Safeguard Scientifics, Inc.
Q2 2017 Earnings Call Transcript

Published: 30 Jul 2017

[Operator:]

Good morning, and welcome to Safeguard Scientifics' Second Quarter 2017 Financial Results Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to John Shave, Senior Vice President, Investor Relations and Corporate Communications. Please go ahead.

[John Shave:]

Good morning, and thank you for joining us for this update on Safeguard Scientifics' second quarter 2017 financial results. Joining me on today's conference call and webcast are Steve Zarrilli, Safeguard's President and CEO; and Jeff McGroarty, Safeguard's Senior Vice President and CFO. During today's call, Steve will review highlights of the quarter as well as other developments at Safeguard and our partner companies. Then Jeff will discuss Safeguard's financial results and strategies. After that, we will open the lines to take your questions. As always, today's presentation includes forward-looking statements. Reliance on forward-looking statements involves certain risks and uncertainties, including, but not limited to, the uncertainty of future performance of our partner companies, the risks associated with our acquisition or disposition of interest in partner companies, risks associated with our decisions about the deployment of capital and the effect of regulatory and economic conditions generally and other uncertainties that are described in our SEC filings. During the course of today's call, words such as expect, anticipate, believe and intend will be used in our discussion of goals or events in the future. Management cannot provide any assurance that future results will be as described in our forward-looking statements. We encourage you to read Safeguard's filings with the SEC, including our Form 10-K, which describe in detail the risks and uncertainties associated with managing our business. The company does not assume any obligation to update any forward-looking statements made today. Now here is Safeguard's President and CEO, Steve Zarrilli.

[Steve Zarrilli:]

Thanks, John, and good morning to all of you, and thanks for joining us for this update on Safeguard and our partner companies. As we enter the second half of the year, the state of the company remains strong. Our portfolio of growth-stage companies is on track to increase 2017 aggregate annual revenue, and we remain focused on achieving a number of exit transactions to drive shareholder value. Safeguard's business model is to target growth-stage, technology-driven enterprises that are developing business-to-business solutions in the health care, financial services and digital media sectors where market opportunities are large and expanding. Technology drivers for us are always evolving as is the broad definition of technology itself. Presently, these drivers include device connectivity, also known as the Internet of Things; security and data analytics or artificial intelligence. We prefer significant minority equity positions in companies with, among other features, recurring revenue, minimal regulatory risk and management teams who themselves, hold significant ownership positions. We generally deploy about $5 million initially, then taking over time up to $25 million of capital into these companies. As these partner companies mature, we also deploy other forms of support personified by Safeguard team members and their deep domain expertise in operating experience. Our capital and expertise help partner companies sharpen their business plans, commercialize their products and services and drive growth in operating earnings and revenue. Our goal is to realize value through well-timed exit transactions that deliver aggregate cash-on-cash returns of at least two times. Increasing the pace of portfolio monetizations and other accretive transactions is an important and essential goal of Safeguard. Although we cannot predict the timing of exit deals, we are encouraged by the growing interest in Safeguard's current stable of companies. We realigned certain internal resources in 2016 and earlier this year to support and enhance partner company growth and to move them to exit opportunities. We have increased our reach to a broad cross-section of financial and strategic investors, and a significant number of our partner companies are actively exploring potential opportunity - exit opportunities or new strategic investments from independent third parties. In general, our partner companies are maturing, operations are accelerating, partnerships are being signed and customer count is ramping. The best evidence of our partner companies' momentum is captured by their aggregate revenue growth, which is projected to be between $370 million and $390 million, a year-over-year increase of between 15% to 22%. Seven of our 28 current partner companies have annual revenue between $5 million and $20 million while another four partner companies have annual revenue that exceed $20 million. Prognos, formerly known as Medivo, is a great example of a partner company gaining improved traction in the marketplace. In early 2017, the company rebranded and refocused its business model on advanced data analytics and artificial intelligence techniques. Today, Prognos is realizing steady revenue growth from its targeting and analytics programs in clinical services, which help life science clients improve patient care by identifying earlier who can benefit from enhanced treatments. Identifying and reaching at-risk patients earlier can help payor organizations reduce avoidable care cost. Based in New York City, Prognos' addressable health care analytics market is estimated to exceed more than $1 billion. Safeguard has deployed $11.6 million of growth capital into Prognos in financing rounds beginning in November of 2011, and we currently hold a 35% primary ownership position. We believe our business model offers patient investors numerous reasons to put their capital to work in Safeguard. Our strong stable of tech-enabled partner companies is focused on dynamic, growing markets in health care, financial services and digital media involving technology themes such as the Internet of Things, security and artificial intelligence. Our team brings to bear deep domain expertise and operating experience to support the growth of the portfolio. In addition, the team is incentivized by appropriate compensation features that align our interest with the shareholders in order to drive value. The accounting for our interest in our partner companies under the equity method of accounting results in a carrying value that does not necessarily reflect fair value. Carrying value of our aggregate partner company holdings is currently less than 50% of original cost. Safeguard's balance sheet demonstrates financial strength, flexibility and liquidity. Our corporate structure is lean and not constrained by the typical limited partner fund structure. Our evergreen funding model is flexible, scalable and allows us to deploy capital across multiple stages of an enterprise's development. In short, we believe that Safeguard is well positioned to grow and deliver improved performance that enhances shareholder value. And with that, I'll turn the call over to Jeff for the review of the quarter's financial results.

