Analysis: ALJ Regional Holdings, Inc. (NASDAQ: ALJJ)

ALJ Regional Holdings, Inc (NASDAQ: ALJJ) is a private-equity-style holding company, with a solid history of operations, that currently trades at a 15% free cash flow yield. The stock has suffered a 50% drawdown over the past year, mainly due to a stream of bad news, including ugly quarterly results, fears of a debt covenant breach, NOL’s taking a hit from the tax bill, and a sexual harassment lawsuit filed against the firm’s CEO and key capital allocator, Jess Ravich (in his role at TCW). The main question is does this negative sentiment match reality?

This document contains an independent analysis of the company. Information on my investment philosophy can be found here. On a side note, I haven’t written much lately as I’ve been busy studying for the CFA Level III exam and interviewing for jobs.

Disclaimer: The author is currently long ALJJ. All of the views expressed in this document are solely those of the author and do not reflect the view of any other person or company. I am not receiving compensation for it nor do I have a business relationship with the company whose stock is mentioned in this document. All investments involve the risk of permanent capital loss and I encourage everyone to do their own due diligence and to reach their own conclusions. To be clear, I do not encourage or recommend for anyone to follow my lead on this or any other stocks, since I may enter, exit, or reverse a position at any time without notice, and I undertake no responsibility to update my disclosures. Under no circumstances should this document be considered an offer to buy or sell any securities mentioned within.

Summary

  • Bad news, capitulation, and a 50% drawdown have created an attractive entry point for new investors seeking an asymmetric risk/reward profile with little market correlation.
  • Investors are currently focused on ALJJ’s debt and fumbles in short-term operations, completely discounting subsidiaries with long histories of consistent cash flows and modest growth.
  • At current valuations, we’re getting ALJJ for ~6x FCF, ~5x EBITDA, and 1.8x adjusted tangible book value.
  • We’re also getting a large NOL asset and the possibility of participating in any future growth.
  • Though it is impossible to say exactly what ALJJ is worth, investor sentiment and emotions after a large drawdown make it more likely that we’re closer to a bottom than a top.
  • Our downside is somewhat protected by a shareholder-friendly management that uses cash flows to deleverage and repurchase shares (tendered for 50% of outstanding shares the last time there was a liquidity event).
  • Management’s large insider ownership (~38%) and incentive to use up NOLs, help ensure that capital allocation decisions are aligned with investor interests.
  • The CEO has steadily been buying up shares during this drawdown (373k shares at an average price of $2.22 over the past two months).
  • The debt overhang is the key downside factor here. Current cash flows are more than enough to service the debt, but a recession could change that quickly. Any subsequent capital raise would likely hurt current shareholders. Managment’s background in leveraged buyouts and willingness to co-invest at today’s prices helps to alleviate some of this fear.

Company Overview

ALJJ is a holding company that consists of three operating businesses:

  • Faneuil – A provider of call center services, back-office operations, staffing services, and toll collection services to government and regulated commercial clients, focusing on the healthcare, utility, transportation, and toll revenue collection industries. Backlog as of December 31, 2017, was $274.6 million, up from $223.6 million a year prior. Their top customer as a percent of revenue was 14%, down from 35%. Faneuil has been a great business to own, growing and diversifying their operations over the years.
  • Carpets – A provider of multiple products for the commercial, retail, and home builder markets in Las Vegas, including all types of flooring, countertops, cabinets, window coverings and garage/closet organizers, with four retail locations, as well as a stone and solid surface fabrication facility. Backlog as of December 31, 2017, was $52.3 million, down from $82.2 million a year prior. Their top customer as a percent of revenue was 26%, down from 28%. Carpets has been a pretty disappointing business to own, but the recent boom in Las Vegas real estate and the bringing on of Rob Christ as CFO (formerly ALJJ’s CFO) could help reverse its fortunes.
  • Phoenix – A manufacturer of book components, educational materials, and related products producing value-added components, heavily illustrated books, and commercial specialty products. Backlog as of December 31, 2017, was $188.1 million, up from $155.2 million a year prior. Their top customer as a percent of revenue was 18%, down from 21%. Phoenix has been a steady producer for ALJJ but recently hit a slowdown in their books and components product line. New acquisitions should help diversify away from this segment.

ALJJ’s basic strategy is to use up its extensive net operating losses (NOLs) by acquiring cash flow producing businesses at attractive valuations. The firm is structured in a decentralized manner, where subsidiary CEOs have considerable autonomy and are rewarded like partners (sharing in EBITDA earned over a watermark and holding a large equity position in the parent). Jess Ravich, the parent CEO and top-down capital allocator, takes home a modest salary of $125,000 plus stock grants and is primarily rewarded by value accruing in his ~38% ownership in the firm.

