Thursday, 24 October 2013

Hmm... Emerson Radio Corp...

First blog post!

I'll be using this blog to express my deepest and innermost feelings, can you feel me? (just kidding). This blog will mostly be used for my own learning - sort of a journal for my thoughts.
I guess I'm still currently unsure about what I'll do with this blog, but I do think most of the upcoming contents will be value investing ideas, focused on small companies facing odd situations. Eventually I want to expand my knowledge of businesses and industries which would help me in analysing more "traditional" investment opportunities.

Well, lets get started, my first post will be on a small cap called Emerson Radio Corporation, (NYSEMKT: MSN)

Really not much I can say about the business. They currently source goods from manufactures in China, the products sourced are your common household items like microwave oven, radio clocks, and Emerson sells it to giant merchandisers like Wal-Mart / Target.

The business itself (as I understand it) is low margin, low barrier to entry, and very competitive, their margins reflects this and revenue has been going downhill as Wal-Mart has been cutting down their purchases from Emerson, why?

To be honest, I'm not sure. I think its a combination of their goods becoming obsolete (they used to sell old-school goods, like audio players, traditional TVs, etc), the quality of goods or that they are "not-labor-intensive-enough", one of the main advantages of sourcing your supplies in Asia is to take advantage of lower-labor costs, of course, the biggest benefactors of this are goods that are labor-intensive, which begs the question, are microwave ovens and radio clocks labor-intensive?  (Either way, the company is still cash flow positive)

What is really profitable for this company is that they license their brand, Emerson makes $6-7m / yr by licensing their Emerson trademark. Emerson's biggest licensee is called Funai (a Japanese electronics manufacturer) pays them ~$5m / yr and has been a licensee for >10yrs, this stream of revenue is awesome, minimal, if any, capital contributions and basically contributes 100% to gross margin.

The company also carries cash & marketable securities at $61m, nominal debt, and this company trades at $51m market cap, and yes, did I mention their operations are cash flow positive?

Yep, something is going on here, and I'll be spending some time explaining the current issues at the company, I find 3 main issues, 1) tax, 2) litigation 3) current control.

1) Tax - Emerson got NOPA'd from the IRS, in fact, they got NOPA'd twice. Twice more than you would want to be NOPA'd. You can read about the details on Emerson's filings, but the damage, as Emerson estimates, would be is around ~$13m for NOPA1, and ~$1m for NOPA2, (oh yeah, NOPA2 is already recorded as liability, NOPA1 is off-balance sheet at this point, Emerson intents to challenge NOPA1).
Emerson may also be liable for withholding tax issues related to S&T, essentially, S&T holds the Emerson shares, but S&T is wholly-owned by Grande Holdings. In 2010, Emerson paid a $1.10 / share dividend, and instead of withholding the portion of the dividend liable to potential taxes, Emerson gave the amount withheld as tax liability associated with the dividend to S&T back to S&T, S&T at first held collateral to indemnify, but later withdrew its collateral based on "good-faith" that the dividend will not be subject to U.S. tax laws. Well the IRS thinks it is, and is after Emerson for this, I estimate this amount to be ~$5-6m= (15m shares owned by S&T)*($1.10 dividend)*(30% withholding tax).

2) Litigation - Emerson is controlled by Grande Holdings (56.2% ownership, since 2006) and since Grande's control, the company has engaged in numerous related-party transactions, which resulted in shareholders suing Grande Holdings and eventually Grande Holdings paid Emerson $3.9m, this was... I believe... in 2010/2011. But this shareholder lawsuit is not the litigation at hand. The situation is much more hairy.

Emerson is a defendant in an active lawsuit, (Fred Kayne v. Christopher Ho), filed in 09 and will be on trial Oct 29, 2013. Emerson, along with other affiliate subsidiaries of Christopher Ho, are alleged as  alter ego of Grande Holdings, and the plaintiffs are attempting to enforce a judgment of $46m entered by a judge in 2011.

This $46m judgment above was actually a previous lawsuit, filed by the same plaintiffs, against Grande Holdings (and some of their subsidiaries but not Emerson), the plaintiffs accused Grande Holding of siphoning assets from one of its controlled subsidiary called MTC Electronics, rendering MTC a judgment-proof shell. These same plaintiffs obtained a summary judgment in 2006 against MTC Electronics, but Grande was able to siphon all of the asset out of MTC Electronics and hence, the subsequent lawsuit by the plaintiff filed against Grande Holdings to enforce the summary judgment.

I know I'm not a poet, but bear with me, I'm almost done.

