Description

WMI Holdings (WMIH) is a holding company without material operations. Its primary asset is a $6 billion NOL generated from the pre-bankruptcy operations of Washington Mutual, and at the current stock price of $2.54/sh, the EV of the company is only 10% of the gross NOL value. It is planning to monetize this NOL through the acquisition of a new business and has embarked upon a number of transactions in the past 18 months to help facilitate such an acquisition, including various transactions with KKR that, in effect, provide WMIH with guaranteed “dry powder” to go after an acquisition large enough to efficiently utilize the NOL. I expect that on announcement of a deal, the stock will re-rate higher to reflect a fuller valuation of the NOL with additional upside if the deal is seen as being particularly attractive. Although dependent on the quality of the deal announced, I believe a “fairer” value for WMIH could be as high as $3.70/sh, or 46% upside from the current price.

Timeline

The best way to understand the WMIH opportunity is to walk through a history of the entity.

Of the above items, the two transactions worth delving into further are the “Initial KKR Investment” and the “Convertible Preferred Transaction”.

Initial KKR Investment

The Initial KKR Investment, announced in December 2013 and completed January 2014, had a number of components:

1.  Note Purchase Agreement

• KKR committed to purchase up to $150M in principal of subordinated 7.5% PIK notes

• Notes could be issued by WMIH in one or more tranches over a 3 year period as long as the proceeds went toward an acquisition

• Subordinated notes matured 7 years after issue

• Subordinated notes could be redeemed in year 3 @ 103.75, year 4 @ 101.875, or year 5 @ 100, or before year 3 with a “make whole”

2.  Investment Agreement

• WMIH sells 1M shares of Series A Convertible Preferred Stock to KKR for $11.1M

• Series A Preferred is convertible @ $1.10/sh at either the option of the holder, or on transfer of the preferreds to a non-affiliated party

• WMIH issues warrants to KKR to purchase 61.4M shares of stock; 50% of which have an exercise price of $1.32/sh, with the remaining 50% at $1.43/sh

• Warrants have a 5 year term

3.  Investor Rights Agreement

• As long as KKR owns 50% of the Series A, they have a right to appoint 1 of 7 directors

• Until Jan 30, 2017, KKR can purchase up to 50% of any future equity issuance or rights offerings up to $1B, as long as KKR pro forma ownership doesn’t exceed 42.5%

• A broad standstill is put into effect until Dec 31, 2016

• KKR is given registration rights for common stock

This deal was important as it effectively gave WMIH guaranteed “dry powder” for a potential deal, giving it credibility when entering M&A discussions with potential targets. KKR was compensated for this commitment primarily with out of the money warrants (at issue) which give KKR considerable “skin in the game” to help find attractive acquisitions and monetize the NOLs effectively. Furthermore, it was structured with the NOL preservation in mind.

Convertible Preferred Transaction

The Convertible Preferred Transaction, announced in December 2014 and completed January 2015, also had a number of components (only relevant ones included below):

1.  Purchase Agreement

• WMIH agrees to sell $600M of Series B Convertible Preferred stock, $200M of which is taken up by KKR, for ~$569M net of offering fees and expenses

• Series B carries a 3% regular cash dividend

• Series B is mandatorily convertible at the 20-day VWAP prior to an acquisition announcement, subject to a $1.75/sh floor and a $2.25/sh ceiling, or automatically redeemed at par 3 years following an agreement

2.  Amendment to Note Purchase Agreement

• Terminates the prior $150M Note Purchase Agreement once the reincorporation to Delaware is complete

3.  Reincorporation

• WMIH commits to reincorporate to Delaware

This deal went a step further than the Initial KKR Investment – it in effect substituted out a $150M commitment in exchange for $570M of called capital, allowing WMIH to go after a larger target (and utilize its NOLs in a more efficient manner). While in the interim they have to cash pay $18M of dividends each year, this creates some urgency and is a signal that a transaction is expected to occur in a reasonable timeframe. With a 3-year term on the Series B, we effectively have a drop-dead date on an acquisition announcement of January 2018, although I believe it is likely to happen before then based on commentary from the management and board in discussions with them at the annual meeting in April.

