Steel Excel is an Attractive Special Situation – SXCL

Shares of Steel Excel are trading well below the value of the merger consideration they will receive when the company is taken over by its majority owner, Steel Partners LP.

On December 7, Steel Partners announced an agreement to acquire the 36% of Steel Excel that it does not own in return for preferred units of Steel Partners LP. The units would carry a 6.0% coupon and mature in nine years. Steel Excel shareholders would receive $17.80 in Steel Partners LP preferred units per share. Evidently, the deal was not acceptable to one of Steel Excel’s major shareholders, GAMCO. After discussions with GAMCO, Steel Partners unveiled an amended merger agreement on December 23. The preferred units’ distribution would now be cumulative, and Steel Partners agreed to offer to redeem at least 20% of the preferred units on a pro rata basis in cash within three years of issuance. Steel Partners also agreed to seek an NYSE listing for the preferred units.

Following the announcement, shares of Steel Excel scarcely budged, though the amended terms offered much better value for Steel Excel shareholders. Specifically, the fact that 20% of the preferred units will be redeemed within three years reduces both the effective maturity and the credit risk of the preferred units.

Modeling the implied IRR of Steel Excel shares is a simple matter. When converted into Steel Partners preferred units, holders will receive $1.07 in dividends per year and will have the option of redeeming 20% of their preferred units some time in the first three years after the merger closes. Assuming Steel Partners waits the full three years to redeem units for cash, the IRR for purchasers of Steel Excel shares at $14.75 is 9.3%. Earlier redemption would result in a higher IRR.

9.3% is a generous return for these Steel Partners LP obligations. Though the preferred units are junior to all of Steel Partners’ other obligations, the holding company is quite well-capitalized. At September 30, Steel Partners LP held cash and investments of over $97 million against debt of $57 million. Upon taking full ownership of Steel Excel, Steel Partners will assume direct ownership of another $122 million in net cash and securities. The full face value of the Steel Partners LP preferred units in issuance as the result of the merger transaction will be $72 million.

So what are Steel Excel shares/Steel Partners LP preferred units worth? I think it’s worthwhile to break down the cash flows into buckets and value each using a spread over treasury rates. I ran some numbers using current treasury rates and various credit spreads: 200 basis points over treasureies for 0-3 year cash flows, 350 basis points over for 3-6 year flows, and 500 basis points over for cash flows in years 6-9. The resulting calculation values Steel Excel shares at $17.09, 16% higher than the current trading price. At $17.09, Steel Excel shares would provide an IRR of 6.7%, which seems fair to me.

In reality, I don’t expect the gap between the current Steel Excel price and the face value of Steel Partners LP units to close because of the rich interest rate spread, I expect it to close because investors will see a listed preferred unit trading at a 17% discount to face value (at a $14.75 trading price for Steel Excel shares) and bid the price up.

The Steel Excel merger is expected to close in the first half of 2017 and is subject to a shareholder vote. Holders of more than half of the 36% of shares not owned by Steel Partners LP must approve the deal. GAMCO owns one third of those shares and has implicitly blessed the merger, so I don’t expect approval to be a problem.

Alluvial Capital Management, LLC manages a private investment partnership. If you are a qualified client and are interested in learning more, please contact us at info@alluvialcapital.com.

Alluvial Capital Management, LLC holds shares of Steel Excel Inc. for client accounts. Alluvial may buy or sell shares of Steel Excel Inc. at any time. 

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

Falling Peso Benefits Rassini SAB de CV

Alluvial Fund, LP is now accepting limited partners. I can’t say much more about it here, but please contact me if you are interested.

The last few years have seen a stunning decline in the value of the Mexican Peso, from around 13 to the US Dollar in 2012 to over 20 today. The scope of this decline spurred me to take a look at an old favorite, Rassini SAB de CV, and I’m very glad I did.

A Mexican company, Rassini is North America’s largest producer of suspension components for light consumer and commercial vehicles, especially pickup trucks. The company is also a major producer of brake components, with two plants in Michigan. Rassini also has operations in Brazil. Notably, Rassini earns nearly all its revenues in US Dollars, but the large majority of its expenses are in Pesos.

My original thesis for investing in Rassini was expected debt reduction and margin expansion, driven by strong US auto sales and the weak Peso. The idea worked very well, and I sold when shares reached a reasonable valuation.

Since then, the company has continued to prosper. Revenues have risen substantially, both organically and debt has been further reduced. Margins have widened as revenues come back in ever more valuable US Dollars. Shares are somewhat higher than where I sold a few years back, but the company’s valuation has once again compressed to very attractive levels.

Simply put, the market has not adequately anticipated the dramatic increase in Rassini’s earnings power as a result of the recent plunge in the Peso’s value.

Here’s a look at Rassini’s most recent results, in Pesos.

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Every figure is a record. Now here are those figures in the context of Rassini’s valuation. The value of Dollar or Real-denominated debt is converted to Pesos, as closely as possible.

