|Shares Out. (in M):||3||P/E||0||0|
|Market Cap (in $M):||36||P/FCF||0||0|
|Net Debt (in $M):||13||EBIT||0||0|
|TEV (in $M):||49||TEV/EBIT||0||0|
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Let me introduce (or re-introduce) the historic saga of Telos Corporation 12% Cumulative Exchangeable Redeemable Preferred Stock (“CERPS”). The story here is stranger than fiction – part history lesson, part international monetary subterfuge, part investment thesis.
This is a small fund or personal investment as it’s illiquid. Nevertheless, I want to pass along a unique fact pattern and non-correlated investment. If nothing else, an interesting read.
Short Company Description
Telos is a government-focused IT company that provides cyber-security, secure communications and identity management solutions to military, intelligence and civilian agencies of the federal government and NATO allies.
Telos common stock is privately held while the CERPS trades OTC. Telos’ current enterprise value through the CERPS is $49 million with the CERPS comprising $36 million, at market, of that total.
The story begins with the 1989 hostile takeover of C3, Inc. by Fred Knoll and Knoll Capital Management. C3 was a Virginia-based systems integrator that served the Department of Defense. In late-80s fashion, Knoll levered the deal to the hilt with $12 million of equity supporting the $133 million transaction. On top of the equity and underneath several layers of debt were the CERPS. The CERPS have a face value of $10/share and accrue a $1.20/share annual dividend. For the past 26 years the CERPS have been both the backbone and the red-headed stepchild of this capital structure.
But before delving too deeply into the detail of the CERPS, back to the cast of characters involved. Fred Knoll, a Columbian-born New York-based financier, was advised on the hostile takeover of C3 by UBS banker John Wood. Shortly following the deal, C3 lost a large government contract which put the company on the precipice (presumably before it had refinanced the UBS bridge financing), which ultimately led to Wood’s termination by UBS. On the heels of his termination, Wood founded his own investment advisory boutique, taking C3 as his first client.
Soon thereafter, in 1992, Wood advised C3 on the $32 million acquisition of Telos, a California-based software and services firm. Beyond advisory work, Wood also invested a significant portion of his personal capital in the deal. The C3-Telos transaction completed a short span of activity that had seen Telos acquired by ConTel in 1989, which was then itself acquired by GTE in 1991, with GTE again selling Telos to C3/Knoll in relatively short order. Not long after C3’s Telos acquisition, Wood received a call from Knoll indicating C3 was on the brink of insolvency as the company continued to suffer under the load of its original LBO capital structure. This spurred Wood to leave his investment advisory boutique and join C3 as COO to undertake a turnaround. As Wood began to manage operations, early-1993 saw significant employee terminations, furloughs and pay cuts. Concurrently, Knoll was trying to find a buyer for the business.
In April 1993, the parties came to blows when Knoll terminated Wood following a Wood-led consortium bidding for the firm; Knoll felt Wood had violated his duty to shareholders to run a fulsome sales process. While Knoll owned roughly 40% of the business and served as chairman, he did not singularly control the firm. Wood, who also served on the board of directors, led a proxy effort amongst the other owners to rally control of the firm from Knoll. In October 1993, Wood’s efforts resulted in Knoll exiting the business while Wood assumed the CEO helm. Thus began Wood’s 20+-year reign that continues to this day.
Company Ownership & Equity Capital
Wood’s success in his proxy efforts against Knoll was founded on the support of C3’s majority owner, John Porter, who had backed Knoll’s initial acquisition of C3. Porter is an English businessman whose family money accrues from his grandfather, Sir Jack Cohen, founder of the Tesco supermarket chain. Cohen’s daughter and Porter’s mother, Dame Shirley Porter, unintentionally hastened the flow of Cohen’s Tesco fortune to her son, John Porter, as a result of Lady Porter’s actions as the Leader of Westminster City Council, London.
In the 1986 Westminster City Council elections, the Conservatives narrowly maintained their electoral majority. As a Conservative and City Council Leader, Shirley Porter was motivated to ensure a continued Conservative majority over Labour. To this end, Lady Porter allegedly enacted a secret policy known as ‘Building Stable Communities,’ which sought to protect Conservative electoral dominance by relocating Labour-inclined voters from those voting wards that were most contested during the last election. This policy took the form of selling public housing within these wards for commercial development rather than continuing their use as residential properties. In addition, the policy allegedly led to the relocation of homeless families to substandard housing in other wards, including abandoned buildings so riddled with asbestos that birds lived in nests made of frayed asbestos. Once exposed to the public, the policy became known as the “Homes for Votes” scandal, and soon thereafter, in 1991, Porter stepped down as Council Leader. Lady Porter then moved to Israel.
