ALLIED DEFENSE GROUP INC ADGI
October 30, 2010 - 12:15pm EST by
bondo119
2010 2011
Price: 2.70 EPS $0.00 $0.00
Shares Out. (in M): 8 P/E 0.0x 0.0x
Market Cap (in $M): 22 P/FCF 0.0x 0.0x
Net Debt (in $M): -46 EBIT 0 0
TEV ($): -24 TEV/EBIT 0.0x 0.0x

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Description

ADGI is a liquidation play with litigation-related hair, but the risk/reward here seems very favorable given that it is trading at about 45% of its liquidation value ex-litigation liability, and as discussed below, the litigation liability seems like it will be minor.

 

In short, ADGI sold substantially all of their assets and is operating under a plan of liquidation.  ADGI estimates that they could pay out approximately $5.70/sh, or $46.9mm, in liquidating dividends before giving effect to any potential liability from a DOJ investigation into a former employee.  [The liquidation estimates are contained in the proxy dated 7/28/10.]  They have already converted their assets to cash, so there isn't any risk on the asset side.  The catch is the DOJ investigation: earlier this year a former employee was arrested as part of a DOJ sting operation into violations of the Foreign Corrupt Practices Act("FCPA").  This will delay any payouts(they will not make any distributions until the legal matter is behind them) and can subject them to potential liability.  The stock price, however, is essentially pricing in one of the largest FCPA-related liabilities in history, despite the fact that the former employee was engaged in a minor sting operation and his alleged illegal activity occurred while he was working for a different employer.  In sum, the FCPA issue seems very overblown, any potential liability should be minor, and is more than compensated for by the stock price.

 

The FCPA Investigation

 

The Foreign Corrupt Practices Act is designed to go after companies that bribe/give kickbacks/etc to foreign government officials.  The potential penalties under the Act aren't necessarily back-breaking(they max out at $2.5mm per incident), but the recent trend(and the real source of liability) has been to force companies to disgorge their illicit profits.  For example, GE recently settled an FCPA claim related to giving bribes/kickbacks in the corrupt Iraqi oil-for-food program.  The settlement amount was $23.4mm, which is one of the largest amounts in history, but only $1mm was actually PENALTIES, the remaining amount was disgorgement of past profits and interest on those profits.  You'll see a similar breakdown in other cases, i.e., the criminal penalties are usually overshadowed by the disgorgement of past profits.

 

So what is ADGI's potential liability here?  IMO, it won't be significant, especially in light of the discount offered by the current stock price.  The former employee got caught up in a DOJ sting operation, where federal agents posed as African government officials and approached U.S. arms manufacturers about giving them contracts in exchange for kickbacks.  Significantly, ADGI's former employee WAS NOT WORKING FOR ADGI when the alleged violations took place, he was moonlighting at another company.  It seems unlikely that ADGI will face ANY liability here.  The only real risk is that the subpoena may turn up additional wrong-doing on the part of ADGI, but it only becomes a real problem if they were engaging in long-term wrongdoing and have substantial profits to show from it.

 

Timing of Distributions

 

ADGI will not make any distributions until this matter is behind them and they have reached some sort of agreement with the DOJ.  It's my understanding that ADGI is being proactive to try and get this done, but it's unclear when they will be able to make distributions.  The trials against the 22 defendants are expected to be held in 2011.  I'd hope that the conclusion of the trials would allow ADGI to settle with the DOJ, which could allow them to start making distributions by the end of next year.  So you will have to wait awhile to get paid, the discount in the stock seems to amply compensate you for the time value. 

 

Conclusion

 

ADGI is in liquidation and expects to be able to pay out $5.70 less any amounts incurred as a result of the DOJ subpoena.  ADGI will not, however, make any distributions until this matter is resolved, which I am hoping means by the end of next year.  The stock is currently at $2.70, giving you about $24.5mm in wiggle room to account for any potential liability and legal fees.  I expect that any liability and increased expenses will be minor.  The risk/reward here seems extremely favorable to me; it seems like a situation where investors see "FCPA investigation" and simply move on to the next idea without really thinking about what the liability is likely to be.   

Catalyst

-Resolution of DOJ subpoena
-Liquidating distributions
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    Description

    ADGI is a liquidation play with litigation-related hair, but the risk/reward here seems very favorable given that it is trading at about 45% of its liquidation value ex-litigation liability, and as discussed below, the litigation liability seems like it will be minor.

     

    In short, ADGI sold substantially all of their assets and is operating under a plan of liquidation.  ADGI estimates that they could pay out approximately $5.70/sh, or $46.9mm, in liquidating dividends before giving effect to any potential liability from a DOJ investigation into a former employee.  [The liquidation estimates are contained in the proxy dated 7/28/10.]  They have already converted their assets to cash, so there isn't any risk on the asset side.  The catch is the DOJ investigation: earlier this year a former employee was arrested as part of a DOJ sting operation into violations of the Foreign Corrupt Practices Act("FCPA").  This will delay any payouts(they will not make any distributions until the legal matter is behind them) and can subject them to potential liability.  The stock price, however, is essentially pricing in one of the largest FCPA-related liabilities in history, despite the fact that the former employee was engaged in a minor sting operation and his alleged illegal activity occurred while he was working for a different employer.  In sum, the FCPA issue seems very overblown, any potential liability should be minor, and is more than compensated for by the stock price.

