Category Archives: Research

Kronos Bio: where did the money go?

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Biotech companies are a fertile hunting ground for the special situation investor. Many of them fail and undergo some form of corporate action (liquidation, reverse merger, bankruptcy…), or they are successful and get acquired. Most of them fail, but whatever the outcome, something always happens. But that something might not always be a positive event, and before that moment comes, they will usually burn cash like crazy with nothing to show for it. Last year Kronos Bio entered my radar when it announced a plan to “evaluate strategic alternatives”.

At the time the company had $124.9 million in cash, but was contending with a significant cash burn rate and large lease liabilities ($25.8 million present value). With a share price around $0.85 and market cap around ~$52 million it’s easy to see the attraction for special situations investors. That setup should offer plenty of room for some cash burn, get rid of the lease liabilities, and still generate a good return, right? Right?…

The Tang Capital Deal

After a couple of months of silence the company announced it would be acquired by Tang Capital for $0.57 in cash/share plus a contingent value right tied to a whole Christmas tree of different milestones. Tang Capital is basically involved in every busted biotech, and he often offers to buy the company at a not too big discount to net cash value, and share in the upside of the disposition of the (failed) clinical assets using a contingent value right.

The $0.57 in cash per share amounts to just $35 million, and was quite a disappointment. Not just for the entrepreneurial special situations investor, but also for the market in general because the stock dropped from ~$0.90 to ~$0.70 the day the deal was announced. So, what happened here? Where did all the cash go?

If we take the latest quarterly statement, filed a week after the merger agreement, we see the following balance sheet:In the six months between the start of the strategic review and the deal announcement, the cash balance dropped from $124.9 million to $99.7 million. Liabilities also decreased by about $10 million, and there were $3.7 million in costs related to an 83% reduction in workforce. That’s a lot of money down the drain, but at the same time nothing too unexpected happened. Adjusting for the changes in liabilities and the one-time restructuring expenses that results in a cash burn of less than $6 million per quarter, and with the 83% reduction in headcount the future cash burn is supposedly a lot lower. Note that this cash-burn figure doesn’t include the lease payments, because they result in lower liabilities on the balance sheet when paid (ignoring some net present value accounting movements).

So looking at this it’s still tough to see why the company is basically being acquired for $35 million plus some rights. A basic analysis would start with the latest cash balance, deduct all liabilities, make an adjustment for the lease liabilities to take the undiscounted value and add one quarter of cash burn until the merger closes. This gets us to the following estimate:

So, did Tang Capital simply get a very good deal? Are shareholders getting screwed? Why is this being sold for $0.57/share?

The contingent value rights

Of course, I haven’t started to discuss the CVR, and at first sight that one offers some hope of a recovery of the missing cash. The CVR has a total of four milestones, two of them related to the disposition proceeds of their clinical assets, one related to the (lease) liabilities and one that is especially of interest with regards to the missing cash question. Shareholders will get the right to get 100% of the Closing Net Cash (capitalized terms, because this is of course a carefully defined term in the merger agreement) above the cash balance of $40 million.

So a rough estimate would suggest that there should be $18 million of cash available above the $40 million threshold, and that could translate into ~$0.30/share of addition consideration. If you would have bought some shares to bet on this contingent payment I wouldn’t fault you, it is a thesis that makes sense, but something doesn’t quite add up. Why agree on a $35 million cash deal if there is no real question that the net cash is a lot higher?

Today, the tender offer statement was released, and it contained some interesting information. Because, surprise, surprise, the estimated payout of this specific milestone of the rights is not close to $0.30/share, but estimated between just $0.02 and $0.05/share. So we are back at our original question, where did the money go? Well, as I said, “Closing Net Cash” is of course a carefully defined term in the merger agreement, and it does not match the calculation above at all.

“Closing Net Cash” means, without duplication, (i) the Company’s cash and cash equivalents, restricted cash, and investments as of the Cash Determination Time, determined in accordance with GAAP, applied on a basis consistent with the Company’s application thereof in the Company’s consolidated financial statements, minus (ii) Indebtedness of the Company as of the Cash Determination Time, minus (iii) the Transaction Expenses, minus (iv) the Estimated Costs Post-Merger Closing, minus (v) $400,000 for the CVR Expense Cap under the CVR Agreement.

