Portfolio Watch

By Pete Gallo

May's market mayhem didn't stop Andreas Halvorsen's Viking Global Investors long/short fund from hitting a resounding home run on one of its recent portfolio picks, Psychiatric Solutions.

Filings with the Securities and Exchange Commission show that Viking at the start of the second quarter owned 1.6 million shares of the Franklin, Tenn., mental health services firm. The position was a new addition to the Viking portfolio and made the hedge fund one of the company's largest shareholders with roughly a 3% stake in the firm, filings show.

It was a daring bet. Psychiatric Solutions shares had been struggling since the final quarter of 2009, when they fell from a high of $27 to a low of $18. The stock later languished, hitting about $21 per share in March, when Viking entered the fray. But since then the stock has skyrocketed, hitting $32.44 per share as of June 4.

The stock's gain of $11.44 over that period would have boosted the value of Viking's stake to $51.9 million, for a gain of $18.3 million since March, assuming no shares were sold or added.

But it's better than that. The gains seen for Viking Global and other shareholders are permanently locked in, thanks to a May 17 announcement that rival United HealthCare Services in King of Prussia, Pa., will be buying Psychiatric Solutions for $2 billion in cash, at a share price of $33.75.

Luck? Unlikely. Viking deserves serious credit for spotting this quirky investment opportunity that seems to be anything but textbook value investing. United HealthCare Services' acquisition of Psychiatric Solutions is seemingly an investor's nightmare, with United pledging to pay $2 billion for a company laden with $1 billion in debt, filings show.

That's tough medicine. In fact, the day after the deal was announced, Fitch lowered United HealthCare Services to noninvestment grade BB and issued a negative outlook for company debt on May 18.

So if Psychiatric Solutions' bulky debt made such a buyout deal unlikely, what tipped off Viking and other investors that an acquisition was in the works? What we do know is that heavy options volume grabbed the attention of some investors, who became aware in late February that Psychiatric Solutions' top executives were putting in place fat exit packages, which suggested some sort of deal was being planned. Those rumors drew headlines, and a number of investors, including Viking, piled into the stock around that time.

But as it turns out, Halvorsen's hedge fund is on both sides of the merger deal. Viking Global owns roughly 4.8 million shares of United HealthCare Services, a 5.3% stake in the company, based on filings for the quarter that ended March 31. That stake was recently and dramatically increased, as filings show only 192,000 shares of United were held in both the previous quarterly filings. United HealthCare Services owns and operates some 25 medical hospitals and 102 behavioral centers in 32 states and in Puerto Rico and the Virgin Islands. So its acquisition of Psychiatric Solutions' 94 inpatient mental health facilities will widen its geographical coverage and consolidate its market position, providing economies of scale.

Yes, that's boilerplate merger talk. But what is the Street's verdict? Following the May 17 announcement, shares of United HealthCare Services have traded in a surprisingly narrow range after an 8% price jump on the day after the merger announcement. And the stock is still up respectably since the start of the quarter, rising from $35 on March 31 to $43 as of June 4, an all-time high. The value of Viking's stake rose to $206 million, for a gain of $38.4 million.

United HealthCare Services' deal to pay $2 billion cash for a mental health company with $1 billion in debt, and the stock's subsequent rise, clearly shows that investors are exceptionally eager to buy and hold just about anything that has strong growth potential in this tough market, even if that growth is in psychiatric services. Notable from a stock-picking perspective, the deal between Psychiatric Solutions and United HealthCare Services also proved a rare double-barreled merger win for Viking. In otherwise uncertain markets, you sometimes have to make your own luck. Just ask the exiting execs at Psychiatric Solutions who will be leaving with $30 million. Even so, investors are so hungry for growth they are bought shares on the same day that Fitch put a downgrade warning on the debt.

By Pete Gallo

All indicators are that billionaire hedge fund manager John Paulson’s firm, Paulson & Co., isn’t letting up in its interest in the embattled financial sector. Paulson & Co. in April took a 13% stake in American Capital, the Bethesda, Maryland–based private equity and asset management firm that trades on the Nasdaq.

American Capital and its addition to Paulson & Co.’s portfolio of financial sector investments is interesting to watch. Why? Remember, Paulson himself was one of the earliest hedge fund managers to correctly call the residential real estate market bust led by the subprime mess. And his firm’s 13% stake in American Capital identifies a new theme the rest of us should be paying attention to.

These days, Paulson is prospecting upside opportunity by buying into financial companies, like American Capital, that have exposure to distressed investments.

Call it special-situations investing in asset managers exposed to distressed debt that desperately need to restructure and recapitalize to hit the next level. In American Capital’s case, in looking to restructure $2.4 billion in debt, the firm raised $295 million through a 58.3 million share offering, based on filings with the Securities and Exchange Commission. (The offering deal inflated overall shares by 20% to 339.2 million shares of outstanding common stock.)

