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Case Study

Disposition Case Study: Broadway and Seymour

In Part 1 of this series, I wrote about why investors should pay close attention to microcaps that choose to get smaller via dispositions.  In this follow on article I will take you through a real world example of a company successfully choosing to get smaller and how investors (me

In Part 1 of this series, I wrote about why investors should pay close attention to microcaps that choose to get smaller via dispositions.  In this follow on article I will take you through a real world example of a company successfully choosing to get smaller and how investors (me included) benefited.  

A micro-cap should strive to get bigger to benefit from economies of scale.  When a microcap company chooses to get smaller, something unusual is happening.  That something will benefit those who made the decision.  Usually the decision maker is the company management themselves but sometimes a “persuasive” controlling shareholder will force the sale.  It’s unlikely a sale will benefit only shareholders without also benefitting the decision makers.  If getting smaller didn’t enrich the decision makers personally, why would they choose to get smaller in the first place?  If you’re an executive, you certainly don’t improve your argument for a bigger salary by managing a smaller company.  Now, if you’re a new and still naive investor, you might argue that management would divest a subsidiary because that was in the best interest of shareholders.  Managers do sometimes act in the best interest of shareholders; when it’s in their own best interests too.  Let’s discuss briefly the concept of  “agency costs.”

Employees of a company generally act in their own best interests and not what’s in the best interests of the corporation.  If you’ve bought or sold a house, you’ve probably experienced real estate agents working for a quick commission-paying deal rather than your best interests.  As a senior engineer at a big corporation, I can’t tell you how much silliness there is in corporate decision making.  One terribly flawed machine design remained in production for years until the executive that had proposed the flawed design earlier in his career retired.  The next year it was gone.  I’ve seen millions of dollars wasted trying to make flawed designs work good enough.  Why?  Because some manager can’t admit to his superiors that the design they’ve previously advocated for is fundamentally flawed.   Patch it up until they can be promoted to a different position and let the next guy straighten out the mess.  I’d imagine anyone who has worked in the corporate world has their own stories of biased decision making.  People working as agents (employees) for a corporation make decisions based on what is best for themselves even when their interests conflict with those of shareholders.   Economists denote the costs of employee’s conflicted decision making as “agency costs.”  As an investor evaluating a company making a divesture, you must answer the question “Why did management choose to get smaller?”  Look for an answer that benefits the decision makers personally.  Hopefully, the decision benefits shareholders also and you can become one.

So you’ve found a company that has chosen to make a divesture.  Where do you look for answers as to why?  Well the obvious thing is to look at the financials of the company before and after the sale.  Let’s take an example.  In April of 1999, Nasdaq-traded Broadway and Seymour put out a press release announcing the sale of their Customer Relationship Management (CRM) software suite.  This was a collection of software products marketed to banks that the company had acquired over the past decade.  Here’s the reported consolidated financials from the 1998 10-K available to all investors in March of 1999 (then and still available now) on the SEC website.

Doesn’t look like anything you’d want to own.  Revenue is falling steadily and in most years they lost money.  These probably aren’t the financial numbers you ask your stock screener to find for you.  Investors weren’t too pleased.  Below is the history of high and low trading prices for the quarters in 1997 and 1998.  You can see that the stock had dropped from a high of $14.38 in 1997 to as low as $2.25 near the end of 1998.  It had been even higher prior to 1997.  This company was a long-time loser.

But the news was out in April 1999 that the company was selling the CRM software business.  What was left and how was it performing?  The remaining division was called Elite and it supplied practice management software to law offices.  The plan was to change the Broadway & Seymour company name to Elite Information Group after the disposition of the CRM business.  Elite had been acquired by Broadway and Seymour in 1995.  How Elite was doing was right there in the March 1999 10-K filing for all to read.  You have to dig to the end of the 10-K document but it’s there.  Here’s the segment reporting from that 10-K.

The CRM business that was being sold had posted an $11 million loss in 1998, but the Elite segment that remained posted a $3.2 million operating profit.  If you read further you would see that the remaining Elite segment had historical numbers that looked like this.

