ALJ Regional Holdings announced the final results of its tender offer last Tuesday. With a proration factor of 90.8 percent almost all shares will be accepted by the company, and my merger arbitrage will be profitable no matter what I get for the remaining shares. I initiated my position at $0.75 and with the company buying 90.8% at $0.84/share I will receive effectively a bit more than $0.76/share. If the remaining part of the position could be sold at $0.75 (latest market price) the total return will be approximately 11 percent in a three month period. I’m happy with that. The big question is: should I actually sell my shares?
The company issued the following statement about it’s balance sheet and share count:
Following the completion of the tender offer, ALJ will have 27,446,598 shares of common stock issued and outstanding (29,646,598 on a fully diluted basis) and approximately $27.8 million in cash and receivables.
That’s $0.94 in cash per share on a fully diluted bases, so currently the company is trading at roughly a 20% discount to it’s cash value. That’s not what I would call a huge bargain, but it is cheap, and the cash is not the only asset ALJJ owns.
The company also has sizable net operating loss carryforwards, and the latest annual report provides some details:
At September 30, 2012, the Company had a net operating loss carry-forward for federal income tax purposes of approximately $258 million that expires from 2020 through 2028. The use of approximately $36 million of this net operating loss in future years may be restricted under Section 382 of the Internal Revenue Code. The realization of the benefits of the net operating losses is dependent upon sufficient taxable income in future years. Lack of consistent future earnings, a change in ownership of the Company, or the application of the alternative minimum tax rules could adversely affect the Company’s ability to utilize these net operating losses.
Additionally, if the Merger is completed, the Company’s ability to utilize our NOLs to offset future tax liabilities may be limited even if it acquires another business which generates taxable income. For example, if it takes the Company substantially more than one year to acquire another business, it may be treated as having liquidated for U.S. federal income tax purposes, which could prevent the Company from being able to its NOLs to offset future income of the new business.
Some of these assets have presumably been used in the sale of the KES division. ALJJ had a negative book value of $13 million before the sale, and after the sale but before the tender offer it had $51 million net in cash. I’m not an expert (far from it!) on US tax rules, but it would seem to me that this would require the company to recognize a gain of $64 million. This would reduce the carryforwards from $258 million to $194 million. $36 million of this amount is restricted, so I’m going to assume that the effective amount is closer to $158M.
With an effective tax rate of 35% this would mean that the company would be able to shield itself from paying $55 million in income taxes. This is however absolutely not the value of the tax shield because it’s probably not easy to generate $158 million in income between now and 2028. We are also talking about cash flows that are far in the future, and therefore should be discounted with an appropriate discount rate.
Since we have no idea what the income characteristics will be of a potential future business it’s going to be a big guess, but just to get a ballpark figure the following example. Lets say that that we can buy for the $27 million in cash a business that generates $3 million in income a year while income grows 10% a year. This would generate a total of $108 million in income between now and 2028 (and potentially a $37 million tax liability) so we would be able to use up a fair amount of the NOL carryforwards. But the present value of not paying those $37 million in taxes is, when we use a 10% discount rate, ‘just’ $14 million. Since you can’t be guaranteed to buy a profitable business, and there are a lot of other uncertainties as well, I would guess that the present value of the tax shield is somewhere between $5 million and $15 million.
One of the attractive aspects of the merger arbitrage, the initial reason I got involved in this name, is that the chairman of the board, Jess M. Ravich, would not tender his shares. This increased his stake from 22% to a bit more than 43%. That’s a good reason not to do anything stupid with the cash! The fact that he did not tender at $0.84 also indicates that he thinks ALJJ is worth more than just the cash alone. What’s perhaps a negative is that he recently joined TCW as group managing director, so how much time can he spend on ALJJ?
A possible catalyst
There is potentially also a catalyst for unlocking the value in ALJJ, and that is the fact that the company must acquire a new business in approximately one year in order to keep the NOL carryforwards valid (see the quote on the NOLs above). If this doesn’t happen I will assume that the cash will be returned to shareholders. The press release that was issued when the sale was announced contained the following language:
Upon completion of the Merger, ALJ will have no or nominal operations and, other than the cash proceeds, no material assets. ALJ intends to retain the remaining proceeds from the Merger for future acquisitions. At this time no specific acquisition targets have been designated and there can be no guarantee that ALJ will designate a suitable target within any particular time frame, or at all. Further, even if a target is identified, there is no guarantee that ALJ will be successful in acquiring such target on commercial terms or at all. Such a target company (or assets) might be in any industry. In the event that ALJ is not successful in acquiring one or more operating businesses within a reasonable period of time, the Board of ALJ will determine an appropriate course of action with respect to ALJ’s remaining cash-on-hand.
I’m thinking that the only appropriate course of action will be a return of capital at that point, and that would not be a bad outcome. With $0.94/share in cash you could be looking at a 25% return for just waiting and seeing nothing happen. A more uncertain outcome valuation and return wise is a successful acquisition of a business. But since the value of the NOL carryforwards would be preserved in this scenario I think it’s actually preferable.
After the completion of the merger and tender offer ALJJ isn’t the most exiting business in the world: it’s just a cash box doing nothing. Nevertheless I think it’s quite attractive at current prices. It’s trading at a 20% discount to cash/share, there are sizable tax assets and we have an insider that has a lot of skin in the game and a good track record. So instead of selling the remainder of my shares I actually bought some more.
Rating: on a scale of one to five I’m going to give this idea two stars. I’m not expecting huge returns, but I also don’t think it’s very risky: think it’s a good spot to park some cash.
Author is long ALJJ