Guest Post by Jennson Wong, CFA
Signature Group Holdings, SGRH, is an investment holding company focused on acquiring “well managed and consistently profitable operations as well as growth opportunities for these operations.” Think SPACs or in some respects, Berkshire Hathaway or Leucadia National Corporation, but on a smaller scale. It is the result of the Fremont General bankruptcy, formerly one of the largest subprime mortgage lenders in its heyday. Signature Group (along some help from Sam Zell) purchased the company under a court-approved bankruptcy reorganization plan. Run by Craig Bouchard, founder of Shale-Inland, SGRH is an interesting play that could provide significant upside that with limited downside risk.
Compared to SPACs or Berkshire, SGRH has an advantage that these players do not: net operating losses (or NOLs for short), almost $1 billion in Federal and California NOLs respectively that it can apply to whatever company it so chooses to acquire and operate.
Signature Group recently sold North American Breaker Company (“NABCO”), a leading circuit breaker distributor targeting the replacement market. It closed on its sale of NABCO in January 11, 2015 for a pre-tax gain of approximately $40 million.
As of Feb 27, Signature closed on its acquisition of Global Recycling and Specification Alloys (“GRSA”) from Aleris Corporation for $525 million and will operate the business as Real Alloys going forward. Real Alloys is the largest independent aluminum recycler in the world, including 18 North American production facilities and 6 European facilities.
Real Alloy makes Signature a compelling investment opportunity for several reasons.
- Real Alloy is an industry leader in the fragmented third-party aluminum recycling industry. The company is the largest player in an otherwise fragmented industry, which provides a significant advantage over its competitors in pricing, capacity and scalability. Real Alloy has production capacity of 1.9 mtpa, multiples above and beyond the production capacity of the next largest player in the industry.
- Real Alloy exhibits stable cash flows through tolling, hedging and contractual cost pass-through arrangements. About 2/3 of production volume is protected from commodity price swings under tolling and hedging arrangements. More importantly, Real Alloy’s competitive advantage is its close proximity to its customers, allowing its facilities to be integrated into the supply chain. Aleris will also continue to be a significant customer and supplier to Real Alloy in the 24 months following the close of the transaction, lowering risk of revenue reductions.
- Significant demand driven growth opportunities that are being overlooked by investors. Much of the demand is expected to come from the auto industry as companies seek to build lighter and more fuel efficient vehicles without compromising on strength and durability in its design. Regardless, secondary production has grown 40% faster than primary production since 2002 and is expected to account for half of North American and European aluminum production by 2022.
- Recycled aluminum has a potential pricing advantage over primary produced aluminum. Recycled aluminum offers approximately 10% cost savings in producing alloyed aluminum from recycled aluminum compared to primary production due to alloying agents already existing in scrap. Customers will find value in saving costs by purchasing recycled aluminum.
- Having been patient and focused in its approach to deploying capital, SGRH found a great investment opportunity that will allow management to play to its strengths in growing a company through lean operations and bolt-on acquisitions. Management has demonstrated this when it bought North American Breaker Company (“NABCO”) for approximately $35 million in 2011 and recently sold the business for $78 million in cash. Senior management has also demonstrated a history of success managing and operating industrial businesses throughout their careers, giving evidence that they will likely succeed with this acquisition as well. Bouchard, SGRH CEO, has considerable accomplishments in growing businesses and making value add acquisitions. Examples: Shale-Inland (2010 – 2013) Founder. The Leading distributor of steel pipes/valves, Grew to ~$1bn in revenues, and second billion dollar business he started. Esmark (2003 – 2008): Founder & President grew from $4mm to $3.5bn in revenues, Took the company public on Nasdaq via reverse merger, best Nasdaq performing stock of 2008, sold to Severstaal for $1.3bn in 2008.
- SGRH will officially list its shares on the NASDAQ on Tuesday April 21 and has been actively courting Wall Street analysts to add them to their coverage. Increased awareness among the investment public and increased liquidity in its shares trading in a public exchange will drive the value of its equity higher.
