Tuesday, January 21, 2014

SWS Group, will they receive a higher takeover bid?

A company is worth what someone will pay, the ultimate cliche regarding fair value.  What happens when the price offered is far too low for the value to be received?  Investors love to purchase businesses at a discount in the market. Yet when a company makes an offer for another public company at less than book value we feel cheated.  "How can they do that?" "Don't they realize how low their offer is?" "This can't be happening.." If only the market were efficient and fair; this sort of thing would never happen.  Of course that means there'd also be no opportunity for a higher bid, which is what investors in SWS Group should be hoping for.

A week and a half ago investors in SWS Group (SWS) might have received what they wanted, a higher share price.  The higher price came in the form of an unsolicited offer to buy the company at $7 per share from Hilltop Holdings (HTH).  Hilltop Holdings is a financial holding company with subsidiaries that include: a bank, an insurance company, a mortgage origination company, a financial advisory.  Hilltop Holdings' businesses aren't that different from SWS Group's holdings.

SWS Group owns a bank, a retail brokerage, an institutional brokerage and a clearing company.  A change for readers of this site, the company is listed on the NYSE and has a sizable market cap.

Sometimes an unsolicited offer to purchase a company is completely unexpected.  A potential acquirer has a company on their radar for years and when an opportune time arises they pounce and make an offer surprising the target company.  I doubt that was the case with SWS Group and Hilltop Holdings.

SWS Group and Hilltop Holdings have a relationship dating back to 2011 when Hilltop Holdings extended a $100m credit line to SWS Group.  SWS Group down streamed some of the proceeds from the credit line to their bank to boost capital levels.  They also used a portion of the credit line to ensure their brokerage could operate without disruption.  As part of the financing deal Hilltop Holdings also received warrants to purchase up to 17% of the common stock, and a seat on the board.

Hilltop Holdings positioned their purchase offer as highly beneficial to both parties, and attractive at the most recent trading price.  SWS Group's businesses do seem like they'd be a good fit inside of Hilltop Holdings, but not at $7 a share.

I think the offer is low because it values a company with a $314m book value at $233m.  If the company isn't worth book value then maybe this is a fair offer.  Without too much investigation I think it's clear SWS Group is worth at least book value.

SWS Group breaks apart their subsidiaries into four reporting segments, retail brokerage, clearing, institutional brokerage, and their bank.  The easiest place to start in determining a valuation is with their bank.

SWS Group's bank, Southwest Securities FSB isn't going to break any records for profitability.  They earn a measly 3.71% on equity and have a lower than average net interest margin.  The bank is fairly well capitalized and their loan book is in relatively good shape.  I have included a snapshot of their current performance metrics as well as a quarterly income summary below.

View Southwest Securities FSB here: https://www.completebankdata.com/banks#details/bank/42671

The bank has only had one loss in the last nine quarters, and in the last nine years lost money in 2010 and 2011.  It's worth noting that they have a terrible efficiency ratio.  For every $100 dollars the bank earns in revenue $98.68 goes towards expenses, which is higher than average, and an opportunity for an acquirer.

The bank is profitable, with some cost cutting they could become even more profitable.  Their book value is $168m, or about $5.06 a share.  The bank valued at book value is 72% of Hilltop's offering price.  Readers can argue in the comments over whether book value is a reasonable take out value for the bank, but it's the peg I'm going to use.  If you haven't noticed there aren't many profitable banks selling for less than book value anymore.  Some might argue this bank is worth 1.2-1.5x book value, not an unreasonable assumption either.

If we subtract the value of the bank, $5.06 from the offer price of $7 we see that Hilltop Holdings is offering $1.94 or $63m for the rest of SWS Groups holdings.  To see if this is a fair price let's take a look at what the company's segments earned last year:



The company's institutional brokerage alone earned $20.8m, retail brokerage and clearing earned $2m combined.  Does 3x earnings seem like a reasonable bid for SWS Group's brokerage and cleaning operations?

One more factor to consider in the $63m valuation is that the Other Consolidated Entities segment holds SWS Capital, a dormant investment vehicle with $20m in assets.  Hilltop Holdings is attempting to acquire the brokers and clearing for effectively two times earnings.

Of course the elephant in the room are the expenses related to Other Consolidated Entities.  The company's Other Consolidated Entities is a catch-all for holding company level related expenses.  It appears based on my research into the bank that the company has classified some segment expenses in this category as well.

It's certainly a reasonable assumption that there are a lot of expenses that could be cut at both the holding company and subsidiary levels.  It's the valuable businesses and expenses waiting to be cut that Hilltop Holdings sees in SWS Group and is hoping to capitalize on.  It's possible that many of the expenses SWS Group's holding company incurs would overlap with expenses at Hilltop Holdings meaning potential synergies from this merger might be realized.

The fact that Hilltop Holdings is offering SWS Group shareholders less than book value for their shares should be the first sign that the offer is low.  If shareholders take a few minutes to evaluate what they own they'll find a lot of value simply beyond the company's book value.  Shareholders already appear to expect a higher bid with shares trading at $7.62, almost 10% higher than the latest bid.  If shareholders were to receive book value for their shares Hilltop Holdings would need to offer $9.52 per share, considerably higher than their initial offer.

Buying at the current price offers the opportunity for a sizable gain if a higher bid is received, and has a maximum loss of 8% if the offer is accepted.

Disclosure: Long SWS


5 comments:

  1. Hey Nate, great post, saw this last week.. 23% upside if Hilltop offers BV, -9% downside current deal is excepted.. but isn't half the deal in stock and Hilltop I believe trades at 1.7-1.9BV (which is understandable given mgmt and BV growth but is something to consider.. are the offering documents out yet? Is there a collar to protect SWS? Another point: I suppose since Hilltop owns approx. 17% there offer at BV is still being acquired below BV given their ownership (kind of like credit bidding in bankruptcies).. I suppose if you could short out the Hilltop stock exposure then this would be interesting.. but we don't know if there is a collar yet.?.

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    1. Thomas,

      Yes, half the deal is in stock, but it's fixed at $7 a share. It looks like there are a few options available on the stock. There are March puts at $.40 strike $7.50, no calls priced higher though. I don't know how feasible it is to write a Call higher than what's available, maybe it's easy and this is possible.

      I found a few things unique about this that I didn't put in the post. The first is that Hilltop said they require zero due diligence because they already have a stake in the business and the board seat. It's not necessarily unusual, but it also gives me a small feeling that there is something else going on behind the scenes. Did their guy on the board get a sense from other board members of whether a deal might be possible? If he knew they were closed to a deal they wouldn't have offered one I'd imagine.

      I'd like to see management counter and get book value or much closer to it, or say forget the deal. I think on its own the company could be worth book if they decided to take action to get it there. I don't know enough about management dynamics to know if that's possible.

      I'm not well versed in takeovers, but it appears this offer is enough to get the ball rolling. It's as if Hilltop expects to pay a bit more, but they wanted to come in low.

      Nate

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  2. Why would Hilltop increase their bid? they already control the stock and the board, they have deep pockets as a affiliate of Bass Bros.

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  3. Nate-are you still long SWS?

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