Elah holdings - ELLH - is an NOL cashbox that has a valuation that makes no sense, but which demonstrates how illiquidity can work to keep a price from finding a level in any way commensurate with fair value.
This is a company that has $15m in assets, 735k shares, and a $99 price tag, as of 2 May 2021. How this can be is a mystery, since it has no meaningful operations - it generated $179,000 in revenue (no, this is not in thousands), but experienced $2m in SGA costs as management set about looking for an operating company to purchase. It DOES have $1bn in NOLs, which, when you think about it, is a pretty impressive achievement. It's hard to make $1bn, but in some ways, it might be harder to lose that much, inasmuch as you have to find investors to provide the capital that was incinerated with such aplomb.
That means that the business, at one time, and likely for some time, had to be a success, growing funds internally and possibly through additions of outside capital. Also, that such a business was so spectacularly mismanaged that management could neither see the hopelessness of the situation (and therefore unload the business) or solve the competitive problem. One would expect that such management would be jettisoned in favor of new owners and leadership that can pick up the pieces. In the case of ELLH, incredibly, the stunning collapse did not result in a wholesale change of management, with the present CEO serving as a holdover; indeed the CFO who presided over the final immolation of the previous incarnation of the business.
But really, what are those NOLs worth? Alas, NOLs are among the lowest quality assets around. Sure, if you have a generally profitable business that has a bad year - like an insurance company hit with a major cat loss, or a cyclical company hit with cyclical weakness - then yes, you are likely to be able to recover or offset taxes from future profits and these are good assets. But what if you have a poor operation that loses money regularly? What if you no longer have any operations at all? Now you have a real problem: you have to find a means of earning a reliable income in order to use those NOLs.
The IRS makes that difficult - you cannot sell the company or simply merge it with another entity. The tax laws are set up to prevent NOL shells from simply selling themselves as tax shelters. No, they have to maintain a pretty stable ownership structure AND acquire assets or operations that generate profits. Since they cannot recapitalize themselves without having the NOLs largely disallowed (the dreaded section 382), the resources that are going to be available in this effort are largely going to be internally financed, which means, they have to bootstrap their own capital. And there are only so many years (about 20) in which to achieve this feat.
Now, if businesses were cheap and inflation were raging - think 1973-1981 or so, this might work out; you could have purchased a dollar of earnings for just a few dollars and then watched as revenues and profits grew in nominal terms without having to expand the business all that much, helping you to consume tax losses generated in earlier years. Of course, the real value of those recoveries would have declined, but you might subsequently enjoy a boost to valuation if inflation declined significantly thereafter.
Today, however, is a different environment. A dollar of earnings is quite expensive. And buying control of a business in present market conditions is very expensive, especially if you cannot use appreciated securities of your own as currency. $15m might buy you just $1 of earnings, but more likely will buy you even less. Yes, there are businesses that have lower multiples, but many of those, like professional services, need to be owner operated to be effective and simply cannot be sold effectively to passive capital because there isn't enough return available to future partners.
There just aren't great incentives, in a world where corporate tax rates are 21% (or 25 or 28%) for someone to cut you in on their good business in order to save those tax costs for a few years. Instead you have to look at buying and fixing a crappy business. That takes time and often generates more losses in the meantime. Moreover, how probable is it that the management that lost $1bn is going to be the fix-it people for the new operation?
Daunting as this task is, one of the biggest factors is the starting position of the firms capital, which represents the major constraint on the size of the business that can be acquired and also sets something of a "lead" on the running room available to fix a business needing some help. The larger the capital, the wider the potential target list can be and larger the scope of a turnaround can be.
So there is nothing worse than seeing a moderate amount of capital in an NOL shell being siphoned off by "management" in it's search for a new asset to acquire, but this is exactly what we see at ELLH. Management - by which I mean officers of the firm; they don't manage operations - takes some $2m a year in SGA in spite of the negligible revenues, while they look for a deal to do. The odds of them finding one have become much much longer in the past year as SPAC-mania has set hold. The amount of capital with no operations in search of a deal to complete (with incentives structured to get deals done even if a high price be paid) means that potential targets are being courted and schmoozed in an auction-like environment.
Meanwhile, the scope of potential investments is being narrowed every year for ELLH. Ok, it is true that in 2020, tax benefits associated with the CARES act offered ELLH a one time benefit of a one-time extended carryback on the losses that provided an extra tax recovery (from a higher tax period) and which generated about $4m in 2020. That has increased the cash balance of the company by about $2m, after management helped itself to half of this one time bounty.
Now, it is true that higher taxes in the future, which seem likely, could both tank asset prices and increase the value of NOLs; so the case is not entirely hopeless, but if the only upside is macro, you can find NOL shells that have similar setups, better management and lower prices. RCBN, to name one.
ELLH is in a strategic dead end with dwindling resources, suspect leadership and is trading for a premium, not a discount, so even a liquidation - likely the best option - would result in a significant capital loss.
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