[Jeff McGroarty:]

Thanks, Steve. At June 30, 2017, we had 28 partner companies compared with 29 companies at the end of 2016. The current total reflects the sale of our interest in Nexxt, Inc., formerly known as Beyond.com, during the first quarter of 2017 for $15.5 million in cash and a $10.5 million note receivable, for which we have deferred recognition of a gain until the note is paid off. In the second quarter, we recognized a $3.6 million impairment charge related to Spongecell. This charge is based on the value at which we expect Spongecell to raise its next round of financing. Despite this impairment, we remain confident in Spongecell's long-term growth prospects. In the second quarter, we also recognized a $2.2 million impairment charge related to Pneuron. At the end of the second quarter, the cost of our interest in our 28 companies was $343.7 million, and the carrying value was $143.3 million. Average capital deployed in our partner companies at June 30 was $12.3 million, and the weighted average length of time that Safeguard has been a shareholder in those companies is 4.3 years. 16 of the 28 companies have been a Safeguard partner company for three years or less. During the second quarter, we deployed $10.5 million of capital in seven existing partner companies. For the six months ended June 30, we have deployed $20.5 million as follow-on capital to 11 partner companies. We expect to deploy $12 million to $16 million in additional follow-on capital to our partner companies during the remainder of 2017. In May 2017, the company entered into a new $75 million secured revolving credit facility that has a three-year term that bears interest at a floating rate. At closing, we drew $50 million under the facility. We entered into this facility to provide us the ability to borrow against the value in our existing companies to fund attractive new and follow-on deployment opportunities. Our previous $25 million credit facility with a commercial bank did not provide us with this capacity, and we allowed that facility to expire at the end of 2016. We also entered into the new credit facility to enable the repurchase of a portion of the company's 5.25% convertible senior debt, which is due in May 2018. Beginning in 2006 when the company's convertible debt balance was $150 million, we have repurchased, refinanced and repaid convertible debt over the course of multiple transactions. In the second quarter, we repurchased convertible debt with a principal value of $11.4 million. In July, we repurchased an additional $2.6 million in principal. Today, the principal balance of outstanding convertible debt is $41 million. The credit facility does contain a number of covenants. Safeguard is required to maintain a liquidity threshold of at least $20 million of unrestricted cash, a tangible net worth plus unrestricted cash of at least 1.75x the amount of the then-outstanding loan advances and a minimum appraised value of the portfolio, plus cash in excess of the $20 million liquidity threshold of $350 million. In addition, we are restricted in our ability to pay dividends limited to the $14.6 million remaining under our Board's previous authorization for the repurchase of our shares. And we'll be required to comply with certain diversification requirements and concentration limits with respect to capital deployments to partner companies. Safeguard's cash, cash equivalents and marketable securities at June 30, 2017, totaled $53.6 million compared to $37.7 million at the end of 2016. The carrying value of outstanding debt was $86.8 million at June 30. During the three months ended June 30, corporate expenses, excluding interest, depreciation and stock-based compensation expense, were $4.1 million versus $4.3 million in the same quarter of 2016. For the six months, those expenses totaled $9 million compared with $8.6 million for the same period of 2016. We expect corporate expenses for 2017 will range from $16.5 million to $17.5 million. Aggregate partner company revenue for 2017 is projected to be between $370 million and $390 million, which includes revenue for all partner companies in which Safeguard had an interest at January 1, 2017, except Nexxt, Inc., formerly Beyond.com. Aggregate revenue for the same partner companies was $321 million for 2016 and $305 million for 2015. Aggregate revenue for all years reflects revenue on a net basis. Revenue data for certain partner companies pertain to periods prior to Safeguard's involvement with those companies and are based solely on information provided to Safeguard by those companies. Safeguard reports the revenue of its equity and cost method partner companies on a one quarter-lag basis. Now here's Steve to lead us through the Q&A segment of the call.

