Here's the reply to my email from Michael Crimini in IR:
Thank you for your email. We do believe our stock is undervalued as Prospect has traded close to or above NAV for most of its history. The current discount has led senior management to purchase over $3.5 million in open-market shares in June and over $60 million since the company’s IPO in 2004. I don’t know of a better way for management to ‘stand behind’ the integrity and performance of a company than to put its money where its mouth is.
If you have any further questions, please do not hesitate to contact me.
Eliasek said during his recent presentation that Prospect intends to monetize the CLO, owned real estate, and peer lending businesses for robust prices. In other words, management intends to receive cash proceeds from the spinoffs. If management cared one whit about shareholders, it would use the cash proceeds to buy back PSEC shares which are currently trading at a roughly 30% discount to stated book value. It would be crazy if management uses the money to buy more "level 3 assets", ie more illiquid loans of the type they already hold in their portfolio. But, the way this management crew operates, doing what ever they can do to enrich themselves while giving short shrift to shareholders, almost nothing they do would surprise me.
Okay, but then what is the point of PSEC sending out written notices via U.S. mail to all PSEC shareholders to notify them of an existing share repurchase authorization? Is it just some kind of head-fake? Why go to the expense of sending out over 10,000 notice letters if the Board has no intention of buying back shares? And, if PSEC is making investments that yield 20%, then why did they have to slash the dividend last December?
I want to know if the Board of Directors really walks the walk. The stated book value of PSEC shares is $10.30, so PSEC shares trade at roughly a 30% discount to book value. I'd like to know if the Board of Directors really thinks PSEC shares are worth $10.30. If they do think the shares are worth $10.30, then they ought to be buying back shares hand-over-foot, thereby boosting shareholder value by retiring shares at $7.42, thereby realizing $2.88 worth of value for each share they buy back. On the other hand, if the Board knows that the $10.30 stated book value is questionable, perhaps because the "third party valuation" of level 3 assets has been set with a wink and a nod, then obviously they won't be eager to repurchase shares. I always say, "Look at what the PSEC Board does, not what they say."
As a PSEC shareholder, I received written notice via U.S. mail of the previous approval of a share repurchase plan by the PSEC Board of Directors. PSEC stock currenly trades at a roughly 30% discount to stated book value. My questions are: Does the PSEC Board of Directors think that PSEC stock is undervalued at this level? And, if the Board feels PSEC stock is undervalued, has the Board directed management to buy back shares in the open market on behalf of the company?
In my opinion, the main investment thesis for owning shares of NRF is that Hamo is going to spin off NRE as a "pure play" reit, which he expects to trade at a premium to what he paid for the underlying assets. Recent corporate presentations telegraph that the NRE spinoff will likely be followed by other "pure play" reit spinoffs. None of the spinoffs has happened yet, so its too soon to evaluate whether this strategy will succeed in creating shareholder value as hoped.
I would liken this situation to a baker baking a chocolate cake. If you taste it before the cake is through baking, it tastes like syrupy sweet glop, so you might then conclude, "This cake is a failure, and the baker has lost his touch", when in reality you are trying to judge it too soon. I realize that stock investors are a fickle, faithless lot who tend to be assailed by their own doubts about management's direction and strategy, and are prone to fall into despair, and dump their shares if the share price dips even temporarily. I would advise patience in regard to NRF. Hamo has a long track record of successfully creating shareholder value through financial engineering, so I think one should give him the benefit of the doubt in this instance. I would also point out that the shares of most reits and all mortgage reits have recently pulled back because of investor jitters over Greece and possible Fed rate increases. It is highly likely that Hamo's strategy of creating shareholder value will succeed in the fullness of time, rewarding patient NRF investors.
I'm of the opinion that management isn't limited to creating shareholder value by simply issuing shares, and then using the cash proceeds to make accretive investments. To me, the main investment thesis for owning NRF shares is that Hamo plans to spin off NRE to NRF shareholders, and company presentations make the case that NRE's assets will trade at a higher multiple post-spinoff. I believe NRF's main investment thesis is that Hamo is going to spin off NRE, and then possibly healthcare properties, New York properties, etc., as "pure play" reits that trade at higher multiples (ie, lower dividend yield) that NRF does currently.
I've been an NRF shareholder since 2009, and it is clear that Hamo is a master-of-the-universe type New York investment banker who is able to pull off some amazing feats of financial engineering. Like the time back in the dark days just after the financial crisis when he bought a CDO for a song, and then did some little tweaks, and suddenly the CDO was gushing free cash flow for the benefit of NRF shareholders.
