The investment analysis below is our eighth in our ongoing series of guest write-ups, and is brought to you by friend of the blog Ben Rosenzweig. Ben is an analyst at Privet Fund Management, a value oriented event-driven hedge fund in Atlanta, GA. Privet was formed in February 2007 and has a compounded annual return of 9% since inception (which we would note is incredible given the relevant time period and relative to the various benchmarks).
Anyhow, for those unfamiliar with GSI and/or the investment attractions of post reorg equities, please read Ben’s fantastic thesis below as well as our recent Visteon write-up for some additional color. We plan on posting our own updated thoughts/analysis on the opportunity soon, so stay tuned. Essentially (long story short), we have a hard time seeing how GSI’s equity doesn’t trade north of $4 within a relatively short time period (year or so) as the catalyst’s outlined below play out and Mr. Market begins to award this quality business with a much more appropriate valuation.
Here’s a mini-update that notes the following events and upcoming catalysts:
1. The release of 2009 financials with 2009 EBITDA being higher than originally disclosed in the Disclosure Statement
2. 2010 announcements show continued bookings growth within the business; my estimate of $60mm in 2010 EBITDA continues to look accurate
3. 2010 financials being caught up completely by December 31
4. Plans to reverse split the stock in late February
5. Plans to re-list on NASDAQ following the reverse split
6. Sizable investor interest sure to follow once the stock is re-listed and trading at a higher price
Update On Rights Offering – yesterday GSI announced the results of its rights offering in conjunction with its Plan of Reorganization. Please see the attached chart for an updated capital structure and transaction sources and uses. In summary:
- 80% of eligible shares subscribed
- $20mm Noteholder backstop
- Additional $5mm of Notes exchanged for new shares
- $10mm in excess cash used to pay down Notes
- Emergence from bankruptcy expected to occur on July 23, 2010
This results in a total of 51.6 million new shares issued for a total post-emergence sharecount of 99.5 million. After the paydown of the Notes, new face value on the 12.25% Senior Secured PIK Notes will be $107 million.
The credit profile of the company post-emergence is phenomenal. I am very conservative with my projection for cash, as I feel it is very likely the company has been generating cash since it last reported its balance in the initial rights offering package on June 4. I also use $60 million for 2010 EBITDA as they have reiterated their forecast of first half EBITDA of $23-27 million and I fully expect the second half to continue the strong trends projected for the second quarter. I see a maximum leverage ratio of 1.1x and minimum interest coverage of 4.6x.
I think that the shareholders that fully subscribed should be happy that the overall percentage of holders to subscribe was under 100%. From the perspective of holders who purchased the maximum number of shares at $1.80, we should want the least amount of dilution possible. To get the maximum return on our investment, we should want as much debt upon emergence as possible (considering the net leverage is around 1x and the interest, which PIKs anyway, is very well covered).
Please see attached pdf for full investment thesis including multiple charts and tables. I am also attaching our prior objection to the previous plan of reorg that we filed 4/27/10. Please feel free to read the objection after the investment thesis.
Privet Fund LP is long GSIGQ common stock. Our post-emergence price target is $5.00 per common share, an internal rate of return of 123% based on closing price of $2.70 and right to purchase .99 shares for every 1 share currently owned at a price of $1.80 per share. The market has failed to fully price in the impact of the Plan of Reorganization that was confirmed on Thursday, May 27, 2010.
We believe GSI is an attractive investment opportunity for the following reasons:
- Due to the efforts of the equity committee throughout the bankruptcy process, the pre-emergence equity holders will be able to maintain an 87% ownership in the post-emergence company, up from an initial distribution of 18.6% in the first Plan of Reorganization
- The end markets for the Company’s precision technology and semiconductor products are coming out of the trough of a cycle and, as a result, GSI’s bookings have been increasing at an exponential rate
- The purging of the previous management regime opens the door for an experienced operator to run the Company much more efficiently and make strategic decisions with a view toward enhancing the value of the enterprise
- The significant reduction in debt gives management the needed flexibility to focus solely on improving operations. This should result in significant fixed cost leverage going forward as evidenced by the Q1 2010 EBITDA margin of 14%, a figure that previous management suggested was not achievable until the end of 2011
- The current market valuation, which includes the right to buy .99 shares at $1.80 per share, implies a 2010 sales figure and discounted cash flow valuation that is simply not possible even if the Company’s financial performance does not follow through on the radical improvements that have been shown during the past two quarters
GSI Group, Inc. (“GSI” or the “Company”, OTC:GSIGQ) designs, develops, manufactures and sells lasers, laser systems, precision motion devices, associated precision motion control technology and systems for use in the products and manufacturing processes for a wide range of applications in the industrial, scientific, electronics, semiconductor, medical and aerospace sectors. The Company’s products enable customers to make advances in materials and processing technology and to meet extremely precise manufacturing specifications. GSI’s products are grouped into the following three segments:
- Precision Technology- The Precision Technology Segment has six major product lines, including lasers, scanners, optics, printed circuit board spindles, encoders and thermal printers. GSI sells the products in the Precision Technology Segment both directly and indirectly through resellers and distributors.
