Calling It - Strategic Alternatives Imminent: $TREC
Writing is on the wall, asymmetric payoff profile to boot
Dear Subs – I trust everyone has been well. You may have noticed the Plum Capital hiatus from mid-September when I published my post on $ATTO (still max long, added modestly around ~$25) – apologies it has taken a while to get back on track. I got married in early October, spent about two weeks in Hawaii, then steadily resumed my daily routine. I am working full-time again to uncover value in the markets, hopefully the updates and new ideas will start to flow again in short order.
Revisiting Trecora Resources (NYSE: TREC)
Recall that I published my long thesis on TREC back in August (linked here) and surprisingly the stock has been flat, despite interesting developments that have occurred along the way. I wanted to bring the current situation to your attention, because TREC is one of the most obvious candidates for strategic review that I’ve come across in my entire career, yet the market is still asleep at the wheel. I strongly believe that something concrete will happen in the next 6 months, leading to very nice returns in a compressed time frame.
The writing is on the wall for the following reasons:
Entrance of a second activist investor
Nature of the shareholder register
Management blunder (failed M&A process)
Timing for the annual shareholder meeting
Reason (1): General Framing
I think most investors would agree that TREC really has no business of remaining a standalone public company for the long term. The business is subscale with only two plants, in an industry where scale really makes a difference. The profitability of the enterprise is crimped by almost $10mm of corporate costs which would be low hanging fruit for any strategic acquirer, not to mention the fact that the Company probably has an inflated cost base vs. larger chemical processors due to lack of purchasing power.
Also, it is very difficult to achieve significant multiple rerating on a status quo basis, even with improved earnings, because the shareholder base for a micro-cap chemical processing business with asset concentration risk (only 2 distinct plants) is quite limited. This is further exacerbated by daily liquidity limitations, as the dollar volume is only ~$300k per a day, which blocks out the majority of real-money institutional buyers. For these reasons, the obvious value-maximizing path is a sale of the business, whether in whole or by parts, especially at the part of the cycle where asset valuations are frothy (i.e. today!)
Reason (2): Incremental Activist Involvement
We have already discussed the involvement of Ortelius Advisors in my last writeup. It is very curious to me why we haven’t heard a peep from them in terms of what their goals are with their TREC investment (even in their recent 13D/A filing, the language was completely boilerplate). Ortelius folks certainly are not shy – they have been extremely vocal in certain situations, such as the Capital Senior Living (NYSE: CSU) debacle, where they ran a very public campaign. My personal theory is that there is already a “wink and a nod” between Ortelius and the mgmt./board, in that they have agreed in principle to begin strategic alternatives in an acceptable time frame. Otherwise the whole situation does not make much sense to me, that a sharp-elbowed activist investor is remaining docile in a situation where value could easily be maximized beyond the current share price.
But just as important, since the publication of my original writeup, a second activist investor has joined the fray. Bradley Radoff and his affiliates have purchased over 7% of total shares in the open market, and is currently the 3rd largest holder behind Ortelius and Wellington. This investor group’s intentions are very clear, from the language in the 13D filing:
Bingo! They explicitly want to sell the business as the value-maximizing outcome, and plan to submit director candidates at the next annual meeting to advance their agenda. This is a potent combination, as not only are the intentions clear, the involvement of multiple activists only means that a corporate action is more likely to happen in the near term.
Reason (3): Shareholder Register
Before we go further, it is useful to examine the shareholder register, as any activist agenda needs support from enough shareholders – otherwise the whole exercise becomes moot. Below, I’ve laid out the key shareholders from the 13F filings as of 9/30/21:
We can see that the two activists combined already own 18% of the company, which is a healthy amount to start off with, when considering a proxy contest. Going down the list, it seems to me that between the chunky holders mentioned here, and maybe a couple others, a majority bloc could easily be created to support the proxy contest. And I would be extremely surprised if the activists have not already reached out to each of the big holders and pitched them the go-forward plan for maximizing value.
I am not privy to those conversations, but I think all the circumstantial evidence points to most sophisticated shareholders rushing into activists’ arms, given the following facts:
Shareholders have a long history of suffering, with any buyer since 2012 likely underwater on their position, while most benchmark indices are up several hundred percent
Equity markets are frothy and corporate credit is readily available at record low yields, creating excellent M&A market conditions in the seller’s favor
Given current stock price of $8.46/share, any reasonable process is likely to result in bids significantly greater than this price
A sale provides a clean exit for any holders who wanted out but found themselves handcuffed due to daily liquidity reasons
Management has committed a terrible blunder of squandering $4mm of cash on a busted M&A process, throwing their competency into question, and wasting precious dollars that could have been utilized for buybacks
The waxes business surprised to the upside by generating $2mm of EBITDA in 3Q’21, which bodes well for a potential sale if the underlying improvements are sufficient to treat this as the go-forward quarterly run-rate earnings power (unclear, but possible)
Finally, the activists and supportive shareholders could easily have bought more shares in the open market since 9/30, which would only tip the balance further into their corner.
Reason (4): Management Blunder
The 3rd quarter earnings release from last week was certainly interesting in many aspects, but the most consequential update, in my opinion, was the disclosure that the Company spent $4mm of cash on a potential M&A process. To avoid any confusion – this is the TREC doing work as a potential buyer of an asset (as opposed to the presumed upcoming sales process). I’ve spoken to several shareholders about this, and the unanimous response was that they were disappointed with the update, in terms of the result ($4mm wasted), the fact that management contemplated M&A in the first place (as opposed to continued capital return), and the manner in which the message was communicated to the shareholders in the press release.
