Second, I felt that the rights offering last year was very shareholder friendly and allowed minority shareholders to acquire additional shares at a discount to the then market price.  Finally, based on my time with some of the Carlson representatives at the annual meeting last month, I feel confident that they are competent in basic capital allocation that will benefit all shareholders over the next few years.  

Stock will likely be up-listed near-term:  A key objective of the annual meeting this year was to give the board the power to effectuate a stock split so the Company could list on a major exchange.  Up-listing will likely bring more attention on the stock and potential analyst coverage.  

Conclusion:  Overall, SWKH is a decently cheap stock, trading at a small premium to book and 13.9x LTM P/E.  The Company will not be paying taxes for many years given its large NOL balance.  Its investment portfolio has consistently generated high-teens and low twenties returns on investment.  Management is incentivized to grow profits and realize stock price appreciation.  

As I said before, the thesis is relatively short and simple and this concludes my major thoughts.  However, I have also included a section on various notes I have on some of the Company’s investment portfolio:  

Date of investment: 12/20/12

Company: Holmdel Pharmaceuticals

Type: Equity investment/royalty

Investment: $6,000,000 from the Company

On 12/20/12, Holmdel Pharmaceuticals, LP (Holmdel) acquired the US marketing authorization rights to InnoPran XL, a beta blocker indicated for the treatment of hypertension from GlaxoSmithKline for $13.0 million.  InnoPran XL was a very small drug in GSK’s portfolio and was relatively immaterial to GSK’s operations.  As a result, InnoPran XL was really under-marketed.  

Through a subsidiary, SWK Holdings GP LLC, the Company acquired an acquired an 84.1% interest in Holmdel for $13 million.  The Company provided $6 million of the capital, while a Swiss investor provided the remaining $7 million.  The other 15.9% interest in Holmdel is owned by a third party, Holmdel Therapeutics, LLC.  

Under the terms of the partnership agreement, SWK GP will receive quarterly distributions of cash flow generated by InnoPran XL.  Until it receives a 1.0x cash on cash return on its interest in Holmdel, SWK GP will receive 84% of InnoPran XL’s cash flow.  As the cash on cash multiple received increases, SWK GP’s interest in the cash flow stream decreases, but will not decline below 39.0%.  In February 2015, the Company fully recouped its investment in Holmdel.  The Company’s return on the Holmdel investment has been spectacular.  SWK generated a 41.2% return on investment in 2013 and 52.3% in 2014.  

I expect 2015 to also be a strong year for Holmdel, although the return should be lower given that the Company recouped its initial investment.  

Date of investment: 08/08/13

Company: Tribute Pharmaceuticals

Investment: $14,000,000

Maturity: 08/08/18

To date, SWK has advanced $14,000,000 million to Tribute as a senior secured first lien loan.  On 06/08/15, POZEN announced it would acquire Tribute Pharmaceuticals.  This would trigger a change in control under the loan agreement with SWK.  If the deal closes before 10/1, SWK will receive a 3.0% prepayment fee on the principal outstanding and a 1.0% exit fee, plus any accrued interest.  

Throughout the financing process, Tribute also issued numerous warrants to SWK.  As of 03/31/15, SWK held the following warrants for Tribute’s common shares: (1) 347,222 warrants at an exercise price of $0.432/share, (2) 755,794 warrants with an exercise price of $0.60/share, and (3) 740,000 warrants at an exercise price of $0.70.  As of the Friday’s close, Tribute’s US shares closed at $1.63/share.  Assuming the Company did not exercise the warrants yet, they would be potentially worth $1.9 million.  

Date of investment:   12/10/13

Company: Private dental products company

Investment: $6,650,000 (all from the Company)

Maturity: 12/10/18

SWKH entered into a credit agreement with a private dental products company wherein it provided a term loan of $6 million.  The Company also received a warrant to purchase up to 225 shares in the private company’s common stock, which if exercised, is equivalent to approximately a four percent ownership on a fully diluted basis. The warrants expire on 12/10/20.  

The private dental company is currently in default under the terms of the credit agreement and the Company has classified it as non-accrual status (since Q4 14).  However, the Company has not recorded any impairments on this investment.  On 01/08/15, SWK advanced another $650,000 to the dental products company.  

The cause of the default was a working capital squeeze.  An Asian partnership that would have had some upfront fees paid to the dental company fell through and the dental company had already spent the money on the working capital.  SWK advanced the additional $650,000 because it felt it was best for the value of the business for certain vendors to be paid.

Date of investment: 12/13/13

Company: SynCardia Systems, Inc.

In December 2013, the SWK originally advanced $4 million to SynCardia in a senior secured first lien credit facility loan and $6 million in a second secured second lien loan.  Further, in September 2014, the Company purchased 1,244,511 shares of Series F preferred shares of Syncardia.  The second secured loan was subsequently repaid in February 2015 for total consideration of $10.2 million, consisting of $1.8 million of cash, $6.9 million of senior secured second lien convertible notes, and 1,079,138 shares of Series F Preferred stock.  The convertible notes are convertible into common shares at a 25% discount to the price of the IPO.  

If SynCardia IPOs, SWK’s ownership on common shares could be in the high single digits to 10%, but it depends a lot on the size of the IPO and at what price.  The interesting thing about SynCardia is that it is a dominant player in the artificial heart market, and from what I understand, superior to alternatives in the market.  Since SynCardia is private, there is not a lot of information out there on the financials.  However, according to a local Tucson news article, in 2012 SynCardia generated $25 million of revenue, up 500% from 2009.  

From my understanding, SynCardia is attempting to IPO itself, potentially as early as this year.  If the IPO process goes smoothly, SWK could potentially get a large return on its preferred shares and convertible notes.  

Catalysts:

• Earnings growth as the Company generates returns on its investments

• Potential up-listing to major exchange

Risks:

• Reinvestment/prepayment risk

• Bad investments

• Industry competition reduces returns and/or ideas

• Carlson decides to dump their stake

• Ownership change occurs, resulting in Section 382 limitations

Catalyst

Catalysts:

• Earnings growth as the Company generates returns on its investments

• Potential up-listing to major exchange