In recent presentations, Hamo is telegraphing that he intends to continue to spin off "pure play" reits from NRF that trade at a premium. If it were anyone else besides Hamo, I'd be more skeptical about the likelihood for success. But, Hamo has a long track record of value creation for NRF shareholders, so I want to stay on this bus. So far, Hamo has been delivering the goods to NRF shareholders. Although I suppose it would be nice if each individual capital raise and subsequent investment is accretive to shareholders, I believe it is more important that such investment cycles further the ultimate goal of creating shareholder value via spinoffs of "pure play" reit(s). If Hamo comes through on NRE and other spinoffs of "pure play" reits, that will constitute a kind of "financial alchemy" in which he buys various assets, and then is able to reconstitute them into reits that trade at a premium to what he paid for them.
What the market sees is declining rig dayrates combined with declining utilization. All the drillers are getting hit by this "double whammy", but PGN is getting hit harder, because it has mostly old, standard spec jackup rigs that are employed on shorter contracts. I think PGN can continue to produce strong free cash flow as long as it can keep its floaters contracted. If Petrobras were to terminate those contracts, then PGN's situation would be dire, but so far that hasn't happened.
Through all of 2015, standard jackup dayrates have been declining and rig utilization has been falling, and that is likely to continue through the end of 2016. After that the outlook is cloudy at best. It's difficult to see a catalyst to turn the market around. As Paragon works down its backlog, it isn't able to sign enough new contracts and extensions to keep its backlog from shrinking. That means revenue, earnings, and free cash flow will continue declining at least through 2016. Again, it's hard to see when or if a turnaround will begin.
I expect Paragon to kick off $150 million of free cash flow in 2Q, and at least $100 million each quarter for 3Q and 4Q of 2015. That will go a long way toward reducing Paragon's bond debt, since they can purchase it for less than half of face value. I can't see any other use for the cash as compelling as buying back senior bond debt.
goskiing, we'll soon know if management has stepped up senior bond purchases. I expect PGN to report free cash flow (before capital investment) in 2Q of at least $150 million. It will be interesting to see how they spent that money. If they didn't buy back senior bonds trading at less than half of face value, they are brain-dead.
newpikachu, I do intend to drop IR a line to recommend Paragon buy back discounted bonds using its free cash flow. Although, I'm 95% sure management is one, two or three steps ahead of me. Paragon management isn't as clueless as some on this board would have us believe. And, I'm convinced management is highly motivated to keep the company solvent, and to navigate the "rough waters" ahead. Paragon has a good chance to survive current weak industry conditions as long as its floaters stay contracted for the next few years. Key to financial sustainability will be Paragon's ability to retire a large chunk of its senior bond debt during the next two years. If Stilley's strategy is to buy back bonds at a discount, then the worst thing he could do would be to announce he intends to buy back bonds at a discount. If bondholders think Paragon in the market to buy back its bonds in a big way, then the bond price goes up. Stilley shouldn't trumpet his interest in buying back bonds, as that would be self-defeating. Rather, he should feign indifference. Stilley has long experience in negotiating deals, and I'm pretty sure he knows "who's on first". He may be better off waiting until individual bondholders approach Paragon about buying back their bonds.
goskiing99, I sympathize with your anxiety, as the stock price has cratered, and that doesn't inspire confidence in Paragon or its management. But, I'm not sure the management actions you propose are truly in the interest of stockholders. The way out of Paragon's existential dilemma is to buy back its senior bonds at a steep discount using its huge free cash flow. In order for that strategy to succeed, the bonds need to continue trading at half of face value or less. So, ironically, it would be counterproductive for management to do anything to reassure bondholders that Paragon will pull through. In other words, it's in shareholders' interest for management to appear to be feckless, so that the senior bonds continue to trade at a steep discount. That will allow management to continue to buy back the bonds for half or less of face value. If management were to buy PGN stock in the open market as a demonstration of their confidence in Paragon's prospects, although it would likely boost shareholder morale, it would also boost bondholder morale, and would likely boost the value of the bonds Paragon needs to buy back. That's why stock purchases by Paragon management are self-defeating. In terms of Paragon's sustainability, it would be more effective if Paragon insiders sell PGN stock, which would serve to fan the flames of investor panic, likely causing both the stock and bonds to trade lower.
Management was busy closing the Prospector acquisition. During the last six months it has become clear to management that reducing debt is a top priority. I expect management to ramp up purchases of senior debt at half or less of face value. The free cash flow is available for Paragon to pare its debt, and buying back debt at 43% of face yields a roughly 16% cash-on-cash return on investment. There isn't any other investment that produces a higher ROI. With the paucity of tenders for new contracts, Paragon won't buy rigs on spec.