As I noodle on what has just transpired, I can’t help but to lean towards being critical. From personal experience of working on large corporate transactions (investments of up to several hundred million dollars), I’ve had plenty of experience working with 3rd parties (consultants, lawyers, accountants, advisors, you name it) and I totally understand that the bill can add up. However, given the size of Trecora, I find it very difficult to believe that the size of the acquisition target was more than $100mm (though I could definitely be wrong if it was a larger, transformative deal), and if so, $4mm is an outrageously large sum to spend on such a process. Even if we generously grant that $4mm is ultimately an acceptable bill, what irks me is that management was committed to spend this amount before they realized that the deal was unattractive from a shareholder value creation standpoint. Surely they could have diligenced the asset in a smarter way and only be 1-2mm out of pocket? Again, I’m relying on personal experience and admit to the possibility of missing something, but with the disclosure provided thus far, can only point to management incompetence as the most likely source of the error.
But my own indignance doesn’t mean much in the grand scheme of things – but I wanted to spell this out as this may well be the final straw for the activist investors. Wouldn’t they also be livid, and much more so because they have significantly more money, time and resources invested in this endeavor?
To wrap up this point, we only need to look at the 3Q earnings call transcript to see the reaction of one informed shareholder. I’d have no trouble guessing who this gentleman is going to be voting for in a proxy contest (though I am in no way trying to put words in his mouth).
Reason (5): Sequence / Timing
So how might the events unfold in the coming months? Well, I believe that either activist (or perhaps in a joint effort) will file a proxy, and nominate a slate of replacement directors in advance of the annual shareholder meeting, which is typically held in May. Trecora does not have a staggered board, so each board member is up for election every year, which is a desirable setup for the activist investors.
If the campaign is run in a logical way (i.e. near-term value maximization, liquidity for shareholders, incompetent management & board), I believe that the activists will easily win over the majority of the votes, as explained earlier. So what does this mean? I think the management and the board members see the writing on the wall – so there is always the possibility that an agreement is reached prior to a proxy contest being publicized. For example, management may agree to hire bankers and advisors to pursue a sale of the business, and give up a couple of board seats, in exchange for a standstill for a period of time.
I think the timeline in general lines up very nicely. I’m writing this as of early November, there is still ample time for the activists to solicit potential director candidates and make their case known to the public before year end, or perhaps by early next year. Once the public announcement is made, I expect the stock to trade up a solid 20-30% on that day, and then steadily grind higher thereafter, and the final bump will come at deal announcement. If mgmt. & BoD are willing to play ball (more likely outcome in my personal opinion), I think these events can transpire very quickly – and if there is a contested situation, the sales process and consummation are likely to happen in 2H’22 upon the activists winning the proxy battle.
Quantifying the Upside
The natural question to ask then, is what we should expect to get upon a successful sale. I think the best case scenario would be to sell the business piecemeal (petrochem vs. waxes) to their respective strategic acquirors, but to simplify the math I assume a sale of the entire business. Rather than arguing for specific numbers for the purchase multiple and the buyer’s underwriting EBITDA, I will present some reasonable sensitivity ranges, and you can make up your own assumptions for where you think the deal will eventually get done at. I always prefer to think in conservative ways, but the upside cases are very interesting here, depending on the assumptions.
I’ve highlighted in grey the region that I think is most likely “transactable”. From a multiple perspective, I don’t want to get too aggressive and assume more than 7-7.5x (though anything is possible if the right strategic buyer comes along). However, I think all the conservatism is on the EBITDA side, as I am not giving credit to any of the following:
Normalized quarterly run-rate after the supply chain and input cost headwinds go away (they won’t overnight, but a strategic buyer will underwrite on a multi-year, look-through basis)
Any further synergies from COGs or ex-corporate SG&A from increased purchasing power and other resources that a larger strategic organization can bring to bear
Flow through from incremental price increases and additional volumes from new contract wins that will come on in 2022
What If You’re Wrong?
As is the case with any investment, I could be wrong. Maybe the activists are happy with the status quo (doubtful), or they lose the proxy contest (again, doubtful). Maybe management loses focus and business performance deteriorates, leading to suboptimal stock performance (possible, but then they would almost certainly lose the proxy).
However, I am very comfortable with my investment in Trecora. Based on my conversations with some follow shareholders, the affinity for strategic alternatives is quite high, and reading between the lines, I am quite confident that the shareholder support for the activists will be overwhelming. Finally, I take comfort from the fact that the Company’s net cash balance sheet and FCF generative profile will keep draconian downside cases at bay. TREC possesses a truly asymmetric return profile, as the upside case will be highly attractive, and the downside case will merely mean that I break even or lose a negligible amount of money. And finally, with the near-term catalyst of the activists showing their hand, I believe the IRR, as well as the absolute returns, will be excellent here.
I’m not one for conspiracy theories. But in this instance couldn’t help but notice a big block trade for TREC stock which crossed just this morning. I’ve never seen a trade this big (~800k shares, ~$6.6mm value, or ~3.3% of total shares outstanding), at least since I’ve been involved. Is it crazy to think that either activist, or a supportive institutional shareholder just beefed up their stake prior to some sort of upcoming announcement? In any case I don’t want to get too fixated on one anecdotal data point, but I did find it interesting.
Plum Capital is long TREC common stock and call options of various strikes and expiries
Nice follow up Plum! Have you spoken to any of the large shareholders or have any further insight in to their motives?