Short Ideas | Tech
HC2 Holdings, Inc.: Asset Rich But Cash Poor
Sep. 22, 2020 5:55 PM ET | About: HC2
Holdings, Inc. (HCHC)
Summary
-
HC2
Holdings 11.5% First Lien Notes is going current end of 2020 and
will likely need to tap high yield market to refinance the bond.
-
While HCHC made progress reducing the amounts on the 11.5% notes,
there is still a sizable ~$342.4 million outstanding, plus $55
million of convertible bonds outstanding.
-
Most
of HCHC's subsidiaries are not generating meaningful cash flow, and
the couple that are cash flow positive don't have enough debt
capacity to absorb the holdco debt.
-
The
proceeds of the recently announced rights issuance are to fund
general corporate expenses, which won't be used to delever the
balance sheet.
-
I
think HCHC will have a tough time refinancing the remaining balance
of the 11.5% notes.
Situation Overview
HC2
Holdings (HCHC)
is an investment holding company previously managed by Philip
Falcone who has since left
the company after a proxy
fight. HC2 holds a diverse array of operating subsidiaries
including DBM
Global, ANG, Continental
LTC Insurance, and HC2
Broadcasting. HC2 also has a portfolio of early-stage life
science investments.
HC2
has been on a journey to delever its balance sheet ever since it ran
into trouble refinancing the previous version of the 11.5% notes where
Mr. Falcone confidently said that he could refinance the debt the next
day in the 7.5%
to 7.75% range, but ended up refinancing the bond at 11.5%
with an additional $55 million 7.5% convertible that drove down the
price of the stock.
To
HC2's credit, it sold Global
Marine, one of its three main cash flow positive operating
subsidiaries, for a total $390 million total value. The net proceeds
to HC2 were ~$175 million after adjusting for subsidiary debt and
pension obligations, as well as the 73% ownership interest. However,
the net proceeds were only sufficient to redeem ~$128 million face
value of the 11.5% notes as the redemption price was set at 104.5% of
the face value under the indenture.
Ever
since the end of the proxy fight, the focus of the board has been on
the refinancing of the 11.5% notes with (hopefully) a lower cost of
capital. The board has essentially put every operating subsidiary
under strategic review. Most recently, HC2 has announced a $65 million
rights offering with the Chairman of the board agree to backstop
$35 million. Two other top shareholders (Michael Gorzynski,
the investor who launched the proxy fight, and Jefferies Group) have
informed the company that they intend to purchase at least their pro
rata portion of the rights offering. HC2 expects to use the proceeds
from the rights offering for general corporate purposes. Obviously,
one of these purposes is to pay the coupon on the 11.5% notes and the
7.5% convert, together cost HC2 $43.5 million a year in interest
payment.
Leaning on DBM Global
In the
absence of a large equity check that delevers the balance sheet, which
is massively dilutive to the existing shareholders, HC2 can only rely
on its remaining two cash flow positive subsidiaries: DBM Global and
Continental LTC Insurance. One strategy would be an outright sale, and
the other one would be a dividend recapitalization of the operating
subsidiary and simultaneously upstream the cash to pay down
corporate-level debt.
Depending on the M&A cycle, I believe DBM Global can be sold for a
total enterprise value of $360 million to $560 million, and net
proceeds to HC2 from ~$220 to $395 million. Some clients of DBM Global
are delaying maintenance capex in 2020 but using 2019 as a "COVID-free"
guidepost, DBM Global can generate $70-$80 million adjusted EBITDA,
and 6.0-7.0x is a reasonable range for a construction business.
Source: Management Guidance, Author's Estimates |
The
main issue with selling DBM Global outright is that the net proceeds
must be sufficient to turn HC2 into a debt-free business (at the
corporate level) because ex-DBM Global HC2 doesn't have much (if any)
debt capacity at the corporate level. This means that HC2 must achieve
the best-case scenario, or it's not worth pursuing this strategy - a
tall order in this environment.
As for
the dividend recapitalization of DBM Global, I agree that DBM Global
has remaining debt capacity but I'm not sure if it's going to be
enough. As shown above, DBM Global is already 1.5x levered. For a
business that's driven by backlog and the revenue can be quite
volatile on a QoQ basis, I think DBM Global can add 1.0x additional
debt at most. That's $60-80 million upstreamed cash vs. close to $400
million of corporate debt ($342.4 million 11.5% notes and $55 million
7.5% convert).
