GECC - Great Elm Group: Hello Small-Cap World

Summary

• During the first week of January 2023, Great Elm Group made two transformative divestures.
• This includes selling its equity ownership interest in Forest, to JPMorgan, for $45 million (if the 1/15/23 put option is exercised) as well as selling its DME for $80million.
• Post deals, and the DME deal is complete, Great Elm has $1.94 per share in net cash and investments. You're buying the remaining business for a low valuation.

Great Elm Group, Inc. ( GEG ) is a small cap business that's under the radar, trades as a very low valuation, and Mr. Market hasn't paid any attention to its two transformative 2023 divestures. In fact, these two divestures both were announced during the first calendar week of 2023, and they dramatically improve GEG's balance sheet and greatly simplify its business structure. The icing on the cake is management and the board are significant insider owners (at least 42% of the equity) and have been steady buyers of shares, on the open market, during various open trading windows.

Lo and behold, there's no sell side coverage of this business, so I decided to share it with the small cap world.

Hello (small-cap) world!

The Two Transformative Deals

1) Selling its Equity Ownership in Forest for $45 million (if the 1/15/23 put option is exercised)

During the first week of January 2023, Great Elm announced a sale of its ownership interest in Forest, one of its subsidiaries, to JPMorgan ( JPM ). The first tranche raised $18 million from the sale of 61% of the common equity and the second tranche is a put option for the remaining ownership interest in the business, exercisable as of Jan. 15, 2023. If exercised, this would raise an incremental $26.5 million.

2) Great Elm Sold its DME business to publicly traded Quipt Home Medical Corp. ( QIPT ) for roughly $80 million.

This sale has been completed and after retiring $37.7 million of 9% preferred shares (the HC LLC, Series A-1 and Series A-2), Great Elm received $26 million of cash and 346K shares of Quipt for its 80% equity ownership in this business.

If you reviewed Great Elm's most recent 10-Q, for the period ending Sept. 30, 2022, and prior to these two January 2023 transactions, you would've noticed Great Elm had $72.7 million of 9% preferred stock outstanding. The sale of the DME business eliminated the HC LLC (the Series A-1 and A-2 preferreds) and if Great Elm exercises its put option, in Forest, the Forest preferred stock moves over to JPM, as they own the entire capital structure of the business, post transaction.

Moreover, and as you see below, post transactions, GEG now has $1.943 per share in net cash and investments. This is a dramatic improvement in its capital structure and equity risk profile, as its relatively high coupon 9% interest, via its preferred stock, is now gone. This results in a big annual interest expense savings.

In terms of the remaining debt, Great Elm has $26.945 million outstanding on a 7.25% baby bond ( GEGGL ). In addition, the company has a $36.1 million outstanding on its 5% convertible bond. This bond is in PIK status and has an exercise price of $3.4722 per share. There's also a 6.5% Seller Note due August 4, 2023 and associated with its Monomoy UpREIT investment management agreement.

Going forward........

You have an alternative investment asset management company. If you read Great Elm's 10-K, outside of its now former DME business, which was sold to Quipt, Great Elm should only have about 20 employees. So this business can definitely scale as the SG&A is relatively capped and fixed (and there mostly variable costs tied to performance).

And as you can see in the slide above, GEG is now greatly simplified.

They own 35.4% of the equity in publicly traded Great Elm Capital Corp ( GECC ), which is a BDC company.

And as of May 2022, they also own the investment management agreement on Monomoy REIT.

Enclosed below, they earn a 1% to 1.5% on management fees on GECC's assets ($221 million, per the slide above) as well as Monomoy REIT's real estate assets (currently $207 million, per the slide above). There's also a 4% of rent collection fee and there are incentive fees based on performance above certain hurdle rates. Also, please note, the overall AUM is $650 million, however, GEG doesn't collect a fee on cash or treasuries, so it is only "capital at risk" where they can earn fees.

The cash flow characteristics of an alternative investment asset management company are attractive given the long duration nature and consistency. Again, the underlying investments are in well curated assets and expressly designed to own long duration assets. Therefore, and to be clear, we are talking 'at scale', these can be strong cash flow generative businesses.

Putting It All Together

Earlier last week, Great Elm made two transformative transactions, yet Mr. Market hasn't yet noticed.

The company did a laudable job of buying and growing its DME business. The DME business generated $60 million of annual revenue and $13 million + annual Adj. EBITDA (FY 2022). Quipt liked the business and was happy to pay 6X Adj. EBITDA to take it off Great Elm's hands. Now Great Elm has a streamlined balance sheet, as well as plenty of cash to opportunistically grow its Alternative Asset Investment Management business.

Also, and many small cap investors are very keen on management having skin in the game. Well, in the case of Great Elm, management is very aligned with shareholders and own at least 42% of the equity. Executive Chairman, Jason Reese, CEO, Pete Reed (via Northern Right Capital Asset Management LLC), and Director, Matt Drapkin, are large holders.

As Great Elm Group's quarter just ended, as of 12/31/2022, management would be in a black out window for additional insider buying, should they be so inclined, and would have to wait for the release of earnings and then usually wait at least another 48 hours.

However, at least if GEG shares continue to go unnoticed and trade in the low $2s, I would venture to guess, management might be inclined to opportunistically add. Again, we won't officially know until mid to February 2023.

In closing, Great Elm has 30 million shares outstanding and has $1.94 in pro-forma net cash and investments. At $2.30 per share, the Jan. 9, 2023, closing price, you are only paying about $10 million for this business. And the company still has over $150 million of NOLs, post the Forest transaction. With a streamlined balance sheet, and plenty of cash, this is a great moment in time to have dry powder and be well positioned to opportunistically take advantage and acquire new alternative investment management assets.

Lastly, just to reiterate, this investment checks all the boxes for me:

1. Under the radar
2. Trading at a highly attractive valuation
3. Has a recent catalyst that is balance sheet transformative and simplifies the structure
4. Is a business with a management team that owns a lot of equity and interests aligned with shareholders

I would argue that fair value is closer to $3 per share and there is upside beyond that level upon further evidence of smart growth initiatives and capital deployment. That said, there's might be some overhead resistance, once you get in the low $3s, given the convertible's $3.47 exercise price.

For further details see: