Pendrell (PCOA) Follow-Up: Reading into a CEO’s Past and the Dangers of “Dark” Stocks
A member commented to the write-up I did yesterday on Pendrell. I think the comment and my response are worth making into a full follow-up “memo”.
So, here they are:
“Geoff,
This company definitely seems promising. I saw the blog post from Hidden Value that you retweeted and ended up buying a small starter position in the company after reading the 10k. That was before even seeing that you ended up writing a post on it.
I’m struggling to decide how to size the position right now, but really I have two open questions I’m working on.
- How big of a cash flow business can Pendrell reasonably acquire using their current cash position?
2. How will the experience of being a “private” shareholder in Pendrell differ from owning stock in a more public position that files with the SEC?
Some further development of those two points:
- I know you assumed that they’d purchase the company with 100% cash equity. That seems like a very conservative assumption. If they’re going to behave and operate as a private corporation, there is no reason we can’t view PCOA as basically a private equity investment without the 2% management fee.
In that situation, wouldn’t they be likely to use leverage in an LBO like purchase? They could use somewhere between 30-50% cash with the rest being debt. That could change your EBIT target from 15 million per year, to something like $30-40 million per year. Therefore, the unleveraged 10.4 P/E could be something like a leveraged P/E of 4-6.
While management hasn’t guided to the use of debt versus all-cash transactions, I don’t see why they would choose to use all cash. By using leverage, they can better take advantage of their deferred tax NOL asset.
Obviously, this is purely an upside discussion, but you’ve already discussed the downside. (minimal)
- Although the company won’t file financial reports with the SEC, do private companies still usually prepare financial statements but not issue them publicly? Perhaps only to shareholders? Or should I assume I’ll not receive any regular updates at all about the financial condition of the underlying company while I hold this stock?
Geoff, any insight you can provide on those points would be most appreciated. Thank you for bringing the stock to my attention through your tweet.”
First of all, this is a reminder to all the members reading this to follow me on Twitter (@GeoffGannon). You can sometimes – if you pay attention to what I re-tweet, tweet, etc. – get an idea of what sort of things I’m reading about and even sometimes which particular company I’m current analyzing. Many times, nothing will come of it. This time, a stock write-up came of it.
Is an Unlisted, “Dark” Company Public or Private?
Just to be clear on the terminology, Pendrell is now an over the counter stock that doesn’t file with the SEC. It says it “went private” and that’s true in a sense. You need to get under a certain shareholder of record number to achieve this – but, it’s a pretty loose requirement for a microcap stock in today’s market. If a microcap really wants to “go private” this way – that is, stop filing with the SEC – it’s not that hard to pull off if you do big reverse splits (Pendrell went from basically a penny stock to a $600 stock through these reverse splits) and cashing out very small shareholders. The threat of a listed stock becoming unlisted and of an SEC filing stock become a non-SEC filing stock can also help drive out small shareholders – especially those who don’t understand that a stock could still be quite liquid even after it’s “gone private” this way.
Why did Pendrell does this? It has saved over $1 million of costs by doing so. However, all it has really done so far is remove its listing from a major exchange and remove the need to file with the SEC. This doesn’t necessarily mean the company won’t release annual reports, audited financial statements, etc. to the public (if they choose to do so: you should be able to find these via OTCMarkets.com under the ticker “PCOA”). They can do that if they choose. They can also choose not to do it. If you want to call it a private company, you’d have to call it a pretty liquid private company as small investors are able to get in and out of the stock much more easily than in the least liquid listed stocks out there. There are days where I think Pendrell has had $100,000 of trading volume. I have accounted for 100% of the daily volume in stocks I’ve bought and sold sometimes. So, $100,000 of volume on some days is plenty for most individual investors. Even “dark”, Pendrell is likely to be more liquid than several stocks I’ve owned that were filing with the SEC.
What Are the Dangers of Investing in a Dark Company?
I have invested in “dark” companies before. In fact, the stock I am now considering buying is not listed on an exchange and doesn’t file with the SEC. It does, however, release quarterly and annual “reports” (only a few pages, but with financial statements) as well as information about the annual meeting. That stock is much less liquid than Pendrell is. Its annual report is maybe 5% to 10% the size of the 10-K a company would file with the SEC. On the other hand, it sometimes provides additional – and quite useful – non-GAAP information that its fully public peers don’t release.
One concern that investors have with “dark” companies is that a company may go dark to allow management to loot it. It’s possible. All companies have some related party transactions. I’ve seen public companies file 10-Ks that fully disclose these related party transactions and still manage to allocate say 1-2% a year of the company in share form to insiders per year and maybe 10% to 20% of what annual income would be without paying for probably unneeded services of these insiders. So, the protection you have with a company that files with the SEC isn’t that management can’t loot the company – it’s just that management has to disclose it’s looting the company.
Pendrell was already – whether listed or not – a company with a pile of cash, a lot of net operating loss carryforwards, and a very rich controlling share (the controlling shareholder here may have a net worth 10 times the size of this company’s market cap). Whatever the IRS’s opinion on this – Pendrell is effectively a holding company for a few insiders. In such situations, you have to either trust the controlling shareholder, the CEO, etc. or not.
At the risk of offending lawyers here, I’d say your 3 key protections as an outside shareholder in any public company are usually:
- Alignment of interests between you and insiders
- The personal honor and integrity of insiders – their sense of shame AND
- The ability of outsiders to “raid” the company
If a company with a professional management team is poorly run – some activist investor, private equity firm, or competitor will make some sort of offer to the board. That’s not going to happen with small, controlled companies. So, your protections are really how honorable insiders are and how closely your interests are aligned with their interests. I don’t think the “motive” to loot changes here whether the company is dark or not. It’s true “opportunity” does change. So, if you feel management’s interests aren’t aligned with you and management isn’t trustworthy – then, yes, going dark is bad.
There’s also a risk that management might sort of intentionally use going dark, de-listing, etc. to dry up liquidity, inconspicuously improve the value of the company, etc. and then eventually offer to buyout outsiders. A lack of liquidity has a sort of drip, drip, drip water torture kind of way on working on the minds of many investors. Outsiders can be pretty quick to give up on a “dead money” stock. If a stock is illiquid and there isn’t any news coming out of the company, some investors will sell out and won’t be too picky about price.
Pendrell has bought back stock from shareholders – though they’re limited in their ability to do huge buybacks. It’s clear that Pendrell’s management is aware that outside shareholders are undervaluing the company and they may be considering ways they can take advantage of that. I mean, buying back stock below net cash is a way of enriching continuing shareholders at the expense of selling shareholders. If you’re a continuing outside shareholder, these buybacks are good for you. But, I’m sure the fact outsiders aren’t valuing the company correctly isn’t lost on management when they do these buybacks. Eventually, management is trained to think outsiders don’t know how to value the company and can be taken advantage. What I’m saying is: insiders know the market for this stock isn’t efficient. What they do without that knowledge is a matter of their personal ethics.
I Don’t Know What Disclosures Will or Won’t Be
Will Pendrell continue to provide information to shareholders along the lines of annual reports? It doesn’t have to. I have seen dark companies that try very hard to hide literally everything about their business from their own “outside” shareholders including such basic information as what land they own, what stocks they hold, etc. In some cases, outside shareholders have only gotten information by making a legal request for it.
In other cases, there isn’t much difference between a closely held, publicly traded over-the-counter but still filing with the SEC stock like George Risk (RSKIA), OPT-Sciences (OPST), etc. and a company like Pendrell. But, it depends. For example, I owned OPT-Sciences when it was filing with the SEC. About 3 years ago, the company finally went dark (it’s a tiny company controlled by a trust) and I don’t think it’s filed any reports since then. I can guess what it looks like. But, I can’t be sure.
So, it’s possible investors would know nothing about Pendrell while it was dark. The company could change quite a bit without you – as a shareholder – knowing how it had changed.