On April 19, Paulson & Co. offered to buy the bulk of that offering, gobbling up some 43.7 million shares at $5.06 each, amounting to a hefty $221.1 investment. Shares priced at a 5% discount.

But that aside, the position has already been a winner for Paulson & Co.

American Capital stock rose in value to $6.45 per share on April 29, up from $5.60 on April 19—roughly a gain of 13.2%. Not bad, though part of that spike surely followed me-too investors trying to flood into a stock drawing commitment from a heavyweight like Paulson & Co.

But will American Capital’s debt restructuring pay off in long-term profits for Paulson & Co.? American Capital has been publicly traded since 1997, but the company was bumped out of the S&P 500 index in February 2009 as a credit crunch crimped its bottom line. (The stock was at an all-time low of 63 cents in March 2009.)

As with all asset managers with distressed and special-situations portfolios, the challenge for American Capital after restructuring debt will be to monetize previously stalled portfolio positions. On May 4, American reported $163 million in cash proceeds from market realizations for the first quarter of 2010 (with $114 million coming from loan sales and principal payments from portfolio companies), as compared with $476 million and $463 million for the two previous quarters, respectively, filings show.

Paulson & Co has reason to be optimistic. American Capital focuses on senior obligations as well as second liens, ABL loans and mezzanine financing. The company’s holdings are also fairly diversified, but its notable focus is in the energy sector, where American Capital has exposure to everything from oil, coal and natural gas to alternatives like solar and nuclear. Service companies, utilities and distribution companies are also in the mix, as are resource-gathering enterprises, including some exotic investments like uranium mining. (Information technology outfits and human resources investments targeting state and local governments are also part of the American Capital portfolio.)

Since the start of the year, Paulson & Co. has bulked up on other financial sector firms, according to filings with the SEC.

For instance, the firm took a 4.4 million-share stake in the CIT Group. (Other hedge fund investors include Icahn Capital and Greenlight Capital.) CIT Group traded at $40 per share on May 4, up from $25 at the start of the year.

Another new position in the Paulson & Co. portfolio at the start of the year was a 1 million-share stake in Northern Trust, which was trading at $53 per share on May 4, up from roughly $50 in early February.

The hedge fund shop also started the year with a new investment in Wells Fargo, 17.5 million shares. The stock hit $33 on May 4, up from a low of $21.50 in January.

Other portfolio positions in the sector are SunTrust Banks and Citigroup. Meanwhile, Bank of America remains one of the firm’s largest positions—some 164.8 million shares. On May 4, shares were worth $18, up from $15 at the start of 2010.

Will the financial sector bet continue to pay off?

By Pete Gallo

Forget the New York Times. Harbinger Capital Partners has finalized the takeover of a company whose technology actually could cover the globe—the satellite and data corporation SkyTerra Communications.

As of late March, Harbinger was the largest shareholder in the Reston, Virginia, company. If you aren't a techie, you've likely never heard of the formerly over-the-counter stock, with a market cap of under $1 billion. But it has been a solid performer, trading right before the deal closed at $5 per share, up from $2.25 a year ago.

But it's too late to add SkyTerra to your portfolio. On March 29, Harbinger completed its all-cash acquisition of the company for $262.5 million with Harbinger founder Phil Falcone and other fund executives directly taking the helm of the board, according to an 8-K filed with the Securities and Exchange Commission.

At $5 per share, Harbinger paid roughly a 56% premium over share prices when the acquisition deal was announced on September 23, 2009.

But that's the past. The future? The acquisition and privatization puts Harbinger in an interesting spot in the growing mobile data game, the purported future of the information technology world that stands in strong contrast to the old leaders in the information and news business such as the New York Times, in which Falcone has been unloading a controversial and unprofitable stake for some time.

Some investors may have miscategorized SkyTerra as a minor mobile phone and satellite play, but Harbinger saw that the company's real upside was in the data transmission and networking business, where SkyTerra has a 13-year track record providing services for government and enterprise clients.

That's Harbinger's clever portfolio move. This doesn't seem to be a quick buy and flip. SkyTerra may serve as a cornerstone for a larger global LTE data network. LTE stands for Long Term Evolution, a mobile communications standard used for so-called 3G (third-generation) phones and mobile computing devices as well as proposed 4G devices.

What's more, SkyTerra has the right friends and regulatory beachheads to secure further market share.

Prior to the Harbinger buyout, the company on March 10 announced its new software that would serve primarily government transportation and public safety agencies in the United States and Canada, including homeland security agencies, based on SEC filings. This includes solutions for tracking government and commercial transportation.

Bigger plans are already on the table. As head of the SkyTerra board, Falcone, along with Harbinger-appointed executives, will continue the company's existing negotiations with government regulators aimed at expanding SkyTerra's usage of the available communications spectrum. Prior to the acquisition, the company had added two new trial markets, Phoenix and Denver, and it aims to add 36,000 terrestrial base stations to serve some 40 million customers by 2015, according to filings.

