Current Price: $4.17
Offer Price: $4.20 + $0.25 in CVR
Expected Closing: Q1 2021
This situation offers an opportunity to collect a seemingly 'free' option of potentially receiving 7% payout sometime over the next 2 years.
Mobile accessories manufacturer Zagg is subject to an acquisition by a consortium led by Evercel (small investment shop). Consideration stands at $4.20/share + a CVR of $0.25/share (total transaction value around $200m in total including debt). CVR is conditioned on Zagg's PPP loan forgiveness until Dec'22. Zagg's shareholder approval will be required. The merger is expected to close in Q1 2021. So the whole idea here is to buy Zagg, get your investment +1% back in less than 3 months, and then have an option to get paid another 6% sometime in the future.
In short, there are multiple arguments that suggest the merger should close successfully and there's a very decent chance that CVR will pay out.
Moreover, what I also like here is that in case the merger breaks, the downside seems very limited/non-existent. The pre-announcement price is ($4/share), while Q4 results are expected to be positive (holidays and new iPhone release). The acquisition price stands at 4.4x 2019 adj. EBITDA (4.1x pre-COVID 2020 guidance), which seems low for a business, which is poised to generate considerable cash flows after recovery from COVID.
This transaction is the biggest Evercel has ever done and the target is larger than the buyer (on market cap basis). However, the merger is not actually contingent on financing and Evercel has already received a $160m financing commitment from two credible parties - Lynx and Keybank. Lynx was introduced (detailed in the proxy) to Evercel by the representative of Arex (activist and largest shareholder at the time), while Keybank is a subsidiary of KeyCorp ($17bn market cap bank).
Overall, I don't see any prominent risks for this merger not to close.
The merger is likely to close
- The buyer seems credible and competent. Evercel is a small listed investing shop with a very concentrated portfolio and investment style of "finding unique situations overlooked by the broader private equity industry, possibly due to some undesired complexity". In the last several years, they've made some very successful investments, i.e. SharpSpring (2x net return in 1.5 years) and Printronix. The company acquired troubled Printronix in 2013 for around $18m, optimized the business and its cost structure, paid off the debt, and in 3 years returned 100% of the investment from one of the segment's sale. Currently, Evercel still retains an 80% stake, while Printronix has generated $58m in revenue and $14.4m in adj. EBITDA in 2019. So if they sold the business now, the actual return on investment should be generous. At the end of 2019, Evercel was highlighting readiness to make further investments/acquisitions, while also noting that they've been slow on that so far as due diligence efforts proved the potential targets to be too expensive or not worthy of acquiring.
Evercel now has a very strong balance sheet to pursue new opportunities, which is our primary focus this upcoming year. [...] Although we are disappointed that we have not closed on any large new investments, we have been disciplined about walking away from opportunities we deemed to be too expensive or that subsequent due diligence proved not worthy of acquiring.
- The due diligence with Zagg has already been completed. I found no cases of EVRC walking away from a definitive agreement in the past. It seems that Zagg is their first acquisition in a few years (and quite a large one compared to their other acquisitions), so I would expect them to stay committed to close the transaction.
- Target company's business is recovering from the pandemic and the transaction looks somewhat opportunistic. Q3 results were better than expected, while Q4 should be even stronger given the holiday season and an additional catalyst of iPhone 12 release. Even if Q4/annual results are released until the transaction is closed, Zagg's performance should not get in the way of the transaction closing.
- EVRC is acquiring Zagg cheaply. Assuming the business recovers in 2021, the 4.4x 2019 adj. EBITDA (4.1x pre-COVID 2020 guidance) acquisition multiple looks like a bargain. Following the announcement of the transaction, EVRC price jumped 30% suggesting shareholders recognize the attractiveness of merger and price.
- One of the risks was opposition from two activist investors - Arex Capital Management (owned 8%) and Roumell Asset Management (4%). However, neither of them have voiced dissatisfaction and seem to be fine with the merger. Both activists were actively pushing the company for a sale in 2020 and each of them put one nominee on Zagg's board. Arex used to be the largest shareholder with 8% stake, which was acquired at around $6+/share. 3 days after the merger announcement, Arex sold its stake at a significant loss. RAM acquired its stake in early 2020 at around $3.35/share and after the merger announcement has remained silent so far. Aside from that, there was some noise from Zagg shareholders in the social media and various retail investor forums arguing that the price is too low, however, given the stance of the activists, it's fair to assume that the vote will go through.
