Current Price: $1.90
Target Price: TBD
Expiration date: TBD
This is a speculative management buy-out, which is still at a non-binding stage. The company currently trades significantly above (3x) the initial offer price. Thus, for this special situation to play out, the buyer would need to increase the bid materially and the likelihood of that happening is not clear.
On the 19th of Nov'20, Steel Connect received a non-binding offer from its parent Steel Partners (owns 55% of fully diluted shares) to acquire the remaining STCN shares for $0.65-$0.72/share in cash and SPLP preferred units (ticker SPLP-PA). The offer is highly opportunistic and was made during the COVID lows, with a 60% discount to mid'19 price levels. The parent has a good track record of similar buyouts over the last few years. A special committee was formed in January and is still reviewing the transaction.
STCN shares currently trade at $1.90, while the highest levels were reached in mid-Jan'20 at $2.90/share. Clearly, the market considers the parent's offer to be absolutely inadequate and sees considerable value in STCN even without the buy-out.
Two major questions here are what are the chances the buyer will proceed with the transaction, especially at multiple times the price of the initial offer, and what kind of downside protection investors have at the current valuation.
Overall, the arguments are quite mixed and although there are a few points supporting favorable development of the situation, the whole thesis gets a bit stuck on the valuation part and attractiveness of STCN at the current price levels. The company currently trades at 5.3x adj. TTM EBITDA/16% FCFE yield and given slightly declining revenues (potential to recover to pre-COVID levels) and unstable FCF conversion, it doesn't look especially cheap. However, the company also has a material amount of NOLs - $2.1bn federal and $117m state. So, in the end, the attractiveness of STCN at current levels depends on valuation of those NOLs. Assuming generous $30-$50m value for NOLs, an increased bid from the parent looks quite possible.
The major risk is that SPLP could decline to pay multiples above the initial offer and wait again for more opportunistic timing.
The downside is difficult to predict. It is not clear if STCN share price would tumble if buyers' offer is withdrawn - likely current price is based more on the company fundamentals than expectations of the higher offer. However, if the shares drop, I would nevertheless expect STCN to stay materially above the pre-announcement price levels (COVID-lows).
STCN has around 62.8m common shares outstanding. SPLP owns 100% of preferred shares convertible into 17.8m common at $1.96/share and $14.9m convertible notes, convertible into common at $2.37/share. So the diluted share count sums up to 86.8m shares. SPLP owns 55% of the fully diluted shares and controls 52% of the voting power.
STCN operates two segments - IWCO (direct marketing) and ModusLink (supply chain management). The company provides very limited information on individual segments and their financial performance.
IWCO services include primarily paper mail marketing services and also various omnichannel (web, social, mobile) marketing. The segment was acquired in Dec’17 for $476m in order to leverage STCN NOLs.
We have been looking to acquire a profitable business with attractive operations and financials, and with a strong management team in order to leverage our approximately $2.1 billion in net operating loss carryforwards (NOLs) and cash.
At the time IWCO generated $82m EBITDA and $18.9m net income, so the acquisition was done at 5.8x EBITDA.
Recently, the company announced a transformation towards digital media, data analysis services with intentions to target financial services, and fintech industries. This seems highly positive, especially given the current tailwinds in those target industries.
ModusLink is STCN legacy business that offers various supply chain services (digital commerce, packaging, kitting & assembling) for consumer electronics, communications, computing industries. A turnaround plan for the troubled business was launched in 2016 when the business reported a $40.6m operating loss. The process looks somewhat successful - the company has exited some unprofitable operations, raised gross margins from 5% in 2016 to 19% in 2020 and lowered SG&A from $57m to $36m. TTM operating profit stands at $26m.
COVID outbreak had a negative impact on STCN businesses (especially IWCO). FYQ1 (October’20) showed revenues -25% YoY, net loss of $3.5m vs $4.8m profit in Q1’19 and EBITDA -38% YoY. FYQ2 (Jan’21) reported revenues -28% YoY, net loss $2.2m vs loss $3.6m Q2’19 and EBITDA -10% YoY.
At the current price levels the company trades at:
Historical adj. EBITDA seems stable (see graph below), however, the conversion rate to FCF is jumping up and down making it difficult to estimate a normalized cash generation level going forwards. For example, despite rather stable adj. EBITDA, FCF in FY19 (ending July) was just $6.3m (and FCFE negative), in FY20 it was $60m, Q1 FY21 showed $25m and in Q2 FY21 it suddenly dropped to -$22m. Some of these movements can be explained by working capital investments and various one-off items, but not to a full extent.
Over the last year revenue was on decline due to COVID-19 impact as well as exit from the unprofitable businesses in the Supply Chain segment.
Segment level net revenue:
Segment level operating income:
What seems quite positive is that despite declining revenues, gross margin of STCN is actually increasing - 19% in FY19, 21% in FY20 and 24% in H1 FY21.
However, overall, 5.3x adj. EBITDA and 16% FCFE yield valuation doesn't look that cheap for this business, especially taking into account the elevated leverage - 5x adj. EBITDA would drop the equity value to $1.60/share and 4.5x to around $1/share.