Since the commencement of lawsuit against Grande Holdings, Grande Holdings has been transferring its assets left and right through related-party transactions, and for the sake of simplicity, I won't mention all their transactions, but Grande Holdings is now bankrupt. (Even their bankruptcy is suspicious, but I won't get into it here)
So now, Grande Holdings has basically little to no assets to fill their obligations, the plaintiffs look to Grande Holding's and Christopher Ho's affiliates (note Christopher Ho is the "sole" beneficiary to a bunch of shell companies which has a majority ownership of Grande Holdings.)  This is the current active lawsuit at hand. The above mentioned Fred Kayne v. Christopher Ho.

If you actually read through all of the above, you are a better man than me.

I've gone through some of the court documents (for my own sake, I disclaim any legal knowledge, and this is not legal advice), Emerson did not direct those transactions to occur and Emerson was never a party to those suspicious related party transactions that rendered MTC or Grande judgment-proof (Emerson was not a defendant in the previous two lawsuits), and Emerson did not benefit, directly or indirectly from those transactions. In fact, the transactions Emerson did with Grande Holding's affiliates were at Emerson's disadvantage (see the shareholder lawsuits above). It would be grossly unfair to the minority shareholders of Emerson to implicate and hold Emerson liable for any amount of the judgment. (dockets 635,674,693 of case: 9-cv-06816). To be honest, I think the main reason why Emerson is named in this lawsuit is because Emerson is based in the States, where it would be the easiest for plaintiffs to collect on the judgment.

3) Current control - This, I believe is Emerson's biggest issue at hand, the Court in Hong Kong appointed FTI Consulting to as the provisional liquidators of Grande Holdings. FTI has control over the Emerson shares held by Grande Holdings, and the Hong Kong Court formally issued judgment for Grande Holdings to be wound up on Sept 12/13 of 2013. 

If Grande Holdings is to be wound up, FTI has two options, sell Emerson's shares or sell Emerson. Normally I would say both of the scenarios will create value for Emerson's shareholders, but... is FTI on the same team as Grande Holding? Perhaps I'm thinking too much, but if you check FTI's recent SC 13D/A filings and compare that with the recent DEF 14A filing, you will see that FTI has not lived up to their words. FTI was proposing to nominate 10 directors and subsequently reduce director count to 7, but FTI did not nominate 10 directors, FTI nominated 8, and FTI did not submit their proposal to reduce director count to 7. The significance is more of Emerson's old directors will continue to be directors, these old directors with ties to Grande Holdings / Christopher Ho, I'm especially worried about Eduard Will.

What I'm particularly worried about is FTI liquidating Emerson's asset to some Christopher Ho controlled subsidiary, liquidating them at a discount to what they are truly worth. Or FTI selling Emerson shares to another Ho controlled subsidiary so that Ho will keep his hard control on Emerson. 

I can't come to a conclusion on which side FTI, and I think this is the biggest risk here. 

But disregarding FTI, what do I think Emerson's assets are worth if liquidated fairly?
well you have...
cash & marketable securities - 61.32m
inventory (70% of BV) - 4.24m
receivables (100% of BV)* - $14.11
all other assets (0% of BV) - 0m
Liabilities (100% of BV) - $15.69
adjusted BV - $64.50m
less: NOPA 1 - $13.3m
less: withholding tax - $5.5m
less: lease termination - $1.04m
further adjust BV - $45m
plus: after-tax residual value of operation - $0m **
plus: after-tax one-time sale of Emerson trademark - $12.32 - 19.97 ***
final liqudation value - ~$57- 65m
current trading price - $51m
upside - 12-24%
*note Wal-mart / Target accounts for over 94% of their product sales
** after selling their Trademark, Emerson can maybe bring in $1-2m FCF to equity a year, for sake of conservatism, I assigned $0 in my valuation
*** assumes that Emerson's biggest licensee pays Emerson ~$5m a year in licensing fees, and this licensee's cost of capital is 10%, and uses the license for another 5-10 years. tax @ 35%. 

I think my valuation on a fair liquidation is pretty conservative - given that Funai is currently paying ~$5m a year for a Emerson trademark with limited use, and in my valuation, Funai would be acquiring all of Emerson's trademark and only be using it for 10 years.

I think the question here is not whether there is value or not, is whether FTI will unlock the value... if FTI is not on Grande's team, then FTI has two choices, to sell Emerson shares or to sell Emerson (or its assets), both scenario will create value - because selling Emerson shares to 3rd party will unlock control and allow shareholders to influence the company, and selling Emerson will unlock value because Emerson is trading at a discount to its assets...

But... FTI may be on Grande's team, and will liquidate Emerson's shares or assets to Grande's affiliates or Christopher Ho's affiliates... in which case, shareholders are screwed, say hello to another decade of protracted litigation.