Description

Company: WMIH Corp (NasdaqCM:WMIH)

Share Price: $0.75

Market Capitalization: $760m (incl. Series B)

Target Price: $1.35 (+80%)

WMIH Corp (“WMIH”) is a tax-advantaged acquisition vehicle formed from the former holding company of Washington Mutual Bank (“WaMu”). As a result of the bankruptcy of WaMu during the financial crisis, WMIH has ~$6bn of unrestricted net operating loss carryforwards (“NOLs”) that don’t begin to expire until 2032. Due to investor fatigue and situational complexity, WMIH's share price offers 80%+ upside in the event that KKR/WMIH announce an acquisition - a catalyst that is at worst uncorrelated and at best negatively correlated with the broader market as volatity increases the willingness of sellers to transact.

Company Background

On March 19, 2012, WMIH emerged from bankruptcy with ~$6bn of NOLs, ~$80m of cash, and substantially no liabilities with the expressed goal of acquiring an operating business to utilize its tax attributes. It wasn’t until KKR’s original January 2014 investment, however, that WMIH had sufficient financial resources and expertise to pursue a cohesive acquisition strategy. As part of KKR’s original January 2014 investment, KKR acquired ~5% of WMIH’s common stock via an $11m Series A Preferred, entered into a commitment to lend $150m of subordinated debt to fund a future acquisition, and received warrants to purchase an additional ~22.5% of the Company. Following this original investment, KKR, in partnership with WMIH, pursued various acquisitions, the most important of which was the potential acquisition of one of the nation’s largest fleet lessors, which was ultimately sold to a strategic.

In January 2015 (one year after the original KKR investment), KKR and WMIH raised $600m of 3-year, 3.0% Series B convertible preferred stock, which would automatically convert into common stock upon the consummation of a qualifying acquisition. The Series B preferred had a conversion range of $1.75-2.25/share depending on the 20-day daily VWAP preceding the announcement of an acquisition. If WMIH was unable to consummate an acquisition prior to January 5, 2018, the preferred stock would be redeemed at par. KKR invested $200m in the Series B convertible preferred off its balance sheet (economically equivalent to a $1bn equity investment from its PE fund at 20% carry) - KKR is thus highly incentivized for WMIH to succeed. Pro forma for the Series B preferred capital raise, KKR owned ~30% of WMIH with an average cost basis of $1.57 - $1.84.

Over the last three years, WMIH and KKR have partnered to evaluate various large acquisition targets with the goal of utilizing WMIH’s $6bn tax attribute. Importantly, the $600m of available cash, combined with a shareholder register of large institutional investors willing to invest additional capital behind a large acquisition, made WMIH a credible acquirer for large businesses. In particular, WMIH focused on large corporate carve-outs in the financial services industry given that they (i) trade at low multiples of pre-tax earnings, (ii) tend to be full U.S. corporate taxpayers, and (iii) do not lend themselves to competition from financial buyers. WMIH further has positioned itself as an attractive alternative to an IPO as Sellers would receive 100% cash up front and to financial buyers given its $6bn tax attribute. As a result, WMIH has aggressively pursued various large corporate carve-outs, including (among others):

• Specialty lending: carveout of leading global inventory finance platform (sold to strategic)
• Consumer finance: carveout of leading branch-based nonprime consumer lender (sold to strategic)
• Insurance: carveout of leading mortgage insurer (sold to strategic)

Latest Developments

Over the last year, WMIH has faced significant uncertainty that caused the share price on its common stock to decline from ~$2.30 to ~$0.75 per share:

1. Corporate Tax Reform: Following the election in Nov-16, uncertainty around corporate tax reform and the Federal corporate tax rate created an overhang in WMIH’s share price.
2. Maturity of the Series B Preferred: Given that WMIH/KKR had been unable to successfully consummate an acquisition (though they got close with multiple targets), the $600m Series B convertible preferred was approaching its three-year maturity. As specified in the original terms, if WMIH was unable to consummate an acquisition prior to January 5, 2018, the preferred stock would be redeemed at par, meaning WMIH would need to raise fresh third-party capital to consummate an acquisition.

Despite the fact that both of these overhangs have been resolved, WMIH's share price remains at ~$0.75/share.

Corporate Tax Reform

As we all know, the Federal corporate tax rate was reduced from 35% to 21%, reducing the value of WMIH’s tax attribute by ~40% from an undiscounted $6bn * 35% = $2.1bn to $6bn * 21% = $1.25bn.

