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HC2's Deal Making Offers Significant UpsideSep. 3, 2014 5:00 AM ETby: Whopper InvestmentsSubscribers to SA PRO had an early look at this article. Learn more about PRO »

SummarySignificant NOLs and shifting balance sheet obscure company's value.While controversial, management has a significant ownership stake and is highly incentivized to increase net

asset value.Near­term catalysts include closing of Schuff deal and uplisting to major exchange.

Whenever I have a big winner or loser, I try to step back and determine the two or three key characteristics that wentinto that investment. I then look for those in future investments, and if I see a similar set up or "pattern" I know to payextra attention. For example, I've lost money several times relying on the value of unique or off­balance sheet assetsthat weren't readily salable, so now when I look at investments with unique off­balance sheet assets, I send out a mentalred flag and subject the investment to a higher bar.

This "pattern recognition" skill may seem silly, but I'm not alone in thinking it's an important skill separatinggood/experienced investors from poor or inexperienced investors. If you read any interview with Alice Schroeder (authorof The Snowball, Warren Buffett's biography) one of the things she always praises Buffett for is his tremendous patternrecognition skills (here's an example where she praises Buffett's pattern recognition), and one of the reasons so manyspecial situations investors (myself included!) praise You Can Be A Stock Market Genius is because it introduces thereader to specific patterns and situations to look out for where significant value appreciation could be on the horizon.

One of my big winners in the past year has been ALJJ. I first wrote about them in late October last year, when they hadjust announced a big acquisition and the stock was at ~$1.05. I did a follow up in mid­July this year with the stock at~$2.50. The company currently trades for ~$3.50 a share. Below are the common elements I found in the ALJJ pattern.

A manager with a history of successful deal making and significant equity stakeTransformative transaction that makes past financials completely irrelevant to future financials, setting up

potential issues with the market recognizing the company's value in the short term that would slowly alleviate asthe company's new financial revealed their results.Significant NOLs that could be used to shield taxes and create additional deal value and cash flowLeveraged acquisitions of companies at low multiples that would amplify shareholder results if successful.

Given how successful ALJJ has been, I've obviously added the ALJJ "pattern" to the types of set­ups I look for. And HC2Holdings (OTCQB:HCHC) has several similar characteristics that could be setting it up for a similar move.

The largest shareholder, Harbinger (NYSE:HRG) owns ~40% of the stock and has a history of producing biggains in controlled companies (though, as discussed in the risks, it's also quite controversial).HC2 just acquired majority control of Schuff (OTCPK:SHFK) and started consolidating it in their financial

statements, so their future financials will look nothing like their past. In addition, their balance sheet has multiplemoving parts that make their underlying value difficult to see.HC2 has significant NOLs that will shield future tax liabilities once they acquire enough of Schuff to consolidate

for tax purposes (80%+) or do other dealsHC2 used significant leverage to buy their SHFK shares and did so at a very low multiple:~11x trailing P/E and,

based on backlog, around 5x forward earnings.

So with that in mind, let's start with some background. HCHC is name of the former PTGI. This was a telecom company

that ended up beginning a liquidating process late last year. They sold off the vast majority of their assets and paid out asignificant dividend with the proceeds; however, before they could finish the liquidation process, Harbinger acquiredabout 40% of their shares for $4.00 per share and sent a letter demanding board representation and the company stoptheir delisting and liquidation process.

What did Harbinger see in PTGI that made them buy these shares and take control of the company? While PTGI did stillhave a small operating business and some cash in escrow held back from their sales, the real thing that Harbinger sawwas all of their NOLs. PTGI had $241m in NOLs (from their 10­K), of which $116m were not subject to section 382limitations, which limit the ability of a company to utilize NOLs in the event there is a change of control. In other words,Harbinger saw a company that they could take control of and use as a vehicle to utilize NOLs.

Because PTGI/HCHC had already sold off the vast majority of their assets, the only way to utilize their NOLs was to buyother businesses. And they've already announced two acquisitions: a purchase of a natural gas motor fuel distributor,and the purchase of 65% of Schuff. Terms of the natural gas purchase have not been disclosed, and it's likely smallcompared to the Schuff deal, so this article will not focus too much on it except to note that it will likely further help thecompany utilize their NOLs.

These are completely new acquisitions that form the bulk of HCHC's assets. Going forward, HCHC will start toconsolidate their results, and their performance will, when combined with any future deals HCHC does, drive HCHC'sresults going forward.

However, just because HCHC has majority ownership and consolidates these companies does not mean they can utilizetheir NOLs. There's an interesting piece to tax law that says just because a company has majority control of anothercompany does not mean they can consolidate the company for tax reasons; instead, 80% ownership is required forconsolidation for tax reasons and to allow intercompany dividends to be non­taxable. Because HCHC only owns 70% ofSHFK (the 65% they owned became 70% when SHFK bought some shares back from former execs), HCHC currentlycannot consolidate SHFK or take dividends from them without paying taxes. So it's no surprise that HCHC is currentlytrying to buy out the 30% of SHFK they don't own.

