Sizing Up Small Caps

Phil Falcone’s Long Game

The controversial HC2 Holdings CEO is looking to repeat the success he enjoyed at HRG Group. Shares could be worth more than double.

By David Englander

April 30, 2016

Phil Falcone made billions for his hedge fund, Harbinger Capital, when he bet against the housing market in 2007. He is also known for his past legal troubles with the Securities and Exchange Commission, and as a large owner of troubled wireless network LightSquared, now called Ligado Networks.

Lost in the shuffle, perhaps, is his successful deal-making record at HRG Group, a holding company that he founded, and where he took major stakes in Spectrum Brands Holdings and Fidelity & Guaranty Life. From 2011, when HRG made its first investment, through 2014, its stock returned 129%, versus the Standard & Poor’s 500 index’s 64%.

A new Falcone play is a venture called HC2 Holdings (ticker: HCHC), a company in the same cut as HRG. While small, with a market value of just $135 million, HC2’s potential could be great, if Falcone can recreate some of his past success.

Over the last two years, HC2 has bought cash-generating businesses at cheap prices, often from motivated sellers. Its holdings include Schuff Steel, a steel-fabrication company; Global Marine Systems, which installs and services undersea fiber-optic cable; a long-term care insurance business; and smaller stakes in about half a dozen or so other businesses.

After a strong start, HC2 shares have dropped 60% since last June, along with other leveraged investment companies, which have fallen out of favor. Selling related to redemptions at some fund holders may also have played a part. At a recent $3.85, the stock looks attractive, but it isn’t without risks.

HC2 is burning cash at the holding-company level, meaning it isn’t collecting enough dividends from its subsidiaries to cover interest and operating expenses. Still, Falcone is on the hunt for a new deal, which could push the company toward break-even.

One holder, Chris Mittleman of Mittleman Brothers, thinks HC2 is worth more than double its current quote. He puts the net asset value at $8.30 a share. A new acquisition could bump that up. As cash flow break-even gets closer, the stock, too, will probably attract a wider group of investors.

In early 2014, HRG Group bought a large stake in a shell company called Primus Telecom; the company was renamed HC2. Falcone became CEO that April, and HC2 completed its first deal, a majority stake in Schuff, in May.

Six months later, Falcone stepped down from HRG, to focus on HC2. Last year, HRG exited its stake in the company. In 2013, as has been widely reported, Falcone agreed to a five-year ban from the securities industry, for borrowing from his hedge fund to pay his taxes, and for giving preferential treatment to some clients.

LAST YEAR, HC2 GENERATED $97 million in Ebitda, or earnings before interest, taxes, depreciation and amortization, on revenue of $1.1 billion. Schuff and Global Marine accounted for almost all the company’s Ebitda and subsidiary dividends of $24.7 million. Free cash flow was negative $32.5 million. No Wall Street analysts cover the stock, so there are no published estimates available.

Schuff does the fabrication and placement for structural steel in large commercial construction projects, such as high-rise office buildings, sports stadiums, and hospitals. Notably, it’s working on Apple’s futuristic new headquarters in Cupertino, Calif. Last year, its Ebitda rose 15%, to $52 million. As long as construction activity keeps up, the business should do well.

Global Marine generates the majority of its revenue from installing and repairing subsea fiber-optic cables for telecom companies, through its fleet of seven ships. Half its revenue is tied to long-term maintenance contracts, which ensure a stable cash-flow stream.

Last year, HC2 bought two long-term care insurance units from American Financial, with a $1.4 billion portfolio of policies. Long-term care has been out of favor, as costs have skyrocketed for insurers, and many have exited the business.

On the March earnings call, Falcone called the industry “a little bit misunderstood,” and added, “selectively, there’s opportunity here.” HC2 plans to build the business by buying existing policies, not underwriting new ones. A key part of the bet is that while people may live longer, they will be healthier, and claims will fall.

HC2 has also invested roughly $60 million in six smaller, venture-capital type businesses, which include natural-gas fueling stations for trucks, a biotech with a skin-lightening technology, and a Nascar-branded videogame developer. Even one success, there, could be a big score.

Mittleman, a 4.4% holder, values HC2’s 91% stake in Schuff and its 97% stake in Global Marine at a multiple of 7.5 times Ebitda. He values the VC-type investments at cost, so they aren’t a big part of his NAV estimate. Mittleman bought his shares last October in a $7.50-a-share private placement from HRG Group, an offering that Falcone participated in, as well.

HC2 had $305 million in debt, and $41 million in cash, at the corporate level, at the end of the year. It reported $158 million in cash, across all its consolidated subsidiaries. Probably reflecting some concern over the negative cash-flow issue, its senior bonds trade for 89 cents on the dollar.

WHEN ASKED BY AN ANALYST about timing for break-even, Falcone responded, “We are probably one acquisition away from doing that. We aren’t quite there yet, but we have adequate resources, so that we don’t have any problems.” In the past, HC2 has sold equity, including preferred stock, to finance deals.

At the end of 2015, HC2 disclosed it spent $54.6 million on unnamed investments, perhaps an indication of a larger investment underway.

Falcone, who through his stock and options owns 13% of HC2, seems to be playing a long game. “It’s all about driving value,” he told investors and analysts. “In the end, value will win.”

Investors who can stomach the risk could turn out to be winners, too. 

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