- Semiconductors- The Company’s Semiconductor Systems Segment designs, develops and sells production systems that process semiconductor wafers using laser beams and high precision motion technology. The Company sells manufacturing systems to integrated device manufacturers and wafer processors. The Company’s systems perform laser based processing on all of the following types of semiconductors: general wafers used for logic or memory purposes, dynamic random access memory (DRAM, NAND) chips and high performance analog chips.
- Excel- Very similar to Precision Technology. Excel was acquired by GSI in mid-2008 and, as of last filing, was not yet fully integrated into GSI’s operations.
In August 2008, GSI acquired Excel Technologies for approximately $369mm. Excel was a direct competitor to the Company’s Precision Technology segment. Coming off of a relative peak in the business cycle, Excel looked like a strong target. During fiscal year 2007 GSI posted net sales of $318mm and Excel had net sales of $160mm. Pro-Forma combined sales for the first half of 2008 (a slowly declining operating environment) was still $218mm, or roughly $436mm annualized. To fund the acquisition, GSI issued $210mm of 11% Senior Notes due 2013 in a private placement to certain funds.
Right away the Company had difficulties integrating Excel’s financial accounting systems. Prior to filing its Q3 2008 form 10-Q, on December 26, 2008 GSI announced that it had identified potential errors in the recognition of revenue related to sales in the first and second quarter of 2008. The Board then decided to conduct a review of the timing of sales going back to 2006. Because of the delay in filing financial statements related to the review, on November 13, 2008 GSI received a letter from NASDAQ advising it of non-compliance. After numerous extensions, including a panel hearing, GSI was finally delisted on November 5, 2009.
In December 2008, in connection with its failure to file financial statements, GSI received notice of its breach of a covenant within its Senior Note credit agreement. In February 2009, GSI entered into a forbearance with the Noteholders while still engaging in discussions with them. On June 30, 2009 the Company announced it had reached an agreement on a non-binding term sheet with the Noteholders to restructure its debt that would, in essence, exchange $115mm of the notes for 81.4% of the new equity. On November 20, 2009 GSI filed Chapter 11 in order to facilitate a pre-packaged bankruptcy that would give the Noteholders an amount far in excess of their claims.
Stephen Bershad, the Chairman of the Equity Committee and the largest shareholder of GSI (over 13% of the common equity), is the former Chairman and CEO of one of GSI’s competitors, Axsys Technologies. Bershad spearheaded the sale of Axsys to General Dynamics in mid 2009 at an extremely attractive valuation (2.4x sales). Bershad had previously headed up Lehman Brothers’ Merchant Bank and had been at the helm of Axsys and its predecessor since 1980. In early 2009, as GSI stock had been in free fall from its accounting mistakes, Bershad began to opportunistically purchase the stock. He had done extensive diligence of Excel while at Axsys and knew of the significant opportunities that the combined entity had in the market.
On February 3, 2009 Mr. Bershad met with GSI’s CEO Dr. Sergio Edelstein to discuss Bershad’s interest in GSI and GSI’s operations. Directly following this meeting, Dr. Edelstein entered into a Termination and Change-In-Control Agreement with the GSI Board providing a “golden parachute” payment to Dr. Edelstein if his employment was to be terminated following a change in control. Between February and late April 2009 Mr. Bershad had multiple conversations with Dr. Edelstein and members of the Board regarding GSI’s prospects and general strategic and governance matters which culminated in a meeting with Dr. Edelstein on April 23 to discuss Bershad’s interest in obtaining Board representation. Following these conversations, once it became sufficiently clear that Mr. Bershad was interested and capable of exerting control upon the Company, in June 2009 GSI announced its first plan to restructure its debt by transferring 80% of its equity ownership to Noteholders along with a new $95 million secured loan.
