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ADVC Reverse arbitrage gone, But value opportunity remains

January 24, 2013 | About:

A few weeks ago, I wrote about the arbitrage opportunity represented by ADVC’s reverse tender. Right after I put that article out, the company decided to cancel the reverse split. While you still could have made a profit if you had sold pretty quickly after the announcement, shares have drifted down since the split cancellation and special dividend payout. So the reverse split’s cancelled, arbitrage opportunity gone, end of story. Time to move on, right?

I don’t think so. In fact, I think this is the beginning of a major value opportunity.

To review why, let’s step completely away from the stock.

I think there are two specific things that separate Buffett and other great investors from the rest of us. The first is their willingness to bet big when the odds are in their favor. The most obvious example of this willingness would be John Paulson w/ subprime mortgages (as detailed in The Big Short), but I think you’ll find plenty of examples from Buffett’s investing past if you do a bit of digging (American Express post salad oil comes to mind). This “bet big” willingness is pretty well known and cited. It’s the reasoning behind all of the “anti-diversification” thinking out there.

But the other, lesser known trait that I think great investors have is their pure pattern recognition. Great investors have extensively studied business, history, and past investments, and they can lean on those studies to recognize when the potential for a big opportunity is developing.

I’ve mentioned this “case study” style before. For example, I’ve (very) loosely compared an investment in Dreamworks (DWA) today to Buffett’s investment in Disney in the 60s.

So let’s do our own case study. We’ll call it the “profitable company getting taken private” case study.

And we’ll use our friend Gannon’s investment in Bancinsurance as an example (see here and here and here and here).

In case you’re too lazy to read the case study, here’s a quick summary.

  1. Bancinsurance had an ongoing SEC investigation. The stock was trading ridiculously cheaply compared to its history due to the investigation.
  2. The investigation is dropped. (Gannon buys shares here).
  3. The stock doesn’t budge for a few months, and then the CEO offers to take them private at a very lowball price (Gannon buys more and writes the board some unhappy letters, seen in the case studies).
  4. The CEO raises his offer price to something that’s still likely much too cheap, but the deal goes through. Investors make a nice profit, but probably still receive a price that’s lower than their intrinsic value.
So with that in mind, let’s go through an overview of ADVC and what we’ve seen.

  1. The company offers to take shareholder’s private at a ridiculous valuation. Many small shareholders express frustration (no links here, but I promise you can find some if you look).
  2. The company starts buying back shares at a ridiculously fast rate (4.3m, or over 6% of shares outstanding, in just more than 1 month).
  3. The company pays out a special dividend (you may remember from TSRI that I believe the cash from these special dividends may eventually be used to take company’s private)
  4. The company cancels the reverse split, citing various complications.
There are other similarities to Bancinsurance here

  • Both companies are run by a CEO w/ super majority (75% in Banc’s case, 55%-ish for ADVC).
  • Both have been consistently profitable cash machines
Of course, there are differences. Mainly, ADVC did not try to take itself private. It just tried to take itself dark by cashing out small shareholders.

So what the heck happened with ADVC’s reverse split?

I think minority shareholders were pissed at the price they were being offered. I wouldn’t be surprised if someone threatened to use dissenter’s rights or sue the company over the takeout (though I have no information to confirm that, merely a suspicion). It’s true that shareholders holding in any size (more than a few thousand dollars worth) would get to keep their holding, but the premium company was paying to go dark was pretty small IMO. In the end, ADVC probably looked it all over and decided that it wasn’t worth it to take so few shares out while risking such huge legal fees.

But there’s no doubt their still considering going dark. Simply consider this line from their release cancelling the split

The Company remains committed to the voluntary suspension of its public reporting obligations, which it intends to achieve as soon as practical.
Add it all up and I think you get this: ADVC is looking to go private.The CEO has freely admitted the only reason they went public was to raise money and they no longer need to consider that. I think the easiest path to go from here is for the CEO to offer to buy the company out- he just got a nice cash infusion from the special dividend, and add that up with the company’s net balance sheet cash plus the special dividends he’s received in the past few years and I think it’d be pretty easy to finance a bid. In fact, I bet he’s probably got enough cash to do the deal w/o any financing.

And I think the take out price just had a floor set: no way the CEO can come in and offer less than the 27 cents per share, especially if you believe the logic that they dropped the split idea because of the possibility of getting sued.

Side note: while the offer was $0.27 per share, the company also agreed to pay out a special dividend of $0.02 per share. Thus, I think it could be argued the effective take private price was $0.29 per share, and that may serve as the effective floor. This is unclear to me and (of course) the whole “effective floor” price is my own invention.

Ok, maybe now you’re thinking I’m crazy for seeing similarities here. These are two vastly different companies, and the situations are definitely different.

But even if you do think I’m crazy, the shares are downright cheap.

Remember, the company just bought back an outstanding 6.4% of their shares in a month. After adjusting for the share repurchase as well as their special dividend, the company currently has $0.044 per share in net cash on their balance sheet. They’re trading for an EV / EBITA of under 4x and an adjusted P/E (assuming 35% tax rate and adding back non-economic amortization) of under 7.5x.

O yeah, and they’re consistently growing their core business at ~8% per year while investing at ROIC’s way above their WACC.

In other words, the company is incredibly cheap even if you don’t believe me on the whole “they’re going private” thing. Management thinks shares are enough of a bargain at today’s price to buyback a ton of shares quite rapidly, and they’ve already tried to take them dark at a price above today’s.

Thus, I think it’s a huge opportunity. I’ve been aggressively adding shares, and will likely continue to do so.

Disclosure: Long ADVC

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The content contained in this blog represents only the opinions of its author(s). I may hold long or short positions in securities mentioned in the blog. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. Read that last line again. Also, this blog is not a solicitation of business. The content herein is intended solely for the entertainment of the reader and the author(s).

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