Investment Analysis: Premier Exhibitions (PRXI) – A Favorable, High Probability Outcome In An Uncertain Environment

Note:

For those not familiar with Premier and its “story,” and that are interested in some further background and excellent analysis, we recommend reading the recent 5-part case study on Premier and turnaround investing at http://variantperceptions.wordpress.com/

Investment Thesis:

Premier Exhibitions (PRXI) is a high quality, deeply discounted business that is currently in the midst of moving past the multitude of temporary issues that have plagued its results over the recent past.  Admittedly there is still much to be done, but evidence is building that this turnaround has already turned and a favorable ruling in a crucial court case is just around the corner. We believe that for investors who purchase Premier at or around today’s price the stars are aligning to earn potentially spectacular returns with relatively little risk, in a relatively short period of time.

Why is it Mis-priced?

Premier is an illiquid micro cap, in the early stages of a turnaround undergoing significant litigation. In an environment where bargains have become increasingly scarce, we are glad to say we can still count on the markets discounting mechanism to get wildly out of whack when attempting to properly price problem-plagued, micro-cap turnarounds.

A Favorable, High Probability Outcome In An Uncertain Environment

At the current price we believe that Premier is cheap enough that investors are more than compensated for bearing the risks and uncertainty associated with this investment. Considering today’s uncertain environment and the myriad of risks/headwinds that still face both the public and private sectors of our economy, we think it makes sense to look for investments with certain defensive characteristics should the market make a significant pullback over the coming year.

We feel that by purchasing a high quality business like Premier, at deep discounts on an absolute basis and relative to the market as a whole – where current value is safeguarded/backed by tangible assets and where a variety of internal and external catalyst(s) are in place to bring about the realization of underlying value – one goes a long way towards ensuring a positive outcome.

In Premiers case, part of why we feel it offers such an attractive investment opportunity revolves around the fact that the catalysts for PRXI are relatively agnostic to the market, and that the unlocking of embedded value will primarily be a matter of decision-making at the executive level and/or the outcome of the court case, and less a function of what happens in the general debt/equity markets.

Framing the Opportunity

Essentially, we view the present opportunity with Premier to be similar in a multitude of ways to fellow “fallen angel” Steak N Shake, which in our opinion is a great example/case study of a successful turnaround. With turnarounds, investors need to be able to both imagine/gain conviction in a future that looks nothing like the recent past. In order to do that they need to have a good understanding of why the underlying business in question performed so poorly, firm conviction that the problems that caused it are temporary, and eventually solid evidence that those problems have been solved, before we feel it is wise to invest. By examining the underlying characteristics of SNS, we feel one can get a good idea of how we think about this opportunity as well as why we think it will result in a similarly successful outcome.

With that said, let’s consider for a moment the similarities between the two situations. Both of these high quality businesses (at least up until the last few quarters) had been dramatically underperforming there potential. Primarily because both were being run by incompetent management teams that didn’t understand basic finance and/or care about shareholder value. Both teams employed failed “Field of Dreams” (if you build it, they will come) strategies in an undisciplined, unorganized manner with a focus on growth at all costs (instead of cash flows and ROIC), which in both cases eventually lead to disastrous results, and a decimated stock price.

Also, in both situations high profile value activists started building positions and eventually took control, seeing underperforming but fundamentally good businesses with solvable problems trading at significant discounts to their intrinsic business values. After all, both companies generated consistently high margin cash flows, had strong, defensible competitive positions, possessed high-quality tangible assets, attractive longer-term growth prospects, not to mention significant “optionality” to unlock additional value by operating the businesses in a more intelligent manner going forward – the only thing that was needed was essentially the replacement of existing management with a team that had the desire, strategy, and know how to run the business intelligently.