In November, after Mr. Bershad had acquired over 10.94% of GSI’s outstanding shares, he requested that the Board call an annual meeting of shareholders for the purpose of electing directors. Once rebuffed, Mr. Bershad informed the Board that he had decided to submit a slate of directors at a Special Meeting of Shareholders and requested that the Board not “undertake any extraordinary transactions” until the shareholders had “exercised their franchise to elect a Board”. Less than one week later, GSI filed for Chapter 11 protection in order to cram down existing equity holders.
Upon filing, Mr. Bershad formed an equity committee to fight the unnecessary transfer of value from the equity holders to the Noteholders. It is necessary to remember that at filing GSI was not a bankrupt company. It had been caused to enter Chapter 11 due to the technical default of not filing financial statements. So although more than solvent (GSI entered bankruptcy with over $60mm in cash), the poor decisions of management and the shareholder un-friendly corporate governance necessitated that the equity committee be formed to realize the rightful value of its ownership stake.
Even with the sandbagged forecast that management had presented in the initial Disclosure Statement that was conceived in November 2009, it was impossible to arrive anywhere near the valuation found in the initial plan (First Modified Plan). Once the equity committee was formed and Jefferies was appointed as financial advisor, some of the Company’s information was shared with the equity for the first time. At this point, the equity committee began looking for sources of alternative financing and considering other restructuring options that would result in less dilution to the pre-petition equity holders.
On February 19, 2010 GSI came out with an 8-K that contained the amount of bookings made in the fourth quarter of 2009. Fourth quarter bookings of $77mm blew away the comparable numbers ($54mm in Q4 2008 and $60mm in Q3 2009) and showed how ridiculous it was that the Disclosure Statement projections had 2010 net sales of $251mm. It was now possible that the $251mm forecast could be reached after only three quarters. At this point, knowing that the Company could no longer rationalize an 81% equity gift to Noteholders, on March 16, 2010 the Company announced a new plan (Second Modified Plan) whereby the Noteholders would convert $100mm of their notes into 58.9% of the new equity. In accordance with the new plan GSI released new financial projections which forecast 2010 sales of $284mm.
The confirmation hearing began in mid-March with the testimony centering on valuation. Three different experts testified as to the correct weighted average cost of capital, definition of “excess cash”, correct comparable company set and many other variables that all impact valuation. As the hearing unfolded, it turned out that the biggest determinants of value were that the Company’s operating performance, and that of its peers, kept improving and that there was real interest from multiple strategic buyers to perform due diligence in the hope of acquiring the complete enterprise.
It is necessary to now point out that not only was management completely inept, they were grossly conflicted. According to the most recent proxy statement filed (2007), the NEO’s that were employed by the company (Dr. Edelstein and Mssrs. Federico and Lyne) owned a combined 746,500 shares, or 1.6% of the shares outstanding, much of this a result of option and stock grants. However, if the Plan were to be confirmed, management stood to gain up to 8% of the new common shares of the post-petition Company under a new management incentive plan. If the Plan were confirmed, the Noteholders would own a majority of the common equity and control the Board, enabling them to grant management the full amount of their incentive plan. At market value, this equated to a grant valued at more than $21 million. Conversely, if the Company were to be sold to a strategic buyer, the most likely outcome would result in senior management losing their jobs. Further, it is our belief that, had management and the Board not pushed the Company into Chapter 11, Mr. Bershad would have taken all necessary steps to ensure that his slate of directors, including himself, would be elected and take control of the company, replacing the current Board of Directors and senior management. Because of this, the people driving the bankruptcy process were never interested in maximizing the value for the equity holders. They took every step to deny the potential acquirers the ability to conduct thorough diligence. They dismissed the offers as “not having any certainty of close” while at the same time prohibiting the interested parties from getting a better look at a Company lacking 5 quarters of financial statements. It was at this point, April 27, 2010, that we at Privet Fund Management LLC filed an objection with the court alleging that the Debtor had aligned itself with the Noteholders and was purposefully engaging in a campaign to withhold information in order to conceal the true value of the Company. (We also detailed several reasons why, at the time, the Plan of Reorg significantly undervalued the Company).
