Valhi (VHI) – Preferred Equity Elimination – 111% Upside

Current Price: $10.69

Book Value Per Share: $22.56

Upside: 111%

Expiration Date: TBD

Press Release

This idea was shared by Brian.

 

Valhi is a holding company that trades at 50% to BV after the recent elimination of the preferred equity. VHI balance sheet is comprised of controlling stakes in listed subsidiaries of Kronos (KRO) and NL Industries (NL) making the sum of parts valuation quite straightforward. In mid August the controlling shareholder agreed to eliminate $667m of preferred equity thereby increasing the book/liquidation value per common share from -$0.84 to $22.56. However, VHI share price showed almost no reaction to this seemingly very positive event so far (not really clear why).

91.5% of VHI is owned by Contran - a private company, previously controlled by a notorious Dallas billionaire Harold Simmons and after his death in Dec'13 inherited by his daughters (one of them passed away recently) and grandchildren and managed through the trust. Back in 2007 Valhi issued $667m of preferred shares to Contran to compensate for tax liability. It was an unusual class of preferred which had a 6% noncumulative dividend, which was never paid in these 13 years. However, the existence of the preferred muddied up Valhi's balance sheet and created uncertainty as to whether, should Valhi ever liquidate or simplify their structure, substantially all of the value would flow to the preferred rather than the common.

And then on the 11th of August, 2020, Valhi announced that the preferred was canceled for no consideration:

Pursuant to the Agreement, on August 10, 2020, the 6% Series A Preferred Stock was voluntarily contributed to the capital of the registrant for no consideration and without issuance of additional securities by the registrant.

The fact that pref. shares were canceled rather quickly (4 months) after one of the two daughters' death, seems to suggest that something is in the works and that the trust might be finally interested in closing the gap between VHI book value and VHI share price.

The day after the preferred announcement, an insider purchased some shares at around the current stock price. It wasn't a large purchase, only 1,500 shares, but the director is the youngest (39) member of the management team and also is the company's treasurer. He previously only owed 1,000 shares.

 

SOTP valuation

VHI holds multiple majority ownership interests including the following:

  • 50% stake in Kronos (KRO) - manufacturer of Titanium Dioxide, the key pigment in paint. Its balance sheet is fairly clean, with under $100 mil in net debt and $300 mil in pension shortfalls. This is a cyclical business, but averages over $200 mil in EBIT. The current value of the stake is worth $760m or $26.67 per VHI share.
  • 83% in NL Industries (NL) - a holding company with stakes including 30% in KRO and 4% in VHI itself. The balance sheet is clean with $130 mil in cash against $150 mil in accrued environmental and legal liabilities, the latter due to a California lead settlement reached some months back. The current market value of the VHI stake in NL is $140m or $4.91 per VHI share.
  • Majority stakes in two real estate development companies BMI (63%) and Landwell (77%), including a bunch of land in Henderson, NV, and water treatment and delivery facility. These subsidiaries generated $40m in revenues and $10.5m EBIT on avg. for the last 3 years ($6.6m in 2017, $10.0m in 2018, and $14.8m in 2019).

Book value before and after pref. share cancellation:

vhi bv

 

Why the situation exists

It is quite puzzling why the market has valued VHI at such a premium prior to the pref. shares cancellation announcement (VHI traded with a $300m market cap, while the common share BV stood at a negative $27m) and also why did after the announcement the share price didn't skyrocket (although common share BV jumped from negative $0.84/share to $22.56/share). A reasonable explanation would be that the market knew/expected the cancellation beforehand - however, I haven't been able to find any announcements/hints on this. And the latest 10-K still indicates that these preferred very much valid and real:

Preferred stock. Our outstanding preferred stock consists of 5,000 shares of our Series A Preferred Stock having a liquidation preference of $133,466.75 per share, or an aggregate liquidation preference of $667.3 million. The outstanding shares of Series A Preferred Stock are held by Contran and represent all of the shares of Series A Preferred Stock we are authorized to issue. <...> Upon the liquidation, dissolution or winding up of our affairs, a holder of the Series A shares is entitled to be paid a liquidation preference of $133,466.75 per share.

Other points that may have an impact on the current discount:

  • Shady background of the family and obvious mismanagement of VHI after Harold Simmons's death (more information below).
  • VHI is currently under intercorporate services agreements with Contran under which the parent charges about $40m/year for management, planning, administrative services, etc. Therefore, there's a risk that the current situation may enter a limbo state, and Simmons's family will continue to milk VHI through their intercorporate services agreement while destroying the BV in one way or another.
  • 25m of KRO shares (varies based on the KRO share price) held by VHI are pledged as collateral for certain debt obligations of Contran (no details on what exactly). The value of the pledged shares amounts to $350m (61% of current BV), so if Contran defaults on it's obligations, VHI stake in Kronos is at risk.
  • Valhi has a very thin float due to the heavy ownership by Contran: of 28.5 mil shares outstanding and only 1.32 million shares are held by the public, with a market value of $14 million. Also, the stock is very thinly covered by the analysts/media.
  • One of the more common explanations for holding company discounts is potential tax leakage if the holdings are sold. However, after a quick glance tax leakage doesn't seem to be an issue here (positive point). Although VHI distribution of TIMET stake in 2007 was taxed at 36% capital gains (more info in the preferred stock section below), it seems that the capital gains from a potential sale of NL/KROS should be minimal. It's not clear when VHI acquired its take in NL, however, it is stated that in 1993 the carrying value of 49% NL stake was $60m. In the following 10 years, the company has increased its stake to 83%, and it seems that they were buying shares at a significant premium to the current $3.50/share price. Most of the stake in KRO also was acquired at a large premium to the current price of $13.15/share - VHI received a 32% stake after NL spun off part of its stake in KRO in 2003 (KRO shares started trading in Dec'03 at $18/share). In the upcoming 2 years, VHI stake in KRO was raised to 60% through further NL distributions. During 2004/2005 KRO traded at about $32-$34/share on average.