If Pendrell does go truly and completely dark – are their ways of getting information about the business once you’re a shareholder? Yes. A dark company is still preparing plenty of financial statements, etc. and shareholders can contact the company to gain access to it. The blog to read for information on all this is “Oddball Stocks”. Go through all the archives and especially the comments to see how Nate and some people commenting on that blog got information on companies that were completely dark to non-shareholders. Often, investors who specialize in truly obscure companies will buy some shares of an ultra-obscure company just for informational purposes.
My Best Guess as To What Will Happen at Pendrell
What do I think is most likely to happen over the next few years at Pendrell? Well, if you look at the way the CEO is compensated and things like that – I’d say the most likely scenario is that Pendrell doesn’t necessarily disclose a lot till it buys something. It then announces it made a big acquisition, it prepares to file with the SEC again, it eventually up-lists to a major exchange and by then the name Pendrell has been changed to the name of whatever it acquired.
FutureFuel
One thing I didn’t mention in my original write-up is that years ago I analyzed a public company Lee Mikles (Pendrell’s current CEO) ran. I never bought the stock. But, I recognized the name Lee Mikles and what he had done at FutureFuel. FutureFuel was really Eastman Chemical. It just used the corporate name FutureFuel, but it was actually Eastman Chemical. Eastman Chemical had a biofuels business. But, its legacy business was supplying custom ingredients in large volumes to a couple big companies under long-term contracts. I’m working from memory here, so I could be way off – but, I want to say their two key customers were P&G (Tide) and Monsanto (RoundUp).
Anyway, the history of FutureFuel was basically this:
2005: Company is formed as a vehicle for acquiring a company “in the oil and gas industry”
2006: Company acquires Eastman Chemical and becomes known as “FutureFuel”
2008: FutureFuel starts trading on the OTC Bulletin Board (“pink sheets”)
2011: FutureFuel lists on the NYSE
Lee Mikles was a member of the board, the CEO, etc. from the time the company started (2005) through all these name changes, etc. I think he owned something like 5% of FutureFuels. The Chairman of FutureFuels (who may have also become CEO when Mikles left) owned more like 40% of the company. If you check the address of the Eastman business, the executive offices of FutureFuel, and the addresses of the various board members it looks like the company’s executive offices were basically the Chairman’s location. I remember that the company used a Missouri address for its executive offices even though it owned a couple thousand acres in Arkansas for its chemical business. You can also see that the company was formed to make acquisitions in the “oil and gas” industry and the Chairman had background in that business. On top of all this, there’s an OTC stock – I’m familiar with it, they make gloves and safety equipment – called Boss Holdings where both Mikles and the Chairman of FutureFuel served as directors.
Anyway, that’s a long story to make a short point. If you’re asking how will Lee Mikles do working with taking a cash pile with a controlling shareholder, having it traded over-the-counter, acquiring something, listing on a major exchange, etc…
Well, that’s exactly what he did at FutureFuels for maybe something like 7 years. I mean, I think his key involvement with the company as a real operating business was between 2006-2013.
How was his record? Well, you can check the stock price and so on. I don’t think it’ll look very impressive on that measure. On the other hand, you could dig more into the history to see whether the underlying acquisition and its subsequent operating results were good or bad.
Regardless, I wouldn’t be surprised if the future of Pendrell looks somewhat like the past of FuturFuel.
The Trouble with Speculating
I have no reason to believe that will happen beyond the stuff you know too. It’s just my guess of which of a bunch of different scenarios is most likely. I think it’s most likely that within 5 years or whatever: Pendrell eventually acquires “ACME Widgets” and then lists on the NASDAQ as ACME Widgets and there is just a brief mention in the 10-K that the company used to be called Pendrell and explaining where the net operating loss carryforwards came from, etc.
As far as how big an acquisition Pendrell could do…
It could be big. I didn’t want to get into all the tax questions. That’s stuff you can explore yourself. I’m no more of an expert on corporate taxes, net operating loss carryforwards, etc. than you are.
