Implant Sciences: A Bankruptcy Liquidation

Company Overview

Implant Sciences Corp. (OTCPK:IMSCQ) (“the Debtors” or “the Company”) makes systems and instruments for the detection of trace amounts of explosives and also drugs and harmful chemicals. Its products are used by the military, Homeland Security and Customs and Border Protection as well as other government and commercial entities such as ports and freight-handling companies. The Company declared bankruptcy on October 10, 2016, by filing under Chapter 11 in Delaware. It has agreed to sell substantially all of its assets to L-3 Communications Holdings (NYSE:LLL) for $117.5mm and the assumption of a large amount of its non-financial liabilities. LLL will be the stalking horse bidder in a 363 auction to be held on December 12th if any additional qualifying bids are received by December 8th and the sale hearing will be held December 16th.

Investment Thesis

IMSCQ has traded OTC for years, has almost no institutional ownership and just a $9mm market cap currently. So it is no surprise that this has fallen below the radar of most funds. Based on our liquidation analysis, the equity recovery should be no less than $0.15 which is a 46% low case return from the current trading price of $0.10. In our expected case, recovery is $0.24 which is a return of 140%. Our high case liquidation value is $0.30 and the return is 200%. This is even before the auction, which if there is another bidder, it would be all incremental upside that goes to shareholders. The Company’s low share count makes the upside leveraged with just a $25mm increase needed to double our expected case recovery. The time frame to a payout is also very short and we hope to see a distribution as early as February which would make for some phenomenal IRRs. Additionally, if the $116mm NOL (and $82mm in state NOLs) could be utilized that would add $0.07-0.14 to our recovery assuming the standard valuation of 5-10% of the nominal NOL amount. However, we do not think this management team is the group to lead that effort taking into account their past track record. We would consider supporting someone else with a value background if they came in to look for ways to utilize the NOL. In fact, other than L-3 pulling their bid for some reason such as violation of the material adverse change clause which we view as very unlikely, the biggest downside in our opinion would be if shareholders voted to allow the current management team to complete their desired acquisition of Zapata Industries SAS (“Zapata”). Management would need 67% of shareholders to vote in favor of a bankruptcy plan that involved completing the deal and we believe a significant portion of the shares have turned over from the original individual shareholders to funds like ours which are looking to maximize value.

Situation Overview

IMSCQ filed for bankruptcy on October 10th and with the immediate backing of the US Trustee, an equity committee was formed on October 24th which is a good sign that the equity will have some support against management. However, the members of that committee are all long-time shareholders and we worry there may be some “true believers” who are willing to give management a long leash and possibly approve the Zapata acquisition. Brown Rudnick, LLP (“Brown Rudnick”), which is the equity committee’s counsel, says that they are all very familiar with the business, which is of little value when it is getting sold, but one has some bankruptcy experience and another is a lawyer. Still, this is not as comforting as it would be if funds with distressed experience were running the committee. Brown Rudnick did say they think the committee is skeptical of the acquisition right now without learning more of the facts but just examining the messages boards it seems many shareholders are mesmerized by the hype surrounding Zapata’s business.

Since going public in 2000, IMSCQ has never turned a profit. In IMSCQ’s fiscal year ending June 2015, they did $13mm in revenue and lost $12mm in EBITDA. In FY ending in June 2016, IMSCQ did $53mm in revenue and was about EBITDA break-even which means revenue grew 308%. Since the Company has never had positive EBITDA, this also represents a remarkable achievement for them. In March 2015, IMSCQ received an IDIQ contract with the TSA for up to $162mm of equipment and services. In September 2016, which means we have yet to see any benefits from this order yet, the TSA ordered $71.3mm of additional equipment under that same task-order. However, the US government was responsible for only 39% of 2016 revenue which means that over $30mm in revenue came from foreign governments and commercial sources which in it of itself represents tremendous growth.

Since the business is being sold at auction to LLL, an analysis of the business is not important to our thesis except to the extent that other defense companies may find it desirable and want to top LLL’s bid. Adoption by the TSA seems to have sparked sales and possibly will attract interest from other companies. IMSCQ claims that theirs is the only equipment on the market which does not have a radioactive ion source for detection and can perform real-time protection, which makes their product much more desirable because of the restrictions on using radioactive instruments especially when scanning passengers at an airport, for example. However, management states in the declaration supporting the 363 motion that the marketing process began in August 2015 and 63 parties were contacted yet only 3 made an indication of interest. The Debtors thought that only 2 of those indications of interest represented realistic valuations. Additionally, Chardan Capital Markets LLC (“Chardan”) which is the Debtors’ financial advisor put out a press release with the Company requesting any indications of interest to purchase IMSCQ. LLL also has a history of making somewhat overvalued acquisitions of small companies with promising technologies which other defense majors do not normally do. However, Brown Rudnick believes that this may have been a half-hearted marketing process with possibly a pre-ordained outcome of selling to LLL and this possibility should be explored in court. The Company may also have been marketed as a going concern in the $0.60-1.00 range in which it was trading over the last year. One competitor has made a telephonic appearance in court so far: OSI Systems, Inc. (NASDAQ:OSIS) which has a $1.6B EV. Another large competitor, Smiths Group PLC (SMIN LN) of the UK with a GBP6.7B EV, just bought another competitor from Safran SA (OTCPK:SAFRF) in April for $710mm. It is somewhat suspicious that the price LLL is paying is just enough so that IMSCQ management can complete their preferred deal with Zapata. Also, Chardan is a very small investment bank so maybe they didn’t get full exposure to possible acquirers for their client. It is certainly possible, therefore, that there is an overbid and we hope there is one but we do not think the chances of it are very high. Success fees for Chardan their other financial advisor would be 2.25% of the $117.5mm and 3% of a Dip loan which are both way too high.

