Pendrell (PCOA): A Company with Cash, a Tax Asset, and Almost No Liabilities
Pendrell is essentially a non-operating company with two assets: cash and net operating loss carryforwards. The cash appears on the balance sheet. The net operating loss carryforwards do not.
The most recent balance sheet is dated December 31st, 2017. It is found in the 10-K. Total liabilities are $9 million while accounts receivable are $17 million. Since accounts receivable alone can cover all liabilities – I’ll assume that all cash is surplus cash.
Cash is $184 million. The company has 242,769 shares outstanding (there are both “A” and “B” shares). That means cash is about $758 a share. Let’s call it $750 a share in cash. As I write this, the stock is trading at $645 a share. So, let’s call that $650 a share.
Let’s try to simplify the situation.
The stock price is about $650. The net cash is about $750 a share. So, if you buy the stock you are more than 100% covered by cash. Liabilities are almost nothing. And there’s no cash burn. So, you’re getting more in cash than you’re putting into the stock. That’s your downside protection.
Where’s the upside?
The company’s net operating loss carryforwards are not listed on the balance sheet. There is a legitimate accounting reason for this. However, the accounting treatment doesn’t reflect economic reality. Let me explain.
Pendrell presents a table (in a note in its 10-K) that shows the net operating loss carryforwards would be $625 million (this includes California) but then shows a “valuation allowance” for the full amount. This means the company has this tax asset on the books for zero dollars.
Why?
The company is taking an allowance for the full amount, because there is nothing in its past history or current operations that would suggest it can use these net operating loss carryforwards. Here’s the quote:
“For all years presented, the Company has considered all available evidence, including the history of tax losses and the uncertainty around future taxable income. Based on the weight of the evidence available at December 31, 2017, a valuation allowance has been recorded to reduce the value of the Company’s deferred tax assets, including the deferred tax assets associated with the NOLs, to an amount that is more likely than not to be realized.”
That amount is essentially zero.
And that’s the right way to account for the net operating loss carryforwards. However, it’s not the right way for an investor to look at their value. How should we look at their value?
Pendrell has federal and state (California) net operating loss carryforwards.
California Net Operating Loss Carryforwards
The state net operating loss carryforwards are for past losses of $1.3 billion suffered in California. They begin to expire in 2028. I’ll just assume these state net operating loss carryforwards are worthless.
Federal Net Operating Loss Carryforwards
These net operating loss carryforwards begin to expire in 2025 with “a significant portion” expiring in 2032. Pendrell has $2.5 billion in federal net operating loss carryforwards. The corporate tax rate in the U.S. is now 21%. So, $2.5 billion times 0.21 equals $525 million. If Pendrell could somehow report $2.5 billion in taxable income right now – it could save itself $525 million.
“Bounding” The Problem: Discounting the Tax Savings
I’m going to establish two “bounds” for this problem. This one is the most optimistic presentation. I will assume that somehow Pendrell is able to produce $2.5 billion in taxable income in 2032. This is a fantasy in two ways. One, how could a company with only $184 million right now ever control $2.5 billion of taxable income? Two, some of the net operating loss carryforwards expire as early as 2025. However, there are some offsetting factors. I’m assuming the California net operating loss carryforwards are worthless and I’m assuming there will be no federal tax savings from 2018 through 2031. As you’ll see when I “discount” the value of this tax asset – the assumption that there are no tax savings for well over a decade gets you a much lower value.
I’m not interested in what other people would value these tax savings at. I just want to look at my own opportunity cost of waiting a really long time for some asset to be monetized. So, what I’m going to do here is apply my own hurdle rate of 10% a year – this is basically the expected return rate below which I wouldn’t touch a stock – to the problem. To have $525 million in 2032, how much money would I have to start with in 2018 if I compounded my initial sum at 10% a year?
The answer is $135 million. So, if we were really sure that Pendrell would have no tax savings between 2018 and 2031 and then suddenly save $525 million on taxable income of $2.5 billion in 2032 – that would be as valuable to us as having another $135 million in cash right now. This hypothetical asset works out to another $550 a share in value.
Don’t get too excited. This isn’t really a stock with $1,300 ($750 in cash plus $550 in tax savings) of assets selling for $645 a share.
