INNOVATE Corp. quarterly report, Q2 FY2016

Business context and reporting period

HC2 Holdings, Inc. (the filing identifies the registrant as HC2 Holdings, not INNOVATE Corp.) filed this unaudited Form 10-Q for the quarter and six months ended June 30, 2016. HC2 is a diversified holding company with seven operating segments: Manufacturing, Marine Services, Insurance, Utilities, Telecommunications, Life Sciences and Other.

Key financial results

Amounts below are in millions except per-share data. The second-quarter comparison is with the three months ended June 30, 2015; the six-month comparison is with the six months ended June 30, 2015.

Q2 operating margin was approximately 1.6% (versus 1.1%); the six-month operating result was a loss. Management-reported Adjusted EBITDA, a non-GAAP measure, was $15.2 million for Q2 versus $19.6 million, and $15.5 million for the first half versus $25.5 million.

Liquidity, debt and balance sheet

• At June 30, 2016, consolidated cash and cash equivalents were $134.5 million, down from $158.6 million at December 31, 2015. HC2 parent-company cash was $40.3 million; Insurance segment cash was $28.9 million.
• Cash declined $24.1 million in the first half. Operating activities provided $46.2 million; investing activities used $65.8 million and financing activities used $4.2 million.
• Long-term obligations were $394.5 million, compared with $371.9 million at year-end. The balance included $307.0 million principal of 11% secured notes due 2019 and $54.2 million in capital leases. Interest expense was $20.9 million for the first half.
• Total assets were $2.845 billion; total liabilities were $2.624 billion. Investments totaled $1.461 billion, including $1.324 billion of available-for-sale fixed-maturity securities.
• HC2 reported compliance with its debt covenants. The notes’ liquidity covenant required approximately $19 million of incremental unrestricted cash at June 30; collateral coverage was above 2.0x, and the minimum collateral coverage covenant was 1.25:1.

Material changes and management commentary

• Revenue rose 27.9% in Q2 and 43.1% in the first half. Growth reflected higher Telecommunications volumes and the Insurance Companies, acquired in December 2015. Telecommunications revenue increased to $164.0 million in Q2 and $313.8 million in the first half; the Insurance segment contributed $36.2 million and $65.3 million, respectively.
• Manufacturing revenue declined as prior-year projects neared completion and project delays reduced comparable work, although segment operating income improved. Marine Services revenue and earnings were pressured by lower installation activity; first-half results also included a $5.5 million expected project loss tied to customer administrative delays and adverse weather.
• Six-month operating results deteriorated despite revenue growth, principally from weaker Marine Services and Insurance results and higher losses in Other and corporate activities. Insurance reported a $9.8 million first-half net loss; its non-GAAP Insurance AOI loss was $7.3 million.
• Cash from operations improved substantially year over year, which management attributed mainly to working-capital movements and $7.2 million in dividends from equity investees. Investing outflows included purchases of investments and capital expenditures, partly offset by investment sales.
• Acquisitions included control of BeneVir, a 60% interest in CWind (with commitments to acquire the remaining interest in stages), and two Arkansas natural-gas fueling stations. A further Arkansas station purchase for $5.5 million occurred after quarter-end.

Outlook, risks and unusual items

• No quantified company-wide earnings or revenue guidance is provided. Management said it expects to meet liquidity needs for at least the next 12 months through subsidiary distributions, additional financing, refinancing, equity or asset sales, while cautioning that these options may not be available on acceptable terms. Subsidiary distributions are subject to contractual, regulatory and other restrictions.
• Insurance subsidiaries are subject to five-year capital-maintenance commitments to maintain at least 400% of authorized control-level risk-based capital. The company reported that statutory capital remained above that threshold at June 30; it also agreed to indemnify Great American for any payments under capped capital-maintenance agreements.
• Insurance reinsurance recoverables were $526.2 million, with 65.0% due from Hannover Life Reassurance. Reserve adequacy, reinsurance collectability, investment performance, interest rates and insurance regulation are significant risks.
• HC2 disclosed that two major credit insurers would not insure ICS and had canceled existing coverage, potentially making suppliers less willing to extend credit. The filing also identifies Brexit-related uncertainty and foreign-exchange exposure, particularly involving the British pound.
• Schuff backlog was $344.3 million, of which $83.2 million was under letters of intent; five commitments represented 50.9% of backlog. Management cautioned that termination or reduced scope of major contracts could materially reduce backlog.
• Q2 results include a correction of an immaterial prior-period depreciation and disposal-accounting error. The cumulative adjustment increased Q2 net income attributable to common and participating preferred stockholders by $1.3 million; excluding it, that measure would have been a $0.4 million loss. The filing says first-half common and participating preferred stockholder loss was reduced by a net $0.5 million due to the correction.
• Pending matters include a Canadian spectrum-license dispute seeking $50 million and Schuff tender-offer stockholder litigation. HC2 said it did not believe pending claims would materially affect the consolidated financial statements. Management reported disclosure controls were effective and no material quarterly change in internal control over financial reporting.
• Preferred holders agreed after quarter-end to convert 10,000 shares into common stock, reducing accrued preferred value to $42.7 million, then convertible into approximately 8.5 million common shares. Additional shares were issued or may be issued for dividends forgone, creating potential dilution.

Important facts for investors to verify

• Confirm the filing entity: the supplied 10-Q is for HC2 Holdings, Inc., despite the request metadata naming INNOVATE Corp.
• Assess whether operating cash flow is sustainable or mainly reflects working-capital timing, and whether parent-level cash is sufficient for interest, preferred dividends and corporate costs.
• Review the high-cost 11% notes, debt maturities and covenant headroom, including the effect of subsidiary restrictions on distributions to HC2.
• Examine Insurance reserve assumptions, capital requirements, reinsurance concentration and the potential for required capital contributions or indemnity payments.
• Track the Marine Services project loss, installation activity, CWind debt and remaining purchase commitments, as well as concentration in Schuff’s backlog.
• Evaluate the durability and margins of Telecommunications growth given supplier-credit insurance cancellations, and monitor Brexit and currency effects.
• Review the accounting correction and preferred-stock conversion terms for their effect on reported earnings, share count and future dilution.