There were 9.228 million diluted shares outstanding and I purchased shares in May, 1999 for $3.  That’s a market cap of just $27.7 million.  This is just 0.66 times sales and 9 times operating profit for the remaining Elite software company.  Elite was rapidly growing their sales and had dominant market share with law firms in the United States.  Dominant market share is a big advantage with software companies as development costs can be spread over a large user base.  The balance sheet showed $15 million in cash with no debt.  Furthermore, the sales price of the CRM business was another $11.1 million.  The stock was trading for just a little more than cash that would be on hand after the CRM sale; this for a software company that had nearly doubled sales in the last two years.  It was not a hard decision to buy.  Yet the stock laid near $3 for most of the Summer of 1999.  You could have bought all you wanted.  Explain that efficient market hypothesis thing to me again?

It’s truly unbelievable how cheap a loser microcap can trade.  It’s also unbelievable how long it takes for investors to realize that a big change has happened and the future will not be like the past.  So why did the company sell the CRM business?  Who got rich from the sale?  Usually the people who get rich are the company management.   Not in this case, however.  Ownership by insiders is revealed in a company’s proxy mailed to shareholders prior to an annual meeting.  Fortunately, this proxy is also posted at the SEC website.  Let me show you some history of the Broadway and Seymour proxy statements to explain what happened to cause the disposition of the CRM business and who got rich from it.  The March 16, 1997 proxy for Broadway and Seymour reveals the following ownership by officers and directors.

The founder of the company, William Seymour owned 4.8% of the shares outstanding.  The rest of the officers and directors own essentially nothing, including the CEO with a whopping 3500 shares.  Maybe the founder wanted the CRM business sold?  He’s 58 in 1999 and perhaps wants to cash in and retire early.  See, we’re looking for personal motivations.  If you read the filings, however, you’ll see that a whole new management team being paid healthy salaries and bonuses had just joined the company in 1996 and 1997.  The founder was thinking of empire building, not selling assets.  Perhaps when the CRM business went bad he came to support the sale, but I think he was pushed into it.

So who pushed him?  That’s fairly clear (to me at least) also from information in the historical Proxies.  Any person or entity that acquires 5% of a company or more is required to file a 13G or 13D within 10 days with the SEC.  The purpose of the law is to force people acquiring large chunks of shares to state their intentions.  Are they going to try to take control of the company or what?  If ownership changes significantly (by 1% or more) after filing the 13G or 13D, the investor is required to amend the original document with a 13G/A or 13D/A within 10 days.  A 13D must be filed before any activist activity is allowed.  A 13G has less information and looser rules for non-activist investors.  Broadway and Seymour therefore knew who their 5% or more holders were and was required to publish it in their Proxy.  The May 1997 proxy shows two beneficial owners.

Pioneer Management Corporation is probably the famous mutual fund family.  Okabena is a money manager for foundations and endowments paid a percent of assets under management.   The May 1998 list of beneficial owners shows significant change.

There are a couple of new owners.  PAR Investment Partners is a hedge fund who apparently bought up 8.5% of the company between May, 1997 and May 1999.  Okabena sold out, but Pioneer is hanging in there a while longer to let the stock go even lower before they sell out.  PAR investment partners continued to acquire shares at depressed prices through the remainder of 1998 filing 13D/A disclosing the purchases when required.  The 1999 annual meeting proxy available to shareholders on May 3, 1999 shows another significant ownership change.

Pioneer is out now too (or at least owns less than 5% so they no longer report to the SEC) .  PAR Investment Partners now owns 14.7% of the company.  Another hedge fund, Tudor Investment Corporation, acquired 6.4%, and Dimensional Fund Advisors owned 8.3%.  Tudor Investment Corporation was founded by now multi-billionaire Paul Tudor Jones.  He became a billionaire by running hedge funds that buy things like dispositions!  Note, however that these hedge funds saw the value in the Elite segment before the sale, bought the stock, and then forced the disposition.  I simply was piggy-backing on their fine work after seeing the disposition announcement.  The principal of PAR Investment Partners had joined the board of directors by 1999 and I assume his invitation was attained by threat of Proxy battle.  With little management ownership and a track record of value destruction, what chance would management have in a proxy battle?  On Jan 15 1999,  three months prior to the announcement of the Elite sale, CRM segment management employment contracts were altered to give them 2 years severance in a change in control.  The decision to sell was made, and this was the consolation to encourage the current management not to fight it.