Amendment of Series B Preferred

Recognizing that there was still substantial value in WMIH’s $6bn of NOLs, on 12/11/17, WMIH announced an amendment to the terms of its Series B convertible preferred in order to extend the mandatory redemption date for an additional 21 months until October 2019. As part of the amendment, WMIH also made the following changes to the terms of the Series B convertible preferred:

• Conversion Price: reduced the conversion price from $1.75-2.25 to $1.35 (~40% reduction from the top end of the range – in line with the ~40% reduction in the undiscounted value of WMIH’s tax attributes)
• Dividend Rate: increased the dividend on the Series B convertible preferred from 3.0% cash to 5.0% paid in common stock at the higher of $1.05 per share and the market value
• Special Common Stock Distribution: Holders of the Series B convertible preferred will receive a special distribution of 19.04762 shares of common stock per share of Series B convertible preferred if and when the Series B convertible preferred is converted in connection with the consummation of an acquisition

Comparative Economics

While the market has responded poorly to the announcement of the amendment to the Series B convertible preferred terms, it is important to note that the Series B holders did not extract much value from the common shareholders after reflecting the fact that WMIH’s tax attribute declined in value by ~40% due to corporate tax reform. In fact, the amendment appears to be very fair to common shareholders, reflective of the fact that WMIH/KKR benefit from a supportive shareholder base when looking to raise capital to fund a future acquisition. On a relative basis, the common stock offers a substantially more attractive risk-reward than the non-traded Series B convert.

Note that WMIH will likely raise additional capital in the context of an acquisition via a rights offering to its existing shareholders as the distribution of non-transferable rights does not cause a Section 382 ownership shift (even if certain shareholders oversubscribe in the offering). Given the ability to price the rights offering at a discount to the prevailing share price gives WMIH full confidence in its ability to complete the rights offering and thus close the acquisition.

Illustrative Returns

Even after the dilution associated with the annual 5% dividend on the Series B convertible preferred, the common stock offers an very attractive return relative to the Series B convertible preferred.

Valuation Matrix

At the current share price, WMIH common shareholders are acquiring the $6bn of NOLs at ~$165m (~13% of the undiscounted cash tax savings at the revised 21% corporate tax rate). By way of comparison, while the common stock is structurally subordinated to the Series B preferred in the event of a redemption, the Series B preferred holders are acquiring the $6bn of NOLs at ~$295m (~23-24% of the undiscounted cash tax savings at the revised 21% corporate tax rate). The common is being well compensated for its structural subordination.

Long-Term Economics (Roll-Up Strategy)

If WMIH can acquire businesses for 9x earnings every two years using only retained cash flows (augmented by the lack of corporate taxes) and grow earnings at +5% per annum, WMIH’s common stock could compound capital at a +23% IRR, generating a +18x MoM 14 years. The comparable return for a non-tax-advantaged investor buying the same businesses would be an +18% IRR / +10x MoM. Note that the return for WMIH is further amplified by acquiring a larger business upfront, which could be enabled by leverage and/or a rights offering.

Share Performance

Historically, WMIH traded at a slight premium to the high end of the Series B conversion price ($2.25). Following the election of Trump and talk about corporate tax reform, however, WMIH’s common stock has declined given its direct (negative) exposure to a reduction in the U.S. corporate tax rate. Despite clarity around the 21% corporate tax rate and the amendment to the Series B convertible preferred, WMIH still trades a significant discount to the share price implied by the reduction in the corporate tax rate by ~40%, which is equal to the reduction in the Series B conversion price ($2.25 * (1-40%) = $1.35).

Risks & Mitigants

• Failure to Consummate an Acquisition: WMIH / KKR have had 3 years to consummate an acquisition and have failed
  • WMIH / KKR have looked at multiple large acquisitions that would have generated highly attractive returns for shareholders but lost the deals to strategic buyers as a result of price discipline; KKR has over $200m of its balance sheet invested in WMIH (economically equivalent to a $1bn equity investment from its PE fund given 20% carry), meaning KKR is highly incentivized for WMIH to succeed
• KKR Fees: KKR will extract fees from WMIH at the detriment of common shareholder
  • KKR does not charge WMIH any management or incentive fees, meaning WMIH is a unique opportunity to invest alongside KKR with no fees or carry
• Limited Float: WMIH’s common stock has ~$165m float
  • The illiquidity of WMIH’s stock is likely the source of the recent trading discount to the Series B conversion price; upon the consummation of an acquisition, WMIH’s float will grow dramatically (~$900m at $1.35/share) given the conversion of the Series B to common stock; WMIH/KKR will likely execute a rights offering to raise additional capital to fund a large acquisition, giving investors the opportunity to deploy additional capital as part of the rights offering
• Limited Financial Resources: Given the size of the tax attribute, WMIH might require additional capital beyond the $600m of cash from the Series B convertible preferred
  • WMIH/KKR might announce a rights offering concurrent with the closing of an acquisition to raise additional capital to fund a large acquisition; given WMIH’s ability to price the rights offering at a discount to the then trading price, WMIH can be assured that the rights offering will be fully subscribed; there are no negative Section 382 tax consequences from a rights offering to existing shareholders (even if certain shareholders oversubscribe for rights in the event of <100% pro-rata uptake from the offering); WMIH can also allow the Seller to retain a 19.9% stake in the acquisition target to further increase the size of the business that WMIH can acquire
• Corporate Tax Reform: the U.S. could further reduce the corporate tax rate, reducing the value of WMIH’s tax attributes
  • Rather than a further reduction in the corporate tax rate, it's more likely that the next administration will need to raise the corporate tax rate to close the budget deficit, which would benefit the value of WMIH’s tax attribute

Appendix: Series B Convertible Preferred Terms

Catalyst

Acquisition Announcement: If WMIH/KKR announce an acquisition, the price on the common stock will likely increase to at least $1.35/share (80%+)