Titanium Asset Management…What A Steal?!

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appraisal rights, asset managers, AUM, Bob Brooks, Clal Finance, Delaware law, fixed income, TAM, TAM:LN, Titanium Asset Management

My asset manager addiction knows no bounds – here’s another I own:

Titanium Asset Management (TAM:LN)

Titanium was a SPAC IPO that raised $120 million (20 mio shares at $6.00) in Jun-2007. Aah, remember the glory days..!? The investment objective was to purchase a number of asset managers – and in little more than a year, facing into the worst financial crisis since the ’30s, they acquired four companies: Wood Asset Management, Boyd Watterson, Sovereign Holdings (since absorbed into Boyd), and National Investment Services. Well…I think you can guess the rest!

Actually, I’ve never really sat down & figured out if they overpaid, experienced a client/AUM exodus, suffered integration issues, lost key personnel, etc. Maybe it was all these & more! But if we fast-forward, the legacy of those acquisitions lives on – here’s a brief summary of the last five years:

Ewww, kinda nasty…

To add insult to injury: i) Clal Finance Ltd. owned a controlling stake in the company, with 5 directors on the board, ii) TAM shares are Reg S, restricted, residual, and settle by paper cert, iii) TAM’s a fish out of water, anyway – the company’s HQ’d in Milwaukee, incorporated in Delaware & listed in London! All this left the stock quoted at $0.35 last December, for a cumulative 94% price decline & a market cap of just $7.2 mio. Definitely not a stock for widows & orphans, or even most active investors…

So think of this write-up as more of a case-study – one which I hope you’ll find as fascinating as I have. I think TAM’s a classic example of the potential risks & rewards you face when investing in such small & unusual stocks. But it’s also a reminder astonishingly cheap businesses can (just as easily) be hiding in plain sight. [Donegal Investment Group (DCP:ID) & Universe Group (UNG:LN) are other good examples]. Basically, TAM’s a stock most people would otherwise never stumble across, but I’m sure it popped on plenty of stock screeners. And perhaps it even looked technically cheap – but I suspect that sorry history of declining AUM, stagnant revenue & never-ending losses persuaded most investors to quickly tag it as a no-hoper & move on.

But if you (like me) stubbornly prefer the Luddite approach of reading every annual report you come across, right down to the footnotes, you sometimes see a very different underlying financial/business reality. You also learn to evaluate this reality in terms of peer valuation methodologies & multiples. Put these together, and occasionally you end up with an exceptional low-risk high-reward investment opportunity on your hands. Let’s take a closer look – we’ll use the beginning of 2010 as our starting point, when a new CEO (Bob Brooks, who’s now Chairman) was appointed. Here’s a graph of AUM since:

This is troubling... Even if you (correctly) suspected the P&L losses were primarily non-cash amortization & impairment charges (which may genuinely reflect a collapsing intrinsic valuation), a declining AUM can suddenly turn into a destructive spiral which melts away remaining shareholder value. But take a second look – almost a billion dollars of AUM is categorized as Distributed Assets (vs. Managed Assets), reflecting fees earned on AUM/clients referred to Attalus Capital. This actually grabbed my attention first – referral fees are low (24.6 bps), but (very) high margin, and I wondered if there was future potential for in-house alternative investment management.

Unfortunately, from end-2010, this business/relationship suddenly went bad – and Titanium’s distributed assets began to steadily melt away. Now I must confess, in response, I wasted far too much time mapping out various AUM/P&L scenarios…until something clicked, and I decided to start over & track the business as if distributed assets simply didn’t exist (actually true by the end of 2012). Here’s how AUM looked on that basis:

Tells a very different story, eh?!

OK, underlying managed AUM growth isn’t spectacular – but that’s because almost 90% of AUM’s in institutional fixed income (separate account) mandates (the rest is in equities & real estate). Since clients tend to withdraw/spend fixed income returns, AUM growth often depends on new clients. And winning those mandates takes time, particularly in recent years. On the other hand, such assets are usually v sticky – especially true of Titanium, whose institutional client base is mostly composed of pension & welfare plans, and governmental & charitable organizations. Actually, if you dig deeper, underlying AUM growth’s actually under-stated in the past few years as TAM’s been unwinding a $700 mio TALF fund they raised back in 2009. Now, let’s look at the P&L – here’s management & incentive fee revenue since 2010:

This reflects growth in managed assets from $8.5 to $8.9 billion, and an expansion of their average fee from 24 bps to 26.8 bps. Now here’s adjusted EBITDA (with certain severance & settlement expenses excluded) over the same period:

I tend to ignore EBITDA (‘bullshit earnings‘, as Charlie Munger would say!), but with asset managers it’s actually a rare proxy for operating profit – since amortization’s usually a non-cash/non-economic charge (presuming AUM is stable/growing) & depreciation’s minimal. However, it’s always wise to corroborate any kind of adjusted profits against the cash flow statement. Here’s the development of free cash flow (broadly equiv. to TAM’s operating free cash flow here, as taxes & interest income/expense are fairly negligible):

Cumulative adjusted EBITDA is $5.7 mio vs. cum. free cash flow of $4.3 m. However, the aforementioned severance & settlement were actual cash expenses, so I estimate (cumulative) free cash flow was $6.0 m if we exclude them – which nicely endorses our reliance on adjusted EBITDA figures.

