Ladenburg: Near-Term Headwinds And Unsustainable Balance Sheet Engineering


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Summary:  Ladenburg Thalmann Financial Services Inc. (LTS)

  • The SEC recently leveled allegations of securities fraud against Ladenburg’s Chairman and largest holder, Phil Frost, who owns ~34% of Ladenburg’s common equity.
  • The company was struggling before the recent news. Ladenburg has regularly generated net losses to common holders and its balance sheet has become increasingly leveraged.
  • When factoring in Ladenburg’s preferred stock – with a liquidation claim of $425 million ahead of the common – the balance sheet is already in deeply negative equity territory for common holders.
  • Ladenburg has been issuing more debt and more preferred stock to pay out hefty dividends and to support common stock buybacks. This dynamic never ends well.
  • The controversy is likely to lead to further fundamental deterioration; financial firms are sensitive to reputational risks. Plus, the worst may not be over; signs point toward possible criminal charges.

Introduction

We think Ladenburg’s (NYSEMKT:LTS) common equity is intrinsically close to worthless. The company has generated consistent net losses for its common shareholders and operating cash flows have regularly failed to cover payment of its hefty preferred dividend.

The balance sheet looks deceptively secure at first glance, but tangible assets available to common shareholders amount to only $126 million after stripping out (i) the massive $425 million preferred holder’s liquidation preference (ii) goodwill, and (iii) intangibles.

Comparing those $126 million in remaining assets against the company’s $357 million in liabilities leaves common holders in starkly negative equity territory.

The picture got significantly worse earlier this month when the SEC filed a complaint alleging fraud against Ladenburg’s Chairman Phillip Frost. The common equity dropped about 15% on the news, which is roughly where it trades as of this writing.

We don’t think the market has fully priced the impact of this news. The company’s already poor earnings and unsustainable balance sheet are likely to deteriorate further from here:

  • Investment banking clients are less likely to associate their businesses with a firm whose Chairman and key holder is facing fraud charges.
  • Asset management clients are more likely to take their business to another firm due to concerns about the reputation of the firm.
  • Top talent across all divisions will be more likely to leave for a firm with stronger financial footing and a stronger brand.

Ladenburg has been in the headlines regularly since the SEC complaint and the potential for more negative attention still looms given that signs point toward possible criminal charges. We think the responsible move would be for Phil Frost to resign as Chairman to avoid further reputational risk to the firm.

A true separation might be easier said than done however. In addition to his role as Chairman, Frost is also the company’s largest holder with ~34% of the outstanding common equity and ~5% of the outstanding Series A preferred shares.

The balance sheet has plenty of liquidity for now with approximately $263 million in cash (including the latest bond offering) but in the absence of a sudden turnaround in fundamentals, we think operating performance and the preferred dividend will slowly eat away at that liquidity until common holders are left with nothing.

Signs Point Toward Possible Criminal Charges

In the near term, headline risks still loom. On September 7th, the SEC filed litigation against Ladenburg’s Chairman Phillip Frost, among others. Note that Ladenburg was not mentioned in the complaint and (other than Frost) no one associated with Ladenburg was alleged to have committed any wrongdoing.

The complaint’s allegations accuse Frost of aiding and abetting multiple pump & dump schemes led by notorious penny stock financier Barry Honig. Frost stands personally accused of violating 7 sections of the Exchange and Securities Acts.

The complaint described one of the fraudulent schemes as relating to “Company A” which has been identified by the WSJ and others as Biozone Pharmaceuticals (now renamed Cocrystal, NASDAQ:COCP).

As I’ve written previously, in early 2017, investigative reporter Teri Buhl wrote that the FBI and the California Department of Justice (DoJ) had been involved in the investigation of Biozone. Per the article, entitled “California DOJ investigating Honig and The Frost Group”:

This reporter has seen a letter from the FBI that states this person is a potential victim of securities fraud. A check in the FBI’s victim notification system, seen by this reporter at press time, show the investigation is still active but doesn’t list specifically who the investigation is about. Biozone is the only company the person interviewed by the FBI held stock in.

