Description

Prospect Japan Fund (PJF) shares trading at 42% discount to high probability exchange offer

Warning: It is possible to build a decent size position given some time but liquidity can be an issue in this trade.

PJF is a Guernsey incorporated fund trading on the London Stock Exchange, it has a USD 111m market cap and has been trading since 1994. As of the 10th of January 2017 PJF been subject to an acquisition offer. We believe it is quite likely that the offer will be successful and that the large implied discount on the shares will be realised resulting in an up to 73% return within an estimated time of 3 to 6 months.

PJF’s suitor is the parent company of its manager - Prospect Co. Ltd (“Prospect”, TSE: 3528). Prospect has offered 2.5 of its own shares for every PJF share. As of the 17th of February this implies a $2.04 value per PJF versus a market price of $1.18. We believe that after the acquisition is completed, the Prospect share will not stray too far from its current price.

Even in the unlikely scenario of the offer not going through, the shares provide a good margin of safety due to a large hidden asset in the form of 135m in-the-money Prospect warrants. These warrants are currently undervalued in the NAV to the tune of $0.49 per share, resulting in a real intrinsic NAV of $1.74 per share. This discount and the specifics of the fund would leave it wide open to value unlocking activism.

PJF: Pro forma standalone NAV and hidden value of warrants

Source: Northern Trust Fund Administration Services (Guernsey) Limited, retrieved on the 16th of February 2017.

The above table shows the pro forma NAV based off closing bid prices as of the 17th of February 2017 at $1.28 per share. The portfolio is pretty concentrated with a large amount of NAV attributed to Daito and Fukushima Bank.

We believe true NAV to be significantly higher than $1.28. In December 2015 PJF purchased 144m Prospect warrants for 2 JPY a piece of which it still owns 135m (remainder exercised). These warrants give PJF the right to purchase 135m Prospect shares for JPY 54 a piece. Getting rid of this warrant overhang in an orderly manner might be a big reason for Prospect’s acquisition offer.

The stock price of Prospect currently stands JPY 92, meaning the intrinsic value of the warrants stands at JPY 38. The warrants are daily exercisable until December 2020. PJF values these warrants at their JPY 2 cost basis in their weekly NAV statement.

Because the Prospect and PJF are related parties, there is an exercise agreement between them with respect to the warrants. This means some steps would need to be followed in order to exercise them in a expedited fashion. The process currently needs shareholder approvals and a multi stage process or additional cash to pay for the strike. However, we see no reason why the full value of the warrants could not be monetised.

Incorporating the intrinsic value of the warrant into the NAV lifts it from $ 1.28 to $1.74 per share - with the shares currently trading at $1.18. Also note that NAV per share consists of $0.26 of cash which is 21.8% of the current purchase price.

Prospect: background and management

Prospect is a Japanese holding company listed on the Tokyo stock exchange. The company was established in 1937 as a textile oriented business but changed its focus to real estate and fund management in the early 90’s.

Prospect has the following segments:

1. Real Estate Development: mainly focused on Tokyo condominiums but also some projects in Hawaii, 53.4% of total revenue.

2. Public construction business: operated through subsidiary Kidoh Construction Industry Co., Ltd. with a specialisation in underground jacking works, 43.7% of revenue.

3. Asset management: currently in run-off, 2.5% of total revenue.

4. Renewable Energy: growth projects in solar and biomass, 0.4% of revenue but JPY 20B of capital investment worth of committed solar projects are coming online in the next two years.

We had a call with Mr. Curtis Freeze, being both the CIO of Prospect Asset Management (PJF’s investment manager) as well as the President of Prospect. He told us the core strategy of Prospect was developing long term investment projects using appropriate leverage and selling these projects at a lower cap rate to yield hungry Japanese pension funds and the like. Prospect started out doing this by developing real estate and over the last few years they aggressively build out a solar project portfolio. The economics of new solar projects is deteriorating because of increased competition (and fewer deals because of the government putting the brakes on) and Prospect is now moving into biomass related opportunities.

Mr. Freeze made a good impression, he definitely understands value of being a first mover and the value of getting out when its gets crowded. We also believe he understands capital allocation and will not accept large amounts of unemployed capital to clog up the balance sheet. He intends to sell all the fund’s investments, except the two largest strategic holdings, and put the capital to work elsewhere. Mr Freeze also has 5.4m Prospect options at a weighted average strike of JPY 55.3. Other management members have decent size option positions as well.