However, even if the above-mentioned points explain the existence of the current discount, it is still puzzling why pref. share elimination made absolutely no effect on VHI price, whereas the book value of common shares has increased drastically.

 

VHI mismanagement

In the current context is worth noting that H. Simmons and his family have been involved with numerous shady stories in the past - burying hazardous wastefamily feuds (his own daughters sued him for mismanagement of his trusts), swiftboatingstock manipulation, etc. Furthermore, in 6 months after the death of H. Simmons in 2013 (until the valuation of the inheritance), his daughters managed to drive VHI price down by 70% (dividend cut by 60%, stock dumping, etc.), losing $3bn in market value in order to save over $1bn in tax liabilities.

After H. Simmons's death, control of VHI was transferred to Simmons's family trust and it seems that over the next 7 years the company has been severely mismanaging. Almost all of the VHI value is concentrated in its KRO stake and the comparison between the two companies clearly shows material underperformance of VHI stock relative to KRO:

VHI

 

Preferred shares

Due to consolidated corporate taxing, VHI belongs to the Contran Tax Group, which allows them to make income tax payments to Contran rather than to IRS. In 2007 VHI held 35% stake in TIMET (valued at $2.1bn). Apparently, due to a valuation gap between VHI BV and its market price, the company has decided to distribute TIMET stake to shareholders via a special dividend. The incurred income tax liability to be paid to Contran stood at $667.3m and instead of paying VHI has issued preferred shares with a total liquidation value of $667.3m, 6% cumulative dividends, and no redemption rights. Interestingly, two days after issue, Contran has amended the agreement and eliminated the cumulative rights. Dividends on pref shares have never been paid since. Contran sold its TIMET stake in 2013.

Although at first glance this pref. equity elimination might look unreasonable (why would you give up on $667m for free), however, the actual loss for Contran is much lower here as almost all of the pref. equity value is now transferred to Contran's 92% in VHI common equity. So the real loss here should be $55m - (8% of $667m). Nonetheless, even for this smaller loss, it is hard to find a tenable explanation of why one would be willing to give this up for free.

 

Contran

Holdings of Contran include Valhi, NL, KRO, and Compx (CIX).

  • VHI holds 50% of KRO + 83% of NL.
  • NL owns 30% of KRO + 4% of VHI and 87% of CIX.
  • H. Simmons's family trust owns 92% of VHI via Contran.

 

Published on: August 26, 2020  •  Published by:
Category: Uncategorized

13 COMMENTS

  1. dt

    Does anyone have any other answers/clarifications on:
    1) Why did VHI trade at such a large premium to NAV before the preferred elimination announcement?
    2) Why did the announcement have almost no effect on the share price?
    3) Why did Contran agree to give up $55m for free?

    Without answers to these, I am feeling that an important piece of the puzzle is missing.

  2. Writser

    Yeah, intriguing idea but it seems a bit sketchy. Needs some more work. Noteworthy is that the ISA fee mentioned in the article is also consolidated, I think. Contran employs basically all management of Kronos, NL Industries and CompX and the subs pay Contran through the ISA for the outsourced management.

    From the NL Industries proxy:
    In each of the last three years, all of our named executive officers were employed by Contran and provided their services to us pursuant to our ISA with Contran. Such individuals also provided services to CompX and Kronos Worldwide under Contran’s ISAs with those companies.

    From the Kronos 10K:
    The net ISA fee charged to us is included in selling, general and administrative expense and corporate expense and was $16.3 million in 2017, $21.1 million in 2018 and $22.8 million in 2019.

    1. dt

      Yes, ISA fees are consolidated from all companies and at VHI holding level are much smaller. When taken all together (and assuming these execs do not receive any other compensation hidden within SG&A), I do no think these fees are that excessive.

  3. Brian

    I agree with DT, I went through where the actual ISA fees go and it doesn’t seem unreasonable. The executive comp is high but not out of line, and substantially all of the ISA is for exec comp, board, tax audit and legal, it appears.

    I stumbled on this idea last month when they were on the daily list for a reverse 1-12 split. You can see my comments here https://seekingalpha.com/article/4340077-contran-corp-undervalued-assets-awaiting-catalyst. I passed b/c of the preferred issue. But the combination of the death of Serena Simmons Connelly, followed by elimination of the pref 4 months later, and then some nominal insider buying, piqued my interest, and it’s a modest weight for me.