Some arguments in support of an increased offer
SPLP is a diversified holding company, which has a track record of similar minority buy-outs - DGTC in 2015 (owned 85%), COSN in 2015 (owned 80%), JPS in 2015 (owned 39%), SLI in 2016 (owned 25%), SXCL in 2017 (owned 64%) and HNH in 2017 (owned 70%). 2018 investor presentation indicates that SPLP has paid 6-8x EBITDA on average for their acquisitions.
The involvement of certain activists also adds confidence in a “fairer” offer price. According to the most recent filings Gabelli Funds own around 2.5m STCN shares. 400k of that amount has been held since 2015, while the majority of the rest of the stake was accumulated during H2’20, around / slightly above the offer price. SPLP has a history of facing substantial activist pushback on their opportunistic deals, including from GAMCO. For example, in 2016 SPLP proposed to acquire the remaining 36% shares of SCLC at $12.50/share. The offer was opposed by GAMCO (owned 12%) as a result of which SPLP raised the price 3 more times to $16/share, then to $17, and eventually to $17.80/share. In 2017 SPLP proposed to acquire HNH at a price range of $35-$37.10/share. Only 57% of minority shareholders participated in the transaction and the rest sued the company and won an additional $30m settlement (equivalent to an additional 30% premium or $10.76/share).
Aside from the operating business, STCN has $2.1bn federal and $117m state NOLs expiring from 2022 to 2038, which could be worth something to the parent. This article puts very high-value expectations on STCN NOLs claiming that SPLP will be able to use it for their own capital gains on the current AJRD merger ($200m profit). This seems highly unlikely. Although some amount of STCN NOLs could flow through to the parent (IRC section 382), I do not believe using NOLs to cover the capital gains is possible (however, I am not a tax expert). Anyways, the NOLs should have some value here and are likely to be worth around $30m-$50m ($0.34-$0.57 per STCN share) in an optimistic scenario.
Assuming the company will be able to continue generating cash-flow at FY20 levels and assigning $30m-$50m value for the NOLs, at the current price SPLP would be getting the remaining business at around 4.8x - 5.0x adj. EBITDA and 20%-23% FCFE yield. Valuation at this level leaves plenty of headroom for an increased offer.
Additionally, SPLP has to acquire only the remaining 45% fully diluted shares, while some of the amount would be paid in SPLP pref. shares. So the actual cash outlay SPLP would have to pay here is not that high if they are really serious about acquiring STCN and see considerable value in the NOLs.
Shareholders won't accept a low price
Another positive aspect is that the privatization will require approval from the majority of unaffiliated STCN shareholders who are unlikely to accept a lowball price. In the preliminary offer announcement, it was stated that SPLP:
Will not proceed with the Proposed Transaction unless it is approved by the Special Committee and that the Proposed Transaction will be subject to a non-waivable condition requiring approval by the holders of a majority of the outstanding shares of common stock of the Issuer that are not owned or controlled by the Reporting Persons.
STCN minority shareholders are not very happy about SPLP control due to certain value-destroying transactions by the parent in the past (more on this in the "Risks" section below). In the 2019 annual meeting of Steel Connect minority sharheolders have clearly voted against re-election of two SPLP directors - W. Lichtenstein (STCN exec-chair, founder and exec-chair of SPLP) and G. Kassan (board member of STCN). Moreover, in April 2018 SPLP wanted to increase management’s incentive award plan from 5m shares to 11m shares. Most of the minority shareholders (11.8m shares) voted against the proposal.
The biggest risk is that SPLP will not agree to raise the price or that the increased offer would still end up below the current market price. SPLP has a somewhat shady history of self-dealing and destroying shareholders' value. This adds some doubt on the legitimacy of their intentions and prospects of a “fairer” price, especially at multiples above the initial offer.
Certain examples of self-dealing via STCN:
- In December 2017, after STCN completed the acquisition of IWCO (major business segment now) and STCN shares skyrocketed 70%, the board (controlled by SPLP) decided to grant 5m shares (worth $12m+) to 3 SPLP affiliates for their “current and future services to the Company”.
- In April 2018, the board proposed to adjust the management’s incentive plan from 5m shares to 11m shares.
- In June 2019, the board approved $3.4m annual management services agreement with a certain SPLP subsidiary Steel Services.
On top of that, HNH takeover, which resulted in a $30m settlement, was highly questionable/shady as well. At the time SPLP was advised by Duff & Phelps and apparently, the transaction was subject to numerous fiduciary duty breaches. The court has essentially agreed with that (PR):
Chairman of the Handy & Harman Special Committee charged with protecting the interests of public stockholders was the friend and former roommate of the Chairman of Steel Partners Holdings and a former partner in the predecessor of Steel Partners Holdings; that the valuation of Handy & Harman was artificially lowered by using stale financial projections that underestimated the Company's forecasts; and that the tender offer materials failed to inform public stockholders of other important facts regarding the merger.
A rather long silence of the current review period and the involvement of a controversial advisor (Houlihan Lockey) adds some uncertainty as well. Especially, when the special committee (should be some or all 4 independent directors) has previously approved various questionable self-dealing transactions by SPLP affiliates.
Yet another negative is that STCN has poison-pill plan, which prevents other companies from acquiring more than 4.99% of shares. This was implemented to preserve NOLs and was recently extended until 2024. It makes impossible for activists to build up larger stakes in the company.