[Steve Zarrilli:]

Thanks, Jeff. Operator, go ahead and open the lines for Q&A.

[Operator:]

[Operator Instructions] And your first question comes from the line of Bob Labick of CJS Securities.

[Robert Majek:]

This is actually Robert Majek filling in for Bob this morning.

[Steve Zarrilli:]

Good morning, Robert.

[Robert Majek:]

Was hoping to talk about your new financing. One covenant caught our eyes. The appraised value covenant says that your cash plus the third-party appraised value of holdings must exceed $250 million. Is it safe to say that you and your lender would build in a margin of safety from the current appraised value? In other words, is the current appraised value likely in excess of $400 million or so?

[Jeff McGroarty:]

Yes. It's a good question, Robert. Clearly, when we set these covenants, we want to build in some cushion. So when we look at the full value of our companies, as we've discussed, the cost of our company is $340 million. The carrying value is less than half of that number. We've got a range - any third-party valuation that's done has a lot of assumptions and estimates. So there's a large range that's established for the value of those companies. And you can assume that we are comfortable setting a covenant that's at the lower end of the range. So we think that that's a very comfortable value for us to continue to meet with our existing partner companies.

[Robert Majek:]

You kind of touched on my second question there. But can you just go into more details and tell us how the appraisal was done?

[Jeff McGroarty:]

Sure. Yes, they were appraising 28 partner companies in total. Most of that was done using either public company comps, transaction multiples for similar companies. And also, a lot of those were done for the newer companies, those with newer follow-on fundings. Some of that was based on the value implied in that most recent transaction.

[Robert Majek:]

Thank you. Just one more for me. Rocket Fuel has recently agreed to be acquired. Can you compare and contrast Rocket Fuel and MediaMath and kind of discuss the key takeaways, if any, from this transaction as it relates to your holding?

[Steve Zarrilli:]

Sure. Robert, this is Steve. I'll take that question. So I think as we've been pretty consistent over the last few years, there has been a pretty distinct difference between what Rocket Fuel does for - as a business versus what, say, a MediaMath does. And I think Rocket Fuel has struggled for the last few years in order to gain appropriate market traction, and I think it's been reflected in their share value. So we look at that transaction for Rocket Fuel as not something that is causing us concern from a MediaMath perspective, either from a valuation perspective, and I'll give you a little bit more color there and why, or from a competitive perspective. The platform that Fuel is going to be a part of, while it's an aggregation of a variety of ad tech players in the marketplace, we believe that it will take time, probably a substantial amount of time, to gain scale in a manner could become a legitimate threat. But Fuel was focused in providing a level of service that was barely unsophisticated as it related to the ability to allow technology to help in guiding a party's activities, in acquiring and placing an online advertising and then managing and evaluating the effect of that advertising in the marketplace. And MediaMath, with its capabilities, is far ahead of Fuel with regard to a set of capabilities that they're able to bring to the market. That's why when we look at the valuation parameters for MediaMath, we not only take into account Rocket Fuel, which arguably, they and Rubicon Project, which also was recently acquired or recapitalized with the new CEO, are at a lower end of that scale of capitalization. And on the other end, you have companies such as Trade Desk and Criteo, which are direct competitors to MediaMath in a number of ways. You have some other players like Alphabet or Google and Adobe that are providing some level of capability in the market and can at times be both competition as well as partners for MediaMath in the marketplace. So when you take all of those various variables and look at the valuation parameters for a company like MediaMath, the average would suggest that we're somewhere between at 3.5 to 4x multiple on forward-looking 12-month revenue. And that number, based upon where we believe MediaMath will end this year with some substantial growth that they've been able to ultimately attain, solidly puts them in that range of value that's approaching $1 billion in market value. So when we look at the landscape for MediaMath compared to Fuel and other players, we do know that there are very distinct differences between these operating models, and growth rates are just one indicator of success. And MediaMath, though it had a bit of a slower year in 2016, has very rapidly gone back on the growth train, both from a revenue perspective, and is now increasing gross margins and actually producing EBITDA profits as they continue to grow. So they would deserve a bigger multiple in the marketplace given their growth, profit scale and even their geographic reach being clearly an international play in the marketplace.