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Rassini appears very reasonably priced on trailing results. However, these results dramatically understate the company’s true trailing profitability, since the Peso was much stronger than it is now for most of the period. The next step is to see what Rassini’s results would have been at current exchange rates.

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At current exchange rates, Rassini’s revenues would have been much higher. Much of the difference would flow directly to EBITDA and EBIT, since Rassini’s cost base is substantially Peso-denominated. (The notable exception is the brakes division, which is US-based. More on that in a second.)

Simply adjusting Rassini’s trailing revenues to current exchange rates revalues revenues upward by nearly 2.3 billion Pesos. What about costs? Costs for the Mexican North American Suspension division would be virtually unchanged, given the salaries and plant expenses are in Pesos. Brakes, which is Michigan-based and pays expenses in dollars, would see a rise in translated expenses. But how much? Translated, the uplift in Brakes division revenue is 678 million Pesos. The 2015 annual report shows EBITDA margins for the brakes division of 19.2%. Assuming depreciation of 5% of sales (higher than the other segments) and an EBIT margin of 15% yields an EBITDA uplift of 130 million Pesos and an EBIT uplift of 102 million Pesos from the Brakes division.

The impact of the weak Peso on translated earnings from the Brazilian business can be ignored, since that business is operating at break-even right now.

The addition of 2.3 billion Pesos to Rassini’s EBITDA and EBIT (less the increased operating costs at Brakes) makes a huge difference in the company’s valuation.

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As the markedly different exchange rate environment translates into higher earnings in 2017, I expect the market to take notice and revalue Rassini’s shares.

Now, there are risks. The largest is the possibility of a slowdown in US auto sales, light trucks in particular. Sales of these vehicles have been strong for several years and may have plateaued. A sales decline would have a magnified negative impact on Rassini’s results due to operating leverage. I would not expect operating margins to decline to the previous low teens range, because of the beneficial currency impact. But they could decline to the high or mid teens range.

Another risk, and probably the one on everyone’s mind, is the possibility that free trade with Mexico will be substantially limited. Again, this could have a meaningfully negative impact on Rassini’s revenues and margins. But I think this risk is somewhat reduced by the fact that Rassini operates two plants in the US that provide many goods jobs. Rassini is less likely to be seen as a “parasitic foreign job-stealer” when it can point to the direct employment benefit it provides US blue collar workers.

Finally, there is the risk that the Peso will reverse its decline and Rassini’s profit bonanza will evaporate. Well, that’s the beauty of being a US investor in foreign companies operating in Dollars! If you convert dollars to Pesos and then use the Pesos to buy Rassini stock, you’ve created a natural hedge that will shield you from fluctuations in the USD/MXN exchange rate. You’ve essentially “locked in” the current exchange rate. For example, if the Peso continues to decline, the value of your Rassini shares will decline in Dollar terms. But, Rassini’s earnings will increase! So it’s a wash. The opposite occurs if the Peso strengthens. Your investment is immediately worth more, but Rassini’s future earnings will decline.

I believe investors purchasing shares at current levels are more than adequately compensated for these risks, and I expect great results from Rassini in 2017.

Alluvial Capital Management, LLC holds shares of Rassini SAB de CV for client accounts. Alluvial may buy or sell shares of Rassini SAB de CV at any time. 

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

 

NYC Trip and Coats Group Plc – LSE:COA

Quick note: I’ll be in Midtown NYC from December 5-7. I’d be happy to meet up with anyone interested in knowing more about Alluvial’s soon-to-be-launched private partnership, or any blog reader. Get in touch.

w2xozx5vI believe shares of Coats Group Plc, traded in London, are attractive. Coats Group’s operating business is valuable and the holding company is significantly over-capitalized. Once the company settles its legacy pension issues, I believe the company will return capital to shareholders.

Coats Group Plc has a storied history. Founded in Scotland in 1755, it predates even the famed Scottish Widows Fund. Coats actually invented cotton thread as a wartime substitute for silken thread. Coats was floated on the London Stock Exchange in 1890 and underwent a series of mergers before being bought by Guinness Peat Group in 2003. Guinness Peat Group itself has an esteemed history, with roots stretching back hundreds of years to the famed Guinness family of Ireland. Guinness Peat once held dozens upon dozens of investments around the world (and actually succeeded in scuppering the proposed merger between the London Stock Exchange and Deutsche Boerse), but has spent years divesting these holdings. Following the final round of divestments, Guinness Peat Group renamed itself after its sole remaining operating business, Coats Group.

Today, Coats is one of the world’s largest manufacturers of sewing threads and fasteners. These range from ordinary crafting yarns to high-specification fiber-optic and heat-resistant threads. Coats is the world’s second-largest supplier of zippers behind YKK. It’s a global business, and its a pretty good one. For the twelve months ended June 30, Coats reported adjusted operating income of $154 million on revenues of $1.46 billion. (Coats reports in USD, though it trades in GBP.) Results for the six months ended June 30 showed excellent improvement in adjusted operating income, as Coats has taken steps to close down loss-making operations and invest in higher-margin, faster-growing segments.