OK, time to move on to valuation – let’s use end-Nov, 2012 as a jump-off date as I began steadily buying shares just after the Q3-2012 results (from Nov to Feb-2013). Trailing 12-mth revenue is $22.3 mio, and adjusted EBITDA’s $2.2 mio, for a 9.7% operating margin. But wait… We know revenue, fee rates & margins are growing steadily, plus we also know intrinsic valuation ultimately depends on AUM (rather than current profitability). It’s entirely reasonable to expect peer operating margins of 25-35% can be earned in due course (via AUM growth/fee increases, expense reduction, cross-selling of equity & real estate strategies & general economies of scale). And if current management can’t achieve that, new management certainly could. In fact, another asset manager could probably capture far higher margins almost overnight – I mean, how many extra people do you really need to manage a larger fixed income portfolio?!

Let’s split the difference, and base our valuation on an average/assumed operating margin of 19.8% – which deserves at least a 1.75 Price/Sales multiple, in my opinion. But we also need to add net cash & investments of $12.2 mio (TAM actually has no debt, and we’ll assume the remaining $24.0 m of net assets are simply part & parcel of the asset management business). Which gives us:

$22.3 mio * 1.75 P/S + $12.2 m Cash/Inv = $51.2 m / 20.6 m Shares = $2.48 Fair Value per share

[NB: i) Valuing asset managers at Net Cash/Investments + X.X Price/Sales (or Y.Y% of AUM) is a pretty standard valuation approach. ii) Investors often assume fixed income asset management is a low-margin business – no, it’s low-fee, not a low-margin business! Admittedly, managers earn lower revenues (& have lower return-based growth) from their AUM base, so it takes longer for economies of scale to kick in. But once they do, 25-35% operating margins are just as common, and acquirers can usually harvest the biggest margin increases from fixed income acquisitions. iii) Yes, I’ve never been a huge fan of (regular) fixed income exposure, particularly as we near the possible end of a decades long bull run. But that’s just my perspective – in reality, a majority of institutional (& retail) investors will still devote a substantial portion of their portfolios to fixed income, regardless of outlook. A fixed income manager who develops sticky relationships, clocks up decent relative performance, and introduces new investment strategies – as TAM appears to be doing – can certainly still look forward to a stable/growing business].

So, let’s make sure we got this straight – at the end of November last year, TAM was a cash rich/zero debt company with an improving, profitable & cash generative asset management business. [I was somewhat concerned at the size of Clal’s stake, but suspected continued AUM/P&L growth & an eventual US listing might be more attractive at that point, rather than an opportunistic bid]. But it was still priced at only $0.35 a share & a $7.2 m market cap, vs. my $2.48 Fair Value estimate – offering a relatively low risk Upside Potential of 609%! No wonder I started buying, eh? 🙂

OK, find that upside hard to believe?! Read on…

Shortly after (just in time for Xmas), senior management (led by Bob Brooks, via TAMCO Holdings LLC) bought out Clal for $18.5 m – equating to a $1.75 per share, or 5 times TAM’s share price at the time! [This was after a failed third party bid for Clal’s stake, which I think helped management to negotiate a valuation based solely on current operating metrics]. If you assume a 9.7% operating margin deserved a 1.0 P/S multiple, plus net cash & investments, you’re looking at a value of $1.67 per share – remarkably similar to the buyout price]. Including their existing stake, management now controlled an aggregate 57.8% stake. Rather astonishingly, the market simply yawned – the yr-end market price was still just $0.35, a month later it was $0.65, and 3 mths later it only reached $0.80!

Then in April, management came back for another bite – or should I say, a bear hug – presenting a non-binding offer of $1.00 per share for the rest of the company! No, that’s not a misprint… Shareholders then suffer total radio silence of almost 5 months from the special committee appointed to consider the offer – surely a bloody record?! Followed by a September announcement, which somewhat predictably confirmed the committee were recommending the offer as ‘fair and reasonable‘ for (minority) shareholders – albeit at the slightly higher price of $1.08 per share. But c’mon, what’s there to complain about – the value of TAM’s shares has tripled! Well, there’s plenty of points shareholders might want to consider (note we’ve had two earnings releases since the original offer, here’s the latest):

– Management’s $1.08 per share offer is at a 38% discount to the $1.75 per share they paid in December, despite TAM’s improved operational & financial performance since

– Management’s offer is at a 45% discount to a recent discounted cash flow analysis of $1.95 per share performed by the company, as cited by the CFO in a memo to the special committee last month

– The offer values Titanium at just $21.3 mio – which effectively values equity (which the company asserts is unimpaired) at a 0.61 Price/Book ratio

– Adjusting for net cash & investments of $13.6 m, management’s only paying a 3.2 times Free Cash Flow multiple for the business