Prospect: valuation

The table below provides some metrics on Prospect using the 30/09/16 TTM financials assuming exercise of the in-the-money PJF warrants. Note we are not using any EV based variables because the leverage employed in Prospect’s business model can vary a lot over time.

* Normalised by excluding all currency gains/losses and unusual items and using a 23.4% tax rate. Gains on the sale of investment projects (non operating profits of JPY 435m before tax) are added back because we consider project development to be an operating activity, amortisation of intangibles is also added back.

On the basis of these metrics, the company looks richly valued, it features a high PE ratio and can not cover its dividend from normalised earnings. This is important because the 3.41% dividend is an important attraction of this stock in the eyes of Japanese investors.

When taking the current pipeline of investment projects and the cash that can be deployed in the future into account the situation looks better. The company has ca. $50m equivalent of backlog of capital gains; $12m equivalent in real estate and about $38m equivalent in solar. These projects that are almost fully covered by firm sales contracts and also seem to feature minimal completion risk. The gains from these projects will be released into profit over the next 3 to 5 years. If we assume these realisation occur linearly over 5 years then they will result in JPY 1.135B of annual non operating profits before tax and a JPY 869m uplift to normalised NI for this period.

We estimate these projects will also return about JPY 8.5B of cash which can be added to the sizable amount of cash already on the balance sheet. We believe management will be very focused on reinvesting excess capital and they mentioned their levered return target is 15% for new projects. They have a good recent track record as they managed to make 20-25% IRR on their Solar and Hawaii property developments. We can assume that Prospect investors apply a 10% pre tax levered return on excess capital. Applying that 10% rate we can calculate the ‘reinvestment adjusted’ NI and PE.

Conclusion: while not being the value stock of the year, Prospect seems able to support its valuation.

Offer economics

The market is providing two very different implied views of the economics after the consummation of the offer: the UK view and the Japanese view. The “UK view” uses the current price of the PJF shares to imply the pro forma market cap of Prospect post offer consummation, the “Japanese view” uses the current Prospect stock price instead.

* Normalised by excluding all currency gains/losses and unusual items and using a 23.4% tax rate. Gains on the sale of investment projects (non operating profits of 435 before tax) are added back, amortisation of intangibles is also added back. Fund management income currently generated through PJF is subtracted and dividends on strategic holdings that Prospect intends to keep are added.

The table below assumes reinvestment of excess capital at a 10% pre tax return to calculate a reinvestment adjusted NI and PE.

The UK view can be seen as the breakeven valuation if an investor buys PJF shares and the offer is consummated. If the offer is successful and the Japanese view of the company prevails PJF investors will make a 73% return.

In the case of the offer being successful, we believe the following is highly likely: (a) The UK view will be our floor valuation so if the offer is consummated there is virtually no downside, and (b) the eventual valuation of the combined company will be much closer to the Japanese view. We lay out the reasons for this below.

1) Prospect is a Japanese stock

First and foremost, the resulting amalgamated company would be traded in Japan where it will be evaluated by mainly Japanese investors who will use Japanese comps. The table below contains a frequency distribution table of the 53 name universe of Japanese companies within GICS sector “Real Estate Management and Development”, a market cap > USD 100m and positive EBITDA retrieved from Bloomberg:

The Japanese view results in a mixed bag of comps: the stock seems richly valued looking at reinvestment adjusted PE and average on P/TBV while still sporting a top 10% dividend yield. It is clear, however, that the UK view results in a relatively cheap stock which comps average on PE but very well on book value and dividend yield.

On the 7th of December 2016 Prospect increased its dividend from JPY 1 to JPY 3 while making the case that the company’s growth projects would be able to comfortably support the new level. The stock promptly jumped 73%. Looking at this and knowing what we know about the yield hungriness of the Japanese market, we believe the dividend yield is the most important factor in Prospect’s valuation.

We find it difficult to believe that Prospect’s dividend yield can rise from it current level to a sustained 4 handle percentage as long as investors believe the dividend can be covered. In this respect Prospects pro forma balance sheet lives up to the task: If we assume all current and future investment projects yield a 0% return (zero non operating income going forward), the JPY 16.9B of net investable capital is enough to cover the difference between the normalized NI and the dividend payment for 33 years.

2) UK investors bailing out

UK investors might have good reasons to ignore fundamentals and dump the stock. Under the offer proposal they will get delivered a JPY denominated security trading 9 time zones away under a different accounting regime. Even if they might like to take part in the offer, their investment mandate might be forcing them to sell.

