Description

Danielson Holding Corp. is an attractive long candidate. Due to its complexity, if there’s ever been a write-up in which I’ve wanted to just say, “it’s cheap,” this is it. In place of that statement, I’ll attempt to wade through the murky waters of an orphaned company dealing with dual bankruptcies, an acquisition that will overhaul the entire business, newly issued convertible notes, a rights offering, $630 million of NOLs, and important inside ownership. Along the way, I’ll try to highlight the important details and layout the investment thesis.

DHC is a massively complex orphaned issue that has $630 million of federal tax net operating loss carryforwards and a pro forma FCF yield on equity of about 40%.

DHC is controlled by Sam Zell, Marty Whitman (Third Avenue Value Fund), and DE Shaw Laminar (herein collectively referred to as the “Large Owners”). Sam Zell is the President and CEO.

DHC has undergone immense change in the past twelve months including the bankruptcy of a major subsidiary, the refocusing of another subsidiary, and, most importantly, the announced purchase of Covanta Energy (see the Covanta Energy section for further detail) out of chapter 11 bankruptcy (exclusive of its geothermal assets). In order to finance the Covanta acquisition, adding to the complexity of the situation, DHC is issuing bridge notes to the Large Owners and is undergoing a huge Rights Offering that allows you to buy 0.75 shares of stock for $1.53, which when averaged with the current market price of $6.60 per share gives an adjusted price of $4.64 per share (see the Rights Offering section). DHC is trading at a substantial discount to estimated intrinsic value and has a downside protected by its huge tax loss carryforwards.

[Please note: The price and market cap that I entered into the VIC website reflect the current price and market cap, not the true Rights Offering-adjusted stock price and market cap ($4.64/share and $292 million market cap), though those are the pertinent ones]


Current Business:
DHC runs an increasingly small P&C insurance concern called NAICC (National Insurance Company of California). Revenue has decreased from $86 million in 2000 to $32 million through the first nine months of 2003. This has been the result of NAICC’s unwillingness to write what it believes is unprofitable business. Over the past few years, NAICC has ceased writing workers’ comp and commercial auto insurance. Currently, all it writes is non-standard private passenger insurance. Considering that $61 million of our precious NOLs expired unused in 2003, this business obviously will never have the scale to appropriately utilize the NOLs.

In December of 2003, DHC announced that it would acquire the aforementioned parts of Covanta Energy. Per Covanta’s 10-Q, “Covanta is engaged in developing, owning and operating power generation projects and providing related infrastructure services. [Covanta] also offers single source design/build/operate capabilities for water and wastewater treatment infrastructure.” While operating in bankruptcy, Covanta’s estimates that the assets DHC is buying produced revenue of $749 million in CY2003 and EBIT of $89 million (inclusive of all charges). Now this is a business that might be able to make use of some NOLs! [see the Covanta Energy section below for more on Covanta]


Background:
I’m not even sure where to begin. Let’s try the loss carryforward. DHC, formerly Mission Insurance Group, Inc., emerged from bankruptcy as DHC in 1990 with massive NOLs. For most of the period since then, DHC’s primary business has been insurance of one sort or another and Third Avenue’s Marty Whitman has been running the show as, at various times, Chairman, CEO, and CIO. In 1999, the well known private investor, Sam Zell, got involved and Mr. Whitman handed over the executive reigns but has remained active and has retained Third Avenue’s shares and board seats (two seats). Since then, DHC has been attempting to buy a concern that could take greater advantage of its slowly evaporating NOLs (the NOLs have been running off in big chunks the past few years…the expiration schedule is in the notes section of the 10-Ks). Finding the appropriate acquisition has been complicated by the strict ownership rules outlined in Section 382(g)(1) of the Internal Revenue code (this has to do with changes in ownership of 5% shareholders). If Section 382 is violated, much of the NOL would be lost. DHC has taken every precaution to avoid this.

In the spring of 2002, DHC bought an asset heavy Mississippi River barge company, American Commercial Lines, LLC (“ACL”) for $25 million in cash and $52 million in debt assumption. By spring of 2003, as domestic barge rates languished and ACL was hemorrhaging money, it was obvious that the purchase was a failure. The ACL subsidiary of DHC declared bankruptcy. In a self dealing turnabout that truly epitomizes the complexity of DHC, Sam Zell had financed a big chunk of the ACL debt and will probably soon own the equity. DHC has completely written off ACL, though it still owns stakes in two ACL subsidiaries. These are accounted for by the equity method and are valued at $4.3 million combined on DHC’s balance sheet as “Investments in Unconsolidated Marine Services Subsidiaries.”

With the bulk of the remaining NOL carryforward set to expire over the next five years, DHC announced in December 2003 that it has agreed to buy Covanta Energy out of chapter 11, inclusive of the energy and water assets but exclusive of its geothermal assets (which were sold to another party for approximately $214 million). The acquisition will cost $30 million in new equity (financed initially by the Large Owners and eventually by the Rights Offering) plus significant debt assumption.


