Description

Summary

We recommend purchasing shares of Standard Diversified Opportunities Inc. (SD).  It is a holding company which has the potential for a 100% return over a 2-3 year period.  The primary asset held by SD is Turning Point Brands (TPB) which we wrote up over a year ago.  SD is compelling since (1) it is a slightly cheaper way to play TPB, (2) our valuation of TPB has increased meaningfully given tax reform, recent successful acquisitions, and ongoing cash generation, (3) SD is a way to invest alongside Standard General (SG) and the CEO of SD without paying management fees and a promote, and (4) given the price the market is paying for Boston Omaha, the idea seemed worth posting.  We think the Boston Omaha principals are very thoughtful, but prefer SD based on valuation and being less followed.

Note: the statistics above such as price, diluted shares, market cap, net debt, and TEV apply to SD the holding company.  The valuation metrics on the right of the table are those for TPB, assuming the excess cash at SD sat proportionately at the TPB level instead.  When we refer to Standard Diversified Opportunities we use "SD", and when we refer to the Class A shares of SD we use the ticker "SDOIA".

History

SD was formerly Special Diversfied Opportunities Inc. and was incorporated in 1990, and until 2013 was engaged in bio-services and industrial bio-detection.  During Q3 2013, Special Diversified sold all assets and interests related to these life sciences businesses, and became a shell company.  On June 1, 2017, SG efffectively took over the shell. 

SG 

SG has carved out a niche for itself as a hedge fund by being a thoughtful special situations investor.  SG has a very solid long-term track record and actually hedges.  The firm does not does promote itself much if at all, and the employees of the fund are not promoters.  SG is one of the few firms which was down modestly during the crisis (much less than the average hedge fund), but was able to participate in the upside as the market rebounded over the years, while still hedging.  To be clear, an investment in SD is not an investment in SG’s fund, but the point is that SG is a successful capital allocator with a strong 10+ year record which includes the financial crisis.  We mention this since one needs to be comfortable with SG to own SD.        

SG owned a majority of TPB shares, and then placed nearly all its TPB shares into SD.  More specifically, SG and TPB's non-executive chairman Thomas Helms contributed approximately 52% of TPB's outstanding common stock in exchange for newly issued shares of SD.  In exchange for the TPB contribution, SG and Helms received Class A shares and Class B shares (via dividend).  SG owns the majority of both the Class A and B shares.  At the time SG dropped its TPB shares into SD, this caused confusion among some of the minority shareholders of TPB, but the move was sensible.  It gives SG a permanent capital vehicle through which to not only hold TPB shares, but also make other investments. 

Moreover, at some point, if TPB runs out of reinvestment opportunities, cash can be sent to SD for deployment outside of the OTP (other tobacco products) sector.  And of course if TPB is sold to a large tobacco player, SG can redeploy the proceeds into another opportunity versus having to find another public company to take over.  The class B shares have 10x the voting power of the class A shares but are otherwise economically equivalent.  We are comfortable with this dual-class structure as the structure makes it easier for SG to maintain control over SD while allowing SD to issue class A shares to reward employees and facilitate acquisitions.  So to be clear, SG controls SD which in turn controls TPB.    

We also think highly of the CEO of SD.  He has a background in both the public markets and with permanent capital vehicles, and is 100% focused on SD.  He will eventually build out a small team there.     

The GAAP financials of SD include TPB.  For financial reporting purposes, TPB was the accounting acquirer since TPB's shareholders gained majority control and this was technically a reverse acquisition.  At the SD level (deconsolidated), there is $16 million of cash, $300,000 of PP&E which is largely due to the purchase of 5 billboards in the Austin, TX area, $1.5 million of accrued liabilities, and 9.8 million shares of TPB.  

Review of recent capital allocation as it relates to TPB

Recent capital allocation has been very solid.  In Q4 2016, TPB acquired four chewing tobacco brands and a twist tobacco brand from Wind River Tobacco for $2.5 million.  This was a small acquisition done at about 4x EBITDA.  The play here is that the brands were good brands but under-distributed.  They were only in 25% of the chewing tobacco market and had a 2.2% national market share -- but an 8% market share in the locations where it is distributed.  