Besides some small differences, and not all negative, because here restricted cash is included in the calculation, the single item that should get you worried is called “Estimated Costs Post-Merger Closing”. In the merger agreement this is defined as following:

“Estimated Costs Post-Merger Closing” means all costs that the Surviving Corporation would incur post-Merger Closing, including costs associated with: (i) CMC Activities; (ii) clinical activities; (iii) remaining lease-related obligations (including rent, common area maintenance, property taxes and insurance); and (iv) an aggregate of $250,000 for any legal Proceedings and settlements.

Paying for the remaining lease obligations, sure, but apparently soon to be former shareholders are paying 100% for all future clinical activities and who knows how much money is budgeted for that? Schedule I, that should contain a pro-forma Closing Net Cash Calculation is strategically not publicly filed with the SEC. Current shareholders will be paying 100% of the costs to maximize the value of the preclinical assets, but will only receive 50% of the proceeds. And that is assuming they will receive anything, because if the assets are not sold in the first two years after the merger closes shareholders will get nothing. Does it make sense for Tang to sit on these assets two years to get all the proceeds? Probably not. I’m skeptical about the value of preclinical assets that failed their trails, but two year old failed assets must be even worse.

Finishing remarks

So where did the money go? I’m not sure. It certainly looks like Tang Capital got a good deal, but perhaps the reality inside the company was worse than expected. Tang Capital started with an offer of $0.95 per share, assuming at least $67.2 million in closing net cash, but that was quickly revised down to the current proposal after due diligence. It still doesn’t quite add up to me.

Perhaps it’s also related to the lease expenses. If we, for a moment, ignore the colossal stupidity of an early-stage biotech company signing an 11-year lease, there’s a curious liquidation analysis in the tender offer documents on page 23. Total lease expenses are estimated at $42.9 million, while the latest quarterly statement lists just a $30.8 million undiscounted liability. Once again, it doesn’t quite add up, but the $12 million difference is more or less what we are missing.

For investors who have confidence in the value of the preclinical assets, the stock might still be of interest. Tang Capital estimates the probability-weighted value of the CVR between $0.21 and $0.35 per share, while you can now effectively buy it for $0.13 per share. Potentially a good deal – but they’re not exactly a neutral party I’d rely on…

Disclosure

No real position, except some shares to track what happens.

My take on TABS Holland

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Last week a fellow Dutch value investing blogger wrote-up TABS Holland. The company supplies wood and building products to the Dutch market, and is traded on the obscure NPEX platform. The platform will actually cease all trading next month because its software doesn’t comply with the latest regulations. They have implemented a weird auction system without a central order book that makes it possible that different lots of shares are simultaneously sold and bought for different prices. An obscure illiquid stock on a weird exchange sounds like the rights ingredients for a cheap valuation, and on the surface that seems to be the case for TABS Holland as well. It’s trading at a 6.6x P/E-ratio while the other valuation metrics are as follows:

Last price: €28.76
Shares outstanding: 6,768,303
Market cap: €194.7 million
Net debt: €63.4 million
Enterprise Value: €258.0 million
P/E (ttm): 6.6x
P/B (mrq): 1.56x
EV/EBITDA (ttm): 5.23x
EV/EBIT (ttm): 6.12x

Based on market cap and enterprise value Timber and Building Supplies Holland (TABS Holland) is actually not that tiny and obscure. Most of the stocks I own are smaller, but in this case the float is ridiculously small. According to VIB.net the free float is roughly 3% which translates to less than €6 million. Most of the shares are held by HAL Holding while management and some other “big” shareholder own the rest.

Financials

Before trying to figure out how much this business is worth it’s a good idea to start with a look at the historical financials, even though that might not be that useful in this case. In 2015 PontMeyer NV acquired Deli Building Supplies and the combined company continued as TABS Holland. The acquisition basically doubled the size of the company. The transaction was completed the 1st of September, so in the financials for the year 2015 the last four months include the results of Deli Building Supplies while 2016 was the first full year of the combined company.

When looking at the historical results it is clear that TABS Holland isn’t a great business. Revenues didn’t grow at all in the 2011-2014 period while profitability was around breakeven. Only in 2015 and 2016 things started to turn around in a big way. While the acquisition of a big competitor can’t have hurt, I think the main reason is simply the fact that the Dutch housing market has rebounded after the crisis and is now running white hot again. The low for the Dutch housing market was in 2012 and 2013, while now things are pretty crazy again. I live in Groningen, which isn’t as hot as Amsterdam, but I  have never seen so many houses being renovated or just being torn down and rebuild in my neighbourhood as in this year. So it’s not a surprise that the more recent results are pretty good, and presumably the full year results for 2017 will be even better. The timing of the acquisition was certainly excellent!