We’ve handled the discounting approach. But, the question we haven’t answered is how much taxable income can Pendrell really produce?
Now, let’s move on to the way I would really think about this stock. Personally, I don’t think the appraisal value for the tax asset I showed you above makes a lick of sense. But, I think the method I’m about to show you below is reasonable.
“Bounding” The Problem: What Would an Acquisition Look Like?
Let’s assume Pendrell will buy something. It will pay roughly what a private equity firm would. However, it will only use its cash – no debt. The company has over $180 million in cash. Last year, private equity firms tended to pay about 8 times EBITDA for acquisitions. They paid more for companies over $250 million in enterprise value than for companies under that amount. Historically – for unleveraged public companies – 8 times EBITDA had been very close to about 10 times EBIT and about 15 times earnings. However, the corporate tax rate declined from 35% to 21%. Most data I have on private equity multiples and the relationships between EBITDA, EBIT, and P/E are from a 35% tax rate world.
Today, an acquisition price of about 12 times EBIT is equivalent – in after-tax terms – to what an acquisition at 10 times EBIT was in 2017 and before.
What if Pendrell Buys a Business at 12 times EBIT?
So, let’s assume Pendrell does an acquisition all in cash where the purchase price is $180 million and the target is producing $15 million a year in EBIT. We’ll assume the acquisition is done this second.
Pendrell has over 13 years to produce taxable income. Nonetheless, $15 million a year in EBIT growing at 0% a year for 13 years only gets you to $195 million in cumulative EBIT. Even if the acquired company grew at 6% a year and even if the free cash flow it produced was plowed back into buying more companies at 12 times EBIT – it doesn’t look like you are going to ever get to use up all these net operating loss carryforwards.
That simplifies things for us. It means whatever Pendrell buys isn’t going to pay taxes for a long, long time.
It Only Matters What a Stock Looks Like When You Sell It
There’s a quote I repeat often – an odd one for a value investor – that goes something like this: “It doesn’t matter what a stock looks like when you buy it. It only matters what a stock looks like when you sell it.”
Today: Pendrell is a cash box with some net operating loss carryforwards. But, the cash is going to be used to buy a business with taxable income. And the net operating loss carryforwards are going to expire (mostly) and get used up (somewhat). We know that in about 14 years, Pendrell will have neither cash nor net operating loss carryforwards. So, should you – as a long-term investor – really think of Pendrell as a cash pile with net operating loss carryforwards?
Or, should you think of Pendrell as what it will become?
What Pendrell Will Become
Pendrell isn’t going to use up all of its net operating loss carryforwards. That means, whatever Pendrell buys isn’t going to be paying U.S. corporate income tax. We could do a DCF to try to see how much of the tax savings will ever get used, when they’ll get used, and how much you should pay for those tax savings today.
But, there’s a much easier way to value Pendrell.
Whatever the company buys will probably grow a bit. It may also throw off some cash that can be used to make more acquisitions. Let’s pretend neither of these things will happen. That’s being unfair to Pendrell. But, we’re going to offset this with another assumption. We’re going to pretend a company that doesn’t pay taxes for the next 14 years should have the same P/E ratio as a company that will never pay taxes. We know this is untrue. But, I’d say that we also know assuming 0% growth for a business, assuming free cash flow is not used for more acquisitions, etc. is also untrue and probably offsets most of the value in any difference between an untaxed company for the next 14 years versus an untaxed company for eternity.
If you agree with me on this assumption, we can really simplify the Pendrell situation down to this…
Pendrell will acquire something with $15 million in EBIT. That something will pay no taxes. So, Pendrell will have $15 million in after-tax income. Pendrell has 242,769 shares outstanding. So, the company will be earning $62 a share after-tax. Pendrell stock now sells for $645 a share. Therefore, Pendrell is now being valued at a P/E of 10.4. That’s a P/E of 10.4 with no net debt or net cash. It’s an unleveraged P/E of 10.4. We can also assume that a business purchased in a roughly $200 million transaction at an EV/EBIT of 12 will be a pretty middle of the road, average “microcap” (though an awfully big microcap) sort of stock.