I've seen similar situations where the bondholders panic and a company is able to buy back its debt at half of face value, eventually retiring a huge chunk of their debt. This is doable!
Again, Paragon isn't even close to being insolvent. Paragon produced $210 million in free cash flow last quarter. I anticipate Paragon will produce at least $150 million in free cash flow in the current quarter, and at least $100 million of quarterly free cash flow for the remaining two quarters in 2015. (The foregoing assumes Paragon doesn't sign a single new contract or extension.)
Paragon senior debt is selling at 43 cents on the dollar. If Paragon devotes its copious free cash flow to buying back senior debt at half of face value, then it should be able to pay off half of its balance sheet debt by 2021 when it needs to refinance the term loan. This is doable!
After the Prospector financing closes in 3Q, Paragon will have roughly $1.7 billion of balance sheet debt. If Paragon applies $200 million of free cash flow to buy senior bonds, it should reduce debt to $1.3 billion by the end of this year. I'm guessing that Paragon can reduce the debt balance to $700 million by the end of 2016. Backlog stood at $1.7 billion at the end of April 2015 after reflecting the Pemex contract cancellations. Paragon doesn't actually have to sign new business to pare its debt because the debt is trading at 43% of face value. I've seen other companies do this.
Errata: I stated in a previous post that the term loan is due in 2019. That's wrong--it's due in 2021. Basically, Paragon has six (6) years to clean up its balance sheet by buying back senior debt before it has to refinance the term loan.
By my reckoning, even if Paragon doesn't sign a single new contract or extension, it will still be kicking off $100 million of free cash flow by 2015 4Q. So, if I were Stilley, my strategy would be to use all of that free cash flow to buy back Paragon's bonds at half of face value or less. The bonds are trading at 43 cents on the dollar or so. If Stilley devotes all of Paragon's free cash flow through the end of 2016 to buying back bonds, he should be able to retire at least $800 million face value of bonds. Look--this is absolutely doable! He needs to ignore the term loan due in 2019, and just put every cent of free cash flow into buying bonds at a steep discount. If he does that, then he'll be able to refinance the term loan when it comes due in 2019, because half of Paragon's current debt will be paid off by then. The balance sheet will be sustainable, and Paragon will be creditworthy enough in 2019 to be able to refinance the term loan.
It is noted that in 2015 1Q, Paragon generated $210 million of cash from operations, and spent roughly $51 million on capital investments. In other words, after Paragon spent $51 million on capital investments, the cash left over from the first quarter cash from operations was enough to pay its debt service for the next 3 quarters. I expect Paragon to generate nearly as much cash from operations in 2015 2Q as it generated in 1Q.
For the record, Stilley bought a pile of PGN shares last December. It might be worth remembering that Stilley's financial well-being is totally dependent on Paragon. Any financial advisor worth his salt would advise Stilley to diversify his investment portfolio, and not to load up on shares of Paragon, because 100% of Stilley's income from employment is derived from Paragon. That is the conventional financial advice that financial advisors give executives like Stilley.
I believe Stilley is diligently pursuing new business, and is making every effort to secure contract extensions. But, the total number of rigs in service is falling across the industry. Stilley can't win new contracts unless there are tenders. I'm confident that Paragon's standard rigs are competitive for many applications, especially for workovers and development work. The stock price has been crushed and suggests possible bankruptcy. Paragon's existing backlog seems to indicate that bankruptcy isn't in the cards, at least through 2016.
It stands to reason that spinoffs of the CLO, online lending and real estate businesses will trade at higher multiples than PSEC does currently. Eliasek stated during the web seminar a week ago that PSEC will look to reinvest the cash it gets from the spinoffs at similar or higher yields than those the spun off businesses were generating, so PSEC's dividend shouldn't be much affected post-spinoffs. The spinoffs all have higher internal ROIC than PSEC does, so should trade at higher multiples than PSEC. Industry comps support this assumption. Investors have a right to be skeptical or even cynical after the dividend cut last December, and considering the fact that the rapid growth in PSEC's assets over the last few years haven't benefited shareholders. But, I still think the planned spinoffs will create shareholder value at the end of the day. And, although many shareholders have questioned management's motives, it can't be denied they have been making large PSEC share purchases recently. So, now John Barry owns over 5.3 million shares after recent purchases. Based on the current PSEC share price, his timing doesn't appear to be prescient. Still, it is noted that he recently bought PSEC shares at their largest discount to book value since the financial crisis, and the spinoffs could be the near-term catalyst for shareholder value creation. It doesn't appear that the market is ascribing any value to the spinoff plan, so it would surprise me if John Barry's PSEC share purchase of last week is in the red a year from now.