So when a company chooses to get smaller somebody stands to benefit personally.  In the case of Broadway and Seymour, the people who benefitted were the hedge fund managers.  The company management got two years salary as severance and did have some significant stock options too.   Considering their recent track record they did okay.  They didn’t have any choice in the sale anyway.

So did the hedge funds get rich?  Yes, but it was a bit more of an adventure than they had planned.  In fact, on February 10, 2000,  less than a year after the disposition announcement, the company announced that the remaining Elite Information Group subsidiary was to be acquired by Solution Six Holdings for $11 a share.  I had nearly quadrupled my investment in 9 months.  This acquisition was in the end blocked by the US government for anti-trust reasons, however.  I still had my shares and was terribly disappointed watching the stock fall all the way back to $4 after the sale was blocked.  However, I had read the SEC filing describing the negotiations for the sale of the company.  Those filings revealed that the company turned down a higher offer for Elite than the $11 offer they accepted.  They believed the $11 Solution Six Holdings offer was better financed and more certain to occur.  The financing wasn’t the problem; it was the U.S. government!  I understood that Elite was in the hands of motivated investors who obviously wanted to sell.  So when the stock fell back to $4,  I doubled up my position.  A couple of years later Elite was sold to another buyer for $12 a share.

So what are the lessons from this story?  When a microcap company chooses to sell a subsidiary something is up and somebody stands to benefit.  Find out who stands to benefit.  Check holdings of officers and directors and also of beneficial owners, both of which are available in the proxy statements.  Check for 13D or 13G and amendments of them that may have been filed since the last proxy statement.  Look for changes in ownership that might reveal a motivation to make the sale.  When you’re investing in a historical loser, you need to understand the reason the future will be better than the past.  After surmising that the new hedge fund owners had taken control of Broadway and Seymour, I knew the value of the Elite subsidiary would be realized going forward.  I didn’t know it would be sold the next year, but I knew the management would no longer draw big salaries to build dubious empires.

Then investigate how the sale might enhance shareholder value.  Is a healthy and growing business that you’d like to own uncovered by the sale?  Dig into the footnotes of the latest 10-K to find the segment financials.  What’s the recent history of the remaining business and what are the prospects.  What does the valuation look like compared to similar companies?  If it’s too good to be true then buy a lot.  It’s probably true!  Don’t be shocked when the clearly undervalued stock continues to languish for some time.  Investors are rightly suspicious of a company with a poor track record.  You understand why the future will be different than the past, but most investors don’t.

Read the SEC filings of companies you own or are considering to buy.  Elite Information Group’s fall to $4 when the company had an offer for more than $11 disclosed in the SEC filing is proof few people read them.  The ownership change revealed in the proxies was also a big clue as to why the disposition happened.   There’s important information in those SEC filings.  If time is an issue, you may need to limit the number of companies you invest in so you can stay on top of them.

Finally, note in this case that the hedge funds being paid 20% of profits were the “smart money”.  Pioneer, a retail mutual fund, and Okabena Partnership, a management firm paid a percentage of assets sold out close to the bottom.  My experience has been that it generally works that way.  Hedge fund managers have a clue what’s happening in a special situation; mutual fund managers and institutional  money managers believe the markets are efficient.  They’re managing a portfolio of 200 stocks selected to be diversified and appropriate for their clients.  Markets usually are efficient, but not in a special situation such as a divesture.  A manager of a portfolio of 200 stocks doesn’t have time to read the footnotes showing segment results.  What shareholder that understood the segment results would have been selling Broadway & Seymour at $2.25 in 1998 to those hedge funds?  When you’re looking at the ownership changes in a divesture situation, keep in mind the objectives of the hedge funds and the mutual fund or pension fund investors.  Follow the “smart money”, but only after you’ve figured out what is happening for yourself.

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