Price Target: $1.80 (112% return)
SWK Holdings Corporation is a shell company trading at a discount to its liquidation value (all of which is cash) run by a focused management team and backed by a board of directors with extensive experience. SWKH is looking to invest in one or more businesses and take advantage of the massive amount of NOLs that they have. SWKH provides an opportunity for substantial gain with extremely low market risk.
Experienced management team and board of directors
The CEO, John Nemelka, is the founder of NightWatch Capital Group, a fund that has been winding down. He has a Wharton MBA and was previously a principal at Graham Partners, a private equity firm. The CFO, Paul Burgon, is the CFO of NightWatch. They both spend all their time looking for and assessing potential transactions for SWKH, which separates this shell from others where the managers only devote a portion of their time to searching for and evaluating deals.
There are 4 board members: William T Clifford, Michael A Margolis, Michael D Weinberg (Chairman), and John F Nemelka. William T Clifford is the CEO of Spencer Trask & Co, a private equity and venture capital firm. Michael A Margolis founded Maric LS, an investment management firm focused on complex or overlooked value-oriented investment opportunities, and received his MBA from Harvard. He was previously a director of Sage Capital Growth, an investment manager focused on public and private investments, and co-founder of Arcadia Partners, a PE firm focused on education and training. Michael D Weinberg, Chairman, was nominated by Carlson Capital (a well known hedge fund) and is a managing member at BirdDog Capital and an employee of Carlson. He was previously the Director of Special Projects at Carlson and the Director of Investments at Richmont Capital Partners. All board members have a tremendous amount of experience in various funds which will ensure proper capital allocation.
Insiders are incentivized and aligned with shareholders
Carlson Capital, as the largest shareholder, owns 28% of the firm and is represented by Michael Weinberg, the Chairman of the Board. Because they are motivated only through their ownership, their interests are aligned with the interests of shareholders. Furthermore, Carlson is essentially in control of SWKH, so shareholders interests will come first. It is also important to note that Carlson purchased their shares from NightWatch and another entity called KVO Capital. They paid KVO $1.05 for their shares (they paid NightWatch slightly less). So a purchase today would be at a sizable discount to shares purchased by Carlson at a time when the company hadn’t even begun searching for a transaction. Additionally, director Michael Margolis owns 2% of SWKH in his fund.
John Nemelka owns 25K shares and 80K options, and Paul Burgon owns 20K shares. NightWatch, Nemelka’s and Burgon’s fund, owns 1.4M warrants, with strike prices at $1.97 and $2.45. These warrants expire in September/October 2012. This gives the 2 people primarily responsible for scouting out deals an incentive to get it done soon so their warrants have a chance of paying off.
On 11/8/10, the 2010 equity incentive plan was approved and gave 200K, 100K, and 100K shares of restricted stock to Weinberg, Clifford, and Margolis, respectively. 50% vest if the average closing price in a 60 day period is $1.80 or more (25% more vest at $2.25 and 25% more at $2.70). The shares cancel if they don't vest before the 5th anniversary of the grant. Not only does this further align their incentives with those of shareholders, it gives us insight into their internal price targets for SWKH. Since the board of directors came up with those prices to determine compensation for themselves, they obviously chose prices they believed SWKH would more likely than not achieve. If anything, they have an incentive to set the price targets low to make sure their compensation gets triggered.
Valuation
As of 9/30/11, SWKH’s diluted liquidation value was $0.91. The balance sheet at that time consisted almost entirely of cash.
They also have $4.25 worth of tax assets, which are essentially all NOLs. They will fully expire by 2031. Since the NOLs are so large in comparison to any possible business SWKH can purchase (even if they take on debt to buy a larger company), we cannot attribute value to all of their deferred tax assets. The best way to value them is to assume SWKH will have a full tax shield through 2031 and take a DCF of the tax benefits. Management has told us that they are comfortable taking on debt to buy a company, but will not fully lever up. I will use the following conservative assumptions: SWKH performs a transaction funded by 67% cash and 33% debt, it purchases at 6 times EBIT (SWKH is looking for a high ROE business and not necessarily a high growth business), the EBIT growth rate is 5%, the interest rate on the debt is 7%, the discount rate is 15%, and the tax rate is 35% (for the sake of conservatism, I ignored the state tax shield). In this manner, the NOLs are worth $0.64 in present value terms.
Adding the value of the NOLs to the liquidation value, you get $1.58. This does not take into consideration any value created from taking a private company public or getting a good deal on a business. To the second point, management has expressed to us its desire to purchase a company where the insiders will remain with the company. This could be were one partner wants out or the primary partner wants to monetize some of his investment. This way they are purchasing from someone whose incentives aren’t the complete opposite of SWKH’s. Insiders obviously believe those 2 factors should add significant value as their price targets range from $1.80 to $2.70 and they have incentives to set those targets low.
Instead of trying to guess how much value they can create, I feel it is appropriately conservative to take the low end of their price range which should already be conservative given the incentives of the board members. This only attributes $0.22 to the value created from taking a private company public or from focused and high quality managers being at the helm of our company. This implies a 112% return from the current price of $0.85.
Summary
SWKH is a shell company trading at a discount to its liquidation value and has essentially unlimited NOLs until 2031. It has a very qualified board of directors that will make sure they money is invested well. Its focused management team and ideal incentive structure mitigate the largest risk when it comes to investing in shells: taking too long to do a deal. At today’s price of $0.85, SWKH represents a 112% return with extremely low market risk.