The key point to takeaway here is that the problems and poor results of both SNS and PRXI were not cases of good businesses becoming poor – in both cases the core earnings power and long term potential of the businesses in question remain firmly in tact – but primarily a function of gross incompetence at the executive level. The combination of allowing costs to spiral out of control relative to the size and earning power of the businesses in question coupled with atrocious capital allocation created a temporary situation that nearly destroyed two fundamentally good businesses. To quote  Buffett, “A great investment opportunity occurs when a marvelous business encounters a one-time, but solvable problem. You just need to know the business to recognize this.” In these cases, the one-time, but solvable problem was management.   

Turnaround Specific Issues/Concerns

With a candid, capable new management team and a proven jockey at its helm for nearly a year now, the foundation for positive change in our opinion is firmly in place.  The changing of management, more than any other aspect, was necessary for us to consider making this investment.

But that in itself wasn’t enough. We still wanted to see firm evidence that the underlying operating performance of its core business had stabilized before we decided to build a position. The results of the last few quarters have convinced us that an operational inflection point has finally been reached (i.e., margins and revenues have not only stabilized but begun to improve). For evidence of this all one needs to do is take a look at the dramatic improvements in costs, operating cash flow, and long-term planning that has taken place over the last few quarters. In fact, if one backs out the legal costs, and D&A - and assuming management continues to make reasonable progress on the G&A line - it is entirely possible that Premier could generate a couple million in excess cash next quarter. If they do, our guess is that the stock will soar.   

One more key aspect worth paying attention with turnarounds is insider activity. The fact that a solid capital allocater like Sellers purchased roughly a million shares in the open market in July and converted  his $12m in debt to equity in september is quite telling (as was the company’s authorization to buy back another million shares).

Thoughts on Upcoming Court Ruling and its Implications

The upcoming court ruling regarding the titanic assets will have a tremendous impact on the value of the company. There are two sets of Titanic artifacts, the first group is owned outright by Premier and was independently appraised at $47 million. The ownership of the second group is whats at stake, and according to recent court testimony (per the appraiser) the liquidation value of these assets is 110m and that even in today’s environment it wouldn’t be an issue finding potential buyers.

In our opinion the most likely outcome is that the court awards Premier ownership of the assets but with certain convenants in place. Probably with the restriction that Premier can only sell the entire set all at once (instead of being able to monetize individual pieces at auction). The judge has stated in the past that one of her fundamental goals in the resolution of this case is to ensure the collection stays together for the benefit of the public. If awarded ownership of the second group of assets (with the covenants/restrictions) the results would be game changing for the company and its valuation. First, the uncertainty regarding the ownership of the Titanic assets would cease. Second, because the ownership issue is cleared up, Premier would now be able to effectively sell itself. Third, it will finally bring an end to the huge legal expenses of fighting this long running court battle. Think about the implications of this – even if Sellers and co. were to turn around tomorrow and conduct a fire sale on these assets, Premier would likely receive proceeds worth twice its current market cap!

Again, because we think the odds strongly favor a favorable court ruling (regarding the second group of titanic assets), we think the most likely outcome for someone making an investment in Premier today is they end up paying roughly $55m to recieve a $100m (at minimum), at some point within the next few years when the titanic business is sold.

Premier recently filed an 8k with the SEC stating that they would create a trust – assuming they recieved a favorable ruling – for “the sole purpose of providing a performance guarantee for the maintence and preservation of the Titanic collection for the public interest”.

Valuation

In our opinion, today’s price simply doesn’t make sense considering the qualitative and quantitative characteristics the business. In fact, it’s difficult to imagine a scenario/outcome where investors who get in around today’s level could lose money as the current valuation places absolutely no value on the non-earning Titanic assets and implies that Premier will not only never return to its normalized eanings capacity, but that the business in general is terminal.

