Destination Maternity: a merger spread you won’t believe

At the end of last year, on the 20th of December, Destination Maternity (NASDAQ:DEST) and Orchestra Prémaman (EPA:KAZI) announced that they had entered in a definitive merger agreement in which Orchestra Prémaman would acquire Destination Maternity in an all stock deal. Destination Maternity shareholders are going to get 0.515 Orchestra Prémaman shares in the form of ADSs that will be listed in the US and will own 28% of the combined company after completion of the transaction. The consideration represented a 34% premium at the time of the announcement, and since it’s a deal between two relative small companies with no regulatory or financing risk you wouldn’t expect a huge merger spread.

This couldn’t be farther from the truth than possible though. Ever since the deal was announced the spread has bounced around 20% (although sometimes spiking down or up significantly), and in the past week the spread has exploded to a totally ridiculous 63%. This week the spread has come down a bit again, but is with 36% still offering an extremely compelling opportunity in my opinion. I wrote an article about it on Seeking Alpha that after a 24 hour embargo is now accessible for everybody. You can find it here.

Source: authors own calculations, based on Yahoo Finance pricing data

Disclosure

Author is long Destination Maternity

Sapec SA offering attractive tax arbitrage opportunity

Sapec SA is a Belgian holding company that sold their main asset last year, and is going to pay out the majority of the proceeds using a dividend of €150/share. After the dividend is paid some additional cash and some small stakes in various businesses will remain in the holding company with a total book value of €41.60/share. Assuming a 30% holding company discount the stub should be worth roughly €30/share. So if there wouldn’t be dividend taxes you would expect that Sapec would currently be trading at roughly €180/share.

Unfortunately for many investors there are dividend taxes, and in case of Belgium these are a hefty 30 percent. Because of that the stock is trading at just €152.50/share which offers an opportunity for investors who can reclaim some of these taxes and/or use paid dividend taxes as a tax deductible. The author of the “value and opportunity” blog who has been following this situation for some time, discusses here how German investors can get around the tax issue.

Dutch investors have a similar opportunity. There is a double taxation treaty with Belgium that makes it possible to reclaim 15% of the dividend taxes from Belgium (I think most countries have this, but reclaiming the tax might not be equally easy for all countries). From what I have read the procedure isn’t that complicated, although it requires some paperwork and patience. Apparently it can take more than a year before Belgium repays the 15% of the dividend taxes. The other 15% of the dividend taxes can be used as a tax credit against the annual Dutch wealth tax. So you have to be careful not to buy a too big position because then can’t fully deduct it from your Dutch taxes (it’s possible to carry the remaining tax forward to the next year, but this add some complications that makes it not attractive for me). So the trade would look like this:

DateCash flowDescription
5/23/2017-152.50Buy Sapec SA
8/20/2017+105.00Payment dividend (estimated date)
8/20/2017+30.00Sell Sapec SA sub (estimated value, estimated date)
6/30/2018+22.50Use tax credit to offset Dutch wealth tax (estimated date)
12/31/2018+22.50Receive Belgium tax reclaim (estimated date)
 IRR 40.78%

As you can see the internal rate of return of this trade is more than excellent! It’s a bit sad though for Belgium investors. Sapec is a Belgium company, and they are the ones who have no way to avoid paying the tax. The company promised to research options to return capital in a tax efficient manner for small shareholders (the big holders don’t have to pay dividend taxes), but in they end they choose the worst option possible for retail investors.

Disclosure

Author is long Sapec SA

The curious case of the T Bancshares dividend

I have a small position in T Bancshares, Inc. (OTCMKTS:TBNC) that is being acquired for $8.0275 in cash plus a special dividend that is based on the equity of the company just before closing. The dividend is estimated to be $2.6067 (subject to adjustment based on the change in equity of TBNC in April), and since all regulatory approvals have been obtained the merger is scheduled to close next Monday on the 15th of May. What makes the situation interesting is that the market is confused whether or not the stock is currently trading ex-dividend. The record date of the dividend is May 12, 2017 with a payment date of May 15, 2017. Normally the ex-dividend date is two days before the record date, so the stock should be trading ex-dividend since Wednesday and the shares should be worth $8.0275. My broker seems to think so:

The cyan colored bar represents the amount and date of the dividend according to my broker

With the shares currently trading with a bid/ask of 10.30/10.45 there is an opportunity. Either the stock is now trading ex-dividend and it’s worth $8.0275 or it’s trading with dividend and it’s worth $10.63. The reason for the confusion is probably because the dividend will only be paid if the merger is completed, and on OTCMarkets.com we can read the following:

The special dividend will only be paid in connection with the merger. FINRA will not set an “ex” date for this distribution.

If no ex-date is set for the distribution it seems to me that the stock can’t be trading ex-dividend currently, and it should still be worth $10.63. I bought a couple of additional shares at $10.40 since I believe that this is the correct interpretation of the situation, but it’s perhaps not the greatest bet. If I’m right I will make $0.23/share (plus an adjustment to the dividend that I expect to be ~$0.10/share) while if I’m wrong I will lose $2.37/share. So I better be right….