VaporBeast was a sizeable and very attractive acquisition.  The integration is doing well.  TPB has a NewGen segment which markets e-cigarettes, e-liquids, vaporizers, and other related products, in addition to distributing a wide assortment of vaping products to non-traditional retail outlets.  VaporBeast serves ~5,000 non-traditional retailers and also directly serves customers.  Access to these non-traditional retailers is key as there has been a massive shift from traditional retailers to accessory & vape shops when it comes to NewGen-type products.  VaporBeast has a low-cost in-house sales & e-commerice platform which provides great access to these new channels.  Although VaporBeast was serving about 5,000 locations at the time of the deal, there are 16,000 non-traditional vape & accessory shops nationally.  VaporBeast grew its sales from $7 million to $53 million (at the time of TPB's purchase) in only a few years, and the purchase price was $27 million, or 4x EBITDA.    

TPB has also paid down debt.  The capital allocation at TPB has been thoughtful, and M&A has been complementary and accretive.  

What is TPB worth?

Please refer to the TPB idea posted last year and the accompanying discussion.  Our summary updated numbers are as follows: $64 million 2018E EBITDA less $2.5 million of capex less $16 million of interest less 28% taxes, divided by 20M shares, gets us to $1.64 in FCF/share.  We are giving no credit to the NOLs, which are modest at this point.  Applying an 18x trailing multiple gets us to $29.52 in a year versus today’s $19.42, for 52% upside.  We then add the present value of the MSA escrow account, and we get $30 for 55% upside.  Obviously, with incremental M&A, which I fully expect over time, the value creation over time can be much higher.  Also, the 28% tax rate is a relatively conservative upper bound (21% federal + local/state/other taxes + taking into account the tax non-deductibility of certain expenses such as lobbying costs, for example).  And lastly, the $16 million of interest is too high for the long-term.  There is an 11% second lien consisting of a $55 million term loan which will eventually get refinanced before its August 2022 maturity.  The call premium is not high – the issue is that to take out the debt with more senior debt could potentially constrain M&A, etc.  But eventually, that 11% paper will get refinanced out.  In conclusion, we feel our estimate of intrinsic value is reasonable.  The consensus estimate on Bloomberg show $58 million for 2018E EBITDA which is too low (TPB has already done $45.3 million YTD through Q3 2017). 

Valuation via Standard Diversified

Assuming TPB is worth $30 in 12 months, the intrinsic value of SDOIA will be 73% higher.  This is because SDOIA’s NAV per share is about 15% higher than its trading price.  NAV is calculated simply by taking SD's TPB shares at market value, adding cash and the purchase value of the billboards, and deducting total liabilities.  But we believe that SD is more compelling than simply a discount to NAV story.  In addition to owning TPB equity and a handful of billboards, SD will soon acquire a small auto insurance company called Maidstone Insurance Company (name of the regulated entity).  On December 20, 2017, SD announced that it finally received approval from the NY State Department of Financial Services to acquire the parent company of Maidstone.  The deal was signed up in late 2016 and originally expected to close in Q2 2017, but the regulatory approval from NY happened several months later than expected. 

Maidstone is an auto-insurer based in NY.  SD is purchasing Maidstone for $2.5 million, which is approximately 50% of statutory capital.  SD will be injecting $10 million into Maidstone and will work to make sure Maidstone can underwrite nationally.  Maidstone was basically an orphaned insurance asset which SD bought at a discount to its capital base in addition to acquiring valuable licenses.  Maidstone used to be part of a larger company which wrote auto and property insurance.  In Q3 2015, UPC Insurance (ticker UIHC) entered into a definitive agreement to purchase the homeowners piece.  At the time, FL property insurers were looking for geographic diversification.  The stock purchase agreement (public filing) included a 3-year noncompete on the property side - this will be expiring soon which is why Maidstone will be in a position to write property and auto nationally.  

Although property has higher loss ratios than certain other lines, like surety, it also generates more float.  Pro forma for the capital injection, Maidstone should have float of ~$50 million which we expect to be managed by SD and SG.  Our interests are more aligned here than with the typical “hedge fund-re” model.  A hedge fund sponsoring an insurance company typically makes most of its money off the investment management fees of the captive separate account.  Investors are often shown a model showing what happens when more premiums are written and investment returns are high – a very high ROE.  But that was fanciful thinking as they generally posted poor returns and had mediocre underwriting.  We expect no conflict of interest since SG’s ownership position in SD massively outweighs any potential investment management fees.  Also, as mentioned earlier, the CEO of SD is a talented, highly experienced investor who is 100% aligned with SD.

