A bit less than two months ago I wrote about the ALJ Regional Holdings going private transaction. The merger closed at the end of last month, but because of some confusing language in the merger documents people where not totally sure if accredited investors would get cash, or would be forced to accept the stock option. I thought it would basically impossible for the company to take this route, because issuing unregistered shares to non-accredited investors could get them in a lot of trouble. Today my broker put the corporate action in their system, and that makes it crystal clear that, if you do nothing, you indeed get the cash option:

Holders electing for the Stock election, Option 2, must complete the Verification Request Form and send back to IBKR for submission to the agent. Once the Verification Request Form has been received by the Information Agent, New ALJ will instruct a third-party accredited investor verification service, VerifyInvestor.com, to initiate the verification process. Holders will receive an electronic communication from the Verification Provider at the email address provided on the Verification Request Form containing instructions to follow in order to complete the verification process. In addition, the Verification Provider or New ALJ’s other representatives or agents may further reach out to confirm whether such investor would qualify as a sophisticated investor in New ALJ’s sole discretion.

Once the verification process is complete, and you receive the confirmation to move forward with the stock election, IBKR will be able to submit the tender electronically via DTC. IBKR cannot tender the shares without receiving the approval from the verification process.

It will probably take till the end of this month for the merger payout to hit my account, but I think we can safely call this trade a success.

Disclosure

Author has no idea if he is still long or not. The shares are still visible in my account, but since the merger closed I guess I technically don’t own them anymore?

I first wrote about ALJ Regional Holdings (ALJJ) more than a decade ago, and now that I’m back in the stock it seems only fitting that I write about it once again. When I first got involved it was trading on the pink sheets and Jess Ravich owned 22.1% of the company. After some years in the daylight on the Nasdaq it is back where it started, on the pink sheets, but now Ravich owns 58.9% (more counting a convertible note) and he is looking to increase that percentage further. 

To make that happen the company is planning a merger in which shareholders will be cashed out at $1.97/share. With the stock currently trading at $1.84/share that is a juicy looking spread of 7.1%. Accredited investors have the option to rollover their stake and get unregistered shares in a private company, but given the current course of the company I doubt many investors would be comfortable with such a structure.

In the proxy statement it is not explicitly written that accredited investors have a choice, if you read it you would think that they have to accept the unregistered shares. But I don’t think that this can be true, because it is impossible for the company to verify who qualifies without cooperation of said shareholders. Issuing non-registered shares to non-accredited investors is presumably a risk they don’t want to take. In section 5(b) of the merger agreement we find:

Cash Consideration. Notwithstanding anything to the contrary in this Agreement, in no event shall NewCo be required to issue any shares of NewCo Common Stock to any person that does not provide duly completed and executed Investor Suitability Documentation (as defined below) establishing to the satisfaction of NewCo that shares of NewCo Common Stock may be issued to such person in connection with the Merger and the other transactions pursuant to an exemption from the registration requirements of the Securities Act and other applicable securities laws. To the extent that NewCo is unable, in its sole discretion, to conclude that NewCo Common Stock may be issued to such stockholder in compliance with the Securities Act and other applicable securities laws, including making a determination that such stockholder is an Accredited Investor, NewCo shall be entitled to pay, in lieu of the Stock Consideration otherwise payable pursuant to Section 5(a)(i), an amount in cash equal to the Cash Consideration.

And in section 5(f) about securities law compliance we read the following (emphasis mine):

Securities Law Compliance. No later than ten (10) business days following the Effective Time, NewCo shall use commercially reasonable efforts (including engaging a third-party service) to distribute to each ALJ shareholder who is eligible to receive Stock Consideration (except for those shareholders who has less than one hundred (100) shares of ALJ Common Stock) the documentation, in form and substance reasonably acceptable to NewCo, necessary to determine whether or not such person is an Accredited Investor (collectively, the “Investor Suitability Documentation”). NewCo shall use its commercially reasonable efforts to cause each ALJ shareholder to promptly deliver such Investor Suitability Documentation. For the avoidance of doubt, if a shareholder has not completed and returned Investor Suitability Documentation to NewCo or its agent or representative, NewCo shall have the right under Section 5 to determine that such shareholder is not an Accredited Investor.

So it sounds that in theory the company has the right to choose what consideration to offer in the merger, but that in practice it will be up to the investor because you will get cash if you don’t provide the proper documentation to prove that you are an accredited investor. But perhaps this is causing some merger arbitrage funds to stay away from this deal.

To approve the merger ALJ Regional Holdings needs >50% of votes in favor of the merger, but despite the fact that Ravich owns 58.9% of the shares he cannot unilaterally approve the transaction. There is no majority of the minority requirement, but he is bound by a voting agreement that limits his votes to 40% of the outstanding shares. His remaining shares are voted proportionally with minority shareholders. So the company needs some minority shareholders to vote in favor of the deal, but not that many. If 7% of shares from minority vote yes (~17% of minorities) Ravich will vote 17% of his stake above 40% in favor as well which would add a bit more than 3% of votes. Combine all the votes and you pass the 50% mark.