Selling Continental LTC Insurance
HC2
was in exclusive talks with a buyer of the Continental LTC Insurance
but after the proxy fight, the board decided to head for a different
direction by letting the exclusivity period lapse. HC2 hasn't provided
any details on the rationale but I suspect that the bid wasn't high
enough is at least a part of it.
It's
always difficult to value a life insurance business. HC2 paid
$15 million for the first major block of this business in
2015. The second block was purchased from Humana where Humana
contributed $195 million, essentially to transfer the long-term care
liability to HC2's insurance subsidiary.
HC2
has been upstreaming cash flow from Continental via management fee.
Effectively, HC2 is acting as the asset manager of Continental's AUMs,
and Continental pays a quarterly management fee to HC2. Initially, HC2
was targeting $15
million annual management fee, and the potential to
dividend out excess capital. However, on the Q4-2019
earnings call, HC2 indicated that "both the management fee
and dividend possibilities would not meet" their long-term
expectations and objectives going forward. In fact, in FY2019 HC2 only
received $11.5 million management fee and $9.5 million was on a LTM
basis as of Q2-2020.
Continental doesn't deserve a high multiple of its management fee
because the big insurance companies have been a net
seller of long-term care insurance businesses. Moreover,
the insurance book is essentially in run-off mode, so it can't
generate organic growth. As long-term interest rate is going to stay
lower for longer, the risk of assets running out before the
liabilities has also decreased (although HC2 has repeatedly said that
their regulatory-based capital position is strong). Let's assume that
an $8 million base management fee can be achieved, and assume an 8.0x
multiple. At most, this hypothetical divestiture brings in $64 million
before taxes and transaction fees. It simply doesn't move the needle
for the deleveraging target.
Selling HC2 Broadcasting
Selling HC2 Broadcasting is almost a non-starter. To my knowledge, HC2
is the only low-power TV station consolidator, so the number of
potential bidders is limited. Also, it seems like asset sale proceeds
must be applied to subsidiary debt first reading from the press
release. This means HC2 won't receive a dime until the
$81.2 million subsidiary notes are paid off first. Finally, it sounds
like even the refreshed board wants to grow this business instead of
divesting it. Either the prospect is just too attractive to let it
pass, or there are limited buyers so HC2 is forced to grow this
business.
One-Two-Three-Punch Approach
Perhaps a multi-step maneuver is needed here. HC2 could (1) sell
Continental for $64 million, (2) dividend recap DBM Global to upstream
~$70 million cash, (3) negotiate with the 7.5% convert holders to
extend the maturity, and finally (4) tap the high yield market for a
more manageable $200 million issuance.
Shareholders of HC2 should realize that any of the steps above is
negative for the equity value of HC2, to different degrees. Selling a
major cash flow contributor, unless the price paid is very dear,
lowers HC2's financial flexibility. Dividend recap DBM is going to
reduce its ability to upstream dividends in the future to service any
debt remaining and paying for the holdco SG&A expenses. Extending
maturity of the 7.5% convert will inevitably come with lowering the
conversion price, that's followed by a wave of short selling by the
convert holders to hedge their delta. Most importantly, even if steps
1 to 3 are achieved, I'm not sure if the $200 million deal will come
at a significantly reduced coupon as HC2 still relies on subsidiary to
upstream dividend to service the holdco bonds.
Conclusion
HC2
has assembled a portfolio of businesses over the years but
unfortunately, there's a major mismatch between characteristics of the
assets and the funding sources (i.e. holdco-level debt). Although the
refreshed board is focused on changing this, I believe the HC2 will
once again run into difficulties refinancing the 11.5% notes - unless
the anchor equity holders are willing to write a much bigger check
than the recently announced $65 million rights offering.
** ** **
Disclosure: I/we
have no positions in any stocks mentioned, and no plans to initiate
any positions within the next 72 hours. I wrote this article myself,
and it expresses my own opinions. I am not receiving compensation for
it (other than from Seeking Alpha). I have no business relationship
with any company whose stock is mentioned in this article.
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