[Operator:]

[Operator Instructions] Your next question comes from the line of Jim MacDonald of First Analysis.

[James MacDonald:]

Yes, good morning, guys, and following up on that question, I see that MediaMath did a debt refinance during the quarter. Does that imply anything for a potential equity restructuring or refinance?

[Steve Zarrilli:]

Well, it - good morning Jim, and it does indicate a couple of things that, I think, are very positive. First of all, it demonstrates that there's real strength growing in MediaMath's core business from a financial perspective. As disclosed a few months ago, it's a $175 million facility led by Goldman Sachs. Participating with Goldman is Santander Bank. And so you wouldn't get those types of players, especially a Goldman Sachs, participating in a facility of that size, which was almost twice the size of the original facility that MediaMath's had, if their financial parameters of the business weren't solid and growing. So point number one, a big vote of approval, I think, from the market as it relates to that instrument. That instrument does give MediaMath some operating flexibility and capital to continue to do what they think is important in the market. But I'll stand by my comments in the past. I believe, under the right circumstances, MediaMath is still looking for some other longer-term, non-debt capital for its business, and it is taking a very thoughtful approach in how they're going about discussing those types of opportunities with a variety of different players in the market. Typically, the parties that they talk to are going to be financial - with a financial orientation, and they are going to participate hopefully in a structure that might allow Safeguard to ultimately have a partial or a full monetization. The management of MediaMath and the board of MediaMath know that that's Safeguard's goal. They've been keeping that in mind as they go through these conversations. And we've been encouraged by a variety of different attributes of MediaMath from the standpoint of strengthening operations, new credit facility and depth of conversation that MediaMath is having a very strong year. And we're hoping that, that value will ultimately transfer to the benefit of Safeguard's shareholders.

[James MacDonald:]

Right. And then just a technical question. So you're repurchasing the convertible debt slowly. How do you expect that to play out between now and the maturity? And are you buying it back around cost or discounts?

[Jeff McGroarty:]

Yes. Good morning, Jim. We have repurchased in total about $14.5 million. We will be opportunistic in repurchases going forward. I mean, it does come due in ten months. So one way or another, we'll be looking at retiring and/or we've got the ability to refinance a portion of the remaining convert into a new convertible facility under our new credit facility. But I think we're - we will be opportunistic if we see opportunities to buy it at what we think is a fair price over the next ten months. And as far as the price goes, it's been trading at $1.03 to $1.04. Our repurchases have been done at $1.03. From our perspective given that we're inside of a year window, that's effectively paying a slight discount to the principal and remaining coupon of 5.25% over the next 10 months. So fairly close to par, plus the remaining coupon.

[James MacDonald:]

Right, thanks.

[Operator:]

There are no further questions at this time. I will turn the call back over to the presenters.

[Steve Zarrilli:]

Thank you, operator, and thank you all for joining us today, and we'll keep you apprised of our progress with regard to monetizations in the second half of 2017.

[Operator:]

This concludes today's conference call. You may now disconnect.