10/23/2018 Ladenburg: Near-Term Headwinds And Unsustainable Balance Sheet Engineering - Ladenburg Thalmann Financial Services Inc.

(NYS…

Summary

The SEC recently leveled allegations of securities fraud against

Ladenburg’s Chairman and largest holder, Phil Frost, who owns ~34% of
Ladenburg’s common equity.

The company was struggling before the recent news. Ladenburg has
regularly generated net losses to common holders and its balance sheet
has become increasingly leveraged.

When factoring in Ladenburg’s preferred stock - with a liquidation claim of

$425 million ahead of the common – the balance sheet is already in
deeply negative equity territory for common holders.

Ladenburg has been issuing more debt and more preferred stock to pay
out hefty dividends and to support common stock buybacks. This dynamic
never ends well.

The controversy is likely to lead to further fundamental deterioration;

financial firms are sensitive to reputational risks. Plus, the worst may not
be over; signs point toward possible criminal charges.

Introduction
We think Ladenburg's (NYSEMKT:LTS) common equity is intrinsically close to
worthless. The company has generated consistent net losses for its common
shareholders and operating cash flows have regularly failed to cover payment
of its hefty preferred dividend.

The balance sheet looks deceptively secure at first glance, but tangible assets
available to common shareholders amount to only $126 million after stripping
out (i) the massive $425 million preferred holder’s liquidation preference (ii)
goodwill, and (iii) intangibles.

Comparing those $126 million in remaining assets against the company’s $357
million in liabilities leaves common holders in starkly negative equity territory.

The picture got significantly worse earlier this month when the SEC filed
a complaint alleging fraud against Ladenburg’s Chairman Phillip Frost. The
common equity dropped about 15% on the news, which is roughly where it
trades as of this writing.

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We don’t think the market has fully priced the impact of this news. The
company’s already poor earnings and unsustainable balance sheet are likely to
deteriorate further from here:

Investment banking clients are less likely to associate their businesses with
a firm whose Chairman and key holder is facing fraud charges.
Asset management clients are more likely to take their business to another
firm due to concerns about the reputation of the firm.
Top talent across all divisions will be more likely to leave for a firm with
stronger financial footing and a stronger brand.

Ladenburg has been in the headlines regularly since the SEC complaint and
the potential for more negative attention still looms given that signs point
toward possible criminal charges. We think the responsible move would be for
Phil Frost to resign as Chairman to avoid further reputational risk to the firm.

A true separation might be easier said than done however. In addition to his
role as Chairman, Frost is also the company’s largest holder with ~34% of the
outstanding common equity and ~5% of the outstanding Series A preferred
shares.

The balance sheet has plenty of liquidity for now with approximately $263
million in cash (including the latest bond offering) but in the absence of a
sudden turnaround in fundamentals, we think operating performance and the
preferred dividend will slowly eat away at that liquidity until common holders
are left with nothing.

Signs Point Toward Possible Criminal Charges

In the near term, headline risks still loom. On September 7th, the SEC filed
litigation against Ladenburg’s Chairman Phillip Frost, among others. Note that
Ladenburg was not mentioned in the complaint and (other than Frost) no one
associated with Ladenburg was alleged to have committed any wrongdoing.

The complaint's allegations accuse Frost of aiding and abetting multiple pump
& dump schemes led by notorious penny stock financier Barry Honig. Frost
stands personally accused of violating 7 sections of the Exchange and
Securities Acts.

The complaint described one of the fraudulent schemes as relating to

"Company A" which has been identified by the WSJ and others as Biozone
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Pharmaceuticals (now renamed Cocrystal, NASDAQ:COCP).

As I've written previously, in early 2017, investigative reporter Teri Buhl wrote
that the FBI and the California Department of Justice (DoJ) had been involved
in the investigation of Biozone. Per the article, entitled “California DOJ
investigating Honig and The Frost Group”:

This reporter has seen a letter from the FBI that states this person is a
potential victim of securities fraud. A check in the FBI’s victim notification
system, seen by this reporter at press time, show the investigation is still
active but doesn’t list specifically who the investigation is about. Biozone
is the only company the person interviewed by the FBI held stock in.

