Once upon a time..
A long time ago in a galaxy far away companies had human resource departments brimming with staff. The HR department was responsible for all sorts of miscellaneous functions such as managing defined benefit plans, screening and verifying employment candidates, and payroll services. Eventually a company figured out they could provide these HR services for many companies at once and due to economies of scale reduce costs for clients. The Professional Employer Organization (PEO) was born. Companies started to outsource HR functionality and reduce HR headcount, PEO firms prospered and everyone was happy. Well not everyone, employees pine for the old days when they could walk down the hall to ask a question instead of calling a 1-800 number.
Fortune Industries was formed in 1988 as a combination of three PEO organizations Century II, Employer Solutions Group, and Professional Staff Management. The three subsidiaries are amongst the oldest PEO's in the country and are considered market leaders.
The company was founded and run by Carter Fortune who remains the Chairman of the Board.
Uncertain way forward
The company is closely held with over 60% of the common shares owned by Mr. Fortune, the CEO Ms. Mayberry, and the CFO Mr. Butler. Outside shareholders currently own about 32% of the company. The company also has a class of preferred stocks which is entirely owned by Mr. Fortune which pays him a generous dividend.
What could go wrong with this? The company is humming along on all cylinders, reporting profits and recovering from the recession. Well it seems the Director Mr. Fortune had a bit of financial difficulties on his own. He pledged his shares in Fortune Industries to the Bank of Indiana as collateral for a loan. Then Mr. Fortune was diagnosed with a terminal illness and went into default on his loan. The bank that holds the loan was working to re-negotiate but was purchased by a larger bank. The bank holds a lien on Mr. Fortune's shares. What a mess!
The company didn't want their largest shareholder to be a disinterested bank so they decided something needed to happen. They offered Mr. Fortune's stake in the company up for sale, a few buyers materialized but weren't able to secure financing. The Board then hired consultants to devise a way forward. The consultants recommended to the company that they do a reverse merger and cash out small shareholders, delist and save $150,000 a year. Then they recommended that a new entity purchase the company and convert the onerous preferred shares into a amortizing bank loan paid down over six years. The result of this transaction would be the CEO, CFO, and Mr. Fortune would own 91% of the company with $12m in debt of which $6m will be owed to a bank and $6m will be owed to Mr. Fortune. The money from the bank loan will be used to pay Mr. Fortune $6m in cash, and the other $6.3m will be given to him in dribbles through the payment of his note. The bank loan has an interest rate of 6% while the note to Mr. Fortune bears a rate of 10%.
When the company announced their plan shares were trading in the $.46 range with consideration given to small holders paid at $.61 a share. The shareholder base doesn't seem to like the plan and presumably they've been selling their shares in droves with the price most recently at $.16 a share.
The above two sections are a lot to digest, so take a break and go get some coffee. If you've made it this far we now need to think about two things, what will this company look like going forward, and with the sharp fall off in share price is there any opportunity here?
To get a grasp of what the company could look like once the merger is complete I think it's appropriate to look at a pro forma balance sheet and income statement.
I took the latest quarterly balance sheet and lumped in the new debt to create an estimate of what Fortune's balance sheet might look like on the day the merger is consummated:
My first thought when working through this was it's incredible how quickly wealth is transferred with debt. This was a company with a book value of $17m that is reduced to $6m in this transaction. The shares are currently trading slightly above book. Something to remember is over the next six years book value is going to double which is growth of 12% a year. This is simply due to the reduction of the bank loan. If the company used their cash to pay off Mr. Fortune it would reduce interest expense but wouldn't change the balance sheet at all. I think this might be part of their strategy, use some cash on hand to pay down a portion of the loan to the founder. Keep this thought in the bank of your mind when looking at the income statement.
In the company's going dark filing they published a nice income statement showing the results over the past few years in addition to what they expect to earn in the next two and a half years. Of course no one knows the future, but these seem like reasonable estimates so I built my model with them.
I used the number of shares that will exist after the merger is complete for past results for comparability sake. I also removed the SEC reporting costs the company expects to save in the future. As you can see the projection is very similar to a leveraged buyout. As the company pays down the bank loan interest costs decrease and net income increases. Earnings should increase even if the company just treads water.
Debt will be 3x EBITDA and interest coverage will be covered by EBITDA 4.73x. This income statement could change a lot with a few simple tweaks by management. For example if they decided to use half of their cash on hand to pay down the Fortune loan net income would increase by $.004 to $.032 a share, a noticeable difference.
Good, bad, indifferent?
I think this transaction is good for the company, there is a lot of uncertainty if they continue down their current path. While the transaction is good for the health of the company shareholders weren't pleased. There are a number of ambulance chaser lawsuits and shares have sold down to $.16 a share. But all is not lost for someone who buys today. A buyer at this price gets a company with a P/E of 5.35 at slightly above book value. If they hold for the next six years and the company is able to pay off their loan book value will grow to $.22 a share and earnings could be in the $.05 range. If trades at the same multiples in six years as it does today it could easily be a double.
Under a best case scenario the company is able to pay off both loans in the next six years which would result in a book value of $.56 p/s. Doing that would increase earnings by a cent or more per share. Instead of owning a double this could be worth 4x the current price or more.
Of course a lot of things could go wrong as well. What was a very conservatively financed company has now become much riskier with a leveraged capital structure. If the economy hits the rocks again Fortune could have a hard time paying down the loans and the built in increase in EPS and book value could never materialize. There are plenty of private equity shops that built out little models like mine in 2007 who are looking at much different results right now.
Of course I'm no expert in looking at these situations, so if you see an error or something I missed please let me know!
I want to thank a reader for sending this idea along to me.
Talk to Nate about Fortune Industries
Disclosure: Long a small amount of shares for the odd lot tender