Peerless: Trading for Cash, Launching Closed-End Fund
Jul/110
This is an excerpt from my most recent quarterly letter. If you would like a copy of the entire letter, please email your full contact information to me, derek.pilecki@gatorcapital.com.
I recently purchased a new position in Peerless Systems . Peerless is a micro cap company with three interesting attributes: 1) It holds more net cash on its balance sheet than its market capitalization, 2) it has a profitable albeit declining business, and 3) the CEO, Timothy Brog, has a background as an activist value investor and has made several savvy financial maneuvers in the recent past that give me confidence that he’ll be able to use the company’s cash to create additional shareholder value.
An investment in Peerless appears to be a free option on Brog’s ability to create shareholder value. Brog became Chairman at Peerless in 2007 after starting a proxy battle for a board seat. Prior to Brog becoming Chairman, Peerless had squandered about $75 million through wasteful R&D spending. Since becoming Chairman, Brog stopped the spending and has steadily managed to extract cash flow from Peerless’s declining business.
In 2009, Brog generated additional profits for Peerless through an activist investment in Highbury Financial. Brog used Peerless’s cash to accumulate a stake in Highbury at extremely attractive prices. At the time, I coincidentally owned a position in Highbury and had posted my investment thesis on Highbury to SeekingAlpha. Brog pressed Highbury’s management team to pay a special dividend to shareholders instead of making an acquisition as management desired. A few months later, management sold the company to Affiliated Managers Group for a price approximately 300% higher than Brog’s initial share purchases of Highbury less than 12 months earlier.
Brog continued to create shareholder value at Peerless in late 2010 with a Dutch tender offer for most of the shares. After liquidating the company’s stake in Affiliated Managers Group, Peerless had about $55 million in cash on its balance sheet and 16 million shares outstanding, or $3.46 per share. The company repurchased 13.2 million shares at $3.25 in the Dutch tender. The result of the tender combined with additional cash flow from the business, increased the cash per share to $3.70. Importantly, the share count declined dramatically from 16 million to 3.4 million, so any future cash flows from the existing business will make a greater impact to shareholder value. This is a small but important point. If the existing business or any new business throws off $1 million a year for five years, the cash balance will increase $1.47 per share with just 3.4 million shares as opposed to $0.31 per share with 16 million shares. While this may not sound like much, it is a potential of an additional 31% return over five years.
The existing business of Peerless has been in steep decline, but it still generates a little cash. Peerless holds the patents on a few pieces of imaging technology that are important for manufacturers of copiers. The business generated operating profits of $1.8 million in the last four quarters. I expect Brog to continue milking this business while he finds a way to create additional shareholder value. He owns approximately 14% of Peerless’s outstanding shares.
Late in the 2nd Quarter, Peerless issued a press release which helps to clarify how Brog will create additional value for Peerless shareholders. In the press release, Peerless announced that the company will attempt to form and sell shares in a new closed-end fund managed by a subsidiary of the Company. Drawing on Brog’s activist experience at Peerless and Highbury, the closed-end fund will take an activist approach to investing. The offering is still in its early stages, so we don’t know the potential size of the closed-end fund and how much revenue it will generate for Peerless. However, we do know that as an inducement for investors to purchase shares in the fund, they will be given warrants in Peerless with a strike at $5. While this could be viewed as dilutive to our stake, I think the path for Peerless’s shares getting to $5 will be much clearer if Brog is able to complete the offering of the closed-end fund. The stock closed the quarter at $3.63.
Disclosure: Long PRLS.
Disclaimer: This is not investment advice. This intended to be a window into my thinking when analyzing of PRLS. Please do you own work before making an investment. My positions listed in the disclosure may change without further update.
JP Morgan Q2 Earnings
Jul/110
JP Morgan Chase is hanging onto most of its gains from this morning. I thought it was a solid quarter with good trading revenues from the investment bank. The bank trades at 1.3x tangible book value and 8x current earnings. Here are some thoughts about the quarter:
1) IB Fixed Income Trading was stronger than expected. Usually Q2 is seasonally weak compared to Q1 at JPM, but the results here were good. It’ll be interesting to see if C, GS and MS have good trading quarters as well.
2) In the IB, the compensation ratio looks a little low at 35% vs. 46% a year ago. Maybe JPM is going to start paying its bankers less going forward.
3) In retail banking, lower mortgage losses led to a profitable quarter. Continued to guide to $1.2B in quarterly mortgage losses vs. $944M this quarter.
4) Continued growth in branches, but for the first time in recent memory, the number of checking accounts is down. This may be a result of eliminating free checking in response to the Durbin Amendment.
5) Dimon pretty much said there will be no mortgage servicing settlement with the State AGs until there is litigation to make sure the bank is not subject to double jeopardy.
6) Commercial banking set records for net income.
7) Nothing of note in Asset Management or Treasury Services.
8 ) Some good private equity gains in the Corporate segment.
9) Company repurchased 80 million shares for $43.33 during the quarter. Interesting considering where the stock traded during the quarter. They must have done most of the buying immediately after reporting earnings in April.
10) Dimon downplayed its stated exposure to the PIIGS by saying that some of the exposure is to companies headquartered in the countries. He mentioned that historically in Argentina and Mexico that corporates performed OK when the sovereign defaulted.
11) Dimon also made clear that they have flexibility to bring down risk-weighted assets to comply with Basel III.
12) Dimon made an interesting comment about the capital generation potential for both JPM and the industry in general. He said people will be surprised by the amount of capital generated in the next 12 months. He also said banks will have so much capital that they won’t know what to do with it. This is interesting because what usually happens when bankers have too much capital is they either get more aggressive on lending or they make acquisitions. If you believe Dimon on this, one way to benefit would be to buy smaller banks with the expectations of an M&A wave starting in the next 12-24 months.