     

    The FCPA Investigation

     

    The Foreign Corrupt Practices Act is designed to go after companies that bribe/give kickbacks/etc to foreign government officials.  The potential penalties under the Act aren't necessarily back-breaking(they max out at $2.5mm per incident), but the recent trend(and the real source of liability) has been to force companies to disgorge their illicit profits.  For example, GE recently settled an FCPA claim related to giving bribes/kickbacks in the corrupt Iraqi oil-for-food program.  The settlement amount was $23.4mm, which is one of the largest amounts in history, but only $1mm was actually PENALTIES, the remaining amount was disgorgement of past profits and interest on those profits.  You'll see a similar breakdown in other cases, i.e., the criminal penalties are usually overshadowed by the disgorgement of past profits.

     

    So what is ADGI's potential liability here?  IMO, it won't be significant, especially in light of the discount offered by the current stock price.  The former employee got caught up in a DOJ sting operation, where federal agents posed as African government officials and approached U.S. arms manufacturers about giving them contracts in exchange for kickbacks.  Significantly, ADGI's former employee WAS NOT WORKING FOR ADGI when the alleged violations took place, he was moonlighting at another company.  It seems unlikely that ADGI will face ANY liability here.  The only real risk is that the subpoena may turn up additional wrong-doing on the part of ADGI, but it only becomes a real problem if they were engaging in long-term wrongdoing and have substantial profits to show from it.

     

    Timing of Distributions

     

    ADGI will not make any distributions until this matter is behind them and they have reached some sort of agreement with the DOJ.  It's my understanding that ADGI is being proactive to try and get this done, but it's unclear when they will be able to make distributions.  The trials against the 22 defendants are expected to be held in 2011.  I'd hope that the conclusion of the trials would allow ADGI to settle with the DOJ, which could allow them to start making distributions by the end of next year.  So you will have to wait awhile to get paid, the discount in the stock seems to amply compensate you for the time value. 

     

    Conclusion

     

    ADGI is in liquidation and expects to be able to pay out $5.70 less any amounts incurred as a result of the DOJ subpoena.  ADGI will not, however, make any distributions until this matter is resolved, which I am hoping means by the end of next year.  The stock is currently at $2.70, giving you about $24.5mm in wiggle room to account for any potential liability and legal fees.  I expect that any liability and increased expenses will be minor.  The risk/reward here seems extremely favorable to me; it seems like a situation where investors see "FCPA investigation" and simply move on to the next idea without really thinking about what the liability is likely to be.   

    Catalyst

    -Resolution of DOJ subpoena
    -Liquidating distributions

    Messages


    Subjectcash burn
    Entry10/30/2010 02:47 PM
    Membermrsox977
    What will they spend "kepeing the lights on" etc. while we wait for the case to be resolved ie what is the monthly cash burn here... ?  thank you   mrSox

    SubjectRE: cash burn
    Entry10/30/2010 03:09 PM
    Memberbondo119
    The $5.70/sh estimate was calculated using liquidation accounting, i.e., they've incorporated reserves for future cash burn and operating expenses that will take them through to the end of the dissolution.  According to the proxy, there's about $2.8mm reserved for future operating expenses.  They've also reserved for severance and any other identified expenses that they will incur.  So cash burn isn't too much of an issue.  Of course it's possible that the reserves are too low, but in my experience with investing in past liquidations, $3mm is often a good ballpark figure for wind-down costs, especially in a case like this where they've already converted everything to cash.  Even if they have significantly under reserved I don't think it changes the thesis in a significant way, e.g., if they need to double reserves then it impacts the final liquidation value by $0.34/sh.

    SubjectRE: RE: cash burn
    Entry10/30/2010 04:49 PM
    Membermrsox977
    Thank you for the reply.  This is an interesting write-up.  A few other points/questions...
     
    1.  You call this a 'minor' sting operation.  I am not sure I would characterize it that way.  The FBI has called this case "the largest single investigation and prosecution against individuals in the history of DOJ's enforcement of the Foreign Corrupt Practices Act (FCPA)."
     