3) Japanese investors have reasons to be bullish about offer

At the same time Japanese investors might have good, lasting, reasons to ascribe a more positive value to the Prospect stock after the offer. Using the current Prospect share price, its traded market cap is about to increase by 136% which is a positive for Prospect’s valuation (lower market cap stocks in the Japanese real estate development and management segment are much cheaper on all variables). The offer will also simplify the company structure and increase its focus. Prospect’s stock rose by 4.5% on the announcement of the possible offer and has continued to appreciate since.

4) More solid price forming in Japan

Despite having similar market caps with Prospect at JPY 15.9B and PJF at 12.3B equivalent, Prospect shares are much more liquid. Prospect shares turned over 3.77% per day vs 0.15% for PJF (90 day average). This extremely low level of turnover for the PJF shares makes it prudent to put more weight on the price forming ability of the trading in Prospect shares.

Offer mechanics, timeline and likelihood

Prospect submitted a “possible offer” as defined under the UK Takeover Code (the “Code”). For the “possible offer” to become an actual offer it needs to be recommended by the independent directors of PJF, to be put to vote at an EGM and sanctioned by the High Court.

The process above implies getting various approvals and taking some hurdles but Prospect management indicated this would mostly be a formality. The only highlight they mentioned is that they are working to get the regulator comfortable that PJF’s minority investors would be protected during and after the offer. Besides all this, the independent directors need to recommend the offer - for which they are currently consulting with the shareholders and performing due diligence.

Given this is a scheme of arrangement, the subsequent EGM requires a simple majority by number and 75% of value of the shareholders present or voting by proxy at the EGM to vote in favour to be binding. Note that this is lower than the the 90% required for an ordinary firm offer that becomes binding on the remaining 10%, and this is likely the reason they went for the more friendly scheme of arrangement route. The High Court sanctioning the scheme thereafter is typically a formality.

The “offer or no offer” deadline (as per rule 2.6(c) of the UK Takeover Code) was extended on the the 7th of February for another 28 days. This is generally seen as a positive for an ultimate offer to ultimately occur because if it was an unequivocal no (after initial shareholder consultations) the extension would not have occurred. We usually see this extension of 28 days happening 2 or even 3 times before an actual offer is made. Assuming a 2 month window from firm offer to closing (typically around 40-45 days) we would expect the offer to be consummated sometime between the start of May and mid August.

The asset manager of PJF and Prospect are basically the same management team and they seem committed to the transaction. Prospect management has also confirmed that large investors (on both sides) are in principle happy with the transaction and that they believe the probability of the offer being successful is very high.

Once an ultimate offer is made it will likely also accepted by the PJF shareholders for the following reasons:

1. The majority shareholders are likely now being asked by the independent directors to give irrevocable undertakings to accept an ultimate offer.

2. PJF has been trading quite uneventfully at a consistent discount to NAV for a long time and the discount to real NAV has dramatically increased since the warrants got in the money last December. Hence we believe shareholders would be generally eager to monetise.

3. Through the Form 8.3 postings possible offer disclosures we can see that 93.2% of the shares are held by 11 investors, with a > 75% majority sitting with 6 institutional investors. This very concentrated shareholder base makes it more likely that the offer will go through. Moreover, most of these institutional investors are value oriented (1607 Capital Partners, CG AM, Weiss AM to name the biggest) and hence we believe they will act rationally in favour of a value monetisation.

What if the offer fails?

If the offer fails the PJF share can be expected to drop significantly. PJF’s discount to reported NAV (with the warrants valued at cost) has varied over time: the 2010-16 average was 19.4%, the 2016 average was 27.2% and just before the possible offer announcement the discount stood at 25.5%. Applying a 10x multiple to the 1.5% management fee and additional recurring costs we think a ca. 25-30% discount to NAV would normally be justified.

A drop back to a 27.2% discount would imply a price of $0.92 for the PJF shares. Panic selling could temporarily cause the stock price to drop even further.

Potential Activism

We doubt that the stock would stay at a depressed level for long however because the combination of the $1.74 intrinsic value and the nature of the institutional shareholder base makes this situation ripe for activism.

If the offer fails management indicated that PJF’s board of directors would have to decide the next steps. Given the size of the NAV discount with the warrant now being so much in the money, we believe a liquidation of PJF or at least monetisation of the warrants would be the logical next step (they are freely transferrable). We believe that the value oriented shareholders mentioned in the previous section would use their large shareholding to push towards this goal. A positive is that Weiss AM has aggressively built up its stake since the potential offer announcement. This firm has a very strong track record of being effective in exactly this type of situation.