Disclosure: Long JPM, C & MS
Disclaimer: This is not investment advice. This intended to be window in my analysis of JPM’s earnings report. Please do you own work before making an investment. My positions listed in the disclosure may change without further update.
Time Arbitrage with Primerica
Jun/110
There is an opportunity to time arbitrage the stock market by owning shares of Primerica. The market is not assigning any premium to the expected low-risk growth at Primerica over the next 5 years. The growth is expected because Citi shrunk the size of Primerica prior to the IPO. Over the next few years, Primerica will replace the term life policies that were removed with new policies. This will translate into attractive earnings growth, but Primerica trades for 1.1x book value and under 9 times this year’s estimated earnings per share. Buyers of the stock can earn an attractive return assuming no multiple growth by relying on the expectations for earnings growth in the coming years.
Last July, I wrote a bullish article about Primerica. I saw an opportunity because the company’s balance sheet was restructured prior to its April 2010 IPO. Through March, the investment thesis played out as Primerica reported 4 quarters of better than expected earnings. The stock rose from $20 last July to $26.
In April, Citigroup announced that it was selling a second tranche of Primerica, which has beaten up Primerica’s stock as the market has struggled to digest the additional supply of shares. This recent decline is an opportunity to buy shares in a company with solid earnings growth prospects at a low valuation. At these levels, I believe there is assymetrical risk / reward in the shares of Primerica.
Read the rest of this post which has my investment thesis on Primerica at Seeking Alpha.
Capital One’s ING Direct Acquisition Terms Are Attractive
Jun/110
After Thursday’s close, Capital One (COF) announced the acquisition of ING Direct and the terms are favorable for Capital One shareholders. Capital One will be paying tangible book value after the mark-to-market of ING Direct’s balance sheet. The deal will be accretive to tangible book value and earnings immediately. Capital One claims the IRR is greater than 20%. In addition to the financial benefits, the operational and strategic benefits for Capital One are:
- substantially reduces risk on liability side of Capital One’s balance sheet,
- reduces future acquisition risk,
- puts capital to work in a low risk manner,
- fixes a mistake Capital One made 8 years ago by allowing ING Direct to become the leader in direct banking, and 5) makes sense because Capital One is the logical acquirer for the national direct banking footprint of ING Direct.
Read the rest of this article on SeekingAlpha.com: Capital One’s ING Direct Acquisition Terms Are a Pleasant Surprise.
Updated Newcastle Liquidation Analysis 2011Q1
Jun/111
The last few quarters I’ve written about my estimation for Newcastle Investment’s (NYSE: NCT) liquidation value. I believe this estimate is conservative because it assumes assets are sold at market value but the liabilities are paid at face value. The actual market value of the liabilities is at a discount to the face value, so if Newcastle’s management were to liquidate the company they would try to buyback the liabilities at a discount before paying them off at face value.
Here the table showing the liquidation value updated for the current quarter:
| 2011 Q1 | 2010 Q4 | 2010 Q3 | 2010 Q2 | 2010 Q1 | 2009 Q4 | |
| Recourse assets | $269.7 | $74.4 | $101.9 | $79.3 | $54.5 | $155.8 |
| Recourse liabilities | 144.5 | 59.5 | 56.3 | 55.8 | 77.9 | 183.6 |
| Net recourse assets | 125.2 | 14.9 | 45.6 | 23.5 | -23.4 | -27.8 |
| 2011 Q1 | ||||||
| CDO note holdings | 367.7 | 348.5 | 80.0 | 25.7 | 1.5 | 1.0 |
| Borrowings from other NCT CDOs | 95.8 | 108.8 | 0.0 | 0.0 | 0.0 | 0.0 |
| MH deal equity | 70.0 | 71.2 | 65.8 | 64.6 | 63.6 | 26.0 |
| Preferred stock | 61.6 | 61.6 | 61.6 | 61.6 | 61.6 | 152.5 |
| Liquidation value | 405.5 | 264.2 | 129.9 | 52.2 | -19.9 | -153.3 |
| Shares outstanding | 79.3 | 62.0 | 62.0 | 62.0 | 53.6 | 52.8 |
| Liquidation value per share | $5.11 | $4.26 | $2.09 | $0.84 | -$0.37 | -$2.90 |
My estimate of liquidation value increased about $0.85 in the quarter. The main drivers were increased valuation of the assets inside the CDOs, which gave greater potential value to Newcastle ownership of the CDO notes. The other drivers were the net interest income earned during the quarter and the slight accretion from the follow-on offering. I note this is the smallest increase in estimated liquidation value since 2010Q1.
I was disappointed that management executed the follow-on offering. I thought the $6 execution price gave away too much value for the company. I think of the company as trading at 3.5x EPS and would not sell equity at this price. Management claims that they have potential high return investments. We’ll see what they have done in Q2.
At Tuesday’s (May 31, 2011) closing price of $5.48, I don’t see much downside given my calculation of a $5.11 liquidation value. Hopefully, management will continue to add value by buying back the CDO notes at a discount to face value.
There is no guarantee that the stock price will remain above my estimated liquidation value. The value of the company’s assets could reverse course and start declining in value. Management could execute another follow-on offering. There is also a large conflict of interest between management and common equity holders of Newcastle because Newcastle managed by a third-party who makes more money if Newcastle is a larger company rather than a more profitable company. There are other reasons the stock may not perform. Please do your own analysis. Maybe this analysis could be a starting point for your own analysis.
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