The SEC is a civil agency, whereas the FBI/DoJ are focused on criminal
matters. If a civil matter is referred for criminal prosecution (or if the FBI/DoJ
requests the SEC's expertise on securities matters) then the two will often
work together. The apparent coordination between the DoJ and the SEC
indicates that parallel criminal charges could follow these SEC civil charges.

Indications show that both civil and criminal agencies are continuing to build
their cases, which further indicates that more news could follow. The
SEC's litigation release on the day of the complaint stated that there is a
"continuing investigation". Weeks ago, Buhl wrote on Twitter:

...based on multiple sources the FBI has recently been interviewing new
informants in this case.

Lastly, the SEC often provides notice of its intent to sue in order to seek to
negotiate a resolution with parties in advance. Based on a statement made by
Frost’s biotech company, Opko Health (NASDAQ:OPK), it appears the SEC had
not afforded Frost & Opko the opportunity to settle. Per the statement, "the
SEC failed to provide notice of its intent to sue prior to filing the complaint."
The lack of any such discussion could indicate that another shoe is poised to
drop.

Balance Sheet Leaves Common Holders Vulnerable

The recent controversy seems to be adding to an already troubling situation
for common holders.

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A basic review of the filings might leave common holders with a false sense of
security. As of Q2 2018, the balance sheet shows a healthy $205 million in
cash and shareholders' equity of $390 million. Despite these high-level signs of
health, a deeper look tells a different story:

Preferred Stock Liquidation Preference. The Series A Preferred shares

are a quiet little balance sheet item that has a massive impact on common
shareholders. As of the most recent quarter the company had 17 million
Series A Preferred shares outstanding with a liquidation preference of $25
per share. In aggregate, this amounts to over $425 million in liquidation
preference standing in front of common shareholders. This item alone
would render common shareholders in a negative equity position in a
liquidation scenario as of the latest balance sheet.

The Series A preferred share class also pays a cumulative 8% dividend per
annum (Pg. F-33), which amounts to about $34 million per year. This creates a
massive drag on earnings and cash flow available to common holders, as we’ll
get into further below.

Goodwill and intangibles. Ladenburg has been highly acquisitive and has
accumulated a large goodwill balance. Intangibles consist of items such as
technology, non-compete covenants, relationships with advisors, and trade
names. (Pg. 20) We exclude these to get a sense of the hard asset base
available to common.

What are common holders left with after factoring in the preferred liquidation
preference, and goodwill/intangibles? Negative $231 million in equity:

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With a lack of tangible assets to support the common equity, shareholders are
left to rely on earnings and cash flow to sustain the value of common shares.

Unfortunately, Ladenburg has consistently generated negative annual net

income available to common holders. Annual operating cash flows have
similarly failed to support the preferred dividend.

Net Income Available to Common Has Provided No

Support
The past 3 years of net income shows that common holders are losing ground.
We can see that after factoring in the preferred dividend the common holders
have been incurring consistent, unsustainable net losses:

(See 2017 10-K Pg F-4 for the full income statement)

The cash flow picture tells a similar story. Cash flow from operations simply
has not covered the preferred dividend for the past 3 annual periods:

So how has the company managed to meet its generous preferred dividend
payments (not to mention the common stock buybacks and common stock
dividends)? Largely through the issuance of debt and yet more preferred
stock:

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(Author created table. See 2017 10-K Pg F-8 for the full cash flow statements
for these years)

It looks to us like the company has consistently used new money to support its
existing obligations. This situation was unsustainable long before Ladenburg’s
Chairman was alleged by the SEC to have committed securities fraud.

Net Income: Modest Improvement In the Past 6 Months

Helped By Accounting Methodology Changes
So far, we have done a basic review of the past 3 years’ annual financial
statements. Notably, reported metrics have improved in the first 6 months of
2018. In that period, net loss available to common was $2.2 million. At first
look, this appears to be a stark improvement compared to the first 6 months
of 2017, which saw a net loss available to common of $18.2 million (pg. 2).
Could this be signs of a major turnaround?