If the directors decline to realise value the investors should be able to force their hand. 10% of the shares can convene a general meeting with 14 days notice. It only takes 5% for a written resolution to be lodged. A simple majority is enough to fire and appoint directors and a 75% majority can choose to put PJF into liquidation.

We expect the next annual meeting in August 2017. As per previous years we expect at minimum 2 out of 3 directors to be subject to re-election at mercy of a simple majority vote. Every 3 years the structure is also subject to a continuation vote with the next one due at this year’s AGM. In the continuation vote a 75% majority can decide to put PJF into liquidation.

In the case PJF wants to execute a value realisation strategy, the management contract with Prospect can be cancelled with 3 months notice. With the management contract terminated it becomes much more easier to exercise the warrants as they are not related party transactions any more and hence would not require any shareholder approval.

NAV revaluation

In 2015 annual report the auditor highlighted the undervaluation of the warrants when the warrant was out of the money (closing price of Prospect at JPY 53 vs strike of JPY 54). For the 2016 annual report, expected at the start of April, the auditors will not be able to ignore the intrinsic value that the warrants now have.

Scenarios

Knowing all this we can capture most ‘offer fails’ outcomes using 3 scenario’s:

• 1. Discount to NAV - For our worst case, we will assume a reversion to the 2016 discount to NAV without the warrants. This means the directors do not take action to realise value, all activism fails and the value of the warrants is not realised or recognised by the market.

• 2. Discount on NAV + warrant - In the intermediate scenario the fund continues but the directors decide to realise the value of the warrant or the market recognises the value of the warrant. In this case we assume the 27.2% discount to 1.74 NAV including the intrinsic value of the warrant.

• 3. Liquidation minus cost - In the most advantageous scenario the fund will be liquidated and the proceeds distributed. We will assume 2m of liquidation cost resulting in 1.72 per share of liquidation proceeds.

Given the high probability of successful activism in this case; if the offer fails we believe the price action will start out at or even below the worst case scenario for the stock price to subsequently appreciate to either the scenario 2 or scenario 3 level.

Conclusion

We now have 5 scenario’s in total:

Next we can do some merger arb analysis using extremely conservative assumptions.

For the ‘offer success’ outcome we will assume Japanese investors are wrong about the valuation of the combined company and after the acquisition the Prospect stock trades at the average of the UK and Japanese views. This would result in a valuation of 160.9 per share. For the ‘offer fails’ outcome we will assume the stock trades to the most negative ‘Discount to NAV’ scenario without any revaluation afterwards, this implies a PJF stock price of 0.92.

This means our binominal tree has: current price = 118, upside = 160.9 (36.4% return), downside = 92 (-21.6% return). This means the implied probability of success is 37.3%. We believe the real success probability is far higher than 50% so even in this extremely conservative scenario a long position in PJF would be recommended. We believe most realistic scenarios that allow for waiting for 6 to 12 months after a offer failing would struggle to produce a realistic negative outcome.

In conclusion, whether the offer works or not, we expect an investment in PJF to result in a significant positive return within 3 to 15 months. Investors could consider keeping part of their powder dry to increase their position in case the offer fails.

Technicals

PJF trades on the SETSqx segment of the London Stock Exchange. Which means most of the volume gets done through 5 scheduled auctions during the day. It is an opaque process but a decent position size can be achieved with patience.

If you can short Prospect, please let us know where to find borrow in case you ever get fed up with putting the long-short trade on.

More information

http://prospectjapanfund.com/pjf/index.php/prospect-co-offer/

Non Japanese speakers can find recent financial data on Prospect in Capital IQ

Risks and mitigants

1. A firm offer is not put forward:

Current high level of cash and activism provide downside protection for a scenario where an offer is not put forward.

2. Deterioration of underlying businesses of Prospect:

The recent trading trend has been positive at Prospect and there is a significant amount of backlog of capital gains that provides downside protection.

3. Dividend decrease:

The current cash and the extra liquidity provided through the backlog provides Prospect ample runway to sustain the current increased dividend rate.

4. Heavy selling by former UK holders post offer consummation:

There always a risk that the enlarged share count and liquidity will be not enough to counter non- Japanese sellers. In this case the Prospect stock could trade down, at least temporarily. We believe the attractive dividend yield should entice Japanese investors to quickly pick up the slack however.

Catalyst

• A firm offer is put forward

• The offer consummates

• Shareholder activism at various points in the process