Following an extended investigation, public officials determined the “Building Stable Communities” policy had been illegal and held Lady Porter jointly and severally liable for damages of £36.1 million. However, from the early 1990s through the end of the decade, as Lady Porter’s potentially significant legal liability became apparent, sources claim John Porter took over the bulk of the Porter family assets and assisted in shifting family money into the protection afforded by offshore trusts. In fact, a Liechtenstein-based advisor implicated in the recent UBS tax evasion scandal is accused of helping funnel Lady Porter’s money into offshore entities, one of which allegedly funded what became the Telos investment. These accused monetary transfers, if true, by 2002 allowed Lady Porter to claim personal assets of only £300k from what had once been a sizeable personal fortune. Finally, in 2004, following over a decade of dispute, Lady Porter settled the claim for £12.3 million. For those interested . . . you can read the detail of all these exploits in Nothing Like a Dame: The Scandals of Shirley Porter.
With that background, one can appreciate the odd circumstances surrounding the equity capital that sits beneath the CERPS in Telos’ capital stack. John Porter via Toxford Corporation – a Panamanian entity domiciled on the UK Isle of Guernsey and wholly owned by a UK trust established by Porter’s parents for his benefit – has controlled Telos for much of its existence. In addition to his equity investment, over the years, Porter has invested significant preferred capital senior to the CERPS, charging hefty interest rates and securing warrants.
First Phase of the Wood Years
Upon arrival in 1992, Wood was effective in reducing expenses and stabilizing the business. In 1995, the company’s name was changed from C3 to Telos as the latter comprised a significant majority of overall revenue. Likewise, the business jettisoned its low-margin hardware distribution business and transitioned toward a software and service model.
Regardless of Woods efforts, from 1995 to 2005, operating results fluctuated between losses of $8 million and earnings of $8 million with average results of breakeven. All the while, the CERPS accrued from a liability of $14 million to $71 million. Between the CERPS and other senior securities, Telos equity stood under senior obligations of $80 to $100 million over this time period. As such, the common stock was effectively out of the money for much of this decade.
Accordingly, the story of Telos is one of its owners and management navigating against the existence and effect of the CERPS. As the terms of the CERPS precluded common dividends, Telos owners and management were creative in finding means by which to extract cash and value from the business:
Porter sub-debt investments
Porter was the majority lender in several series of sub notes that accrued interest rates ranging from 14% to 17%. Additionally, the notes had a rather egregious 13.5% per annum pre-payment premium.
Porter senior preferred stock investments
Porter has been the majority investor in tranches of preferred stock earning a 14.125% dividend.
In the late-1990s during the Internet boom, Telos created a subsidiary for its promising enterprise risk management software business, Xacta. In 2000, Telos began issuing employee stock options tethered to Xacta equity. The stock option plan ultimately transferred a significant portion of Xacta ownership to Telos’ management. Subsequently, Telos considered a sale of Xacta which would have enriched company management, to the exclusion of the CERPS, from the sale of assets that were rightly Telos’.
An initial draft report from a special litigation committee formed by Telos’ board noted, Xacta’s structure “had become little more than a scheme to set the stage for senior management to ‘get money out,’ while avoiding scrutiny of Telos’ overhead and the burden of the Telos’ balance sheet, particularly as it relates to the [CERPS].”
In 1996, Telos created Enterworks, a subsidiary focused on Internet-related software products. Out of the gate, Enterworks was financed with $3.3 million of 8% sub debt with attached warrants; conspicuously the financing was led by Telos’ management, board and common equity. From 1996 to 1999, significant Enterworks options were also granted to management while Telos funded over $30 million developing the subsidiary. In 1999 and 2000, Telos management prepped Enterworks for an IPO, raising $23 million in preferred stock while Telos forgave $25 million debt owed by Enterworks. Management’s various machinations had the effect of reducing Telos’ ownership of Enterworks from 99.7% to 34.8%. Management and the board owned 15.1% and Porter owned 11.3% of Enterworks.
Unfortunately for management and insiders, the Enterworks’ S-1 was filed March 7, 2000, three days before the NASDAQ hit its all-time high from which it would precipitously fall. With the NASDAQ fell the strategy to monetize Enterworks outside of Telos and around the CERPS.
Porter “consulting fees”
Between 1997 and 2008, Porter was paid $200,000 to $260,000 per year, totaling over $2 million.
The company justified this arrangement with reasoning around Porter having “urg[ed] the company to ‘master the internet’ as a commercial and marketing tool as early as 1994 or 1995” and for his “good will and historical beneficence.”
