Wednesday, September 22, 2010

Profiting From NOLs

A net operating loss (NOL) can be carried forward to offset future income for the purposes of calculating a company's taxes. The market doesn't always properly recognize these assets (which are often not on company balance sheets), as we've seen a couple of examples where investors were offered great discounts on NOLs. A current example may be ADPT Corp. (ADPT), formerly known as Adaptec.

ADPT trades for $350 million, despite net current assets of $380 million. In addition, the company has over $50 million of tax assets (due to NOLs) that it can carry forward.

Unfortunately, the company is currently burning cash; however, new management has been shrinking the business, selling off patents and assets to realize shareholder value. (For more on this, see this article at the Motley Fool.)

But with almost no operations now, the company cannot use its NOLs as it currently stands, leaving it with two options. It can sell the company to someone who can utilize the assets, or it can buy a profitable company in the same business line and apply the NOLs to the new business.

In the former case, the gains realized are immediate and can benefit shareholders with little risk. Unfortunately, management appears to have decided to pursue* the latter option, which spreads the gains out over time (in the form of reduced taxes owing) and subjects the investor to operating risk (i.e. if business is not so good, the gains may never be realized!) Likely contributing to management's decision in this regard is that there are legal restrictions on the amount of NOLs that an acquiring company can apply (to avoid having successful companies buy failed companies simply for their NOLs).

ADPT trades at a discount to cash less liabilities, and has a bunch of NOLs as well. But this is no ordinary situation for investors looking to capitalize on these NOLs; in order to capture them, management appears intent on spending the cash, which would otherwise act as a margin of safety. As a result, the downside risk to this stock is not limited despite the upside potential.

* From the company's latest 10-Q: "Going forward, our business is expected to consist of capital redeployment and identification of new, profitable business operations in which we can utilize our existing working capital and maximize the use of our net operating losses"

Disclosure: None


Anonymous said...

Can't freely use NOLs in change of control situations anymore:

More specifically, if as a result of a stock transfer or a reorganization, a corporation undergoes an “ownership change,” Code Section 382 limits the corporation’s right to use its NOLs each year thereafter to an annual percentage (for May 2009, the federal long-term tax-exempt rate is 4.61%) of the fair market value of the corporation at the time of the ownership change (the “Section 382 Limitation”). For example, if a corporation with current NOLs of $20 million underwent an ownership change this month, and assuming that the value of the stock of the corporation is worth only $5 million, the corporation’s annual Section 382 Limitation is $230,500 ($5,000,000 x 4.61%). Over twenty years, the maximum amount of NOLs that the corporation will be able to use is now $4,610,000 ($230,500 x 20 years), effectively losing a NOL tax asset of $15,090,000.

Anonymous said...

You can't use NOLs in the US like you can in Canada. Section 382 prohibits use of NOLs by other parties thru a change in control provision. So you can't simply sell the co. to someone who wants to sue the NOLs. It's not that simple.

Not so in Canada, which I believe you're from and maybe more familiar. In fact, Bell Canada Int'l sold their business and their NOLs and it ended up being a very good liquidation.

Now, when talking about ADPT, one of the knocks has been that Steel has a history of sitting on shells for years. I'd venture a guess that this won't be the case here because they've committed close to $100mln in cash to this shell. They don't manage billions anymore. Something's up. I can smell it.

Anonymous said...

Thanks Anon!

Where did you get the 20 years figure from? Is that just an example of the NOLs useful life?

Anonymous said...


Great Blog ! What do you think about $PRXI ?

Anonymous said...

I think Prxi should be ok for the next month. Despite somewhat weak management.

They never mention sharebuybacks in their calls. Even though it is the most important thing they do for shareholders.