LHX - Steel Partners Should Come Back With A More Equitable Offer For Steel Connect

Summary

• Steel Connect has a large amount of tax assets on its balance sheet.
• These are valuable to Steel Connect or to its major shareholder Steel Partners.
• A previously proposed deal was rejected by Steel Connect shareholders.
• It seems likely, after some time, Steel Partners will come back to the table with a more reasonable offer.

Steel Connect ( STCN ) is a U.S. based global supply chain service provider formerly known as ModusLink Global Solutions. It is an operation of modest size and STCN has a market cap of only $86 million. However, the company is also sitting on a huge amount of "net operating losses"(over $2 billion worth of these). You are probably thinking; "great, they're sitting on huge losses..." "Tell me more please." But among value investors these are often considered interesting as NOLs, as they're called, can be utilized to offset future profitability. The company and the market often heavily discounts NOLs if the operating company that holds them isn't profitable enough to be likely to ever use them. This is sometimes made extra difficult because NOLs expire after time. Federal NOLs tend to take a long time to expire, but ultimately they do. Most of STCN NOLs expire somewhere in the 2040's though so that gives them some time.

Once upon a time there was a lot of activity around NOLs and companies would actively buy up empty shells (with NOLs) to use them to offset taxes. But that's been made a lot more difficult. In addition corporate taxes have trended down in the U.S. which makes NOLs clearly less valuable. Interestingly, I think you can make a point that inflation slightly increases the value of NOLs that previously couldn't be fully utilized.

Steel Connect has a 50% shareholder called Steel Partners Holdings ( SPLP ) and this allows that company to buy the rest of Steel Connect without triggering rules intended to stop companies from acquiring what are essentially tax offsets. Steel Partners Holdings has a market cap of $920 million. It generates greater profits so it would be able to benefit more from the NOLs. In addition Steel Partners Holdings owns 4.95% of defense company Aerojet Rocketdyne Holdings, Inc. ( AJRD ). From my cursory review so far it also looks like Steel Partners is a very interesting company in its own right. I hope to go into that at a later date.

A stake that's worth around $232 million based on the deal struck with L3Harris ( LHX ), a strategic acquirer, to buy the company. That's before taxes though and as AJRD is being acquired by L3Harris we'll need to see if the deal closes. A previous deal with Lockheed Martin ( LMT ) was ultimately blocked.

The deal spread is fairly modest in the AJRD LHX deal. Shares are trading at around ~$56.9 while it is being acquired for $58. That's a spread of roughly 1.9% and it will be a while before this big and somewhat sensitive deal will close (announced in December 22').

Previously Steel Connect actually had an offer in place from Steel Partners to acquire it at $1.39 and a contingent value right. The contingent value right would be based on the sales price of the ModusLink operations for a price in excess of $80 million. This more or less implies a fair value of $80 million for that company and that Steel Partners acquired the 50% it didn't own to be able to utilize the NOLs.

The purchase price also implied they were paying very little to get access to these NOLs. Steel Connect holds around $59 million in cash (arguably a bunch of it is needed to run the business), per last quarter it does $51 million in revenue, $14 million in gross profit and $3.8 million in gross profit. EBITDA is around ~$8 million and free cash flow ahead of ~$7 million.

That deal was vehemently opposed by my fellow contributor Hillandale Advisors. You can read their latest work here . They also publish communications (like letters to the board) related to this investment on their website which you'll find here .

Hillandale argues that SPLP was underpaying for the NOL's and suggested a different deal structure:

We are open to an alternative structure where SPLP appropriately shares in the significant tax savings expected from STCN’s $2 billion in tax assets. We have proposed a structure where minority shareholders could be granted “Tax CVRs” (contingent value rights) for 50% of cash tax savings at SPLP, which could deliver an additional $2.00+ per share to STCN’s minority shareholders, who hold roughly 38 million shares.

This is something of a classic ultimatum game situation . SPLP owns 50% of the Steel Connect shares. Because of tax rules it is the only viable option to take over Steel Connect. However, if it doesn't share any of the tax advantages with Steel Connect shareholders, these have minimal incentive to let the deal pass and feel cheated.

In the Ultimatum game to players have to split $100 and player 1 may propose a split ($75 for them and $25 for the other or $50 each, etc.). Player 2 can either reject or accept. Rationally, player 2 should accept ANY split because anything is better than nothing. However, we are humans and we don't like to be treated what we find is unfairly.

In real-life I'd argue there's also a meta-game going on, where you don't want to roll over on a 99:1 split now if this information is publicly available. You'll increase the odds of getting put in tough spots in later situations as well. That's what happens to funds that get low-balled out of this investment proposition here. SPLP is also somewhat of a serial acquirer so the odds of something happening again are less than remote.

Another thing that's different about real-life is that there is no real ultimatum. Steel Partners can lay down a deal but Steel Connect can more safely reject it as long as the NOLs haven't expired. Even without the deal it can squeak out some value out of the NOLs.

The L3Harris acquisition of Aerojet could provide a nudge here (because it will bump taxable profits substantially) for Steel Partners to return to the table with a more equitable offer designed not to trigger deal rejections. If a deal is off the table I can see this trading down between $0.70 - $1 per share because special-situations investors sell out. However, I'd argue it makes a fairly compelling buy at that level given this is a profitable company and it could grow and utilize some of the NOLs itself over time. On the upside it appears shareholders like Hillandale would accept ~$3.35.

All parties would be best off if Steel Partners came to the table with an equitable deal and this got solved. I think there's no rush to buy a stake here although I obviously wouldn't mind if things were solved quickly. I have a small stake and intend to build it when shares dip now and then and time passes. I do believe both parties understand the positions they are in and as the Aerojet deal closing draws nearer, Steel Connect's position becomes stronger. Steel Connect can get the most value out of its NOL through cooperating with Steel Partners. Steel Partners can only get at any of the value of the NOLs coming through with an offer that doesn't anger Steel Connect shareholders.

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