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48) -‐ August 11, 2011 The Brains, Capital, and Deal Flow of a Billionaire Investor at a 38% Discount to NAV" When someone has the audacity to claim, even tentatively, that they may have stumbled upon the next Berkshire Hathaway, experienced investors should rightly cringe with skepticism. Berkshire Hathaway (BRKA) was a slowly dying textile manufacturer when Warren Buffett first began acquiring its stock at around $8 per share in 1962 (when its net tangible book value was $22.51). After becoming the company's controlling shareholder in 1965 and redeploying its capital into better returning assets, the stock price has since risen to $107,100 per share, a compounded annual growth rate (CAGR) of 21.4% over 49 years, turning each $1 million invested then into $13.4 billion today; a nonpareil compounding machine over such a long time frame. Whether or not any other publicly traded conglomerate will ever be able to exceed both the amplitude and duration of Berkshire Hathaway's track record remains to be seen, but a few noteworthy candidates appear to be well on their way to doing just that. And there now appears to be another upstart joining in on that quest. When Ian M. Cumming and Joseph S. Steinberg bought control of Leucadia National (LUK) in 1979 (then called Talcott National), it had ended the year prior with a split-‐adjusted stock price of $0.01 per share (and negative shareholder equity of $7.7 million). Today it's $28.22 per share (with shareholder equity of $7 billion), a CAGR of 27.2% over 33 years, not including substantial dividends paid along the way. Brothers Steven M. Rales and Mitchell P. Rales paid $6.6 million for 30% of a nearly bankrupt publicly traded REIT called DMG and converted it into an acquisition vehicle which they renamed Danaher Corp. (DHR) in 1983. Their cost per share (split-‐adjusted) appears to have been about $0.032. Today it's $43.35, a CAGR of 29.7% over 28 years. I began my investing career in 1990 as a stock broker trainee at Shearson Lehman Hutton, before starting what would become an eleven year stint at PaineWebber on September 21, 1990. That day, had I been smart enough to take advantage of it (I was not), the publicly traded Canadian LBO firm Onex Corp. (OCX CN) was available for C$1.00 per share (split-‐adjusted). Today it's C$33.50, a CAGR of 18.2% over 21 years, not including dividends. Onex Corp. was founded and is still controlled by Gerry Schwartz, a great investor and businessman. When exceptional investors and/or business operators take control of otherwise unremarkable public corporations, it's often a prelude to a lucrative transformation of which outside investors can also take advantage, if they happen to notice what's going on before Wall Street wakes up to metamorphosis in progress.
For example, many clients of our investment advisory firm, Mittleman Brothers, LLC, have been with me since my days as a stockbroker and will recall investing at my behest in Icahn Enterprises L.P. (IEP) beginning in 1996 (then just a pile of cash and real estate known as American Real Estate Partners L.P. (ACP)) at around $9.00 per share (with a net tangible book value then in the low $20s). For the next six years it frustratingly stayed anchored around that $9.00 price as I continued to buy it for clients, and as Carl Icahn increased his stake from 50% to 86%. Finally in 2003, once Carl had bought enough stock on the cheap, he then started focusing on maximizing the share price, and we sold our position on average in the $50+ range during 2006 (it then reached over $135 in 2007, but is back to $41.50 today). Even the most unfortunate of my clients who bought that stock six years too early in 1996, and had to wait a full decade for it to reach and then exceed my estimate of fair value, still achieved an estimated CAGR of about 19.6% on average ($9 to $54) on that investment over those ten years. When we were investing in what would become Carl Icahn's primary investment vehicle back in 1996, one of the reasons it was available so cheaply was because Icahn's reputation was at a low point, with his investment in airline company TWA wiped out after its second bankruptcy (TWA's first bankruptcy was in 1992, the second and final one occurred in 1995), and his investment in bankrupt comic book company Marvel Entertainment also going down the tubes in 1996. But with the margin of safety provided by a discount to NAV in excess of 50%, and operating under the simple assumption that decades of outstanding investment returns are not undone by one or two bad bets, we correctly decided that Icahn had not suddenly become an inept investor in the mid-‐1990s, and so by the time he was considered an investing genius again about a decade later, the discount to NAV that had plagued those shares for so many years very suddenly became a substantial premium. Today we see the possibility of a similarly successful investment vehicle taking shape with Harbinger Group, Inc. (HRG) which closed yesterday (08/11/11) at $4.48 per share (Mittleman Brothers, LLC controls 1,674,846 shares of HRG (1.2% of shares outstanding) at average cost of $5.68 per share). In this case the out of favor billionaire investor is Phillip Falcone, who along with his hedge fund owns 93.3% of HRG's shares outstanding. With a discernable investment track record dating only back to 2001, it's not yet clear if Falcone's phenomenal results managing hedge fund Harbinger Capital Partners, L.P. from 2001 to 2007 should be weighed more heavily in judging his investing talent than his disappointing results from 2008 to 2011. Sometimes sudden wealth can cloud judgment, and lead to disastrous distractions. So it remains to be seen if he will rebound in a second act like a Carl Icahn, or flame-‐out like a Saul Steinberg (a high-‐living corporate raider of the '70s and '80s who lost everything when his insurance conglomerate Reliance Group failed in 2001). We’re obviously betting on the Icahn scenario playing out, mainly because Falcone’s investments have tended to be in companies we like: strong franchises with high barriers to entry yielding significant and sustained free cash flow production.
