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In November 2020, Steel Connect's (NASDAQ:STCN ) largest shareholder Steel Partners (SPLP) proposed acquiring all outstanding shares of STCN. In January 2021, STCN's Special Committee of independent Board Members announced they had engaged investment bank Houlihan Lokey and they are actively evaluating alternatives. Since SPLP's offer, over 80 million shares have traded at a weighted average price of ~$2.20.
In February 2021, we laid out the investment thesis on Steel Connect, highlighting that through the sale of one or both of STCN's businesses (IWCO Direct and ModusLink) and the separate monetization of the company’s valuable $2.1 billion in tax assets (NOLs), STCN could unlock value of at least $6.00 per share at STCN. That report provides more background on STCN's two great businesses with negative working capital, high returns on tangible capital (ROTC) and high free cash flow generation. In FY 2020 ending July 31, 2020, Steel Connect generated $783mm in sales, $87mm in adjusted EBITDA, $60mm in free cash flow and over 70% ROTC.
On July 26, at the Steel Connect Annual Meeting, STCN Board Member Jack Howard updated shareholders that STCN's Special Committee and their advisors continue to be in negotiations with Steel Partners, regarding SPLP's November 19 offer to buy all of STCN. No updates will be made until they reach an agreement on price. Although shareholders approved a 1-10 reverse stock split at the meeting, the Board has still not finalized or communicated any plans to execute a split.
On August 3, STCN's subsidiary IWCO Direct’s closest competitor, Quad/Graphics (QUAD), reported Q2 earnings and raised 2021 sales, EBITDA and free cash flow guidance. Sales were up 18% YOY with strength in Direct Mail. QUAD also sold their QuadExpress, a third party logistics (3PL) business, for $40 million, representing an Adjusted EBITDA multiple of over 8 times. At 8x ModusLink’s 2020A EBITDA of $34mm, that puts a value of $4.32 per share on ModusLink, before adding value for IWCO Direct and NOLs.
On August 5, SPLP reported their Q2 earnings with sales +31%, EBITDA +88% ($297mm run-rate) and an income tax provision of $100mm+ annual run-rate. SPLP is in great position to acquire STCN's $2 billion of NOLs to shield future taxes at SPLP. SPLP hit an all-time high of $35.66 on August 13 after strong earnings, accelerating its significant 6.5mm share repurchase program (21.5mm outstanding as of August 2) and investor optimism about a deal with STCN.
On August 13, Steel Connect and its Board settled a four-year shareholder lawsuit paying $2.75mm in cash and surrendering 3.3 million shares of STCN stock that was previously granted to management and Board members. Given this important settlement and the fact that SPLP is nearing the completion of its 6.5mm share repurchase program (purchased $83mm at an average price of $14.53 vs. ~$31.00 last), we believe SPLP and STCN are coming close to announcing a deal.
Net operating losses (NOLs) are created when a company has deductions or expenses that exceed its taxable income during a tax year. NOLs could come from past operating losses of a business or realized losses from the sale of a business/investment. NOLs are used to offset a company's tax income in future tax years through what is called a tax loss carryforward.
For STCN, the company was formed in 1968 as College Marketing Group Inc., known as CMGI. In 1999, the company agreed to acquire an 83% stake in AltaVista from Compaq for $2.3 billion, along with making several other tech investments during the dot-com bubble. In 2001, CMGI took a $3.4 billion impairment on AltaVista and other tech investments, hence the over $2 billion of NOLs at STCN today!
Many investors have asked if SPLP acquires STCN, if the NOLs would be limited or restricted in value. IRS Code Section 382 states that if the percentage of stock owned by one or more 5%+ shareholders (only SPLP) increases by more than 50 percentage points, there would be a change of control, therefore restricting the NOL usage. However, in SPLP's case, they own slightly over 50% of STCN fully diluted shares (including SPLP management's shares), so even if SPLP tenders all of STCN's minority shares, there would not be a change of control. Consult with a tax advisor for further guidance.
In 2011-2012, Clinton Group, Peerless Systems and Steel Partners were all aggressively buying millions of ModusLink (now STCN) shares, to gain control of the company’s valuable $2.1 billion in tax assets (“NOLs”). In late 2011, with ModusLink’s stock trading between $3.50-5.50 per share, SPLP wrote to the ModusLink Board, requesting approval to acquire 14.9% of ModusLink, as they believed the stock was trading at an attractive discount to intrinsic value. In May 2012, Clinton Group offered to acquire an additional block of 8.5mm ModusLink shares for $4.90 per share. Steel Partners paid as much as $5.60 per share in February 2012 and later agreed to acquire 9.5mm ModusLink shares for $4.00-5.00 per share in February 2013.