Disclosure

Author is long TBNC

First Safeway CVR finally paying out (a negligible amount)

More than two years ago, in January 2015, I participated in my first merger arbitrage deal that had a contingent value right (actually two) as part of the payment. Since then I have participated in more deals with CVRs, but since the payment is usually contingent on events pretty far in the future I haven’t got a single cent from them so far. That’s however going to change soon since Albertsons announced that the first CVR will pay 1.7 cents with a possible additional 0.03 cents coming later. It’s a very insignificant amount (adding just 0.0156% to this years return), and also a bit disappointing since the CVR was valued at $0.0488/share at the time of the merger. Nevertheless, it’s fun to finally get a little bit of money from my collection of CVRs.

The real action will be next year when the far more important CVR connected to the value of Casa Ley will expire. That one was valued at $1.0149/share at the time of the deal, and could have a more material positive impact on my portfolio :).

Disclosure

Author is long the two CVRs issued in connection with the SWY merger

HemaCare: deep value turning into growth story

When I see that one of my favorite bloggers has a 50% portfolio allocation to one stock I take note, even though the large allocation is partially the result of the stock already having gained ~500% the last year when it went from $0.50/share to $2.50/share. Nevertheless, my interest was piqued enough to do a little bit of research. HemaCare Corporation (OTCMKTS:HEMA) is emerging as a successful turnaround story. The company, focusing on blood products and services, deregistered with the SEC in 2012 after reporting losses for a couple of years. Since then they have sold all their divisions with the exception of the new bioresearch division that was started in 2013. The new business consists of selling cryopreserved human cells for biomedical research purposes all over the world (you can see their catalog here).

The new business is proving to be a big hit so far, and this year the company posted an operating profit for the first time in years. Another interesting part of the story comes from the fact that the 10th of January HemaCare announced a strategic partnership with OneBlood:

OneBlood is an industry-leading blood center that is known for its innovative and progressive approaches. Partnering with them provides HemaCare with an East Coast presence and at the same time brings validation of our evolution as a leading provider of a wide array of specialized blood products to the high growth biotechnology, pharmaceutical and academic research markets,” said Pete van der Wal, Chief Executive Officer for HemaCare. “In addition, we are also honored to have Bud Scholl, Executive Vice President and Chief Strategy Officer for OneBlood, join the HemaCare Board of Directors and look forward to his strategic insight as we move forward,” said van der Wal.

While a partnership like this is probably pretty good news for the growth prospects of the company, I have no real way to quantify them. But what is interesting is that OneBlood also invested into HemaCare by buying $2.5 million worth of shares at $3.44/share. At the time of the announcement shares of HemaCare were trading at $0.65, so I think this is quite a strong statement of what the stock should be worth. Usually when a company issues a large block of stock it gives the buyers a good deal, and does it at a bit of a discount to the latest market price. Presumably the buyers already knew the (preliminary) results of 2016 while the market didn’t, but issuing shares at such a big premium can’t have be the easiest sell. The market price always acts a bit as an anchor point.

Thinking that this means that the stock should be worth at least $3.44/share right now, just based on this transaction, is however also a bit optimistic. As part of the deal OneBlood also received warrants to purchase $2.5 million more shares at the same price, half of them expiring at the end of 2017 and half at the end of 2018. If you play a little bit with a Black-Scholes-model and use an implied volatility of 50% you will find that it’s perhaps better to say that they spend approximately $3.00/share to buy stock, and spend the remaining $0.44/share on the warrants. But OneBlood is not just a financier of HemaCare, they are also a partner in business operations. Giving a party like that a good deal, or even giving shares/options for free just to provide an incentive to make the partnership a success, makes sense to me. So the fact that OneBlood actually paid $3.44/share is in my opinion an incredible strong signal.

Historical financials

So far I have just talked a bit about the story, but of course, that doesn’t really point us in a direction of how much HemaCare should be worth without combining it with some numbers. Since the remaining business is quite new it’s not that useful to look far back in the past. When we look at the historical income statements from 2013 onward we see that the company has made a remarkable turnaround, finally earning enough to cover fixed costs and make a small profit. However, it does seem that revenue growth is slowing. Growing fast from a low starting point is of course a lot easier than from a more meaningful revenue base. But also in absolute numbers growth has slowed down last year. In 2015 the company managed to grow revenues by $4.9 million, while in 2016 growth was $4.2 million.

While growth appears to be slowing a bit I would still call these results pretty healthy, and they are accompanied by a balance sheet that is also looking good. I have adjusted the amount of available cash and the number of shares outstanding for the shares issued after the end of 2016. Thanks to the sale of their discontinued operations they already had a few million of cash on the balance sheet, and with the issuance of the shares to OneBlood another $2.5 million has been added. Presumably most will be required to fund growth. Based on the past few years, the business doesn’t require big capital expenditures to grow, but when you grow revenues that rapidly a lot of cash also disappears as working capital.