It was a big acquisition, and to finance it TABS Holland issued a bunch of new shares while the amount of debt outstanding also exploded. They have been paying down the debt rapidly, and last year they even found some money to pay out a decent dividend.

Valuation

How much is TABS Holland worth? it’s a good question. It’s a cyclical business that probably is near the top of the cycle. The housing market in the Netherlands isn’t showing signs of slowing down yet, but when you play a game of musical chairs the music always continues playing until it doesn’t. Based on current earnings the business is clearly cheap, but a lesson about cyclical businesses that stuck with me is that they are best bought when they appear expensive, not when they appear cheap. But maybe a 6.6x P/E ratio is cheap enough to overcome this risk.

A reasonable base-case scenario is perhaps to assume a couple of years like this year, followed by more average results (adjusted for the doubling in size of the company). This gives some credit to the current good results, while also building a bit of mean reversion into the valuation.

In the valuation I have doubled the operating profit numbers from 2011 till 2014 to account for the fact that the business is now roughly twice as big. Since 2015 already included 4 months of the combined company I multiplied those results by a factor 1.5. This gives us an average operating profit of €21.2 million. Deduct €1.4 million in interest costs (assuming they keep operating with the current debt load), deduct 25% in taxes and normalised net income is €14.9 million. Slap a 10x multiple on that and we have a €149 million terminal value. Additionally I will assume that the next 3 years will be great, and the company will earn €30 million in each of these years. Discount this with a 10% rate and we get a valuation of €182 million.

The current market cap is actually a bit higher than that, so to me the market price seems pretty reasonable. A P/E-ratio of 6.6x sounds pretty cheap, but at the same time I don’t want to be paying a 10x ratio if it’s indeed near a cyclical top.

Conclusion

When I read about TABS Holland I thought that it was a pretty interesting situation, and I already had opened a NPEX account and transferred some money. After doing a little bit of research I’m less convinced. The company doesn’t appear particularly expensive, especially compared to other publicly traded equities, but at the same time it isn’t obvious cheap either. I think a conservative valuation needs to take into account a bit of mean reversion at this point in time, and because of that it should be looking cheap from the outside. You could come up with some reasons why looking at the past results is too pessimistic or why a 10% discount rate is too high though. The combined company probably has realised some synergies while the market has become less competitive.

I have to admit that I would have loved to buy something on such an obscure platform as NPEX, but I think I’m going to pass on this opportunity… TABS Holland is probably a bit undervalued, but not enough for me.

Disclosure

Author has no position in TABS Holland

Industrial Milk Company: farming in Ukraine

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Coincidentally, Black Earth Farming isn’t the only farming company in the Russia region that hit my radar this month. Before stumbling on that merger idea I was already looking at Industrial Milk Company. Despite its name, the company is mainly focused on raising crops. Its assets are located at the other side of the border, in Ukraine, and it has roughly the same size as Black Earth Farming while focusing on the same mix of crops. So I think the transaction is a nice data point that can act a bit as a sanity check on our valuation. I started looking at Industrial Milk Company based on a tip from a reader, who described it as having a normalized P/E ratio of 2x. While investing in Ukraine isn’t without risk, that’s certainly cheap enough to arouse my interest. Before we continue discussing the company in more detail, some quick statistics first:

Ticker: IMC:WSE
Latest price: 9.86PLN ($2.48)
Market cap: US$77.5 million
P/E: 7.15
P/B: 1.10
EV/EBIT: 3.22
EV/EBITDA: 2.71

Based on these statistics the company doesn’t immediately looks like a screaming buy, but there are a lot of moving parts that impact the income and balance sheet statements. Industrial Milk Company has the Ukrainian Hryvnia as functional currency while using the US dollar as presentation currency, and as a result it has been incurring large FX losses the past years. Since its assets are mainly land and machinery while it sells most of its production internationally these losses are presumably mostly accounting issues, not real economic losses.