Chardan also did a very poor job of soliciting interest to provide a DIP loan. Initially, the secured lender, various funds associated with Platinum Partners Value Arbitrage Fund LP (“Platinum”), agreed to provide the loan in May 2016 but backed out in August. LLL was approached but they declined. Chardan only went to 3 other parties between August and the October 10th filing date and the party they picked was of course headed by the former CEO of Chardan who still owns a significant equity stake in the boutique bank. Needless to say, the terms were egregious. The equity committee opposed the DIP and another lender, Tanner Partners, came in to replace the ex-Chardan CEO. However, the terms are not much better: the interest rate is 12% and the default rate is 24%. Fees are $35k for origination and a $425k exit fee minus any interest paid. Altogether it was a net savings of $300k in fees. These terms are for a maximum term of 6 months and a likely term of 2 months if the current auction schedule holds. The loan amount is $8mm which is 15x over-collateralized by LLL’s bid. LLL is also not some fly-by-night private company whose financials are largely unknown or some Chinese company where regulatory approval or intent to actually close is in question. LLL is an S&P 500 company with a $10.8B market cap. Based on a two-month payback period, the IRR for this loan would be 41% compared to two-month LIBOR of 0.67%.

The acquisition of Zapata does not sound like any great opportunity to us but just an attempt by management to continue running a public company and paying themselves large salaries. Zapata has nothing to do with explosives or narcotics detection but instead sells backpacks and boards (“Flyboard 3.0” and “Jetpack 1.0” hydro-flyers) that one sometimes sees at beach resorts that shoot water downwards allowing the person to fly above the water a few dozen feet connected by a hose. This business does around $8mm in revenue and $2mm in EBITDA according to IMSCQ investor relations. However, IMSCQ says that this is not the business they are interested in but instead the ancillary business of Flyboard Air which is a product still in development. The Flyboard Air is a jet-powered board which allows the user to fly and hover for up to 20 minutes with a 10k ft ceiling and provides 12 ft/sec of lift according to the claims of Zapata. Videos of the founder using a prototype sometimes go viral. They expect this technology to be used for military applications as well as larger platforms to transport personnel and materiel. These businesses are both pre-revenue but management is basically asking shareholders to trust them even though we are in the midst of bankruptcy of the last business they ran. We do not think their track record supports giving them another chance. Also, the only point of reorganizing would be to utilize the $116mm NOL which you can’t do if the business you’re buying not only has no cash flow but needs significant R&D dollars. IMSCQ also does not have the capital resources to support a start-up business like this which is likely to burn cash for many years until/if the product becomes commercially viable and will probably lead to another bankruptcy eventually. The price being paid is also ridiculous: $15mm in cash plus 60% of the total outstanding shares of common stock ($5.8mm value currently) and 50mm 4-year warrants to purchase stock at $1.50 (which has a Black Scholes value of $3.5mm). There is also a break-up fee of $350k but from our conversations with investor relations, it sounds like the Letter of Intent is not finalized and/or management believes there are ways to get out of the deal without paying the breakup fee. The president of IMSCQ also has an agreement with IMSCQ that says if the transaction if not consummated or he is not hired by the new company then he is owed $300k. Employment agreements with senior management say that they are entitled to change of control payments of 12.5% of equity value. It is items like this that make us think that this is a sub rosa plan and many of these actions have been orchestrated to force shareholders to accept the Zapata acquisition. We believe these types of claims would likely be struck down by the court as either preferences or just invalid. Needless to say, we think the conservative course of action is to liquidate at more than double the current market value of the company rather than blowing it all on another speculative venture. Shareholders are lucky to be getting anything.