- Management has expressed its intention of acquiring additional companies of similar transaction size as Real Alloys with a goal of completing one acquisition per year for the foreseeable future. A disciplined investment approach will increase the value of SGRH in a step-up fashion that should drive share prices higher for the company.
With SGRH moving into aluminum recycling, there are two catalysts at play that could significantly drive the stock price higher.
- In order to comply with revised CAFE standards, the auto industry is redesigning its vehicles to contain more aluminum. For example, the 2015 Ford F-150 will have an all-aluminum body, helping the truck to shed 700 pounds of weight that will help increase fuel efficiency. Increased demand from the auto industry is expected to benefit all players in aluminum production, but Real Alloy is in an attractive position of taking advantage of its increased use in automotives through its relationships with auto makers and the locations of its plans that are located close to their manufacturing facilities.
- With SGRH uplisting to the NASDAQ and renaming itself to Real Industry, Inc., awareness about the company among the investing public will increase and attract investors, driving the price of its shares higher.
There are not a lot of good comps and there is no financials for when Real Alloy was private. Real Alloy was purchased at 6.25x EBITDA, which management has admitted is a little rich for their liking. They are confident that Real Alloy’s ability to pay down its debt will be achieved and its prospects for growth are promising as I believe its strategy to grow through acquisitions, its prospects to deepen relationships and SGRH’s application of NOL’s on the business make this purchase price attractive and compelling. According to historical financial data provided by SGRH, Real Alloy has been profitable every year since 2011 and has been cash flow positive for the years presented.
Based on 2016 FCF to equity of $45M and the close to $1B in NOLs analyst valuations range from $280M to $340M for the business. This is up to 70% above the current market cap of under $200M.
- Strong dollar could negatively impact revenue and earnings to Real Alloy. Real Alloy’s European business is slightly less than half of its total revenue and about 30% of its production volume. However, Real Alloy is mostly exposed to translation risk, which does not necessarily affect its profitability on a cash basis.
- Availability of aluminum scrap may be limited, reducing Real Alloy’s ability to meet its obligations to deliver on its contracts. Aluminum scrap availability has decreased over time in the last decade, partly due to increasing demand coming from China. However, scrap availability will likely normalize as China’s demand for scrap has been decreasing over the last several years due to government regulation and a slowing economy.
- The spread between primary aluminum and scrap prices may narrow in the future, reducing customer incentive to purchase recycled aluminum from Real Alloy. Management expects the spread between primary aluminum and scrap to remain stable in the near term. Almost two-thirds of its revenues and invoicing is unaffected by market pricing of aluminum, which bodes well for Real Alloy’s prospects of generating stable and sustainable earnings in the long run.
- Increasing energy prices – Energy markets have experienced a precipitous decline over the past 6-12 months as a result of supplies outstripping demand. While the risk of rising energy prices is ever present, we believe that subdued energy prices is part of a multi-year cycle where production will likely outweigh demand for the next 12 months and longer.
- Tightening credit markets could adversely affect operations, demand for its products and services and create headwinds to its performance as its cost of debt is driven higher. However, the ECB recently launched a quantitative easing program and credit markets have remained robust during this period since the financial crisis. We view a scenario of tightening credit markets and increasing interest rates to be unlikely at this point in time.
- Follow-on equity offerings may dilute existing shareholder equity values as the company grows through acquisitions. Management emphasized on the investor call that its acquisition strategy will be financed with as little new equity shares as possible. This may come in the form of issuing debt, risking overleverage placed on a company and constraining cash flows of the businesses. However, we believe that management will likely turn to preferred equity issuances to be used as a tool to avoid issuing too much debt and avoiding common stock dilution. We remain confident of management’s disciplined investment approach in finding attractively priced businesses, which should mitigate these risks.
Tarsier Capital Management, LLC holds shares of RELY/SGRH in client accounts.
Tarsier 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 Tarsier’s holdings please email, email@example.com.