In addition, the company recognized a $16 million loss in the trailing twelve months because it loaned money from the IFC that came with a warrant agreement that allowed IFC to claim $21 million if it would not exercise the warrants. With the warrants having a strike at $6.45/share while the stock is currently trading at $2.48 they obviously went for the cash payment. Bit weird accounting wise in my opinion, but certainly shouldn’t be a recurring issue. Because of this additional liability net debt stayed stable the past nine months even though the company generated a good amount of cash flow:

Normalizing earnings by ignoring FX losses and adding back the “Loss on recognition of additional return on financial liability” is tempting to do (the company does this, see for example page 5 here), but based on the amount of free cash flow the company is generating I think that is a too optimistic approach. To be honest, I have a bit of trouble figuring out where the earnings disappear. Since the company is valuing their biological assets at fair value there is a large non-cash component to earnings, and part of that disappears as a non-cash element of “cost of sales”, but inventories, biological assets and receivables aren’t really growing. Guess that must be because of the FX losses?

So instead of using earnings, I’m inclined to look at free cash flow as the best way to value the company. But that’s also a bit tricky, since cash generated from operations hasn’t been very stable historically. The past three years have been solid, but before then results have been more mixed.

As a starting point I will take TTM cash from operations of $36.9 million, add back interest expense of $13.1 million and subtract depreciation of $8.5 million. Current capex is below depreciation, but I have no reason to believe that that is sustainable. It might even be too low if the book value of the PP&E is artificially low due to the FX losses. This gives a total cash flow that is available to the whole firm of $41.5 million. Now the big question is what kind of return should investors require here. Industrial Milk Company is not some save western company, and that is reflected in the interest rates that the company pays on its USD loans that are between 10 and 12%. Add an equity risk premium of something like 6%, and we probably should require a return of roughly 17.5% on unlevered equity. That would mean that the whole company is worth $237 million. Subtract $91.9 million in net debt and we arrive at an equity value of $145.2 million: implying that there is roughly 85% upside from the current market price. Not bad, but also not as high as you would have hoped if the starting promise is a 2x P/E ratio.

We can use the Black Earth Farming as a bit of a sanity check of what the company should be worth as well. Some statistics side by side, and the implied upside:

The financial statements of IMC might be difficult, but when you buy a farm in the end not a lot of variables matter. How much land you buy (as measured by surface area) and how many crops grow every year on it (measured in tons and/or dollar value) is basically everything you need to know. And based on this I think my simplistic free cash flow model is pointing in roughly the right direction. Just based on hectares the upside potential isn’t that big, but IMC is a lot more productive based on sales volume and total revenue. With 1.5x more equipment, 1.5x times higher production volumes and 1.4x times higher revenue I would say that IMC in an optimistic valuation is maybe roughly worth 50% more than Black Earth farming: so $300 million. After accounting for the debt that would mean an upside potential of 168%.

Conclusion

Industrial Milk Company is for sure not expensive, but at the same time I’m not yet totally convinced that it is a great buy. If you take a leveraged company and value it based on the acquisition price of a comparable almost anything will look great. Based on free cash flow it is still a decent deal, but I’m worried that basing my valuation on just the past twelve months is also too optimistic. Historically, the conversion of operating earnings to cash hasn’t been great. So I’m still a bit on the fence if I should buy it or not. The upside is there, but it isn’t insanely big and at the same time I have a bit of troubles fully grasping how the accounting works.

What do you think?

Disclosure

Author has no position at the moment

Itasca Capital: asymmetrical exposure to Limbach

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Itasca Capital (CVE:ICL) is an interesting company that offers a creative way to get asymmetrical and leveraged exposure to Limbach Holdings (NASDAQ:LMB). Itasca Capital is the new name of Kobex Capital that was taken over by activist investors last year. After repurchasing roughly 50% of the outstanding shares in a tender offer the company invested substantially all its assets in the most senior securities of 1347 LLC, a holding company that owns various parts of the Limbach Holdings capital structure. Limbach Holdings is a former SPAC that acquired an “integrated buildings systems provider” that manages, according to themselves, all components of mechanical, electrical, plumbing and control systems, from system design and construction through service and maintenance.

On Seeking Alpha there are a number of decent articles that argue that Limbach is currently moderately undervalued and on VIC there is a write-up that argues that Itasca is substantially undervalued. If you want some background information I suggest reading those articles, because I will start straight with the valuation of the company.