Rights Offering, Bridge Notes, and “True” Market Cap:
To finance the acquisition of Covanta, to finance the transaction costs, and to provide some working capital, DHC is issuing $40 million of convertible notes to the Large Owners as a bridge. These notes pay 12% interest for a time, then 14% thereafter. They are convertible at $1.53 per 1.0 share. $30 million of the notes will be used to buy the equity of Covanta. In order to pay off the bridge loan ASAP, DHC is undergoing a Rights Offering of 0.75 shares per share at $1.53 per Right. By adding together the current share price of $6.60 and the Rights Offering price of $1.53, you can buy 1.75 shares of DHC for $8.13 (this equates to $4.59 per share). The Rights Offering is designed to pay off the bridge notes. Various of the Large Owners have “kindly” volunteered to make up any shortfall (subject to not violating any Section 382 clauses that would endanger the NOL carryforward) at $1.53 per 1.0 shares (which is also the conversion rate of the convertible notes). In consideration for offering the notes, the Large Owners have also been issued 5.121 million shares of newly issued stock. I presume that these shares also will partake in the Rights Offering, subject to not violating Section 382. Basic shares outstanding before any of this was 30.69 million shares. Assuming 80% of holders partake in the Rights Offering (theoretically everyone should, but for conservatism I’m allowing for slippage) and the Large Owners make up the shortfall, post Rights Offering and convertible note payoff, there will be about 63 million shares outstanding at a share price of $4.64 implying a market cap of $292 million.


Covanta Energy:
Per Covanta’s website, its mission is to “provide low-cost, environmentally sound power to meet the growing needs of an increasingly developing world.” It develops, owns and operates power generation projects and provides related infrastructure services. “[Covanta’s] independent power business develops, structures, owns, operates and maintains projects that generate power for sale to utilities and industrial users worldwide. Covanta Energy's waste-to-energy facilities convert municipal solid waste into energy for numerous communities, predominantly in the United States. The Company also offers single-source design/build/operate capabilities for water and wastewater treatment infrastructures.”

Prior to bankruptcy, Covanta had taken on significant debt and had entered several unfavorable operating agreements with municipalities across America. Through bankruptcy, many of these agreements have been favorably modified or terminated. Many of the agreements that Covanta has with municipalities require letters of credit. Under the terms of the acquisition, DHC is arranging a new $118 million replacement letter of credit facility for Covanta, secured by a second lien on Covanta’s domestic assets. The Large Owners have supplied commitments for this letter. Additional financing has also been arranged.


Valuation:
Per Covanta’s January 14, 2004 filing (http://www.covantaenergy.com/downloads/040114/DS-Exhibit-C.pdf), it expects to wipe out $120 million or so of debt through the bankruptcy process. It will emerge with about $52 million in cash and $1.386 billion of debt (the $1.012 billion of various Project Debt is non-recourse to the parent and is recourse only to the assets of the subsidiary created for each specific project). Total assets will be $2.08 billion offset by $2.05 billion of liabilities (best I can tell, for $30 million DHC is receiving $2 billion worth of assets…not too shabby). DHC itself has about $20 million in liquid assets. So:

Pro Forma Market Cap: $292 million
+ Pro Forma Debt: $1386 million
- Pro Forma Cash: ($72 million)
= Pro Forma Enterprise Value: $1.60 billion

The following financials are assuming zero revenue and income/loss for DHC’s current insurance business. Additionally, I’m assuming that Covanta’s international operations provide $38 million of the EBIT in both years, taxed at 35% with no associated interest expense reduction (if interest expense can offset this, all the better):

2004 2005
Revenue $724 $801
EBIT $135 $145
Less Taxes ($13) ($13)
Tax Adjusted EBIT $122 $132
Plus D&A $55 $61
Less CapEx ($15) ($9)
Less Cash for Minority Int. ($8) ($9)
FCF (pre interest) $154 $175
Less: Net Interest ($45) ($47)
FCF to Equity $109 $128

Pre-Interest FCF yield on EV:
2004: $154 million / $1.60 billion = 9.6%
2005: $175 million / $1.58 billion = 10.9%

Equity FCF yield on market cap:
2004: $109 million / $289 million = 37.7%
2005: $128 million / $289 million = 44.3%

…ahh, the powers of leverage and NOLs.

Over time, as the company de-levers, there is obviously the possibility of massive stock price appreciation. In the meantime, owners of the equity can enjoy yields of 40%. The reduction of debt alone is expected to be more than $91 million per year. So from just a capital structure conversion standpoint (assuming the EV doesn’t ever change), the return on today’s price is 31% per annum or better ($91 million of debt reduction divided by $292 million market cap).


Risks:
- The purchase is not yet approved by Covanta debt holders: If it is not ever approved, we’re back to square one on finding a way to use the NOLs. I’d say the downside here is to $3.
- Covanta’s business does not pan out: I also give this a low probability due to the long term nature of Covanta’s contracts and the dependence of local municipalities on Covanta. The first nine months of 2003 are in the books and they were very good. Covanta has de-levered a bit and modified or terminated many of its unfavorable contracts. However, complete failure is obviously the big risk. This would be bad, but the downside here is that we sunk $30 million of cash and lots of energy into Covanta and we’re back to square one on finding a way to use the NOLs (though, if Covanta fails, the NOLs may have grown some in the meantime).

Catalyst

- Acquisition is approved by Covanta creditors.
- Covanta continues its improved performance. If Covanta produces anywhere near the FCF it’s forecasting, there will be many happy shareholders (via debt reduction and/or additional capital appreciation).