Yet, as of today, we can find absolutely no good reason to believe that Premier won’t be in business 5 years from now, and better yet, why it could not generate the level of revenue, at similar margins, that it has been able to historically (with a similar level of exhibits in operation). Keep in mind, that this is an inherently high return, low cap-ex business with ridiculously high gross margins, so as long as the management team in charge can manage to keep G & A at a sane level (and not reinvest the excess cash in value destroying investments), Premier will once again become the cash machine it has been in the past. If the previous self-dealing management team, who was clearly incompetent, could do so well for so long, imagine what Sellers & co. could accomplish given time. The previous team sowed the seeds of their own destruction in a unique, and difficult to replicate way (again, the two sets of analysis mentioned at the beginning of this write-up tell the tale beautifully). Their demise comes down to the fact that they tried to take on a variety of initiatives all at once, instead of one at a time, and the result was they stretched themselves to thin. They ended up burning through roughly 20 million in cash in a handful of quarters attempting to do a variety of things that they did not have the competence to do one at a time, let alone all at once (please see the turnaround case study at wwww.variantperceptions.com for a much more in depth analysis of the underlying dynamics that went on here).

PRXI is currently trading hands at only 5x our estimate of the roughly 10m in free cash we feel its core business should be able to generate in a normal environment – making this business dramatically undervalued even if we assume no value to their other non-core, non-earning assets (which again are likely worth a multiple of the current EV – at least according to the independent appraisals that have been done on the assets in question in the past).

In our experience it’s pretty hard to lose money paying roughly 5x FCF for a business possessing 1) a dominant competitive position, 2) the ability to generate unlevered returns on invested capital north of 20% on a sustained basis, 3) attractive growth prospects, 4) a candid, fully incentivized management team focused on the right things, and 5) tremendous hidden assets likely worth 100m +.

To reiterate, around current levels (in our base case scenario), investors are essentially paying 55 million for:

(1) – An unimpaired franchise, run by a candid, capable, fully incentivized management team with a dominant competitive position and attractive longer-term growth prospects. Again, Premiers core business should conservatively generate somewhere between 8-10 million in FCF in a normal environment on its existing asset base.

(2) – Unique, impossible to replicate tangible assets worth at least 110 million

Relevant Risks

Obviously, if the upcoming court decision regarding some of Premiers Titanic assets goes against them (an outcome I find unlikely considering it would guarantee the only outcome the judge has explicitly stated she wants to avoid), they would still own out-right the entire collection of artifacts used in their existing exhibits (which were independently valued at $47m in ’87).

Again, there is no current dispute regarding the titanic assets that Premier utilizes in its core titanic exhibits. It’s not as if the core earnings power of their Titanic business would be permanently impaired assuming the worst case outcome. The litigation risk concerns the ownership of non-earning assets, a detail I am not sure many understand. It would be a blow in the sense that a multi-bagger is no longer in the cards – but our conservative base-case scenario values the existing operating assets (& the high margin cash flows they are likely to generate) at twice what we are paying for the business as a whole – so the outcome here isn’t material to our investment thesis.

Another risk worth keeping an eye on is the possibility that the legal and other non-operating costs of fixing legacy issues and continuing to defend their ownership of their assets is larger than what they can earn in the short-term – causing management to raise equity at an inopportune time and at high cost (i.e., that dilutes existing shareholders meaningfully). The fact that Premier has over 10 million in cash, is unlevered, and is on the cusp of returning to profitability (according to recent results) makes us feel that the probability of such an outcome is very unlikely. Assuming a positive ruling regarding their non-earning titanic assets, we feel that the risk of a dilutive equity raise at any point going forward goes away entirely. At that point they would be able to either borrow against and/or simply monetize them if they needed cash.

Catalysts - When can we expect the gap between price and value to converge? 

Internal – Premier’s operations become positive again on a cash basis (3 – 6 months)

External – Favorable court ruling  regarding the titanic assets (within the next 12 months) 

Conclusion

The bottom line here is that after taking into account the qualitative and quantitative characteristics of Premiers business, the fact that the fundamental issues that were responsible for previous problems/results are essentially a non-issue going forward and the clear, tangible evidence that an effective turnaround is already under way – and last but not least, the potential for internal and external catalysts to bring about the realization of underlying value within the next few quarters – we feel that investors have a short window of time to purchase an unimpaired franchise with attractive growth prospects at a fraction of its intrinsic value and in turn the opportunity to generate outsized returns (potentially multiples of the current price) with very low risk.