– Adjusting for $13.6 m of net cash/investments, management’s only paying a 0.31 Price/Sales multiple for a business that enjoys $24.8 m of revenue & an adjusted EBITDA margin of 13.8% (exc. a recent $266 K settlement). In similar fashion, the offer’s an incredible 0.087% of AUM (vs. a usual 0.60-1.00% of AUM peer multiple)

– Management’s only paying a 2.25 EV/Adjusted EBITDA multiple for Titanium

– Noting TAMCO Holdings’s 53.6% stake, they’ll achieve 100% control of $13.6 m in net cash/investments (plus a business generating $24.8 m in revenue), in return for a cash outlay of about $10 m

– The special committee left shareholders in the dark for almost 5 mths, and didn’t seek alternative offers (or consider a recapitalization). [Justified by TAMCO’s assertion it had no interest in selling its shares & wouldn’t support an alternative transaction!?] All shareholders received in return was a measly 8% increase in the offer price (which I also believe is far less than the step-up in valuation during the same period)

– The special committee engaged Berkshire Capital to provide a fairness opinion. Berkshire utilized only $1.2 m of excess working capital in its Enterprise Value calculation & a 17.5% discount rate. They also performed a comparison with current valuations for a (select) group of public investment management firms – on average, the TAM transaction’s valued at 75% of the minimum multiple & just 49% of the median multiple. Another comparison with prior (comparable) M&A deals was also performed – on average, the TAM transaction was valued at 116% of the minimum multiple & just 59% of the median multiple

– Since end-April, the TAM share price has actually been quoted/traded in excess of both the original & final offer prices. Even now, it’s quoted at $1.25 per share (based on a $1.10-1.40 bid-ask)

Really, how many more ways can I tell you this is one shitty joke of a deal… Hmm, judging by the metrics, maybe management thinks they’re buying some kind of mediocre Midwestern supermarket chain?!

And I haven’t even updated my current TAM valuation… OK, let’s add some fuel to the fire: As I mentioned, the company’s current revenue run-rate is $24.8 m. [Including $1.2 m of incentive fees (plus a last gasp $127 K of referral fees), which management indicates may be much lower this yr-end. But so bloody what? You only get to agree a takeover price once, these fees are only 5% of overall revenue, and I’m confident management will enjoy far larger cumulative incentive fees in the future]. Adjusted EBITDA’s $3.4 m, and let’s deduct depreciation this time ’round – giving us an adjusted operating margin of $3.3 m, or 13.2% – a continued & significant improvement on 2012. Again, I’ll split the difference (vs. a 30% margin) & base my valuation on an average/  assumed operating margin of 21.6% – which I think now deserves a 2.0 P/S multiple. Plus net cash/investments of $13.6 mio, of course, which gives us:

$24.8 mio * 2.0 P/S + $13.6 m Cash/Inv = $63.2 m / 19.7 m Shares = $3.20 Fair Value per share

[Exc. cash/investments, this valuation’s still equiv. to just 0.56% of AUM].

So, despite the huge share price rally, we still have an Upside Potential of 196% vs. the offer price! Well, to put it another way – management’s offer for the company is priced at an astounding 66% discount to my current fair value estimate. Investors should perhaps take comfort from that upside potential & margin of safety, and call management’s bluff. Yup, reject the offer & remain a shareholder, even if the company de-lists. [TAM was never a liquid stock, or an investor-friendly company, anyway!] If enough shareholders remain hold-outs, management can’t gain (complete) control & may not even be in a position to de-list the stock.

Well, it’s a nice theory…

In reality (as you may have suspected from the lower pricing of the bid), the UK Takeover Code is but a fond dream here. The company’s incorporated in Delaware, which lost the plot decades ago when it started putting management ahead of their masters – shareholders. But even I didn’t realize this was possible – the level of investor hold-outs is basically irrelevant! Actually, before I explain why, please ask your kids to leave the room first – this is really one nasty evil scheme…

It’s called the Top-Up: If TAMCO doesn’t manage to exceed 90% ownership, it can’t compulsorily acquire the shareholdings of investors who didn’t accept the offer. But not to worry… Titanium’s actually granted TAMCO (i.e. senior management) the right, if necessary, to purchase newly issued shares so that Tamco can ensure its ownership will ultimately exceed the 90% threshold!

Now, in theory, all is not lost – there’s no automatic acquisition of dissenters’ shares, i.e. shareholdings held by investors who are entitled to & have properly exercised appraisal rights under Delaware law. These dissenters can petition the Chancery Court for an independent determination of the ‘fair value‘ of their stake (plus interest) as an alternative to accepting the offered deal price. Of course, this can potentially turn into a long, difficult & expensive process – clearly something that’s probably best left to the big boys...

But it’s worth noting Wellington Management recently sold a 2 mio+ share stake above the offer price, and other institutions & hedge funds have previously reported decent shareholdings – it will be interesting to see who might possibly accept, reject or challenge the offer, or might otherwise opt for appraisal rights?!

Of course, if you’ve got a decent stake in TAM, I’d be delighted to hear from you – just email me at wexboymail@yahoo.com – thanks!

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