A $54M EBITDA Business Trading at $4M Market Cap - KLDI
Case study on a very cheap stock today, and how to assess this deep value / restructuring opportunity
I came across KLDiscovery (KLDI) here, a great writeup by
a month ago:Let’s say you have a business with a $10MM market cap. How much EBITDA would you need that business to generate for it to be considered cheap? $3 million? What about $5 million? $5MM would be 2x P/EBITDA. What about $10MM? We’re approaching an absurd value at $10MM of EBITDA.
At $0.24/share, KLDI has a ~$10MM market cap. Last year the business generated $75MM of adjusted EBITDA.
KLDI trades at a P/EBITDA of 0.13x.
Additionally, EBITDA isn’t impacted by a one-time accounting quirk. It’s legit. 2022 adjusted EBITDA was $57MM.
KLDI provides eDiscovery, information governance and data recovery solutions to corporations, law firms, insurance companies and individuals. The company basically provides a software product that helps with data management as part of the legal process. This is a fundamentally good business.
KLDI boasts 96% of the AM Law 100 as clients. The AM Law 100 represents the 100 highest grossing law firms in the United States. KLDI also has 50% of the Fortune 500 as clients. This is a good business. So, what’s wrong with the stock? Debt.
The reason that equity was trading so cheap was that roughly $550M ($250M in convertible debentures and $300M in bank debt - rounded for simplicity) of debt principal repayment was coming due that they could not pay. After speaking with a friend who worked in restructuring investment banking, I decided that there was not enough clarity on the potential outcome to warrant an investment.
In the one month since that post, the stock has fallen from 24 cents to 8 cents, or less than $4M market cap. So the potential upside had tripled. More importantly, there was a resolution to the debt situation. The $300M in bank debt owed was pushed back a few years, and company was able to convert the ~$250M of convertible debentures for 96% of the equity. Meaning 96% dilution to the equity, which was actually on the good side of potential outcomes in my opinion, and resolving the biggest question mark to the situation. Basically, it converted at face value of the debt ($250M / $250M + $10M equity value = 96%).
I applaud
for being quite accurate on what could happen. He predicted three potential outcomes:Debt gets extended
Chapter 11 bankruptcy in which debt is converted at face value
Just the debentures get restructured / converted
And while no single outcome was entirely correct, all three occurred to varying degrees. The bank debt got extended (outcome 1), the debentures got converted (outcome 3) at face value (outcome 2).
Lesson one here is that in restructuring situations, the equity isn’t always wiped out. Lots of reasons for this - for example, to keep management incentivized, prevent potential lawsuits from original equity holders, and save fees and time undergoing bankruptcy. This was good learning for me, since I rarely deal with near-bankruptcy cases.
Now that the company has overcome the most difficult part, the question is, what is fair value of 4% of the equity of this company? The equity value is trading at $3.6M today.
The company is a stable software business, but not a growing one. for the last five years, revenue has fluctuated between ~$290M and $345M.
While earnings and free cash flow to equity are negative, if we adjust for the go-forward interest expense by estimating that about half the interest expense will be gone with the debt to equity conversion, or ~$25M, we’ll get about $15-20M in FCFE (FCF to Equity; a more accurate version of owner earnings). Let’s use the midpoint $17M.
If we give the business a 12x EV/EBITDA (about the S&P 500 historical average and what stable low growth sectors like utilities, materials, and communications trade at today) we can give it an enterprise value of $54M * 12 = ~$650M (I use 54M for EBITDA rather than the 75M adjusted EBITDA because adjusted EBITDA is exactly that… adjusted and not reality).
Subtract $300M in debt to get $350M in equity value.
4% of this is $14M, or a 3.5x from today’s market cap of $3.7M.
As a sanity check, $350M in equity value means a ~20x P/FCFE (again, this is basically P/E) on our FCFE estimate of $17M above.
Given that almost half the enterprise value is in debt, it shouldn’t trade at that high of a multiple.
For those confused why - the DCF version of this would be modeling out paying off the $300M in debt using earnings at some point in the lifecycle of the company. Naturally, this will reduce the present value of cash flows, leading to a lower P/E.
Standard estimates say that 60% of the DCF value of a 20x P/E stock is in year 15 and beyond. If we assume the $17M in earnings grows 3% / year, it would average $20M across the next 15 years, the cumulative amount which is coincidentally the amount of debt to repay ($300M). So we lose 15 years of cash flows paying debt, meaning that we only have 60% of the equity value left. So perhaps it should trade at a 12x P/E multiple (20x PE * 60%)
Side note: this shows that our initial 12x EV/EBITDA estimate was too high and that 9x EV/EBITDA is fairer (9 is gotten by back-solving)
12x P/E = ~$200M. 4% of this is $8M. Current equity value = $3.7M. So we have potentially a 2x investment.
Note that this analysis means that I saw no upside on the $10M equity value a month ago, as opposed to the original author who wrote about KLDI. That said, we also didn’t know the range of potential outcomes with the restructuring. That is a huge piece of information. He did a great job outlining the situation and finding this opportunity.
Liquidity?
Tiny, around $5K a day. As an individual investor, you could still build a decent position across several weeks assuming volume remains steady.
With the $250M in debentures converting to equity (owned by MGG Investment Group), I suspect more liquidity will enter after the convert happens.
Is a double worth the hassle of liquidity, in entering and potentially in the exit? I guess that depends on your opportunity set. Do your own diligence. I hope this was helpful.
May 19 Update: A few notes based on some people’s comments.
Update 1:
It’s worth calculating what the implied multiple is at the current price.
$3.7M / 4% = ~$92M. At $17M of owner earnings, thats about a 5.5x P/E multiple and a 7x EV/EBITDA multiple.
Update 2:
One astute observer commented that I may be overestimating the boost to FCFE. Turns out he was right. Initially, I saw that in 2023, $22M was in PIK interest (this is non-cash interest) and given that the terms of the convertible debt were 4% in PIK and 4% in cash, I assumed that the cash interest was about that much, in the $20-$25M range, which would be the boost to earnings post debt-to-equity conversion.
However, the convertible debt also had this term: “…the Company will increase the principal amount of the Debentures by an amount equal to 3.00% of the original aggregate principal amount of the Debentures outstanding.” I believe this also goes in as PIK, rendering the PIK interest higher than cash interest. So I overestimated the savings from the cash interest, which should be closer to $10M rather than $25M.
Naturally, this lowers our annual FCFE to around $2M. Not enough to cover the debt service. Of course, we can model in the earnings growing at quite a fast pace, since it’s levered (the amount going to interest payments will stay stable, so increases in revenue will flow to bottom line). But that’s hard to predict and model out. An easier way to think about valuation here is as follows.
Three ways the company may tackle this situation is through an asset sale for more cash, equity injection (further dilution), refinancing the debt (which is just kicking the can down the road) or another debt to equity conversion. I find the last scenario to be the most likely, if not a combination of these.
Let’s look at a debt to equity conversion scenario:
If the debt is converted to equity, we get at $27M boost in cash flow that used to go towards interest ($300M in debt * 12% interest * 1 - 25% tax rate). That would bring our FCFE to ~$30M. 3% terminal growth and 10% discount rate (or a ~14x multiple) gives us ~$430M in equity value. How much of this would the debt holders own? Like the first debt-to-equity conversion, about face value, $300M in this case (this also makes sense theoretically - $27M in interest perpetually at a 9% discount rate = $300M. The original principal would be paid back in year infinity and hence discounted down to 0 in a model).
4% of the $130M in equity value is about $5.2M. That’s just a 40% upside for a lot of uncertainty. A pass for me.