PIK dividend reversal
Telos has never paid cash dividends on the CERPS. In 1990 and 1991, the company declared and paid PIK dividends on the CERPS. Concurrent with Woods’ arrival, in 1992, Telos made the nebulous claim that provisions in its articles of incorporation precluded the distribution of PIK dividends, but the company did accrue PIK dividends from 1992 to 1995 before transitioning to accrual of cash dividends in 1995 (from 1995 forward, PIK dividends were no longer allowed under the terms of the CERPS).
In 2006, eleven years after the fact, Telos’ board reversed its accrual of PIK dividends for the period 1992-1995 and changed the related dividend accruals to a cash basis. This reversal (if ultimately honored and effective) transferred an estimated $40 million of value from the CERPS to the common stock.
Second Phase of the Wood Years
Throughout time the CERPS have proved a popular vehicle for value investors, including some active ones. In fact, Bill Ackman was involved twenty years ago via Gotham Partners. Unfortunately, the lack of teeth in the CERPS instrument prevented much effective leverage.
However, in 2005, the pressure from the CERPS holders was ratcheted up with the entry of Costa Brava Partnership (Seth Hamot & Andrew Siegel). By the terms of the CERPS, on December 1, 2005, Telos was required to begin retiring the preferred shares in annual 20% increments through December 2009. These mandatory annual redemptions were not made based on the company’s claims related to “substantial senior obligations, limitations set forth in the covenants in the [revolver], foreseeable capital and operational requirements, and restrictions and prohibitions of our Articles of Amendment and Restatement.” This failure to redeem the CERPS in conjunction with the historic transgressions detailed in the previous section of this write-up led Costa Brava to file an October 2005 derivative suit against Telos and Porter, seeking various forms of relief. Moreover, Hamot and Siegel ultimately joined Telos’ board, sitting as Class D directors representing the CERPS class.
In response to the derivative suit, the board formed a special litigation committee ostensibly to determine whether the litigation was in the best of interest of the company. In addition, in June 2006, the board formed a transaction committee to explore strategic alternatives for rationalizing Telos’ capital structure, which resulted in the board’s financial advisor recommending that Telos be sold. Due to management and ownership intransigence with respect to executing a sale of the entire business or otherwise broadly considering strategic alternatives, August 2006 saw a mass resignation of six of Telos’ seven independent directors. The board was then repopulated with a group of retired big brass military men – two retired lieutenant generals and a retired vice admiral. With the new board in place (and Costa Brava on the board), things seem to have settled down in terms of corporate strategies that have the effect of shifting cash and assets from the business (and the CERPS).
In the meanwhile, the Costa Brava litigation has dragged on in fits and starts for the past ten years in Baltimore City Court and state appellate courts. My own personal read of the litigation is that it is not likely to be successful in terms of driving a redemption of the CERPS. It is also worth noting Costa Brava has tallied material legal expenses associated with its efforts. Thus, to some extent, Costa Brava’s interests are not fully aligned with the rest of the CERPS class as legal expense reimbursement is likely a primary motivation of Costa Brava in any negotiated settlement between Telos and the CERPS class.
In sum, this background provides a high-level overview of Telos and the CERPS security over the past twenty years. The first decade saw a lot of shenanigans that could be viewed as attempts to siphon money to management and common shareholders to the detriment of the senior CERPS. The most recent decade involved a board that while not necessarily dynamic has largely put an end to the prior decade’s scheming.
Current Situation & Investment Prospects
So how does this all shake out in terms of current status?
Here is the detail concerning the capital stack, excluding common stock:
The balance sheet value of the accrued CERPS is $121 million or $38/share. Inclusive of an estimated $40 million of value that was transferred from the CERPS via the 2006 PIK dividend reversal, the total is ~$161 million or $50/share. The validity of the incremental $40 million depends on one’s interpretation of Maryland corporate law, but at the very least, it’s a negotiating point for the CERPS class.
In terms of company profitability, here are the last five years:
As is evident, Telos has been hammered by the fiscal sequester and current politics around defense appropriations. The company produced $22 million of 2012 EBITDA, and many of the parties involved with Telos feel this is the latent earnings power of the business when defense appropriations normalize. This earnings power is also burdened with an estimated ~$5 million of opex an acquirer would eliminate (CERPS litigation expenses, heightened executive comp, etc.). This suggests the normalized, demonstrated business can produce $200 to $220 million revenue and $20 million EBITDA.
While there is a wide confidence interval on company valuation, the current CERPS market pricing offers an attractive risk-reward dynamic.