At this point, it's probably time to do a bit of discussion on Schuff. The stock has actually been written up several timeson seeking alpha, so I would encourage reading those for more background (I'd start with this one).

Schuff is a steel fabrication and erector company (check out this page on their website for more description on what theydo). This is a business that is highly exposed to the non­residential construction cycle, which is obviously cyclical andvolatile. As you might imagine, results fell off a cliff during the Great Recession. Revenues dropped from $736m in 2007to $288m in 2011, operating income fell from almost $100m to $4m, and backlog fell from almost $400m to under$200m. However, the cycle appears to be turning, as backlog grew to over $425m at the end of 2013 and industrytrends continue to improve. Revenues for Schuff in Q1 were up almost 20%, and operating income was up 75% to over$5m.

This is where Schuff's cyclicality and all of the leverage HCHC is applying come into play. At the offered share price of$31.50, HCHC is acquiring Schuff for $122m market cap (based on this filing, which shows 4.2m shares outstandingless 328k subsequently purchased) or roughly $140m enterprise value. Schuff did $22m in operating income in thetwelve months ended March 2014 (we don't have full results for June yet), but based on the huge increase in backlog,it's likely conservative to say the company does $550m in revenue and $33m in operating income this year. Based onthose numbers, HCHC is buying Schuff at 5­6x operating income at the start of a big upswing in earnings. It's worthnoting that the last time backlogs were this high, Schuff was doing ~$700m annually in revenue and over $90m inoperating income, so the upside here is quite high. Because HCHC is using significant amounts of debt to purchaseSchuff, if that operating leverage does continue and Schuff generates significant cash, shareholders will make outextremely well as they use the NOLs to shield cash and rapidly accrue value.

Perhaps it sounds like Schuff is getting undervalued in this deal. And that's certainly a possibility; one of the reasons Ilike the acquisition is because the near­term outlook appears so bright, which will allow HCHC to utilize all of their NOLsquickly. Several shareholders are floating a presentation that suggest the tender price is much too cheap and thatshares should be worth at least $50 in a tender, and shares are trading over the deal price, suggesting investors thinkthe ultimate price paid to shareholders will be increased.

I don't necessarily disagree with investors who think HCHC is getting a good deal on SHFK (again, one of the reasons Ilike HCHC is because of the upside I see in Schuff), but it is worth noting that HCHC acquired their ownership by buyingthe (now former) CEO's 60% share ownership from him for $31.50 a share. Given it could be argued that price shouldincorporate a control premium, it isn't hard to argue that minority shareholders are being offered a decent deal to cashout at the same price. In addition, as mentioned above, SHFK bought back shares from former execs after the deal had

closed that brought HCHC's ownership from 65% to 70%; in their 10­Q, they disclosed buying 327.6k share for $8.7m,which equates to ~$26.55 per share. Again, this isn't to argue that Schuff shares aren't cheap at these levels; just thatit's tough to argue minority shareholders aren't getting at least the same or even better value than informed insiders.

So what is HCHC ultimately worth? Currently, their value comes from

Their 70% SHFK ownershipPlus $41m in cash on their balance sheet at June 30th (some of this belongs to SHFK, but because SHFK made

the share repurchase and had less than $1m on their balance sheet in March, it's safe to say almost all of this isHCHC's. Some of this cash will go to the purchase of ANG Holding, but since we're assuming that's a value neutralpurchase we will just use the $41m number).Plus $22.5m cash received from escrow in July (p. 35 of 10­Q, most goes towards paying down debt)Plus $11m still in escrow that should eventually come their way (p. 32 of their 10­Q; ultimately this cash deserves

some discount until received but not a big enough value driver to adjust here)Plus $10m in cash from warrants exercise in July (see p. 28­29 of their 10­Q)Less $70m in HCHC debt (the balance sheet reports $86m, but $16m of that is SHFK's)Less $30m in convertible preferred stock (which converts into 7.1m shares at $4.25m a share)Plus whatever value their $116m in NOLs not subject to limitation and $125m subject to limitation are worth.

Ultimately, the value comes to negative $20m ($10m positive if you believe the common is worth more than $4.25 andthe preferreds ultimately convert to common) plus their SHFK stake plus the value of the NOLs divided by their sharesoutstanding (23.3m without preferred conversion and after adjusting for the warrants; 30.4m if preferreds convert). A fewsample scenarios are listed below. All of these scenarios assume that HCHC manages to purchase SHFK in order toutilize their NOLs and ignores any "gain on bargain purchase" of the minority stake; instead, it only seeks to valueHCHC's current stake (in other words, if SHFK is actually worth $50 a share, it assumes HCHC's stake is worth $50 ashare and that they pay minority shareholders $50 a share. The math looks even better if SHFK is worth $50 and HCHCbuys the rest of minority shareholders out for only $31.50. The math obviously looks much worse if you think SHFK isworth less than $31.50 a share and they buy SHFK for $31.50).

