|Shares Out. (in M):||13||P/E||0||0|
|Market Cap (in $M):||133||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
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Caveat: This is even smaller than it looks. While book value is $212m and market cap is $133m, this remains a stock with a very small float (probably under $30m) and very limited liquidity. It has traded $20k cumulatively over the past two weeks, although there have been $100-300k days occasionally, and $1.6m changed hands on March 23. Hopefully that saves some of you some time…
I was not the first to post SWKH on VIC - NOL fans have been watching this one since its days as a shell company (2010/2011 writeups). I posted SWKH as a long idea five years ago in June 2013 at $8.30 (split-adjusted from 83c for 1:10 reverse split) once an operating strategy to exploit the NOLs had been implemented, and I also posted several positive updates/comments along the way at higher prices following a fellow VICer’s recommendation in June 2015 at $16 (I agreed, but unfortunately this turned out to be the peak)… I liked it in Dec 2015 at $11-12, loved it in Nov 2016 at $9.50, still loved it in Aug 2017 at $11.25… and now here I go again, not just commenting, but dedicating a fresh writeup to this very tired idea at $10.15. Even since my original pitch at $8.30, this stock has underperformed the market by 8-9% annually. Unless you bought near lows in 2013 and sold at highs in 2015, to this point, SWKH has mostly been a total laggard, and not an easy one to get in and out of for those with liquidity constraints.
However, I believe we may finally be within striking distance of an event which should unlock value, perhaps enough to make for a highly attractive return from here/today. Risk, as has been the case all along, remains low at the current price. So this combination makes me tentatively (and not for the first time) propose this idea as a highly attractive risk/reward (liquidity concerns set aside, which I understand is a luxury).
Instead of wasting time and space on the detailed history, I’d ask those who need a refresher or are new to the company to read the previous writeups, as well as some of my updates along the way:
Next, instead of detailing SWKH’s elusive potential to become a truly great specialty finance company, one capable of compounding capital in its niche area of expertise at high returns for years to come, and potentially trading from a significant discount to book to a significant premium to (increasingly higher) book… I’ll take a more sober view. Frankly, the team has done a fairly good job, but has had trouble driving the pipeline to keep up with deals which come back early, and also has had some growing pains along the learning curve and during, at times, a very crowded lending environment (even in their niche), all of which has conspired to leave returns decent, but not exceptional, and leverage has been unnecessary as their best deals often come back early and refill the coffers. While I don’t think it is impossible that they finally get ahead (while maintaining underwriting discipline - can’t just write the checks and cross the fingers), particularly if the lending environment tightens (including equity and “dequity” as a competing sources of capital), I am going to put aside, for now, the case where they lever up and earn the mid teens levered returns on equity they (and I) initially believed were possible. Let’s assume for now that a very HSD unlevered return, maybe 10%, is as good as it’s going to get on a sustainable basis. The $376m NOL seems to be valued fairly/conservatively on the balance sheet at $22m, given that a majority of it expires in 2021, and the company is currently earning around $15m a year of taxable income, with potential for growth closer to $20m without much changing. Then maybe this should trade for book value ($16.21 per share at 3/31/18), but it doesn’t; it trades for 0.63x BV and 0.70x TBV, and I’m not sure we can expect this to change materially anytime soon given the overhangs of limited liquidity; small size; large, “stuck” controlling shareholder (Carlson still 69%); no major listing; no coverage; niche strategy with no natural owners; 4.9% poison pill to protect NOL’s; occasional blow-ups; talented but small, stretched management team handicapped from growing by small size (chicken and egg); etc.etc.
So first, what is the portfolio worth without all the baggage listed above? I think that we can look at the fair value of the current book a few different ways. Then we can assume that Carlson, as a rational and very stuck investor in this illiquid position, will look to use this window while NOL’s remain intact with maximum Sec 382 shift available to pursue a value-unlocking transaction of some sort: merger, sale, or if all else fails, perhaps even liquidation. Ultimately, we should arrive at a value no lower, and potentially 60%+ higher, than where we are today. And it is not to say that they can’t still become the best little specialty finance company in the public markets - we are investing in equities with limitless upside, and dreams occasionally come true - but let’s set those odds at zero and hope to be surprised.