The SEC is a civil agency, whereas the FBI/DoJ are focused on criminal matters. If a civil matter is referred for criminal prosecution (or if the FBI/DoJ requests the SEC’s expertise on securities matters) then the two will often work together. The apparent coordination between the DoJ and the SEC indicates that parallel criminal charges could follow these SEC civil charges.

Indications show that both civil and criminal agencies are continuing to build their cases, which further indicates that more news could follow. The SEC’s litigation release on the day of the complaint stated that there is a “continuing investigation”. Weeks ago, Buhl wrote on Twitter:

…based on multiple sources the FBI has recently been interviewing new informants in this case.

Lastly, the SEC often provides notice of its intent to sue in order to seek to negotiate a resolution with parties in advance. Based on a statement made by Frost’s biotech company, Opko Health (NASDAQ:OPK), it appears the SEC had not afforded Frost & Opko the opportunity to settle. Per the statement, “the SEC failed to provide notice of its intent to sue prior to filing the complaint.” The lack of any such discussion could indicate that another shoe is poised to drop.

Balance Sheet Leaves Common Holders Vulnerable

The recent controversy seems to be adding to an already troubling situation for common holders.

A basic review of the filings might leave common holders with a false sense of security. As of Q2 2018, the balance sheet shows a healthy $205 million in cash and shareholders’ equity of $390 million. Despite these high-level signs of health, a deeper look tells a different story:

  • Preferred Stock Liquidation Preference. The Series A Preferred shares are a quiet little balance sheet item that has a massive impact on common shareholders. As of the most recent quarter the company had 17 million Series A Preferred shares outstanding with a liquidation preference of $25 per share. In aggregate, this amounts to over $425 million in liquidation preference standing in front of common shareholders. This item alone would render common shareholders in a negative equity position in a liquidation scenario as of the latest balance sheet.

This item alone would render common shareholders in a negative equity position in a liquidation scenario as of the latest balance sheet.

The Series A preferred share class also pays a cumulative 8% dividend per annum (Pg. F-33), which amounts to about $34 million per year. This creates a massive drag on earnings and cash flow available to common holders, as we’ll get into further below.

  • Goodwill and intangibles. Ladenburg has been highly acquisitive and has accumulated a large goodwill balance. Intangibles consist of items such as technology, non-compete covenants, relationships with advisors, and trade names. (Pg. 20) We exclude these to get a sense of the hard asset base available to common.

What are common holders left with after factoring in the preferred liquidation preference, and goodwill/intangibles? Negative $231 million in equity:

What are common holders left with after factoring in the preferred liquidation preference, and goodwill/intangibles? Negative $231 million in equity:

With a lack of tangible assets to support the common equity, shareholders are left to rely on earnings and cash flow to sustain the value of common shares.

Unfortunately, Ladenburg has consistently generated negative annual net income available to common holders. Annual operating cash flows have similarly failed to support the preferred dividend.

Net Income Available to Common Has Provided No Support

The past 3 years of net income shows that common holders are losing ground. We can see that after factoring in the preferred dividend the common holders have been incurring consistent, unsustainable net losses:

We can see that after factoring in the preferred dividend the common holders have been incurring consistent, unsustainable net losses:

The cash flow picture tells a similar story. Cash flow from operations simply has not covered the preferred dividend for the past 3 annual periods:

The cash flow picture tells a similar story. Cash flow from operations simply has not covered the preferred dividend for the past 3 annual periods:

So how has the company managed to meet its generous preferred dividend payments (not to mention the common stock buybacks and common stock dividends)? Largely through the issuance of debt and yet more preferred stock:

So how has the company managed to meet its generous preferred dividend payments (not to mention the common stock buybacks and common stock dividends)? Largely through the issuance of debt and yet more preferred stock:

(Author created table. See 2017 10-K Pg F-8 for the full cash flow statements for these years)

It looks to us like the company has consistently used new money to support its existing obligations. This situation was unsustainable long before Ladenburg’s Chairman was alleged by the SEC to have committed securities fraud.