    Coincidentally, Kingdom capital published a similar article yesterday on SA https://seekingalpha.com/article/4370714-valhi-cancellation-of-preferred-shares-massively-increases-shareholder-equity. This is purely coincidental as I submitted this to DT days before 8/25, and KC and I did not correspond at all aside from the comment section of his Contran article. In full disclosure

  4. dt

    Had some further look into this.

    Analysis in the write-up looked at VHI valuation based on market valuations of its direct holdings of KRO and NL. However, NL Industries is really just another holding company with:
    – $100m in cash;
    – 30% stake in KRO ($462m)
    – 86% stake in CIX ($145m)
    – 4% stake in VHI ($13m)
    – Large liabilities for litigation settlement and ongoing accruals environmental remediation costs (-$166m in total).

    Altogether this results in NL Industries NAV of $555m (vs. $165m market cap).

    Replacing NL market cap with NAV in the VHI valuation table results in VHI NAV of $971m or $34/share – so almost 200% upside from current prices. I think this valuation is for super overoptimistic scenario. Reaching these levels would require both VHI and NL sell/distribute holdings in KRO and CIX (or in some other way collapse the holding company structure) with minimal tax leakage and without pushing down the market prices of these two entities (i.e. KRO and CIX) lower.

    A bit on NL Industries.

    NL trades at a large discount to NAV mainly due to uncertainty regarding any yet unreserved litigation liabilities from the old operation of disposed businesses + all the same governance issues as described for VHI. Settlement in ‘Lead pigment litigation’ was reached in mid 2019 and is fully reserved ($73m liability). However, reg fillings note that new filling related to lead in paint (relates to cases from 1980s) might continue to be filled. Reserves for ‘Environmental remediation and related costs’ amount to $94m. Management estimates that the upper end of costs for remediation and related matters that are possible to estimate are $115m (however, notes that for 5 out of 37 sites the costs are not possible to estimate). Overall the largest addition to reserves was back in 2013 (+$70m – probably EPA ordered cleanup of Raritan Bay) and since then additions of reserves were significantly lower (zero in 2019 and H1 2020).

    I do not think NL Industries would be able to liquidate or distribute full amount of KRO/CIX due to liabilities (and ongoing uncertainty on environmental matters) noted above. But at least a portion of these investments should be allowed to be released (by regulators) for shareholder benefit if the controlling owners wanted it. NL has assets of $700m against $166m-$250m (max) of potential liabilities – so seems to be plenty of excess capital.

    P.S. I still have not found the answers to the questions I raised in the first comment.

    1. dt

      Also, VHI freefoat stands at less than 5% and Contran ownership at around 95% after taking into account NL Industries cross-ownership of VHI shares.

  5. dt

    And some more additional perspective.

    YTD share price changes (at write up prices):
    – VHI down 53% – from $22.44 to $10.66;
    – KRO unchanged at $13.4;
    – NL down 14% – from $3.91 to $3.38;
    – CIX down 4% – from $14.59 to $14.00.

    VHI ownership of subsidiaries has not changed in the meantime.

    The only VHI level events that happened since were:
    – Leaving of chief tax officer;
    – Reverse split – took VHI stock out of penny stock area;
    – Dividend reduction by 67% – the only potential negative and VHI shares declined 20% upon announcement.
    – Unexplained elimination of preferred (seemingly very positive).

  6. Tom

    Do you think it’s possible that Contran was able to take a tax write-off for the $667mm preferred redemption and this was worth more than the $55mm? I have no expertise in this area so this may just be a silly question.

    1. dt

      Interesting idea and sounds plausible, but like you, I am not able to comment on tax matters.

  7. John

    So, we basically get a 40% discount to NAV for a holding with a crappy history? Not unreasonable to me.

    1. dt

      There is more to the story than simply buying a holding company at 40% discount to NAV.

      The main point of the thesis is that BV of common shares was lifted from $0 to $20/share due to the elimination of preferred equity, however, the price of VHI shares has barely changed. So either VHI shares were significantly overvalued before or are very much undervalued currently.

      Also almost the whole BV is comprised of ownership of publically listed companies and can be hedged.

      To realize the full book value, the holding company structure needs to collapse or the company has to be liquidated. So far it is unclear if anything is happening towards this direction, although the preferred eliminations seem to point that way.

      Also it the book value itself depends on the method used in calculations – see my message on the 27th of August.

      1. ijw

        Looking at 2011-2013, this was trading at a large premium.

        I think it was simply dividend investors shaken out coupled with the small float that causes current discount.

        Generally, dividend investors dumping a stock because their precious dividend is cut, is a fertile hunting ground for bargains.

  8. Brian

    I talked to their IR gal the other day. She didn’t have a ton to add, some historical color. She said the high dividend “wasn’t doing anything for the stock price” which I don’t necessarily agree with but so be it. She said they’re going to redirect the saved cash flow from the lower div toward reducing the credit line.

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