In April'20 Zagg received $9.4m loan from the Paycheck Protection Program (PPP) to tackle the costs and impact of the pandemic. If the company meets certain requirements and passes the audit of the U.S. Small Business Administration, the loan will be forgiven and under the merger agreement, loan amount will be distributed to CVR holders.
The requirements for loan forgiveness are:
- Only the expenses incurred 24 weeks after receiving the loan are eligible for forgiveness.
- At least 60% of the loan was used for payroll costs.
- Full-time employee equivalent headcount was maintained. If 8 or 24 weeks after receiving the loan the number of employees was not lower than in the period either from (Feb'19 to June'19) or (Jan'20 to end of Feb'20), then the requirement was successfully met.
- Wages were not cut by more than 25%.
- Rent/utility/mortgage contracts were in place before the 15th of Feb'20.
The fact that they've agreed to include CVR into the consideration clearly indicates that Zagg beliefs it satisfies all of the requirements. Q3 report also states that the company is compliant so far, however, is cautious regarding potential regulation changes:
We made good faith certifications of our necessity for the PPP Loan, and believe that we are in full compliance with the terms and conditions outlined in the CARES Act. [...] Due to the incomplete and changing regulations around the PPP, new pronouncements may also change our current compliance status under the law, and any potential allowable forgiveness of the outstanding PPP Loan amount
Two more points worth noting:
- In contrast to pharma merger CVRs, the risk of the buyer messing with the process to derail the payment seems significantly lower. The period which will be audited has already ended (in 2020) and the proxy states that the required filings for loan forgiveness will be made by the 31st of Jan'21 (the merger is expected to close at a later date).
- $9.4m is a considerable sum for Zagg and if it's not forgiven the company might be even forced to take on additional debt. Considering that, it's fair to assume that the management did its best to comply with the requirements in the 24 week reference period and there's a high likelihood that eventually the loan will be forgiven.
Some Zagg Background
Zagg manufactures smartphone screen protection and various other mobile phone/tablet accessories. Despite the increasing competition, the company has retained a leading U.S. market share across its key segments (presentation):
Since 2019 the company has faced several headwinds (slowing new phone sales, competition, etc.), however, the largest impact came from the increased China import tariffs, which considerably impacted Zagg's margins and earnings. As a result, the company had to adjust its adj. EBITDA guidance two times in 2019. This caused 3% YoY fall in revenues in 2019, while adj. EBITDA of the year fell 41% to $45m from $76m in 2018. This resulted in a failed strategic review and significant share price deterioration from $12/share to $6-$8/share. The company has started various cost-cutting initiatives and began transferring its manufacturing operations outside China. The start of 2020 was solid (15% revenue increase in Q1'20 YoY), however, the company was hit with COVID outbreak and closures of wholesale partners stores (online segment is just 10%-12% of revenues). This resulted in significant sales and profitability drop. Q2 revenues fell 28% YoY and adj. EBITDA was zero. The business started recovering by the end of Q2 and Q3 results came in relatively strong, beating analysts' and management expectations. Revenue was still -20% YoY, however, EBITDA returned to growth levels and was $15m vs $21m YoY. Due to conservative inventory approach, Zagg had to take increased expedited freight costs ($2-$3m estimated by the management) to meet the higher than expected demand. In the Q3 call (November), management stated that the business seems to be normalizing and that it sees "some strong signs that we're kind of getting back to a more normal Q4 experience.".
So overall, the recent two years were very troublesome for Zagg. However, there are multiple catalysts ahead now, including the recovery from COVID in 2021 (elimination of extra freight costs, which persisted throughout 2020) and the eventual transfer of manufacturing away from China (elimination of tariff burden). The company has already moved its screen protection and wireless power products to Vietnam. The company holds a leading market share in the U.S. so it poised to experience the quickest benefits of the recovery.
- Dimensional Fund Advisors - 5.8%
- RBC Global Asset Management - 5.2%
- Directors - 3.5%.
One more thing worth mentioning
Aside from Evercel, the company had several other bidders in 2020 and the offers were similarly priced. However, none of the other parties indicated a willingness to proceed after the DD. The most recent proposal ($4.90/share) actually came on the 24th of Dec, after the agreement with Evercel was already signed. However, after a few days of DD, the bidder walked away.