So, I think there’s the potential here investing in Pendrell at about $650 a share today to be like buying an average public company with a $200 million market cap with a clean balance sheet at a P/E of 10.
Is this really what Pendrell will become?
I don’t know. It could buy many different things. It could buy something in a more complex deal where the seller wants a buyer with net operating loss carryforwards.
Pendrell has an uncertain future. But, it seems like you can get in a little cheap on that future.
Nothing is certain. But, I don’t think you should pay less for something that’s less certain but no more risky. Pendrell can’t be called risky right now. You could say that there’s a risk the company will overpay or make a bad acquisition. That’s true. Management has actually avoided making an acquisition for now, because they say prices are too high. There’s also uncertainty the other way. There may be some more complex deal – rather than just buying any old business at 12 times EBIT – that could make better use of the net operating loss carryforwards. The company could buy back stock at below net cash (it’s done that before). Current operations – basically they have some patents they license – could produce some free cash flow. I’ve assumed all assets that aren’t cash or tax assets are worthless and operations neither add nor detract value.
Uncertain vs. Bad
I’d also add that while Pendrell does have more uncertainty than public companies at this size and price normally do – it doesn’t have more bad features. This cash will eventually be freshly allocated to a new acquisition. There is no troubled business here, no large amount of liabilities, etc. So, it might be easy to underestimate what Pendrell would be worth after it buys an operating business, changes its name to reflect the business it acquires, and then starts reporting earnings produced by that business and improved in EPS terms by the net operating loss carryforwards. I think it’s very possible an investor looking at the stock right now would underestimate just how attractive this kind of stock would be 5 years down the road when things look more certain.
Quibbles
There are a ton of assumptions in what I just laid out. And, I think you could argue that some of those assumptions are more likely to be wrong than right. On the other hand, if you look through the different assumptions favorable to Pendrell that I didn’t make – I’m not sure that trying to adjust my assumptions one-by-one would lead you to assume Pendrell is worth less than a stock with a clean balance sheet and a P/E of 10 as of today.
What the quibbles do is point out the uncertainty on both sides of the situation here. There’s no clear story here as to what will actually happen.
In my experience, that tends to be the number one reason investors ignore a stock. Investors don’t like stocks where it will take time for value to be clearly present. They either want earnings today, cash today, or hard assets today. They don’t want to invest in something that will probably turn into something that will – on an earnings basis – likely be valued higher than this thing is today.
Today, I think value investors may be valuing Pendrell on its cash. So, they are willing to buy the stock up to the point where it trades at net cash. But, they aren’t willing to pay anything above net cash.
Once Pendrell acquires an operating business and that business doesn’t pay taxes – value investors may look at the stock in terms of P/E instead of in terms of net cash per share.
What about the Wait?
Of course, Pendrell (with the current CEO in place – he joined in late 2014) was clearly on the hunt for a business to acquire in 2015, 2016, and 2017 and found none. So, even if Pendrell does eventually make a good acquisition the upside could be limited compared to other stocks you might buy today because you will own a stock without knowing if it will produce meaningful free cash flow relative to your purchase price within the next few years.
Technically, free cash flow versus purchase price (FCF yield) was actually good as of last year. But, this depends on patents I can’t judge the value of. So, I’ve ignored the fact that the existing business is currently cash generative. I’m not saying these patents are worthless. I’m just saying that this post is all about making conservative, simplifying assumptions to do a first check of whether this is a stock I should research further. So, right now, I’m pretending the patents are worthless.
What about the “Qualitative” Issues Here?
Most posts you read about Pendrell will talk about the people involved, the satellite business that lost all this money in the first place, etc.
I think that’s all important. But, I think it’s too early to talk about that. First, you need to know the price is right to buy into this corporation. Then, you can worry about who is running the corporation and what they want to turn it into.
I could go into who controls Pendrell, what incentives they have, how the company has being allocating capital so far, what they say about the future, etc. – and I may, in a later write-up.
But, I don’t think that’s a good first step. The first step is to figure out how cheap or expensive the stock is versus net cash as it stands now and – more importantly – how cheap or expensive the stock would be once it converted the cash pile into a tax-advantaged earnings stream.
I’m almost certain to write about Pendrell again.
Geoff’s Initial Interest Level: 90%