Itasca’s main asset is a stake in 1347 LLC. This holding company owns 400,000 Limbach preferred shares with a par value of $25 that are convertible in 800,000 common shares. The preferreds were issued half a year ago when the SPAC transaction closed and have an interest rate of 8% for the first three years, 10% for the following two year and 12% for the last year after which they will be redeemable. I have valued the preferreds at par plus the value of the conversion option as calculated by a Black-Scholes model. In addition to the preferreds 1347 LLC has a large stake in the common shares and two small warrant positions with a $11.50 strike and a $15.00 strike. I have valued all the options/warrants using a volatility of 30% to estimate fair value. The $11.50 strike warrants are also publicly traded (ticker: LMBHW) and are almost exactly traded at this level:

With the warrants valued it’s easy to compute the value of 1347 LLC itself:

Itasca doesn’t own the whole holding company though, they own $10 million of the Class A shares that accrue interest at 1%/month and after the other share classes are paid they are entitled to 44.44% of the remaining profit. Based on the current value of Limbach, and taking into account that 8 months have passed since the securities were issued the waterfall of the profit distribution looks as follows:

With this waterfall and the total value of 1347 LLC we can calculate what the current value is of the Class A shares that Itasca owns. The value is simply the value of the priority amount plus 44.44% of the remaining value, after subtracting the preferred claims of the other equity classes. Accounting for some small assets and liabilities at Itasca NAV/share is US$0.89:

With an upside of just 30% the picture is completely different from the VIC write-up that estimates more than 100% upside. There are various reasons for this difference, the big one being the inclusion of $13.5 million of debt at the 1347 LLC level and accounting for the accrued interest at the other share classes.

While 30% upside might still sound attractive to some I would argue that in reality the picture is a bit worse. Because the lower level share classes also have interest that accrues before the profit share is paid the amount of debt that has priority will grow in time. After 5 years (when the Class A shares can be redeemed) the value of the B, C and D classes will have grown from $10.5 million to $16.8 million. In addition: 1347 LLC has to pay more interest on its own 13.5% debt than it is being paid on the Limbach preferred shares which means it will incur an additional $3.8 million in liabilities. The result is that if Limbach would be at $13.50 in 5 years time the upside isn’t 30%, but just 6%. What is nice to see though if we plot the value of Itasca after a 5 year period with various prices for Limbach that the asymmetrical nature of the bet becomes quite clear:

This payoff diagram makes it clear that despite the small discount to NAV it is still possible to make a good case for an investment in Itasca Capital since the payoff diagram is superior to a investment in Limbach itself. As long as the stock doesn’t drop more than 40% this investment might still make a little bit of money while there is leverage to the upside at the same time. If the stock goes from $13.50 to $22 you make 63% while with this investment you stand to make 107%. That sounds relatively good to me!

And there is more good news: Itasca Capital has $20 million in NOLs that expire between 2026 and 2036. To make use of these the company would need to acquire a profitable operating business for which it doesn’t have money at the moment, but it might be able to do this though when 1347 LLC returns the capital that is now tied up in Limbach. It’s worth more than zero.

Conclusion

Is Itasca a good deal? I don’t think it’s a bad investment at current prices, but certainly not great either. It has some (small) costs at the company level and it’s very illiquid, so it deserves to trade a bit at a discount to the underlying value of Limbach. Usually I don’t agree with the size of the discount that the market places on holding companies, and here it might also be a bit high. It’s hard to pinpoint the exact number, but I guess it’s around 20%. Not high enough for me to get interested in buying shares.

Disclosure

Author has no position in Itasca Capital or Limbach Holdings.

Philips Lighting IPO: a small idea for my Dutch readers

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Philips, a well-known Dutch company, is going to separate itself in two companies later this month through an IPO. Usually participating in IPOs is a losers game for retail investors because the shares of the most attractive companies are often allocated to the most important clients of the big banks. Here in the Netherlands the situation is a bit different though, because retail investors often get preferential treatment and the case of Philips Lighting is not different.

Royal Philips is offering 37.5 million shares of Philips Lighting, and up to 10% of the offering is reserved for retail investors who will be allocated the first 250 shares without being prorated. This means that a maximum of 15,000 retail investors can subscribe to the offer without fear of being prorated. The shares have an indicative price range of €18.50 – €22.50. Since most IPOs are priced at a point where you are expected to make a profit on the first day of trading I have subscribed to a couple of shares. I don’t expect a big upwards move on the first day, Philips Lighting is not World Online, but just like ABN Amro last year I expect to make a few percent.

Philips Lighting IPO illustration

Disclosure

No position (yet)