Not necessarily. The improved numbers look to be due in part from a change
in accounting methodology. The latest earnings release details these
methodology changes which consist of:

1. The booking of revenue for commissions on future renewals of insurance

policies sold for sales that are estimated to happen in the future.
2. Capitalizing costs to obtain a contract with a customer rather than booking
the costs as period expenses.
3. Amortizing forgivable loans to independent financial advisors over the
“expected useful lives of their relationship period” rather than amortizing
the loans based on their actual legal terms.

For the six months ended June 30, 2018, the impact of the new accounting
standard was an increase in net income attributable to the company by $5.7
million. All told, these numbers represent an improvement over prior periods
(with or without the adjustment), but it still leaves common holders with a net
loss in either accounting scenario.

Cash Flow Improvements In The Past Quarter Looks

Unsustainable
Similarly, cash flow from operations during the 6 months ended June 2018 was
$26 million compared to negative $3.7 million in the comparable 2017 period.
This is substantial improvement. However, the numbers have been erratic:
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Q1 ’18 Cash flow from operations: Negative $15 million (Pg. 4)

Q2 ’18 Cash flow from operations: Positive $41 million (Pg. 4)

So why the enormous variance? Net income available to the company was
$9.3 million in Q2 versus in $5.5 million Q1, which doesn’t explain the wide
gap. The other key sources of operating cash flow consisted largely of pushing
out payables and pulling in receivables:

+$9.2 million net additions to commissions and fees payable

+$8.6 million net additions to accrued compensation payable
+$1.9 million net additions to accounts payable and accrued liabilities
+$4.1 million net receivables collections

Operating cash flow of $41 million in a quarter that saw only $9.3 million in
net income is clearly not a sustainable balance. Cash flow should revert in the
next quarter or two; the key question for us is ‘how big will that swing be’?

It is essential that the company find sustainable growth that can actually
support the preferred dividend without relying on short-term working capital
swings and without levering up the balance sheet further. Given recent
headlines however, we think it is unlikely that we see any near-term positive
surprises.

Liquidity: Fine For Now But A Ticking Clock For Common

Holders
The company has raised $202 million in cash in roughly the past year and a
half through the net issuance of debt, preferred stock, and common stock.
There is no immediate threat from the debt waterfall as the majority of
Ladenburg’s $194 million in notes payable don’t come due for 9-10 years.
(Sources: Pg. 1 and recent debt offering announcement)

With roughly $263 million in cash (counting the recent debt offering) and no
major debt maturities on the horizon, Ladenburg has enough to sustain its
preferred dividend for the foreseeable future.

However, with the balance sheet levered up and with a tremendous amount of
preferred stock outstanding there seems to be little left for the common
holders. Over time we think the preferred dividend will suck the cash out of
the business, barring a sudden and sustained improvement in fundamentals.

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What Should Ladenburg Do From Here?

We think Phil Frost should resign to avoid more reputational damage to the
firm. As the investigation and enforcement process continues forward, it is
almost assured to create more negative headlines and spook clients.

Additionally, we think the company should suspend its common stock dividend
and buyback programs. Both strike us as little more than window dressing.
Issuing debt and preferred stock to support common stock buybacks and
dividends is nonsensical. This is especially the case when common
shareholders are regularly experiencing net losses and negative to spotty cash
flow.

We doubt the company will do this (because of the negative signaling it would
create in the short term) but it would nonetheless extend the runway.

Conclusion: We’re Short The Common And Keeping An

Eye On The Preferred
We think the common is already intrinsically worth close to nothing and makes
for an obvious short here. The potential for more near-term headline catalysts
and the risks of poor near-term operating results would disproportionately
affect the common holders.

We’re keeping an eye on the preferred but not taking a position either way.
There looks to be enough liquidity with the cash balance to keep the dividend
chasers happy for the foreseeable future, but we don’t have enough faith that
the fundamentals will hold up to justify a long position or even a pair trade.

Best of luck to all.

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