There is a bunch of potential upside I didn’t discuss. I mean, if John Malone controlled Pendrell – it would be worth a lot. Because we know he’d use as little owner’s equity as possible and pay as little taxes as possible. I know of companies – publicly traded, but I assume there are some private ones too – that have been reluctant to sell the company because whoever buys them would apply a discount to the fact there is embedded within what they are buying an unusually big need to pay taxes in the future. But, I think it gets very speculative to talk about those sorts of things. It gets very speculative to talk about the absolute best way to take advantage of net operating loss carryforwards, because we don’t know enough about the capital allocation ideas management has. How committed are they to minimizing taxes, maximizing the earnings bang they get for their acquisition buck, and doing it sooner rather than later?
I don’t know. I can speculate. But, I’m not sure it’d be helpful to do so.
But, yes, there is – if the buyer and seller are working together to minimize taxes for everyone – some ways to structure a deal that might mean the seller would get a better bid from a buyer with net operating loss carryforwards than a buyer without any.
What My First Pendrell Write-Up Was All About
As usual, what I tried to do in that “memo” is lay out some conservative assumptions that might work here. I think I was very conservative with Pendrell. I think the upside – if run by the right capital allocator – is potentially very big in this stock. So, far, Pendrell’s management has done mostly the right things. But, so far, the right things have mostly been getting smaller and doing nothing. When it’s time to get bigger and do more – will their decisions be just as good?
Obviously, there is the potential for a bigger acquisition, there is the potential for plowing back free cash flow into acquiring more taxable operating businesses and snowballing like that over time so that a lot of the net operating loss carryforwards could be used in later years, there is the potential for the acquired business (or businesses) to grow organically, etc.
But, I’m not sure we should ever count on optimal capital allocation at a company we invest in. It’s very easy to confuse what you would do if you controlled the company with what the management of the company will actually do. They’re rarely the same thing.
What I did in that post is lay out the two sort of extreme boundaries of what Pendrell should – if managed right – be worth. I don’t think you should strongly prefer a $200 million stock with a P/E of 10 over Pendrell. You might look at the two at being roughly equal. But, you shouldn’t much prefer one over the other. I do, however, think you should prefer a stock trading at 50% of your appraisal value to Pendrell though. As I laid out in the extreme example of what would happen if Pendrell eventually uses up all the net operating loss carryforwards by 2032 – I still didn’t get a value for the stock (to me personally) of over $1,300 as of today. I think that shows pretty clearly that Pendrell is not worth more than double was it now trades for.
Pendrell is definitely worth more than its current stock price. But, I also think it’s definitely worth no more than double that stock price. Those are the “bounds” I sketched out.
So, I’m just saying that I see Pendrell initially as being something that’s probably trading at more than 50% but maybe less than say 75% of its appraisal value. That’s pretty good for a stock with cash on hand, no liabilities, etc.
Right now, I think value investors see it as a stock trading at 90% of cash. That’s true. But, I don’t think that’s an accurate gauge of appraisal value, because the net operating loss carryforwards here are very big relative to the market cap and the company is not currently burning cash or saddled with a lot of liabilities. It’s rare to find a very clean balance sheet, lack of cash burn, etc. accompanied by such large net operating loss carryforwards. So, I think there’s a lot of flexibility here.
Why Most Value Investors Won’t Make Much Money on This One
What do I think can go wrong with this investment?
I think a lot of value investors buying this stock will end up losing a little money, breaking even, or making a little money over the next couple years. I think, eventually, most value investors who buy this stock will come around to seeing it as “dead money” and decide to recycle the capital from Pendrell into a better, livelier idea. That’s usually what happens with these kinds of stocks. Value investors who get in under net cash don’t actually stick it out for the transformation. It’s very tiring to watch a stock go nowhere, hear no news about it, etc. for a few years while you are buying and selling other stocks, making profits and – above all else, simply “doing things”. If Pendrell takes a while to buy something, most of the value investors who buy in today will have sold out before that acquisition is ever announced.
As always, feel free to comment below. Sometimes, I’ll do a full follow-up memo like this one where a comment calls for that.