We should take some time to stress the importance of Mr. Ravich to the firm since part of the recent poor performance in its share price was due to the sexual harassment lawsuit filed against him and TCW Group. Historically, ALJJ has been able to acquire businesses at valuations under 5x unlevered FCF, with no competitive bidding, primarily because of Mr. Ravich’s extensive deal flow network. It is fair to say that without Mr. Ravich, the deal flow would dry up, and with it, any major growth for the firm. As such, we should focus our analysis on what the steady state of the firm is worth today and discount any future growth.

Company History

2002 ($1.17/share): ALJJ’s (YouthStream Media Networks) tech-boom venture goes bust, creating a shell corporation that has no operations, ~$1 million dollars in cash, ~$14 million in liabilities, and ~$300 million in NOLs.

2003 ($0.05/share): ALJJ’s new board plans to leverage up and acquire a business that can harvest those NOLs. ALJJ begins purchasing a minority interest in Kentucky Electric Steel (KES), a bankrupt steel manufacture.

2004 ($0.23/share): KES restarts its steel mill operations. Mr. Ravich purchases ALJJ’s convertible debt with the intention of taking control of ALJJ.

2005 ($0.31/share): ALJJ, under Mr. Ravich’s guidance, acquires complete control of KES for a total consideration of $65 million, funded by preferred stock and debt. ALJJ now owns a profitable steel mill with a mountain of debt on top of it.

2006 ($0.11/share): Mr. Ravich acquires control of ALJJ (changes its name from YouthStream to ALJ) and focuses on producing enough cash flows at KES to pay down its debt. This works well.

2013 ($0.79/share): ALJJ sells KES for a large profit and immediately tenders for half of its outstanding shares ($0.84/share), providing long-time investors with an exit at a roughly 30% compounded IRR since Mr. Ravich took control in 2006. ALJJ was back to being a corporate shell with no operating business, ~$30 million in cash, and ~$180 million in NOLs.

Late in the year, ALJJ acquires Faneuil for $53 million, funded in cash, seller financing, and ALJJ stock. The seller was Harland Clark (a subsidiary of billionaire Ronald Perelman’s M&F Holdings) who had previously purchased Faneuil for $70 million in 2012. Notably, ALJJ was not the highest bidder for Faneuil, but the seller was happy to get stock and representation on ALJJ’s board, so they went with the lower bid. Faneuil’s CEO, Anna Van Buren, co-invested in the buyout and stayed on with an incentive plan of 10% of EBITDA earned over $5 million.

2014 ($1.56/share): ALJJ acquires Carpets N More for $5.5 million, funded in cash, seller financing, and ALJJ stock. The seller was Leichtman Capital who had previously purchased Carpets for about ~$45 million at the hight of the Las Vegas housing boom in 2007. Carpet’s CEO, Steve Chesin, co-invested his 12% equity in the buyout and stayed on with an incentive plan of 5% of EBITDA earned over $1.5 million.

2015 ($4.04/share): ALJJ acquires Phoenix Color for $90 million, funded entirely in debt. The seller was Visant Corporation who in turn was an underperforming KKR LBO. Visant’s CEO, Marc Reisch, purchased 400k ALJJ shares ($3.80/share) and stayed on with an incentive plan of 10% of EBITDA earned over $20 million.

As part of the Phoenix acquisition, ALJJ also secured access to financing from Cerberus in order to fund future deals, however, the balance sheet took a large hit. Cash from the original KES sale and operations was all used up. Like with KES, the future would depend on producing enough cash flows to service the debt.

2016 ($4.85/share): ALJJ up-lists from the OTCMKTS to the NASDAQ exchange. ALJJ acquires Color Optics (cosmetic packaging) for $7 million, funded by the Cerberus loan and ALJJ stock. The business is added to the Phoenix subsidiary.

2017 ($3.99/share): ALJJ acquires Vertex’s BPO and contact center operations (utility call centers) for $13 million, funded by the Cerberus loan and ALJJ stock. The business is added to the Faneuil subsidiary. ALJJ acquires Moore-Langen Printing (advertising products) for $10 million, funded by the Cerberus loan and a private placement of ALJJ stock ($3.14/share). The business is added to the Phoenix subsidiary.

2018 ($3.16/share): ALJJ reports ugly quarterly results, mainly due to the poor performance at Phoenix and Carpets, the costs of incorporating new acquisitions, and the large hit to their tax asset. Mr. Ravich is named in a $30 million sexual harassment lawsuit. ALJJ’s share price craters to $1.90.

