Taking a Private Equity Approach to Small-Cap Investing:  SEAC, JMBA and CRWN

July 12, 2012

Our client portfolios contain three examples of a core tenet of our investment philosophy:  taking a private equity approach to public market investing.  We actively seek undervalued companies that have a savvy dominant shareholder that usually plays a positive strategic and governance role at the portfolio company and is unlikely (often unable) to exit its investment until the company is sold.  Often the large shareholder’s original investment was structured as preferred equity or convertible debt that recapitalized the company at a time of distress.  Or the large shareholder is an activist fund highly motivated to realize a solid return.  Either way, provided the company is recovering from the circumstances that attracted the rescue financing in the first place, we try to align ourselves as closely as possible in terms of entry price and wait for the M&A event that will often (though not always) allow the large investor to exit.

SeaChange International (SEAC) is a software vendor to video distributors and content providers in the midst of a corporate restructuring and turnaround being quietly engineered by activist investment firm Starboard Value, which has two board seats from a 2009 original investment.  Following a significant stock purchase in April 2012 at $8.12 per share, Starboard now owns about 8.6% of the company.  Starboard was instrumental in replacing SEAC’s founder and longtime CEO last autumn and recruiting new management (the current CEO was one of its two board nominees in 2010) and it has played a key role in streamlining SEAC’s asset portfolio during 2012 (the company has made two divestitures in 2012 of low-margin operating units).  

Trading recently at $7.80 per share yields a market value of $254 million for SEAC.  Backing out $122 million of balance sheet cash expected at June 30 (47% of its market value) means that SEAC is trading at just 6.7x our estimate of $20 million of 2012 EBITDA and just over 5x next year’s estimate.  Accrued tax benefits and real estate assets of perhaps $10 million further reduce the trading multiples.  The company announced a $25 million share repurchase plan earlier this year and made some small stock purchases at $8.  Given the expanding cash pile, SEAC’s management and board will very soon face questions about more aggressively returning it to shareholders.  

Starboard’s plan for value creation appears well underway – the management change, the sale of non-strategic assets, the stock repurchase announcement, management execution toward industry leadership in video streaming software and positioning the company to be sold in 2013.  We expect the last two items to come into focus over the next few quarters and we count four highly plausible prospective buyers of SEAC, perhaps at a share price in the low teens.  Skeptics may argue that the company unsuccessfully attempted to sell itself in 2011; we would respond that SEAC is a different company now, software-focused in a compelling category and with a top-notch balance sheet.  Given the size of Starboard’s SEAC position, it seems unlikely that they can successfully exit without a sale of the company.  If we’re wrong, shareholders should still benefit as the company returns cash in the form of a special dividend, perhaps, or SEAC could take a cue from another Starboard company, AOL, and conduct a modified Dutch auction.  

Jamba (JMBA) is a 769-store purveyor of fruit smoothies that is in the midst of a corporate repositioning toward healthy “specialty beverages and food offerings” only months after completing a re-franchising initiative aimed at boosting margins and bolstering its balance sheet.  Management has done a creditable job during this transition, growing revenues levels above expectations for owned-and-operated stores, adding franchised locations, delivering an international growth story in Canada and Asia and creating a consumer product line for grocery stores – all in the face of growing competition in the smoothie space from giants like McDonald’s and Starbucks.  

In 2009, JMBA was forced to seek rescue financing from two private equity firms in the form of an 8% convertible preferred stock that converts into common stock totaling about 20% ownership of the company at about $1.15 per share.  As in the case of SEAC, the private equity investors gained board seats and have played a key role in JMBA’s turnaround.  The preferred is convertible any time at the holder’s option, though not many have converted due to the preferred dividend that consumes about $1.4 million annually of JMBA’s cash, a significant portion of $26 million of estimated 2012 EBITDA.  Only in the past two weeks as JMBA shares have moved higher has the prospect of a mandatory conversion of the preferred become a reality.  The company may trigger a mandatory conversion at $2.875 per share if trading volume exceeds 150,000 shares per day on 20 the preceding 30 trading days, which it has.  Converting the preferred to common will clean up JMBA’s capitalization and preserve $1.4 million per year, significant positives for JMBA shareholders.  

The market has recently taken notice but even despite a 25% move in JMBA shares to $2.55 over the past two weeks, we do not see its valuation as excessive.  Assuming full conversion of the preferred and backing out $19 million of cash, JMBA’s market value is below $200 million or about 7.3x our estimate of 2012 EBITDA.  Led by international franchise momentum and the Jamba Go kiosk initiative in airports and schools, we are forecasting 11% EBITDA growth for 2013, which brings the valuation multiple to 6.5x.  Unlike SEAC, JMBA has the trading liquidity for private equity to sell some stock in the market, though it’s unlikely that full realization of the 20% private equity-owned stake can be done efficiently in the market.  Further, like SEAC, is not difficult to envision JMBA being acquired by a strategic buyer or private equity at a premium.
Crown Media (CRWN) is the owner of two Hallmark-branded cable networks, including the widely distributed and family-oriented Hallmark Channel.  The company is 91 per cent owned by privately-held Hallmark Cards, Inc. (HCI) and another 3 per cent is held by Liberty Media; only 6% of the 360 million shares float.  HCI gained a significant portion of its equity stake following a controversial debt-for-equity conversion in 2010 that it was forced to (successfully) defend in court following a legal challenge from certain minority shareholders.  

We are looking for CRWN to deliver $154 million of EBITDA in 2012 and $168 million in 2013, up 9%.  Corresponding EBITDA trading multiples are therefore about 7x and 6.5x at a recent share price of $1.73, quite reasonable even applying a controlling shareholder discount.  By contrast, NBCUniversal’s recently announced sale of its 15.8% stake in A&E Networks for $3.025 billion values A&E Networks at $19 billion or about 15x EBITDA.  

Given the valuation that Disney and Hearst, A&E’s controlling shareholders, applied to NBCUniversal’s minority stake, HCI should immediately pursue a sale of CRWN.  We think the two Hallmark channels would fit nicely in at least a couple of cable programming houses, including A&E Networks.  And CRWN can likely be purchased, if HCI is a seller, for a much lower multiple than 15x.  Putting just a 10x multiple on CRWN’s 2013 projected EBITDA yields a share price considerably above $3 per share and a strategic buyer should be able to realize significant efficiencies by combining CRWN’s operations with those of an existing cable programming house.

However, quite unlike with SEAC and JMBA, we apply a discount for the presence of the large CRWN shareholder, as there is no historical evidence that HCI considers minority shareholders (or even communicates with them), though one must put some faith in HCI’s fiduciary duty and its own presumed interest in maximizing the value of its CRWN investment.  In light of the A&E transaction, now would be the time to do it.