Valuation

While one can construct a near-infinite set of possibilities for the precise mechanics of how this situation plays out (what is purchased, when, for how much), I think a more constructive approach to valuation is to assess what the current EV is on a fully-diluted basis (assuming a deal has been announced), and then to compare this to the size of the NOL.

If we work our way through the various transactions, we see that there are 531M fully diluted shares (post warrant & preferred conversions), yielding a $1.35B fully-diluted market cap at the current share price. Netting off the current run-off valuation of the balance sheet (cash & investments less run-off insurance reserves), the cash proceeds from the Series B financing, and the cash from the exercise of the 61M of warrants yields an EV of $607M.

To figure out the value of the NOLs, we can look at it in a couple of ways.

First, the maximum the NOLs could possibly be worth (if they were utilized immediately) is approximately equal to the value of the deferred tax assets on the balance sheet (gross of the valuation allowance), which is $2.2B – this would be equivalent to a share price of $5.45.

More realistically, we can look at how long it might take to realize the NOLs and value it on that basis. If we assume they are used ratably over the remaining 14 year life of the NOLs (they expire in 2029), there is $150M of tax avoided each year ($6B / 14 * 0.35). Taking the NPV of this tax avoidance stream at 8% yields a value of $1.2B, or 21% of the NOL – this would be equivalent to a share price of $3.70.

Note that avoiding $150M of tax per year requires EBT of $429M, which is going to be tough to reach with only ~$740M of cash to invest, along with maybe another $1.5B in debt and junior securities that could be raised for a transaction – in reality a deal is likely to require a concurrent equity raise, or equity consideration to be given to the target (appropriate if it is a RTO-type deal) – if raised post-announcement of an attractive deal, the equity price will probably re-rate to a level where it is not too dilutive to fair value.

If we want to be really punitive, we can construct scenarios where no new equity is raised at all and WMIH has to utilize the NOL on its own – in such a scenario it’s unlikely that WMIH can utilize the entire $6B NOL by 2029. A reasonable way to think about valuation in this case is that WMIH equity should be valued on a pre-tax basis the same way another firm would be valued on a post-tax basis. Given a 35% tax rate and ~$740M of equity capital to invest, in this punitive scenario we would expect the market cap to be 740 / (1-35%), or $1.1B – this would be equivalent to a share price of $2.05, which can be taken as our downside price.

Upside Optionality

The prior approaches only give value to the actual tax avoidance associated with an acquisition. However, it is entirely plausible that the announced acquisition is perceived as particularly attractive, in which case you can also benefit from multiple expansion as the trading multiple of the acquired business expands beyond the acquisition multiple. I believe that this is a reasonable possibility given the involvement of both Blackstone and KKR, and in particular given KKR’s incentives to maximize the value of their warrants and Series B holdings. Furthermore, a similar situation has already occurred with BGRP (the former CPMK), which was recently written up on VIC and currently trades for 35% higher than when the deal was announced, with another 77% of upside if eal820 is correct. Notably, WMIH has hired Bill Gallagher and Thomas Fairfield as CEO and COO respectively, the same positions they held at CPMK from 2011 to 2014 where they were instrumental in executing on the Bluestem transaction.

Risks

Dependence on NOL - In the absence of the NOL, there is very little value at WMIH – I estimate ~$0.30/sh. Clearly if there is any reason why WMIH is permanently prevented from utilizing the NOL there is material downside from current prices. The long-dated nature of the NOL (2029 expiry) mitigates this though, as there should always be material option value here even if the existing arrangements with KKR etc. fall through

Lemon Effect – KKR isn’t obligated to present WMIH with opportunities, and to the extent they do so, WMIH could be getting “2nd pick” – if any officer or director (KKR included) comes across an acquisition opportunity, they are obligated to first offer it to any related entities to which they have a current fiduciary or contractual obligation. That being said, there are numerous independent channels of deal flow that WMIH has, including Bill Gallagher (CEO) and Thomas Fairfield (COO) who joined from CPMK and therefore have experience looking for an NOL shell target, and Blackstone.

Catalyst

Pretty straightforward – the catalyst here is the announcement and ultimate closure of a transformative acquisition