Investment Thesis

Over the past year, the once high flying shares ALJJ have been brought back down to earth. The reasons are threefold:

  1. First quarter results were ugly. The company reported a net loss, primarily due to the cost of incorporating the acquisitions at Phoenix, new contract start-up costs at Faneuil, inflated depreciation and amortization for the acquisitions, and a tax asset write-off (ALJJ has a large tax asset that is worth less now that tax rates are lower). Excluding acquisitions, sales were up 12.9% at Faneuil, down 6.9% at Phoenix, and up 7.1% at Carpets. Including acquisitions, sales were up 35.3%, 11.7%, and 7.1% respectively.
  2. Debt is starting to spook investors. Beginning with the acquisition of Phoenix in 2015, debt has steadily increased with each new acquisition. Net debt (loans, capital leases, less cash) has grown from $99.6 million in 2015 to $116.8 million today. EBITDA has grown at a faster rate, but there is still the risk that a negative shock to operations will trigger debt covenants on the Cerberus loan (Leverage Ratio < 3.5 | currently 3.38, Fixed Charges Ratio > 1.25 | currently 1.35). In the event of such a breach, it is likely that Mr. Ravich would backstop the firm but at terms likely unfriendly to current investors.
  3. The sexual harassment lawsuit at TCW (Mr. Ravich is a managing partner at TCW) greatly increases the risk that the deal flow growth model of ALJJ will be cut off. As such, our valuation today will focus solely on current operations.

Longtime readers of this blog know I’m a contrarian by nature and like to go where the “ick” factor is high, so this whole ALJJ situation jumps out at me. Luckily for us, when the reasons for undervaluation can be readily identified, it creates a more predictable environment for assessing a companies value relative to the prevailing market sentiment.

At the current market price, we are getting consistent cash flows at a 15% yield, two solid businesses (plus the less solid carpet business) for less than book value, whatever non-zero value the NOLs have, and the low probability upside of any future growth. As such, I have built a position in ALJJ over the past month at a price of around $2.00/share. This investment can be classified in the same bucket as the PCOA idea from my last post – uncorrelated deep value at a time when valuations are stretched.

Valuation

Cash Flows

We can start with a standardized view of ALJJ’s financials:

  • ALJJ 2018 revenues at the low end of extrapolated guidance.
  • Ignores efforts to reign in costs.
  • Ignores future growth.
  • Faneuil 2018 EBITDA at 8.5% of revenues (historic levels).
  • Carpets 2018 EBITDA at 2.5% of revenues (above historic levels).
  • Phoenix 2018 EBITDA at 15.5% of revenues (historic levels).
  • Maintenance Capex at 2.5% of revenues (historic levels).
  • The assumption that NOLs cover tax expense.

overview metrics.png

Assuming a base case of $11.3 million in FCF ($0.30/share) for 2018, we can build a valuation framework at different Price/FCF multiples. Today’s valuation is highlighted (note that the historical average multiple of 20x is way above our range).

price fcf.png

If we apply a more reasonable 8x multiple (12% yield) to the stock, it would be worth about 20% more than it is today. At a 13x multiple (8% yield), 93% more. What multiple correctly accounts for the debt load and management issues? I don’t know, but if we add back in the possibility of returning to historic growth rates, the non-zero value of the NOLs, and the fact that negative sentiment is high, it’s easy to argue that the multiple should be higher than it is today.

Replacement Value

Turning to the balance sheet, we can try to work out the replacement value of the company. We will slightly mark up accounts receivable to reflect the difficulty of winning government contracts and significantly discount the intangible assets:

Asset value

We end up with a company trading at about 0.8x book value and 1.8x adjusted replacement value. This seems fair, but considering the asset-light nature of the business and its high ROTIC, replacement value probably isn’t the best valuation metric.

Sum-of-the-Parts

As a sanity check, we can take a look at the sum-of-the-parts breakup valuation for the three subsidiaries. To keep things conservative we will use:

  • Historical EBIT, even though that doesn’t account for the new acquisitions and growth.
  • Historical depreciation and amortization, even though that doesn’t account for the asset-light nature of the firms.
  • Estimated industry EV/EBIT multiples (source).
  • A 15% conglomerate discount.

sotp.png

So, If ALJJ implodes and has to be broken up and sold off, we still get a conservative base case sum-of-the-parts valuation of $2.91/share, ~45% higher than the current market price.

Conclusion

I have no idea exactly what ALJJ is worth, but I have a strong feeling it is more than 6x FCF. Evidence for that feeling:

  • Markets tend to overcorrect to the downside when faced with bad news.
  • A conservative estimate of 2018 cash flows at an 8% yield would give us a market price 98% higher.
  • A conservative estimate of the sum-of-the-parts breakup value would give us a market price 45% higher.
  • Both estimates ignore the long history of growth at the firm.
  • Both estimates ignore the value of the NOL asset.

As such, I am happy to be a buyer of ALJJ below $2.00/share.

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