Another source of recovery may be actions against Platinum who is the lender of IMSCQ’s $84.2mm in loans and pre-petition accrued interest. Brown Rudnick believes that there may be grounds to pursue equitable disallowance remedies against Platinum based on pre-petition actions that may have driven IMSCQ into bankruptcy. We don’t know how far those theories would go with a judge since we did not see anything glaring when we read the history but you never know. It seems like there were some actions which were not disclosed to the public. Also, Platinum is in bankruptcy itself after being accused of fraud, bribery and rigging a bondholder vote and is under multiple federal investigations. As they have their hands full, they may take a haircut just to make any additional trouble go away. Additionally, Platinum and IMSCQ renegotiated and amended the terms of the loans many times before bankruptcy with the most recent one falling in the 90-day preference period. Any fees paid for these amendments and waivers may be able to be clawed back. Platinum also has conversion rights for a couple of its loans. They’d get 66.1mm shares if Platinum converted their $5.3mm March 2009 debt at $0.08/share and 36.8mm shares if they converted $7mm of the 2012 note at $0.19/share. In total they’d control 60% of the stock if they converted all their debt. However, they have an agreement with IMSCQ to limit their total ownership percentage to 4.99% to protect the NOL from a Section 382 limitation and the ability to convert debt in bankruptcy has mixed case law so it may be contestable if they even tried.

Most recently on Oct. 26th, Brown Rudnick was able to successfully push back the auction to mid-December instead of late November. They were also able to reduce the break-up fee from $7mm to $3.5mm and expense reimbursement to $1.5mm and the initial overbid to $3mm with a $1mm increment beyond that. In addition to the $117.5mm in cash that LLL will be paying they are also planning to assume a lot of the pre-petition trade debt, contracts with their associated cure amounts up to a $1.5mm limit and accrued expenses. These total $10.5mm based on the 6/30/16 balance sheet. We haven’t been given an updated number. But LLL is also taking nearly all of the current assets and cash which had a value of $14.8mm on 6/30/16. That implies net working capital of $4.3mm but if at closing net working capital is not $9.5mm the difference is payable to LLL with any overage going to the IMSCQ estate. We don’t know if that is a realistic number or it is just a way to make the $117.5mm seem higher than it is. One worrying feature is that the APA includes avoidance actions as an asset LLL is acquiring. This smacks of management trying to protect themselves and Platinum and we aren’t sure if that has been changed in the revised bidding order.

We expect the sale will close in the days after the sale is approved. Once the cash is in the estate we expect management will put forth a plan probably in early January with their proposed use of the proceeds: the Zapata acquisition in all likelihood. However, management also seems like they are going to attempt to solicit votes on an acquisition of Zapata in December at a shareholders meeting they have announced which we think will be disregarded by the court. If the disclosure statement is approved by the court in late January we could see a vote in February with the transaction shortly thereafter. If less than two thirds of shareholders vote to approve the plan, then it is back to the drawing board and IMSCQ investor relations says it will respect shareholders’ wishes and liquidate. If management can be convinced to follow through on that promise and distribute the proceeds to shareholders, it could happen as soon as April or May if that plan is put forth by management and approved. Management could stall however and they would have up to 18 months from the filing date of exclusivity when only they could file a plan which they could use to look for alternative transactions while continuing to pay themselves. There could be various ways to fight that kind of delay though. With the help of the US Trustee and the judge, a trustee could be requested which would remove management from control and if a trustee is denied then an examiner is automatically appointed which could investigate management’s past actions. Or a conversion to Chapter 7 could be requested where a liquidation would take place almost immediately.

Valuation

This is almost free money because the retail investors that largely make up the shareholder base do not know how to value a company in bankruptcy or are just exhausted after years of holding it and are taking the loss or are scared by the bankruptcy process.

Excluding the NOL, the only asset that really matters is the cash from LLL. We estimate this as $115.2mm in our low case to $119.9mm in our high case which reflects possible differences in net working capital. On the liability side, the Debtors have provided us with some handy tables of excluded assets and liabilities. The balance sheet date is from 6/30/16 however. They show that $80.4mm is debt and there is $1.4mm of payables and $8.8mm of accrued liabilities. On a table with a further breakdown, we see that $7.7mm of those accrued liabilities is accrued interest. The Debtors have provided a different chart with indebtedness as of 9/30/16 with $10.7mm in accrued interest and $73.5mm in loan principal which we have factored into our liquidation analysis on the liability side already. We don’t want to double count so we remove that $7.7mm. Adding up the 30 top creditors (with the 30th top creditor having a claim of just $44k), we come up with an updated payables number of $5.5mm which is higher than the 6/30/16 figure so we use that. The Debtors have requested $3.4mm of these claims be paid as critical vendors and which they have included in their 13 week DIP budget. Therefore, we add the $8mm in DIP principal which includes the $300k in origination fees and add the difference between the $5.5mm pre-petition claims and the $3.4mm in requested critical vendor claims to our liability side. We also know what professional fees are expected to be during the 13 week DIP period and they average about $600k per month. Since this is the time during the case with the most activity and work, we expect this number will drop maybe by half or more in January. Therefore, we have assumed $1.2mm in additional professional fees which should give the Debtors enough time to eventually pay a distribution in the spring. Adding all this up gets us to $0.24 per share in our mid case which is a 140% return and a 473% IRR assuming a 6 month payout. Since there is a lot of leverage here to what claims and net working capital finally work out to, there is risk but we think an $18mm distribution or $0.15 is the low case for equity recovery and that would have to be cut by a third to lose money on this position. Again, none of this assumes and overbid which would just be gravy for the equity.