Before we can get closer to determining a value for Coats, we must consider a very significant confounding factor: legacy pensions. Though Coats (remember, formerly Guinness Peat) owns only one business, it remains responsible for multiple pension plans. Turns out these plans are rather under-funded. This finding by the British government put a halt to Coats’ plans to return its holding company-level cash to shareholders. Here’s a graphic from Coats most recent report showing the deficits at each legacy pension.

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Coats Group’s three major legacy pension plans are Brunel, Staveley, and Coats UK. Brunel is 68% funded. Staveley is 91% funded, and Coats UK sits at 84%. You might be thinking “by American standards, these really aren’t bad.” However, the UK pensions regulator doesn’t see it that way. In 2015, Coats agreed to contribute £55 million to the Brunel plan over 10 years. In June, Coats agreed to contribute £74 million to the Staveley plan.

Investigations into the funding status of all three pensions continue. For now, Coats has agreed not to distribute any of its holding company cash to shareholders and to use its substantial cash balance to support the pensions. The company continues to negotiate a settlement with the regulators. In its last report, the company indicated it would proceed to court hearings if a settlement could not be reached. No update has been provided, but I believe it is very likely the parties will arrive at an agreement, court-arranged or otherwise, before the end of 2017.

I believe any settlement will provide Coats with substantial leeway to return capital to shareholders. Coats actually holds enough cash (in GBP) at the holding company level to eliminate its pension obligations in their entirety. But there is no reason to assume the regulator will force Coats to bring its pensions to 100% funded status immediately. That would be absolutely unprecedented. Rather, the regulatory body and Coats will almost definitely agree on a plan in which Coats contributes a lump sum to the plans and commits to annual contributions.

Back to the operating business. As I mentioned earlier, Coats is producing normalized operating income of $154 million. This figure should rise in 2017 as Coats exits its unprofitable UK crafts business and benefits from strategic investments in high-performance threads and a promising software business. Long-term, Coats should be able to grow its top-line revenues slightly faster than world GDP growth. People will always need clothing, and Coats high-specification specialty threads should see growing demand.

I would be perfectly comfortable buying Coats for 10-12x EBIT. Assuming Coats can produce $160 million in operating income in 2017, that values the operating business at $1,600-$1,920 million. The operating company has net debt of $337 million for net value of $1,263-$1,583 million. Now, Coats does not own 100% of all of its operating subsidaries. Specifically, the Bangladeshi and Vietnamese subsidiaries are very profitable but not 100% owned. For the twelve trailing months, income attributable to minority interests was $12 million. When considering Coats Group’s valuation, these minority interests must be capitalized. I think a 12x multiple of income is reasonable for minority interests in emerging markets ventures.

At the holding company level, Coats has $396 million in cash versus combined pension deficits of $349 million. (In reality, this cash is held in Pounds. But the pensions are also GBP-denominated, so the net effect of currency movements is limited.) Just to be extra pessimistic, let’s say the regulators and Coats come to agreement to bring pension funding to 95%. Again, that would be unpredecented. But let’s go with it, because there is the possibility that the pension liabilities are under-stated. Anyway, 95% funding would require Coats to commit another $241 million of its holding company funds to the pensions. That would leave $155 million in funds available for distribution to shareholders, or for investment in the operating business.

Let’s compare Coats Group’s present valuation against the value of the operating subsidiary and the example excess holding company cash. Coats has a market capitalization of £528 million, or $668 million at current exchange rates. To that we must add the capitalized minority interest, which I’d put at $144 million. Total market capitalization: $812 million. There’s $337 million in operating company net debt, plus my very rough and conservative estimate of $155 million in excess holding company cash. That’s ultimate net debt of $182 million for an enterprise value of $994 million.

For your $994 million, you get $160 million or so in operating income for a multiple of 6.2x EBIT. That strikes me as extremely cheap for a reasonably good business producing high levels of free cash flow, albeit with only moderate growth potential. If my estimate of the value of the operating business is anywhere close to accurate, then shares of Coats should be worth nearly twice the current trading price. I think my valuation is supported by Coats Group’s free cash flow yield, which exceeds 10%.

Why so cheap? I think it all comes down to uncertainty. The market is fearful that the UK pensions regulator could proclaim the pension deficit is larger than anticipated or could call for onerous contributions. Brexit still weight heavily, then there is the fact that Coats Group is a small company despite its once mightly stature. Still, I think the current price represents a good value for investors willing to look past the next few quarters.

Alluvial Capital Management, LLC does not hold shares of Coats Group Plc for client accounts. Alluvial may buy or sell Coat Group Plc shares at any time. 

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial, please see alluvialcapital.com.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.