Valuation

I usually stay away from growth stocks, not because I don’t like stocks that are growing, but it’s usually just too hard for me to estimate fair value with a bit of confidence. Estimating what HemaCare is worth is also not an easy exercise, and you can get wildly different results based on what kind of model you use. Nevertheless, doing a little bit of simple modelling can give us some idea of the range of plausible values. What I have done as a starting point is to assume that the company will be able to grow revenues by 40% while “cost of revenue” of “general and administrative expenses” will grow with the same percentage as they did between 2015 and 2016. This model nicely demonstrates the huge amount of operating leverage that the company currently has at the current point where it is just above the break-even point.

Two years of 40% revenue growth sounds like an aggressive assumption, especially since last year growth slowed down a bit, but it’s basically a doubling in revenue for a company that in the past three years managed to increase revenues by a factor of eight. Since this year already started promising with the OneBlood partnership I don’t think it’s a pie in the sky scenario. What would be aggressive in my book would be to model high-growth for a way longer period.

If HemaCare could double revenues net income would increase with more than a factor ten, thanks to the huge operating leverage that the company now has after just surpassing the break-even point.  Given the high gross margins a large part of any growth in revenues now drops down directly to the bottom line since fixed costs are already covered.

Note that I have assumed here that OneBlood will exercise their warrants to get another 727,572 shares, but that no additional shares need to be issued to fund growth. This would give the company $7.3 million in cash, which based on their current amount of working capital and historical capex requirements should easily be enough to support a doubling in revenues. I also assumed that the amount of options outstanding will increase slightly. In addition, the company will presumably also start generating free cash flow that can further support growth.

Also noteworthy is that I have basically modeled zero income taxes. The company has some (small) net operating loss carryforwards that should be roughly enough to shield it from paying taxes the next few years (they have $6.0 million in federal and $2.9 million in state NOLs). So after 2018 we probably have to model that HemaCare will start paying a 35% tax rate.

So how much is the stock worth today with these kind of assumptions? The question depends, of course, on what kind of P/E multiple HemaCare would be trading in 2018 if they achieve 2 years of 40% growth? I would say that a 15x multiple would be quite conservative, so with a 35% tax rate that would imply that the company would be worth $84 million. But we have to account for the fact that we have to wait two years for that to happen, and with a high-growth stock I think we also have to model a decent probability that this whole thing doesn’t work out. In that case the stock is probably worth very little or nothing at all. So I’m discounting the future value to the present using a 10% discount rate, and at the same time I’m assuming a 25% probability that the stock will be a zero (I know that this is a bit double, you could argue to simply use a higher discount rate, or just increase the probability of failure and use the risk free rate).

By coincidence, I’m getting almost exactly the same value/share as the issuance price in the OneBlood transaction. I wasn’t trying to reverse engineer anything, but by ending up at almost the same number it increases my confidence of being correct. With the stock currently trading at $2.60/share that means that there is an upside potential of 31% to fair value.

Insiders

What I like about the HemaCare story is that it appears to me that they are shareholder friendly. After deregistering with the SEC in 2012 they haven’t disclosed how much insiders own, but at the time of the 2011 annual report insiders controlled 32.87% of the outstanding shares (the number in the table below is lower because it’s based on the current higher share count). Since then there have been some changes to the board that I see as positive. Large shareholders have gained a seat on the board, while directors with small stakes have left the company. Assuming that insiders haven’t bought or sold shares since then (improbable) they would now own 38.37% of the outstanding shares. I also like that Gil Avidar, who has a background in finance and is currently an independent private investor, managed to get a board seat. This seems to be the kind of board that would care about per share value:

What’s perhaps less great is that the management team gets paid a decent amount of stock options. With a nano cap company it’s unavoidable to some extent that any option incentive program can cause significant dilution. I can only hope that with the recent strong increase in stock price the number of future options that will be issued will be decreased commensurately. A small positive that caught my attention in the 2016 annual report is that HemaCare spend $26,000 to repurchase 39,474 shares at $0.66/share. It’s not a meaningful amount, but it provides a hint that the company does know how to allocate capital. Even with their super high organic growth they couldn’t resist buying back some (extremely undervalued) shares. At current prices the case for repurchases versus investing in the business itself is less strong.

Conclusion

HemaCare doesn’t appear to be trading at a huge discount to fair value. It’s for sure a stock that can be worth a lot more in a few years time, but it’s also not without risk. If growth stalls for some reason this stock can be in a lot of trouble since it just barely managed to get above break-even last year. But for a growth stock I think it’s more than reasonably priced. Often those stocks are priced like nothing can go wrong, but that is certainly not the case here. There is a bit of upside, and if anything, my valuation is a bit on the pessimistic side (modelling a 25% probability of the stock being a zero is quite punitive for example). Giving the very strong growth in revenue I think it’s actually quite unlikely that it will completely stall. Maybe it will slow down, but three years of 25% growth will get us to the same point as two years of 40% growth for example. There is more than one way to get where we need to get.

What I also like here is that I have a very high confidence that the current price is too low, even though it is not by a whole lot. When a sophisticated buyer is willing to buy stock at $3.44 (~$3.00 accounting for the warrants) other market participants should be thrilled to get in on the same deal at a similar price. Because of that I decided to take a small position in HemaCare.

Disclosure

Author is long HemaCare