As the proceedings continued over many weeks, the operating business kept improving. Due to the high switching costs associated with semiconductor systems and the continued financial solvency of GSI, there was very little danger of losing market share. Once the Company closed its first fiscal quarter and shared the results with all parties subject to an NDA, it became evident that the dilution associated with the Second and Third modified plan (Third and Second had the same terms but some different legal jargon) was no longer defensible. On April 29, 2010, the equity committee filed an objection to the Plan where the members proposed their own financing transaction. They proposed a rights offering that they were willing to fully backstop in order to reduce the principal of the Notes. After about two weeks of negotiations, all parties settled on what would become known as the Fourth Modified Plan in which there would be a rights offering that would be backstopped by certain Noteholders (who acknowledge how valuable GSI is and have wanted as much equity as they could get all along) and would result in the pre-petition shareholders receiving as much as 87% of the post-petition company (contingent upon the rights offering being fully subscribed). To recap, when GSI filed in November 2009, the equity was slated to get 18.6%. After Q4 numbers came out the equity recovery was bumped to 41.1%. Finally, after Q1 numbers were about to be released and the equity committee proposed a transaction in which they would backstop a rights offering, the equity was able to come away with 87% by offering the Noteholders the opportunity to participate in the equity upside through the backstop of the rights offering.
Terms of the Fourth Modified Plan
- $85mm rights offering to existing shareholders at a purchase price of $1.80 per share (47.2mm new shares issued to existing holders)
- $5mm of Notes to be exchanged for equity at $1.80 per share
- $20mm of Notes from Noteholders who agreed to backstop exchanged for equity at $1.80 per share
- $10mm in Balance Sheet cash to be used to pay down the principal on the Notes
- New $90mm 12.25% Senior Secured Note issued to existing Noteholders
- The rights offering will commence June 4, extending for 20 business days until approximately July 8. With July 5 as a market holiday, the ex-date to purchase the stock in order to receive the rights is July 2
Perhaps just as importantly as the financial terms, as part of the agreement there will be significant management turnover with the existing CEO, Dr. Edelstein, resigning. His temporary replacement will be Michael Katzenstein, a Senior Managing Director at FTI Consulting, who will serve as Chief Restructuring Officer. Also, the Board of Directors of the Company will be radically altered to include two directors selected by the Noteholders, two directors selected by the Equity Committee, one director selected by mutual agreement between the Noteholders and the Equity Committee, one director to be selected from the Company’s current board of directors, and the chief executive officer of the reorganized Company. It is widely assumed that Stephen Bershad will be the non-executive Chairman of the Company upon emergence. The Plan will likely become effective by late July. To understand the effect that the rights offering will have on GSI’s capital structure, see below.
In the same press release as the announcement of the Fourth Modified Plan, the Company disclosed that its bookings for the first quarter of 2010 were $95mm. This compared to $77mm in the fourth quarter of 2009, a massive sequential improvement. Since the business lacks seasonality, the uptick in bookings over the past few quarters shows that the worst part of the cycle is now over and that growth has returned. On its first quarter conference call, the CEO of Newport Corp, one of GSI’s closest competitors said the following about the trends he sees in the market:
“As mentioned earlier, we have seen meaningful improvements in activity levels, in all of our key end markets, which we expect to continue throughout most, if not all of 2010. Our strong order level in the first quarter reflected these market conditions and was also boosted by a few large blanket orders from OEM customers that will begin shipping in the second half of 2010 and into 2011. As such, we expect second quarter revenue to be similar to, or perhaps slightly higher than, the first quarter level.” (Robert J Phillippy, NEWP Q1 Conf Call 4/28/2010 pg 3)
Also, taken from the second fiscal quarter (ended 4/03/2010) conference call of close competitor Coherent Inc:
“The strong first half performance combined with a record backlog supports increasing our full fiscal year net sales outlook to a range of 590 to $600 million, which represents a very healthy 35 to 38% increase over fiscal 2009.” (John Ambroseo, COHR Q2 Conf Call 4/29/2010 pg 3)
Due to the limited amount of financial information for GSI since the Company has not filed 5 quarters worth of financial statements, it is necessary to attempt to extrapolate year-end 2010 sales through the information that is available. We examine three scenarios. In the first scenario, Q1 was an outlier and bookings for the back half of the year will slow markedly. In scenario two, we simply assume that bookings remain flat for the duration of the year. In our third scenario, what could be called optimistic but what we still view as very conservative given all of the industry color and where we are in the cycle, we forecast a modest 5% sequential growth in bookings for the next three quarters. The assumptions that underpin our analysis are fully explained in the footnotes found below. Further, in a disclosure found within GSI’s Rights Offering Package filed with the court on May 24, 2010, GSI disclosed that Q1 actual revenue was $73.2mm. We use this within our analysis to back-in to an 80% figure for the percentage of prior quarter bookings that ship within the current quarter.