Harbinger Group, Inc. (HRG $4.48) used to be known as Zapata Corp. (ZAP), an oil company founded by former President George H. W. Bush in the 1950s, which then became an investment vehicle controlled by Malcolm Glazer in 1994 until he sold his controlling stake to Falcone (Harbinger) in June 2009 for $7.50 per share, the approximate net cash value per share of the company at the time, which had been liquidated years earlier. In January 2011 Falcone and his hedge fund further increased their stake in HRG by exchanging a 54.4% stake in Spectrum Brands (27.757 million shares) for 120 million newly issued HRG shares, thus increasing Falcone's stake in HRG from 51.6% to 93.3%. That was when we became interested in HRG, as we had already been amassing a stake in Spectrum Brands since it emerged from bankruptcy in September 2009 (Mittleman Brothers, LLC led an official equity committee that contested, unsuccessfully, what we viewed as an opportunistic and unfair bankruptcy reorganization plan that awarded Falcone's hedge fund with the bulk of Spectrum Brand's new equity. So to find ourselves investing in an entity he controls does feel a bit odd). Spectrum Brands is a highly recession-‐resistant group of value-‐priced consumer brands such as Rayovac batteries, Remington personal grooming products, home and garden products like Hot Shot, Cutter, Spectracide, and a sizable global pet products division, among other businesses. EBITDA and free cash flow have grown substantially since 2007, uninterrupted by the Great Recession. HRG has 139.202 million shares outstanding. Its stake in Spectrum Brands, valued at SPB's last trade of $22.96, is worth $637 million or $4.58 per HRG share. HRG also owns a recently acquired 3.7 million share stake in Canadian firm North American Energy Partners Inc. (NOA CN C$5.12), worth $19 million today or $0.14 per HRG share. There is also about $70 million of cash worth $0.50 per HRG share. That totals $5.22 per share in NAV, only 16.5% higher than the current stock price. So where's the big discount? Most of the obvious upside potential lies in Spectrum Brands (SPB $22.96), which looks absurdly undervalued, trading at a Total Enterprise Value (TEV) of $2.95 billion which is only 5.9x the $500 million in EBITDA we think they can produce in 2012, and a market cap. of only $1.2 billion, or 6.0x the $200 million in Free Cash Flow (FCF) the company has forecast for 2012. Comparable companies trade at much higher multiples. For example, Clorox (CLX $67.75) currently trades at a TEV/EBITDA multiple of 10.0x, and a market cap. to FCF multiple of 11.7x. Fortune Brands (FO $55.31) currently trades at a TEV/EBITDA multiple of 10.8x, and a market cap. to FCF multiple of 12.0x. We estimate Spectrum Brands would be fairly valued at $48 per share, which would be a TEV/EBITDA multiple of 8.5x and a market cap. to FCF multiple of 12.5x. If Spectrum Brands were to hit our estimate of fair value, HRG's stake in SPB would be worth $9.57 per HRG share. Another source of upside potential comes from HRG's recent $350 million acquisition of a life insurance company from Old Mutual PLC called Old Mutual U.S. Life Holdings, Inc., which has now been renamed Fidelity & Guaranty Life (FGL). HRG issued $350 million of 10.625% senior secured notes due 11/15/15 in order fund the deal which closed in April 2011. In HRG's
quarterly results released last night, they state the current equity value of that acquisition is now $625 million, which adds $1.98 per HRG share in incremental NAV net of the $350 million associated debt. That mark-‐up could be conservative because FGL's subsidiaries had statutory capital of $941 million as of 07/03/11, with net income of $39 million in Q2 2011 alone (excluding investment trading gains). And they control a massive float ($17 billion in assets under management). If Falcone can improve the investment returns on that float, even slightly, it could result in huge returns on the capital invested to acquire that business. HRG also created a reinsurance subsidiary to hold and invest reinsurance reserves on the life-‐insurance