    2.  It seems that the employee is Mark Frederick Morales, 37, the owner and agent of a Decatur, Ga., company that sells ammunition and other law enforcement and military equipment.  Yes, he was not working for Allied at the time.  However, it seems that Allied must have some reason to believe that Morales wasn't too clean while he worked at Allied.  Otherwise, why not just distribute the cash and tell the DOJ that they will have to go after Morales personally for any illegal gains he may have reaped?  My point is why does Allied have an obligation to reserve cash to settle a matter involving an ex-employee.  If I worked for Lehman Brothers and committed some fraudulent act at my next employer, Goldman, can the DOJ come after a now defunct Lehman for penalties or ill-gotten gains?  It would seem as if somebody at the DOJ must have approaced the Board of Allied (probably a bunch of retired Generals) and said "hey, we have a lot of info on this Morales, and it isn't pretty.  You better reserve against this or we will come after you all personally as Directors, even after Allied is gone."
     
    3.  To your knowledge, does the DOJ probe include other former employers of the other individuals?  Here is the link to the FBI article about the probe.
     
    http://washingtondc.fbi.gov/dojpressrel/pressrel10/wfo011910.htm
     
    thanks - again, I do think this is interesting, and I would enjoy discussing it more...
     
    mrSox

    SubjectRE: RE: RE: cash burn
    Entry10/30/2010 06:23 PM
    Memberbondo119
    Being hyper-conservative is standard operating procedure when a company is in liquidation and has a significant legal matter to resolve(or any contingent claim for that matter).  I.e., don't pay out anything until everything is totally resolved, even if you really have plenty of leeway to make a distribution sooner rather than later.  Management has no incentive to be aggressive with distributions and projections; they simply want to wind things up and go to their next job without getting sued.   In sum, I've invested in a lot of liquidations and in my experience any legal matter pretty much always holds up any further distribution until it is totally resolved, regardless of the company's potential liability or the merits of any claim.  I don't think you should read into it.
     
    I think your scenario about the DOJ telling Allied to reserve seems far-fetched.  The sting took place in January and ADGI received the subpoena on January 19.  Since then, there hasn't been any announcement of an escalation in the probe as it relates to ADGI.  And as I said above, holding back distributions is normal and there don't need to be any DOJ threats involved.  Further, even in your scenario it doesn't seem plausible that the DOJ would threaten to hold the directors personally liable--shareholders in a liquidating corporation are themselves personally liable to creditors, with their liability capped at the amount of liquidating distributions that they received.  I.e., if there is corporate liability that comes to light after you get your money, the creditor can claw back anything that you received.  Plus, I don't think there would be any legal grounds to hold directors personally liable(unless of course they the directors were personally involved in FCPA violations).  I'm not sure about that last point though.
     
     
    I know that an exec or VP at Smith and Wesson got caught up in this, so I would imagine that they are dealing with the DOJ as well.  I don't know about any other companies that have been involved in the probe, but it would seem that the DOJ likely subpoenaed everyone related to the guys that got caught up in the sting, former employers included.
     

    SubjectRE: RE: RE: RE: cash burn
    Entry10/30/2010 08:39 PM
    Membermrsox977
    The risk reward may still be there, however the more I read, the more the plot thickens.  There are some things here I think you should have mentioned.
     
    It turns out that Aliied subsidiary Mecar USA had indeed transacted business with six individuals indicted in the undercover operation, either directly or indirectly through their companies.  This is a different story than the picture you paint.
     
    As for the $5.70 in value, Allied's assumptions reserve nothing for taxes, and if you read the filing it seems as if taxes could be an issue.  They also do not include an estimate of the amount that Allied may pay under to satisfy indemnification obligations to Chemring.  Under the Sale Agreement, Allied has agreed to indemnify Chemring and certain of its related parties against any losses arising out of the Mecar SA completed contracts that will be transferred to ADG and any of Mecar USA's retained liabilities (including the Mecar USA completed contracts). 
     
     

    SubjectFCPA
    Entry10/31/2010 01:30 PM
    Memberoogum858
    i looked at this briefly.  there are two really good blogs about the FCPA which are worth reading.  i forget their names but a quick google search should get you there.
        also, if you include FCPA settlements, i think your "highest ever" number is way off.  i think there was a halliburton case which involved a third party agent (ie, not even a direct company employee) that resulted in like a $500mm settlement/fine.  
         the FCPA penalties are based on revenues, so they can be really really high numbers, and you can get slammed even if the wrongdoing was done by a third party agent.  there are also more and more of these things every year. . .
         so, there are some big risks here.  also, there is a poison pill at only 5% and some large shareholders are lobbying to get that removed (presumably so they can sell).  
         there are also potentially some governance issues with this company as one of the largest shareholders has had various conflicts with the management/board in recent months. . .i don't know the full story, but it's worth exploring further.  a real issue is obviously how hard the CEO and board bust their ass to get this investigation done with as quickly as possible.  perhaps the best play here is for someone with some great connections and some really good lawyers to buy the company and take over the defense/lobbying.  
        as for the big question about whether another shoe will drop in the investigation, who knows
     

    SubjectRE: FCPA
    Entry10/31/2010 01:33 PM
    Memberoogum858
    oh yeah that's another point. . .the CEO and CFO don't own a significant number of shares.  .so they don't have a huge incentive to really work 24/7 to get out of this mess. 
     
     
     
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