Maidstone could potentially be a homerun if executed well over the long run.  We were surprised to see the high level of float and premiums in comparison to the low purchase price.  Clearly Maidstone was undercapitalized and SD will aim to improve the underwriting.  This year Maidstone should be around break-even.  It's worth noting that the preliminary purchase price allocation had $16 million of net identifiable assets acquired versus a consideration paid of $2.5 million - resulting in a "gain on bargain purchase" of $13.5 million.  But it will all come down to execution and take time.  We are optimistic here but our valuation of SDOIA does not yet bake in any gains from Maidstone.

Earlier we mentioned that SG purchased $300,000 of billboards in the Austin area.  This is a very small deal, but the principal of Metro Austin will be working with SD to own a critical mass of billboards.  The rough economics are that land expense is around 25% of revenues, and the pre-tax cash flow net of maintenance capex is around 50%.  The economics will vary depending on the terms of the land lease and the billboard location (urban vs. rural, etc.), but the economics are compelling. 

Although Maidstone and the billboard deals are small relative to the TPB stake, they illustrate SD's desire for high cash flows and float.  And TPB is a high-quality cash-flowing asset.  As the markets get more comfortable with SD and SD proves out its capital allocation, we think SD could trade at a 15% premium to NAV.  To do so requires earning a very modest spread over its cost of equity, which we think SG and SD can prove out.  So taking a $30 TPB target price, SD's NAV is $18.80.  Again, this simply takes SD's TPB stake, adds $16.3 million of cash and $0.3 million of billboards, and deducts $1.5 million of liabilities.  (We can debate about including an SG&A drag, but the TPB dividend to SD (about $1.6 million) will cover a good portion of that, and the team should add value over time.  Also, Maidstone has around 60 employees and some SG&A tasks can be done at the Maidstone level).  We then take 115% of $18.80 (15% NAV premium), and we get $21.62, or 99% higher than today's price.  So there are 3 elements of the investment: TPB trading at intrinsic value + SD trading at NAV + SD earning a premium over time.   The latter will take time since a premium to NAV is earned over a long period of time, but given SG's track record we feel this is merited.  In any case, the primary drivers of the return are the first two components.   

SD has a very flexible investment mandate.  The only assets which are off-limits are in life sciences.  SD cannot re-enter the antibody and assay design business until July 2018 (5 years following the July 2013 sale of the life sciences assets)...we do not suspect this to be a limiting factor!      

In August 2017, the 2017 Omnibus Equity Compensation Plan, which authorizes 1 million shares of Class A stock to be issued, became effective.  As of September 30, 2017, no awards were issued.    

Risks/Negatives

Poor capital allocation.  This idea is very dependent on SG’s and the CEO's capital allocation – but we view their capital allocation to be a definite positive.  Also, a poor acquisition by TPB would impair value.  We think very highly of Larry Wexler and Mark Stegeman of TPB, and they will only pursue M&A if it makes sense. 

TPB leverage.  It has come down and is now at 3.4x net debt to EBITDA.  The TPB team prefers to keep leverage around this level or slightly below.  We prefer modest leverage as well, especially since lower tax rates make the tax shield less valuable than before.    

SDOIA is not a liquid security and trading volume is very low.  The stock can gap up and down on low volume.  It is possible that SDOIA remains undervalued for an extended period.  But just as TPB plans to create more liquidity in its stock over time, eventually there will be more liquidity in SDOIA as the assets are more appropriately valued and opportunities for share issuance become available via M&A and private placements.         

Maidstone execution.   

Catalyst

---Further accretive M&A by TPB. 

---Refinancing the expensive 11% tranche at TPB.   

---More activity on the SD side – this consists of steps to develop Maidstone and further insurance M&A, more purchases of cash flowing assets.   FCF and book value growth. 

---Getting off OTC. 

---Modest leverage over time at SD (mentioned as a possibility in the prospectus).  

---A large tobacco player purchasing TPB.  If and when TPB runs out of inorganic growth opportunities, a sale of TPB may make sense.  This would not be anytime soon given TPB’s runway, but it        should put a floor on valuation since TPB would be highly accretive to a larger player.  A large player like Altria could take out significant costs.