policies and annuities of FGL, another chunk of float for Falcone to invest. So FGL may really be worth around $700 million (74% of statutory capital), and that $75 million in incremental value above current book value would add another $0.54 per HRG share to NAV. HRG subsequently issued $150 million additional 10.625% senior secured notes, capital which we think will be used to fund the reinsurance company, but not effecting NAV yet. HRG has raised equity capital twice in the past three months. In May 2011 HRG sold $280 million in convertible preferred stock (8% dividend rate) to Fortress Investment Group (FIG) and Wilton Re, convertible at $6.50 per HRG share. And on August 5th HRG announced they sold another $120 million in convertible preferred stock (8% dividend rate), convertible at $7.00 per HRG share, to a number of institutional investors and pension funds. The value of those preferred stocks will accrete quarterly at annual rate of 4%, unless HRG grows its NAV at certain hurdle rates, in which case the accretion rate on the preferred will drop to 2% or 0%. So HRG has about $470 million in cash to invest right now (excluding $150 mil. we presume will fund the reinsurance subsidiary). Whatever their plan, one would think that in order to justify raising such expensive capital upfront, that HRG must have some strong sense of how and when they'd like to deploy it; presumably sooner rather than later. Lastly, it's important to note what HRG is not. HRG is Harbinger Group, Inc., not Harbinger Capital Partners, L.P., which is Falcone's hedge fund that invested $2.9 billion in LightSquared, a wireless spectrum owner that plans to build a 4G LTE network which will sell capacity wholesale to various wireless carriers. It appears that fund is in a liquidation mode, suffering heavy redemption requests from investors who are unsatisfied that what they thought was a value-‐ oriented / distressed assets fund is now so concentrated in a huge, illiquid, venture capital stage investment. And while HRG does not have any of its capital invested in LightSquared at the moment, given LightSquared's huge capital needs to build out its planned network, HRG might presumably be used as a source of funds for that venture at some point, which we would be against, unless LightSquared actually works out, in which case we'd be all for it. Billionaire investors go in and out of favor, just like stocks. And while the main impetus behind our interest in HRG is that their largest asset appears to offer 100% upside potential, we also think Falcone’s investment acumen, access to capital, and deal flow are not properly appreciated by the market at HRG’s current price. So even if it’s not destined to become another Berkshire Hathaway, it looks like a very good risk/reward trade-‐off to us.
Harbinger Group, Inc. (HRG $4.48) on 08/11/11 139.202 mil. shares outstanding, 93.3% owned by Falcone and Harbinger Capital Partners, L.P. (199.412 mil. fully diluted shares if preferred stocks convert) Assets (current value) Liabilities NAV per share $4.58 Potential Asset Value Potential NAV per share $9.57
Spectrum Brands (SPB $22.96) 27.757 mil. shares worth $637 mil. Cash $70 mil.
SPB at $48, worth $1.332 bil.
$0.50 Average target price of eight brokerage firms covering stock is C$8.54, worth $32 mil. $700 mil. ?
North American Energy Partners (NOA CN C$5.12) 3.7 mil. shares worth $19 mil. FGL at current book value of $625 mil.
$350 mil. 10.625% $1.98 notes
$150 mil. capital $150 mil. 10.625% $0.00 assumed for notes reinsurance company $280 mil. cash $280 mil. $0.00 convertible preferred stock convertible at $6.50 $120 mil. cash $120 mil. $0.00 convertible 8% preferred stock convertible at $7.00 TOTALS: $1.901 bil. $900 mil. $7.19
$12.82 ($10.95 fully diluted)
Christopher P. Mittleman Managing Partner / Chief Investment Officer
Past performance is no guarantee of future results. This is not an offer to buy or sell any securities. Partners and employees of Mittleman Brothers, LLC own shares in Harbinger Group, Inc. (HRG).
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