Steel Partners wrote the following to the ModusLink Board:
We believe the Company’s current stock price does not reflect the intrinsic value of the Company and continues to represent an attractive investment opportunity. Accordingly, we are interested in continuing to increase our investment in the Company… We recognize the value of the Company’s significant NOLs and the role of similar rights agreements to protect these tax benefits. However, to the extent the Board is unwilling to fully disclose the current number of Available Shares and current “ownership change” percentage and to promptly comply with our request, we would have to assume that the Plan was adopted as an anti-takeover measure intended to insulate the current Board from the influence of all stockholders. If this were the case, we would be left with no choice but to take any and all action necessary to protect our investment in the Company. As time is of the essence in this matter, we demand that the Board respond to this request promptly.
SPLP stands to benefit immensely with STCN's $2.1 billion in NOLs. SPLP is realizing an impressive $200 million+ gain on its 4 million shares of Aerojet Rocketdyne (AJRD), assuming the deal closes with Lockheed Martin (LMT) this year. Additionally, SPLP’s will likely run out of its NOLs in the next year and based on their latest quarterly report, SPLP has a run-rate of $100 million+ in income tax provision for 2021. This tax bill would accelerate when SPLP adds STCN's operating income and realizes significant overhead and public company synergies.
Earlier this year, we surveyed investors for the largest publicly traded NOL companies and received a lot of great ideas and feedback. We then reviewed over twenty publicly traded NOL-rich companies with $25 billion of tax assets, including SandRidge Energy (SD), EXCO Resources (OTC:EXCE), P10 Holdings (PIOE), Crossroads Systems (OTCQX:CRSS), Support.com (SPRT), Rubicon Technology (RBCN), Elah Holdings (OTCPK:ELLH) and more.
Our conclusion is that the potential combination of STCN and SPLP could be the largest and most valuable NOL public company in the world. The combined company, with pro forma $2.5 billion of NOLs, could generate ~$350-400 million in EBITDA and ~$250-300 million in free cash flow, which is quite attractive on SPLP's current ~$660 million market cap.
We arrive at a minimum value of $2.00-3.00 per share for STCN's NOLs based on:
- comparable recent NOL valuations in Delaware courts of 6-7% of face value ($136mm) or $2.17 per share. Given STCN’s NOLs can be used faster at SPLP, their value should be significantly higher,
- $100mm+ in annual tax savings to Steel Partners,
- $100mm+ in annual free cash flow uplift at Steel Partners from STCN’s cash flow, STCN’s NOL tax shelter and overhead / public company synergies, worth $1 billion+ in equity value based on a 10% free cash flow yield.
To highlight the “value accretion” from SPLP acquiring STCN, we have laid out below that SPLP’s $150mm in free cash flow (FCF) in 2020 or $6.50 per share (on 23mm shares) jumps to $10.20 per share when adding STCN’s $60mm of 2020 FCF and the $38mm in cash taxes SPLP paid in 2020. Given SPLP’s annual run-rate taxes based on the latest quarterly results are closer to $100mm and that there would be significant overhead synergies between the companies, SPLP FCF per share could jump to over $15.00 on a $31 stock , highlighting the significant accretion of a combination with Steel Connect.
STCN recently completed their fiscal year on July 31, 2021, which would update the financials on which SPLP and the Special Committee, along with their bankers, are negotiating. In past SPLP deals, like SL Industries (SLI), SPLP updated their offer to acquire SLI, on February 9, after the annual results were in. Two months later, SPLP raised their offer another $4.50 per share, or 12.7%, and began a tender offer for all shares.
On a stand-alone basis, before pursuing strategic alternatives to unlock value, we believe STCN has a compelling growth story. IWCO is accelerating investment and growth in digital as they expand their offering and long-standing relationship with the largest credit card, insurance, and banking customers. ModusLink has tremendous growth opportunities with tight supply chains, booming e-commerce sales and tailwinds in an accelerating global economy.
As a reminder on our financial and valuation assumptions, we estimate STCN’s stand-alone earnings power of $90-110mm EBITDA and annual free cash flow of $30-50mm, used for debt paydown ($283mm as of Q3, plus $35mm of preferred stock). Using a conservative 7.0-8.0x EV/EBITDA multiple on $90mm in F2022E, we arrive at a stand-alone value for Steel Connect of $5.51 - $6.94 per share on a 1-year basis (FY2022). Future free cash flow would flow to STCN’s equity shareholders in 2023 and going forward.
Please note that this does not give STCN's shareholders credit for the company's $2 billion of NOLs, for which Steel Partners paid an average of $3.80-4.20 per share when the company had negative free cash flow. We value the NOLs minimally at an additional $2.00-3.00 per STCN share, reflecting a total value between $7.51 and $9.94 per share for Steel Connect on a 1-year basis.
Given STCN has completed its fiscal year ending July 31, the STCN Board has settled a significant four-year shareholder lawsuit and SPLP is nearing the completion of its enormous share repurchase program, we believe SPLP and STCN are coming close to announcing a deal. We believe STCN is worth at least $6.00 per share and its Board has multiple strategic levers to get there.
This article was written by
Disclosure: I/we have a beneficial long position in the shares of STCN either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: We own both STCN and SPLP common stock.