The essential view of individuals familiar with Telos is that the business is worth $200 to $300 million in a normal defense appropriation environment. A $200 million valuation could be supported with a 10x multiple on normalized EBITDA, or alternatively, $300 million is feasible relative to $200 million+ of revenue given the efficiencies that would accrue to a larger acquiring firm. These valuation multiples on a normalized Telos appear reasonable relative to a few transactions I’ve identified – Raytheon’s $420 million 2014 acquisition of Blackbird Technologies for what appears to be perhaps over 2x revenue, General Dynamics 2006 acquisition of Anteon for 13x EBITDA, and Madison Dearborn’s 2014 acquisition of LGS Innovations, which based upon research suggests a revenue multiple above 1x. While I do not consider these transactions comps perfect or exhaustive, I do believe they are generally supportive of suggested Telos value of $200 to $300 million. I would welcome any thoughts or insights into comparable transactions and multiples.
Although the CERPS are owed $120 million to $160 million, I believe the reality is there will likely be some negotiated settlement when the business is sold. As it stands, the CERPS balance sheet value is $38/share. Inclusive of the PIK dividend value, the total is ~$50/share. These amounts increase $1.20/share/year. In terms of an estimate, I would predict the company ends up offering to redeem the CERPS at $25 to $30/share, which would be roughly 2.2x to 2.7x current market pricing.
Importantly, in an odd sense, at this point there is an alignment of interests amongst management, the common holders and the CERPS. The only way in which the common gets paid is through a sale of the business, and management is further incentivized toward a transaction given roughly $15 million of change in control payments. Furthering this motivation toward a transaction is the fact that Porter has reduced his ownership from 63% to 36% over the past ten years through the issuance of management options. This has created a situation in which the workforce and management are financially incentivized toward a transaction.
With a $200 million transaction, roughly $51 million would waterfall to equity, assuming a $30/share CERPS redemption, and management would receive a total of $25 million:
With a $300 million transaction, roughly $151 million would waterfall to equity, assuming a $30/share CERPS redemption, and management would receive a total of $51 million:
Either of these scenarios would represent attractive outcomes to the CERPS, management and the common. Based on my research, I believe there is a desire for a transaction amongst all parties as employee-owners and other common holders are getting older and everyone is generally fatigued of the situation. Additionally, the incentives now appear to be more clearly aligned than ever toward a transaction.
Nevertheless, the obvious key here is “normalization” of the business. A rising tide will lift all boats amongst Telos’ interested parties. For this to occur, the most recent NETCENTS contract will need to be fully implemented and the defense appropriation process return to semi-functional status. Historically, NETCENTS has funded roughly 60% of Telos’ revenue, a primary revenue driver. However, following the March 2014 selection of Telos as a prime contractor under the most recent NETCENTS contract, several protests were lodged by NETCENTS bidders (against the NETCENTS process, not against Telos specifically). These protests have stifled funding under the contract and materially adversely affected Telos’ revenue. Resolution of the NETCENTS issue is critical to Telos’ business normalizing.
In short, NETCENTS appropriations specifically and defense funding generally need to rebound in order for Telos to return to historical levels of profitability and position the business for a sale. Assuming normalization of spending, as a cybersecurity and secure communications provider, Telos is well positioned to capture defense spending within a primary area of focus.
In the interim, the company is managing liquidity through a number of mechanisms. In December 2014, Telos sold 10% of its interest in Telos ID for $5 million in order to fund repayment of a portion of its term loan and provide incremental liquidity. Additionally, in March 2015, John Porter agreed to provide $5 million of 12% subnotes. I believe this latter development suggests Porter (as well as the common class more generally) is sufficiently aligned with the CERPS toward seeing the business through its current struggles toward an ultimate transaction as defense funding returns. I would also note that research indicates the company has a number of levers it can pull to reduce expenses should revenue not return as quickly as desired. Regardless, Porter and the other common holders are highly motivated to ensure the company avoids a restructuring as that process would likely provide the CERPS with just the leverage it needs (but lacks in its covenants) to position toward repayment (or company ownership).
Telos CERPS offer an interesting risk-reward. While Telos is currently battling revenue headwinds, the reality is the EV through the CERPS is only $49 million – roughly 0.4x LTM revenue and 0.25x normalized revenue or 2.5x normalized EBITDA. Company value appears more than sufficient to cover the CERPS at current market prices, and as the business rebounds the CERPS could see 2x to 3x upside associated with a sale of the business.
Thawing of NETCENTS spending and defense appropriations driving rebound in business, leading to transaction.
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