I don’t think that shareholders will love this deal and approve it with an overwhelming majority. The deal is done at a meager premium to the market price before announcement, it is done at a small discount compared to the price of the tender offer the company did at the end of 2022, and most importantly, it appears to be significantly below fair value. I also doubt that accredited investors will be trilled by the opportunity to swap their shares to unregistered stock in a new private company. But 17% of minority investors voting in favor is not a particular high hurdle, and I suspect that they will reach that number. The low to non-existent premium also reduces the risk for those who want to play the merger arbitrage game. If for some reason the deal doesn’t go through, the downside is presumably not too big either.

It should be noted that the merger is not an iron clad deal, the company can basically decide to abandon the transaction at any point in time if it chooses to do so. Given that the transaction is a sweet deal for Ravich I think it will happen, but there is less certainty than in a normal merger. There are appraisal rights available for shareholders, so perhaps if a large number will go for that route it will throw a wrench in the merger plans. Perhaps going for appraisal is a superior plan to trying to eek out a few percent in the merger arbitrage, although I’m not quite sure if that is even possible for new holders. The record date for the special shareholder meeting is March 31, 2023, and I believe you need to vote against the merger in order to perfect your appraisal rights? Not sure though, since I have never participated in one before.

Disclosure

Author is long ALJJ

I started my position in ALJ Regional Holdings (ALJJ) at the end of last year as a tender offer/merger arbitrage play, but when the tender offer was completed I actually bought a few more shares. The company is a cash box with tax assets and was at that point in time trading at a fairly big discount. Between then and now nothing has happened, but the share price is up ~15%. In absolute sense that isn’t a whole lot, but for a cash box it’s a big change. There is no way you could make an argument that the intrinsic value has changed in a similar way. I think that ALJJ is still cheap at todays price since it’s still trading at a discount, but with the amount of cash in my portfolio near zero I wanted to sell something, and ALJJ seemed a good choice.

Disclosure

No position in ALJJ anymore

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?

Cash

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.

Tax shield

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.

Insiders

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.

Conclusion

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.

Disclosure

Author is long ALJJ

ALJ Regional Holdings (ALJJ) announced yesterday that the company has entered into a definitive merger agreement to sell their KES subsidary. After the merger is completed the company will basically be an empty shell with approximately $51 million in cash ($0.86/share) and large net operating losses. The company also announced that they will buy back more than 50% of the outstanding shares after the merger is completed at a price between $0.84 and $0.86 per share. For some background on the company I recommend checking out this post at OTC Adventures.

The company has 59,467,498 diluted shares outstanding as of yesterday, and Mr. Ravich, chairman of the board and owner of 13,142,221 shares (22.1%), has indicated that he will not tender his shares. This means that if everybody except Ravich tenders their shares you can sell 64.8% of your position to the company at $0.84/share. If you would buy $1000 worth of shares at $0.72 you would get back ~$750. What you keep are 490 shares with a $244 cost basis, or a 43% discount to the future net cash position of the company.

There are multiple ways to win here. I think it’s highly likely that not all shareholders will tender their shares. The current board, with Ravich as the leader, accomplished a lot the past years, and after the offer is completed the chairman will own almost 50% of the company. And while the tender offer is for roughly the cash value per share it ignores the valuable NOL assets. I imagine that there are investors who want to remain invested.

In a best case scenario the company will buy all or almost all your shares at $0.86/share and you make a quick 19%, but if the proration factor is for example not 64.8% but 85.7% you are already free rolling on your remaining position (assuming a $0.84/share price in this case).

A second way to win is if the discount to net cash value shrinks after the deal and tender offer are completed. If the discount for example would shrink from the current 43% to 20% it would mean that the share price post tender offer would only drop from the current $0.72/share to $0.70/share. Again using a hypothetical $1000 investment: you would own 1389 shares and sell 899 shares to the company at $0.84/share. The remaining 490 shares would be sold for $0.70/share for a total amount of ~$1100 or a 10% return.

The worst case scenario is obviously that the merger isn’t completed and the tender offer is cancelled. In general a very high percentage of definite merger agreements are successfully executed, and don’t think there are any special issues in this deal that makes this one above average risky. The acquirer has executed multiple successful deals in the past, and I don’t think there are potential regulatory or political issues with a small deal like this. A risk is financing since Optima has not yet closed the necessary arrangements, but with Jefferies as an advisor I would expect that they got this covered.

Conclusion

While it’s hard to know how this will exactly play out I think the odds are in my favor at the current prices. If the deal is completed successfully, and I think it will, the worst case scenario is that I bought a cash shell at a 43% discount to net cash value. I’m comfortable with that investment given the big discount and the fact that Mr. Ravich will be a major co-owner. And most likely I’ll effectively be buying less shares at an even higher discount if not all shareholders decide to tender.

Disclosure

Long ALJJ

More reading

Whopper had basically the same idea as me, and you can find his thought here.