SHFK shares are fairly priced at $31.50, and SHFK earns $20m in operating income per year. In this case,HCHC's stake is worth $85m, and the NOLs will shield around $7m in tax payment per year. The NPV of those taxshields would be worth about $50m, and HCHC overall would be worth just about $4.75 per share (+$10m valuefrom debt and cash excluding preferreds plus $85m plus $50m divided by 30.4m shares out).If SHFK is actually worth $42.50 per share, then it would do ~$30m in operating income per year. In this case,

HCHC's stake is worth $115m and the NOLs are worth $65m. Total value per share come out to $6.25.If SHFK could, on average, earn $50m in operating income per year and was worth 6x operating income, the

shares would be worth over $70 and HCHC's stake would be worth $200m. The NPV of the tax shield would bevery high (around $85m), as they would all be used within the next 7 years or so, and HCHC shares are wortharound $9.50 per share.

Again, none of this is to suggest what SHFK actually is or is not worth. It's just to show that the value of HCHC's NOLsput shareholders in a unique situation: if they are acquiring SHFK for roughly fair value, then HCHC shares are fairlyvalued or perhaps slightly undervalued. If the cycle continues to turn favorably and HCHC acquired SHFK cheaply, thenthe NOLs and leverage HCHC used to acquire SHFK will result in a massive home run.

There's one final catalyst worth mentioning. The interest rate on the company's preferred stock will increase significantlyif the common stock is not listed on a national exchange within one year, so HCHC will likely be looking to "uplist" to alarger exchange, which should result in increased volumes and the potential for increased institutional ownership just asHCHC approaches the one year mark on their ownership of Schuff and their financial statements start to normalize. Thisuplisting could serve as a strong catalyst to drive shares higher.

There are certainly some risks here. Obviously there's the risk that we enter another huge recession and SHFK's resultsfall off the cliff just like in the Great Recession, in which case all of the leverage HCHC used to buy Schuff will be a hugechoke on them. Leverage cuts both ways: the interest payments will consume all of the cash and make HCHC's NOLsuseless, and the debt will magnify HCHC's losses if it turns out they overpaid for Schuff. And there is of course the riskthat HCHC has overpaid for SHFK, in which case the leverage would (again) be very negative for the equity holders.

Other than that, the biggest risk is majority control. Phil Falcone controls ~40% of the stock through Harbinger, so forbetter or worse, investors are tied to him and what he does with HC2. Falcone is obviously a very controversial figure,and the controversy around him is quite public (his Wikipedia page is a great start) so there's not much of a need torecount it here. It's something a potential investor needs to get comfortable with, and I've done so by reviewing the trackrecords of companies that he's taken control or effective control of. In general, minority shareholders of companies

Harbinger has taken control of have done very well. For example, Harbinger took majority control of Spectrum Brands inSeptember 2010; below is how the company's shares have performed since then.

(click to enlarge)

Obviously every situation is unique, and past results at a different controlled company don't mean the same thing willhappen here. However, it does show minority shareholders can do very well under Harbinger, and if HCHC followsanything close to a similar pattern, investors at today's prices will obviously be very happy. In addition to past history,execs at HCHC are rewarded significantly if they increase value at HCHC; per their new employment agreement, they'llcapture 12% of any gains in asset value over 7% annually, so management will be highly incented to continue makingaccretive deals.

Finally, there's the risk that the Schuff deal doesn't go through so HCHC can't utilize their NOLs. In addition to thecriticism from investors, the deal has attracted heat from the New York Post. While the deal failing to close is definitely arisk, I think it's a small one. HCHC already controls 70% of SHFK, so I'm sure they can figure out something to make anacquisition work. If not, there are always other potential acquisitions, and HCHC can borrow against their Schuff stake(or outright sell Schuff at a profit!) in order to fund the full purchase of a business that they can consolidate.

In sum, while there are certainly risks and controversies around HCHC, the company has a unique set of assets and aclear path towards value creation. If SHFK investors are right and HCHC's proposal undervalues SHFK, then HCHC's70% ownership implies an underlying value significantly higher than today's prices. If SHFK shareholders are wrong andHCHC's offer fairly values SHFK, then the NOLs and continued potential for deal making imply that HCHC is still slightlyundervalued. Either way, investors at today's prices should do well.

Editor's Note: This article covers a stock trading at less than $1 per share and/or with less than a $100 million marketcap. Please be aware of the risks associated with these stocks.

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