Net Income: Modest Improvement In the Past 6 Months Helped By Accounting Methodology Changes

So far, we have done a basic review of the past 3 years’ annual financial statements. Notably, reported metrics have improved in the first 6 months of 2018. In that period, net loss available to common was $2.2 million. At first look, this appears to be a stark improvement compared to the first 6 months of 2017, which saw a net loss available to common of $18.2 million (pg. 2). Could this be signs of a major turnaround?

Not necessarily. The improved numbers look to be due in part from a change in accounting methodology. The latest earnings release details these methodology changes which consist of:

  1. The booking of revenue for commissions on future renewals of insurance policies sold for sales that are estimated to happen in the future.
  2. Capitalizing costs to obtain a contract with a customer rather than booking the costs as period expenses.
  3. Amortizing forgivable loans to independent financial advisors over the “expected useful lives of their relationship period” rather than amortizing the loans based on their actual legal terms.

For the six months ended June 30, 2018, the impact of the new accounting standard was an increase in net income attributable to the company by $5.7 million. All told, these numbers represent an improvement over prior periods (with or without the adjustment), but it still leaves common holders with a net loss in either accounting scenario.

Cash Flow Improvements In The Past Quarter Looks Unsustainable

Similarly, cash flow from operations during the 6 months ended June 2018 was $26 million compared to negative $3.7 million in the comparable 2017 period. This is substantial improvement. However, the numbers have been erratic:

  • Q1 ’18 Cash flow from operations: Negative $15 million (Pg. 4)
  • Q2 ’18 Cash flow from operations: Positive $41 million (Pg. 4)

So why the enormous variance? Net income available to the company was $9.3 million in Q2 versus in $5.5 million Q1, which doesn’t explain the wide gap. The other key sources of operating cash flow consisted largely of pushing out payables and pulling in receivables:

  • +$9.2 million net additions to commissions and fees payable
  • +$8.6 million net additions to accrued compensation payable
  • +$1.9 million net additions to accounts payable and accrued liabilities
  • +$4.1 million net receivables collections

Operating cash flow of $41 million in a quarter that saw only $9.3 million in net income is clearly not a sustainable balance. Cash flow should revert in the next quarter or two; the key question for us is ‘how big will that swing be’?

It is essential that the company find sustainable growth that can actually support the preferred dividend without relying on short-term working capital swings and without levering up the balance sheet further. Given recent headlines however, we think it is unlikely that we see any near-term positive surprises.

Liquidity: Fine For Now But A Ticking Clock For Common Holders

The company has raised $202 million in cash in roughly the past year and a half through the net issuance of debt, preferred stock, and common stock. There is no immediate threat from the debt waterfall as the majority of Ladenburg’s $194 million in notes payable don’t come due for 9-10 years. (Sources: Pg. 1 and recent debt offering announcement)

With roughly $263 million in cash (counting the recent debt offering) and no major debt maturities on the horizon, Ladenburg has enough to sustain its preferred dividend for the foreseeable future.

However, with the balance sheet levered up and with a tremendous amount of preferred stock outstanding there seems to be little left for the common holders. Over time we think the preferred dividend will suck the cash out of the business, barring a sudden and sustained improvement in fundamentals.

What Should Ladenburg Do From Here?

We think Phil Frost should resign to avoid more reputational damage to the firm. As the investigation and enforcement process continues forward, it is almost assured to create more negative headlines and spook clients.

Additionally, we think the company should suspend its common stock dividend and buyback programs. Both strike us as little more than window dressing. Issuing debt and preferred stock to support common stock buybacks and dividends is nonsensical. This is especially the case when common shareholders are regularly experiencing net losses and negative to spotty cash flow.

We doubt the company will do this (because of the negative signaling it would create in the short term) but it would nonetheless extend the runway.

Conclusion: We’re Short The Common And Keeping An Eye On The Preferred

We think the common is already intrinsically worth close to nothing and makes for an obvious short here. The potential for more near-term headline catalysts and the risks of poor near-term operating results would disproportionately affect the common holders.

We’re keeping an eye on the preferred but not taking a position either way. There looks to be enough liquidity with the cash balance to keep the dividend chasers happy for the foreseeable future, but we don’t have enough faith that the fundamentals will hold up to justify a long position or even a pair trade.

Best of luck to all.

Disclosure: I am/we are short LTS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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