To ascertain the most relevant enterprise value, we took the midpoint of our sales estimate (as we believe it to be extremely conservative) and the high end of our estimate and attempted to apply an enterprise value multiple that compared to GSI’s most relevant competitor set. We break out our comp set into two tiers to show the companies that are most similar to GSI and the companies that GSI may compete with across one or more product lines. We then examined the relevant multiples of Enterprise Value to both LTM and forecast 2010 sales in order to arrive at our multiple range. By using a sales multiple range of 1.0x – 1.4x we arrive at an Enterprise Value range of $393mm – $550mm.
Next, using our 2010 sales estimate midpoint, we attempt to produce a full financial forecast for the next five years. It is necessary to understand that we based the full extent of this analysis on the forecast that GSI management filed in tandem with its Second Modified Plan in early March. Although we altered the 2010 sales figure, we kept the basic framework of the forecast. We extrapolated Gross Profit and all expenses based on the Company’s predicted stabilized margins. We altered the interest expense based on the face value of the new notes. We kept the same nominal amount of depreciation as the asset base has not changed and we also maintained the forecast of capital expenditures. It is very likely that these margins are low as there is a good bit of fixed cost leverage inherent within the business and it is very likely that new management will take an even more active role in reducing costs. However, for conservatism, we will maintain management’s forecast margins. (It is also necessary to remember that this forecast was used to back up a valuation that necessitated in the equity only receiving 41% of the Company when, in reality, that recovery has now more than doubled as actual performance has been shown to be much more robust than this forecast would suggest). Further, in the Rights Offering Package filed on May 24, GSI disclosed it had generated $10.2mm of EBITDA in Q1 and was projecting $13mm to $17mm in Q2. This is a first half midpoint EBITDA of $25mm. Comparatively, GSI’s plan forecast EBITDA estimate is only $29mm for full year 2010. This should show how sandbagged the forecast is that we are using as the basis of our analysis.
Our full Income Statement and Cash Flow Statement can be found as an appendix at the end of this report. Shown below is our discounted cash flow analysis which shows a post-emergence, fully-diluted share price of $4.53. This assumes a terminal growth rate of 2% and a WACC of 12%.
Before we present our full valuation conclusion (shown below) it is important to explain how to appropriately calculate an internal rate of return for the investment in the pre-emergence shares of GSI Group. Due to the size of the rights offering, the purchase of 1 share of GSIGQ right now entitles the bearer to a right to purchase .99 additional shares at a price of $1.80 per share. By weighting our Comparable Company Analysis equally with our Discounted Cash Flow Analysis we arrive at a low-end post- emergence stock price of $3.65 and a high-end price of $4.88. Now, assume the purchaser invested in one common share of GSIGQ right now at the market price of $2.70. Upon emergence the purchaser would then exercise his right to buy .99 shares at a cost of $1.77 (.99 shares x $1.80). Total cost basis for 1.99 shares would be $4.28. At our low-end estimate of $3.65 per share, the market value of the purchaser’s 1.99 shares would be $7.25 (1.99 shares x $3.65). This results in an IRR of 62% on our low-end estimate and an IRR of 117% on our high-end estimate.
The only reason that GSI Group was forced to enter bankruptcy was due to a technical default resulting from its inability to file financial statements. This company has been and continues to be solvent and capable of generating significant amounts of free cash. Now that equity holders have successfully fended off an attempt by creditors to effectively equitize a large portion of their debt, the focus can shift back to the improving industry landscape and the value inherent within the business. The most exciting thing for investors might just be the ouster of the management that continuously attempted to destroy equity value and the Board that facilitated their actions. The new Board members have no agenda other than maximizing the value of this company. It is very possible that they will explore selling the company in its entirety or divesting business lines that are believed to be a drag on profitability. I also believe that if there is a chance to roll complimentary businesses into the GSI platform, the Board will examine that option very carefully.
With the current valuation implying a 2010 sales figure of approximately $280mm , the stock is priced as though the Company is approaching the trough of the cycle when, in reality, it is at least two quarters removed.
Near-term catalysts include:
- The distribution of the rights on July 8th (ex-date July 2nd);
- The filing of five quarters of financial statements;
- The re-listing of the stock on an exchange; and
- A plethora of operational enhancements to be made by a vastly improved management team that should continue to yield visible financial results.
Appendix: Financial Projections
GSI Group Investment Thesis (Privet Fund) 6-2-2010
GSI Group Post Rights Offering 7-14-2010
GSI Group – Privet Fund Objection – 4-27-2010