The portfolio occasionally hits bumps. Some small bumps have become larger bumps. Management is thoughtful and highly competent, and everything makes sense at the time, but it doesn’t always work out. Sound familiar? Unfortunately, it sounds a lot like my portfolio over the past 20 years. If yours is perfect, please send me wiring instructions so I can make the capital markets more efficient and hand you my keys :)
Brief overview of current problem children, with current principal balance:
ABT - $11.6m, or 89c per share
This one is the largest risk, I believe. They are in molecular imaging. The company has been in trouble for a couple of years. The first lien lender, SquareOne, blocked payments in 2015. The equity sponsor put some more money in and began a sale process. We’re still waiting on a resolution. In order to drive the boat to a greater degree, SWKH took out the first lien lender in early 2016, emboldened by strong management and perceived strategic value (capital problem, not operational problem). The equity sponsor has since stopped supporting the business, but SWKH has stepped in and tried to bridge the company to a sale. We are still waiting, which is why I am inclined to mark this one down further than they already have in a base case. Philips is the most logical buyer, as they are looking to compete with GE in this area. The banker representing ABT also represented MNK when it recently sold its nuclear imaging division for $670m in 2017 (a process which took 1.5 years). So maybe it’s just slow, but probably safer at this point to assume they may have to mark this one down further.
They advanced $10m in a second lien note in 2014. They have since bought out and funded additional capital to ABT through the first lien, currently at $8.3m and counting. They recently marked down the second lien by $7.6m, leaving $11.6m on the books (includes interest).
B&D Dental - $8.2m, or 63c per share
B&D is also for sale. This is a dental products company. Like many of SWK’s problem children, the distress stems from poor working capital management. A key Japanese supplier required advance cash payment resulting in a 4-6 month cash cycle for a key ingredient, and B&D couldn’t make it work. The business has excellent economics, selling units for $100 which cost them $18 to make, but they spent too much on R&D and hit a wall with the working capital. This late 2013 deal ($6m) went on non-accrual status in late 2015, and an additional $2.2m has been funded/accrued since. SWK also controls 15-20% of the equity through warrants. The business sounds like it is turning around and could potentially return to cash pay this year. This company is also being bridged to a sale, and SWK has had a CRO in house for some time.
There is private equity interest in the business, and I’m inclined not to mark this one down in my base case.
Hooper Holmes - $13.3m, or $1.02 per share
This is their newest problem child, and suddenly their largest. HPHW is public, so anyone can follow along through their filings. Most notably, SWKH has funded an additional $5m since the end of the 3/31/18 quarter to bridge this one to a sale as well (detect a pattern)? Note that this strategy failed with Syncardia a few years ago (bridge to a sale ended up being good money after bad). But this strategy is not flawed in and of itself - we just haven’t seen it work for SWK, yet.
This was a high risk, high reward deal, providing expensive capital to fund HPHW’s merger with Provant. Initial funding was $6.5m last year, and the IRR penciled out into the 20’s for three years if it worked. HPHW management repeatedly fell short, and they are now in their cash hungry part of the calendar with a PE sponsor (Century) who is between funds and not able to cross-invest, leaving HPHW quite stuck. With additional amounts advanced, SWKH now has $13.3m of principal at risk. Again, SWK is forcing a sale process, extending forbearance through 8/31/18 with loans due 9/4/18. The banker advising HPHW on the sale process is Raymond James, one SWK has often worked with.
HPHW does around $13m+ of portal software revenues alone. This piece alone should cover SWKH. They are shopping the company in a sector which has seen active M&A / private equity activity, using a banker seemingly hand-picked by SWK. For these reasons I am inclined not to mark this one down either at this stage.
Cambia - $6.6m, or 51c per share
In 2014/2015, SWKH paid $8.5m in two tranches for a combined 50% interest in royalties generated by migraine solution Cambia (marketed by Depomed and Aralez in US/Canada). Scrips were weak last year, as DEPO transitioned its salesforce, and SWK marked down the royalty interest by $1.2m. The situation seems to have stabilized, and IRR could still pencil out to be >10% (was underwritten closer to mid/high teens). To the positive, on 5/10/18 DEPO announced they in-licensed a new delivery method of Cambia expected to hit the market by 2020. This is covered under SWK’s royalty agreement, so could prove to be found money.
Female Health Royalty - $0.6m, or 4c per share
Going to gloss over in interest of time - it’s 4c - but this was a $3m piece of a $100m deal, was marked down by $1.4m, and is currently on non-accrual, with $600k remaining on the books.
Adjustments to most recent 3/31/2018 marks:
These are the adjustments I make for my base case. Same construct used for best and downside cases (see below).
Q1 2018 Adj Risked TBV
ABT 11.6 50% 5.8
B&D Dental 8.2 – 8.2
Hooper Holmes 13.3 – 13.3
Cambia 6.6 – 6.6
Female Health Rty 0.6 – 0.6
OraMetrix 8.5 (8.5) –
Cash 16.4 8.5 24.9
% of TBV 9% 14%
Current TBV 189.9 184.1
TBV / share $14.54 $14.10
Price / TBV 0.70x 0.72x
DTA 21.8 50% 10.9
Book Value 211.7 195.0
BV / share $16.21 $14.93
Price / BV 0.63x 0.68x
And as an aside, as pertains to the income statement, OraMetrix was sold after the quarter, and Narcan (an exceptionally profitable deal) will slow way down in Q2 after hitting a cash-on-cash return cap. So you need to normalize Q1 revenue from $6.8m to maybe $5.2m… but that’s too low, not giving credit for the undeployed cash.
Three valuation cases:
Case Description Risked BV Discount Return
Best case - all good, including NOL at BV $16.21 (37%) 60%
Base case - ABT and NOL’s -50%, rest good $14.93 (32%) 47%
Downside - all problem loans / NOL’s to zero $11.46 (11%) 13%
(Q2 earnings excluded from all scenarios)
Of course a takeout doesn’t require much analysis. Carlson probably still doesn’t want to own outright this book of loans, but if they can get over that, they can buy in the piece they don’t own (only 31% shift, so NOL’s stay intact) )and immediately fold in other taxable income producing investments to absorb more of the NOL’s before they expire. They paid a 10% premium to book value for effective control in 2014 (going from 29% to 69% ownership). Who knows exactly what they would be willing to pay if they see a path to meaningfully pulling forward those NOL’s, but I would expect as a minority shareholder to be compensated fully for what we have, and then, realistically/unfortunately, leave additional NOL upside to Carlson. Personally, I’m otherwise in no hurry to get taken out of these assets at a discount, but I’m not the only minority shareholder.
A liquidation would be wasteful, but there is a good chance they could sell their portfolio near fair value and wind down without major leakage.
The scenario that requires the most thought is the most likely - some kind of transformative merger or acquisition that allows for accelerated NOL utilization in advance of expiration and hopefully also increases scale to the point where an uplisting to NASDAQ makes sense, bringing more liquidity and attention to the stock and hopefully reducing significantly the trading discount to fair value. The key is that, with 13.1m shares currently outstanding, they have had, since August 2017, the ability to issue up to 13m shares without impairing their NOLs (Sec 382). How a partner would value these (up to) 13m shares vs. their own assets will be the key in any deal’s upside.
One option would be to issue up to 13m shares in exchange for a large royalty, or some other income producing asset they feel they can value. It is my understanding that these large, orphaned royalties come out of major pharma companies at the rate of “none to a few” each year, and often the separations are structured in a way that makes them unapproachable. However, SWKH should be a competitive bidder given its tax advantage. Let’s say for illustrative purposes SWKH can buy a royalty that will produce an estimated $50m of income a year for the next 4+ years, before eventually tailing off to zero. Perhaps their 13m shares are valued at $14-15 apiece by the seller, or $185-190m total. Pro forma book value is over $375m at $14.50. NOL’s could be used for the next four years, at least, to offset taxes on the existing business and the royalties. If you can compound and redeploy capital along the way to some extent, which they have proven they can, seems that the present value could be worth at least a 40% premium to today’s stock price.
Another option could be to merge with another investment portfolio. Maybe a private partnership, or maybe a private or public BDC. Let’s say you merge with a BDC with “fair value”, or “scrubbed book value”, of $180m. Again, I’m assuming the other party would give credit to SWKH for $14-15 a share of fair value, but this might need to be adjusted higher, or lower. So we would have $375m of pro forma book value, as above. If the BDC yielded 9%, and SWKH has shown it can yield the same, then put together, they should be able to produce $30-35m of tax-free income, and growing. With $1.15 to $1.35 of EPS, mostly paid out as a dividend, it seems this would likely trade in the low/mid teens, at least. Lever it up (BDC’s can have way too much leverage these days), and as long as you don’t blow up, those returns can get much higher. With a filled-out management roster afforded by a larger asset base, you might be able to work through a significantly larger pipeline and finally get ahead of the capital base, with deals fighting for capital as opposed to capital fighting for deals. If it all sounds very hypothetical, that is because it is… but if you’re Carlson, aren’t you going to try very hard to do something like one of these things? The NOL’s are wasting away, and the present illiquid situation is untenable for long.
Carlson is big and this is small, so who cares… right? I am not so sure. Carlson’s 13F filings suggest their AUM has come under some pressure, and returns have allegedly not been so hot over the past several years. Being a highly diversified, multi-strategy fund, this is actually quite a large position for Carlson - in fact, at approximately $100m at cost and $90m at market, SWKH would rank as their #14 position out of 223 in total, with most of their largest positions being levered risk-arb positions and stubs like TWX, NXPI, XL, COL, OA, CAVM, MON, DVMT, AET, ABA, DPS, etc. The only disclosed positions at 3/31/18 larger than SWKH which are not deal stocks or stubs (I think, I’m not a dedicated special sits / risk arb type) are CFG, BG and V. SWKH may very well be a top 5 position on a fundamental basis. They may have thought it was a diversified bet, and that this was an arm’s-length portfolio of tiny royalty finance and similar deals… but at this point, I have to believe they are viewing it as one big, illiquid problem child. I also understand anecdotally that this one “matters” to them and is receiving particularly close attention internally.
The Sec 382 shift restrictions expired in August 2017. On the other end of the timeline, the NOL’s begin expiring (rapidly) in 2021. So the clock is ticking. Carlson made its investment long before SWK had any investment strategy other than to maximize the value of its NOL’s. I have to believe they will try their hardest, and soon, to find some taxable income beyond what Winston and his talented, but small, team can prudently produce.
Another clue - SWKH has been threatening to close a credit facility for months (see new language in quarterly filings beginning Q4 2017). They are seemingly one deal away from running out of capital and claim to have a full pipeline, which I don’t doubt. We have a high level of confidence from conversations with the lending community that they could borrow, and cheaply, if and when they wanted to. Maybe not a ton of capital, but more than they need. We believe they have lined up financing, but for some reason they have not closed on a deal. Perhaps they are waiting to see whether or not something bigger pans out, something which might require a different capital structure solution. Otherwise, the delay makes little sense. Now watch a new credit facility get announced this week!
Finally, why not earlier? Why not have announced a deal in September 2017 and maximize NOL utilization before 2021? I don’t know. My only weak hypothesis is that they wanted to clean up their book, and ABT and B&D seemed close enough to resolution that waiting for “100% clean” made sense. Or maybe they had some plans which fell through - happens all the time. Now with HPHW added to the list, and no resolution for ABT or B&D, it may now make more sense to just accept that 100% clean does not exist, and with even less time remaining on the clock, it’s time to just get something done.
That’s it - just an update on what I believe to be a very low-risk position that seems to offer substantial reward and have potential for a catalyst to unlock value in the relatively near term (this year?) My best guess is that 2018 does not end without some sort of event. But given the history here, and mine in particular, don’t hold me to it! And another caveat: my numbers are loose and directional. I have given up precision on this one. Frankly, I have no idea what a transaction might look like if one should occur, how the relative valuation negotiation with some unknown asset(s) might or might not shake out, or whether SWK’s core strategy is an 8% unlevered endeavor ar a 12% unlevered endeavor through a “cycle” (not business cycle, but this niche sector’s specific credit cycle, which accounts for biotech equity markets, general liquidity levels, and rise and fall of popularity of this theoretically uncorrelated investment strategy). I just think the range of conceivable outcomes from here is highly attractive.
Transformational royalty purchase / merger with investment portfolio
Up-listing to NASDAQ
Increased share count, market cap, trading liquidity, market awareness
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