But are Falcone and Harbinger prepared to see this strategy through? The hedge fund's acquisition deal drew fire from AT&T and Verizon, both of which criticized the Federal Communications Commission and claimed the buyout deal may be unlawful in that it effectively inhibits the ability of other communications players such as themselves to commercially lease airwaves.

No doubt having a substantial base of government clients may help a Harbinger-owned SkyTerra stave off such a regulatory turf war over bandwidth. A Harbinger filing with the FCC suggested the deal would add greater competition, helping retail customers and "enabling competitive carriers and new entrants to enjoy a level playing field in network performance and economics."

With Harbinger having just won its bid and received regulatory approval for the takeover, it may be too soon to speculate about its exit strategy. For the moment, Harbinger seems to have gobbled up a company with strong short- and long-term growth prospects with the proper strategic and regulatory positioning to execute on its plan. Why hurry to sell it?

Harbinger has shown great interest in the wireless communications sector. In September, it took a 25% stake in Augere Holdings, which in 2009 launched Internet and broadband services in Bangladesh and Pakistan. Harbinger's $50 million private equity investment was directly tied to the firm's investment in WiMAX and Internet technologies in these emerging markets, according to Augere. AR

By Pete Gallo

If they ever form a club for contrarian hedge fund managers, it's likely Carl Icahn would refuse to join, just to show he was the most contrarian investor of all.

That's too bad because other contrarians would probably want to ask him about one of his more unusual bets—especially his big investment in video-game maker Take-Two Interactive Software, which has recently rebounded. (The stock on March 10 set a recent high of $10.50 per share, up from an abysmal low of $7 set in early December.)

Icahn Partners has been a major shareholder in the company since 2007. But in the final days of 2009, the hedge fund upped its stake in the company from a speculative two million shares to an eye-popping 6.7 million shares, representing an 11% stake in the company.

So what was he thinking? Certainly Icahn couldn't allow himself to miss out on a buying opportunity. As the stock slipped by more than $3 per share between November and December, filings with the SEC show Icahn Partners went on a shopping spree. In doing so, the hedge fund widened its lead as the game maker's largest shareholder. (Harbinger Capital Management is the company's second-largest stakeholder with 5.8 million shares, according to regulatory filings.)

The bet proved a winner for Icahn. As the stock rose to $10.50 (on March 10), the hedge fund's position stood to jump to roughly $70.4 million, as shares climbed roughly 50% over December lows.

But all of this was less than obvious. Projections for the video gaming sector's revenues after a huge growth spurt were on a trajectory to slump when Icahn upped his fund's stake.

Analysts predicted the gaming sector was too crowded and that effects of the recession would squeeze sales. Even Icahn's market fans cringed at his big bet.

It turns out that the naysayers were right—at least in part. The sector's sales came in worse than anticipated at $624 million in February, a 15% drop over the same period 12 months earlier.

The only thing they missed in their thesis—which Icahn got right—was that the top video game titles with the highest sales for the sector came from Take-Two's lineup.

In other words, Wall Street analysts saw the sector as an overgrown forest, but only Icahn's contrarian eye managed to paint a bull's-eye on the right tree.

And he deserves kudos for throwing cash at a company many had considered a has-been at exactly the time the stock slumped on wider fears of an industry-wide contraction.

Still, the critics may eventually be right. Rival game maker Electronic Arts two years ago wanted to buy out the company for $2 billion, and it seems unlikely that Take-Two will see another $26 per share bid anytime soon.

Icahn surely can see that if consolidation is inevitable for the industry, players like Activision Blizzard or others might come to the table at some point down the road.

As the largest shareholder in Take-Two, he must also be aware that the company has inked a deal with OnLive, a platform that starting in June will allow gamers to stream Take-Two console titles over the Internet, which should boost sales and perhaps provide recurring revenues, considered the Holy Grail of the gaming industry. Until now this has been a PC phenomenon, dominated by Activision Blizzard's World of Warcraft franchise.

Somehow I don't see Icahn leaving board meetings early to secretly play World of Warcraft.

But he is certainly a crafty enough investor to see that recurring revenue models and licensing opportunities are just in their infancy for the video game industry.

And any involvement by Take-Two will not only help his bottom line on a quarterly basis, it will also make the company a more attractive takeover target down the line, if he is thinking about an exit strategy.

If anything, Icahn may be secretly hoping that Wall Street analysts continue to overgeneralize about the sector's short-term prospects so that Take-Two shares occasionally dip low enough to make adding to his stake less expensive.

Other large positions in the Icahn Partners' portfolio are Genzyme, Wendy's, Biogen Idec and Lions Gate Entertainment, for which Icahn launched a hostile takeover bid on March 19.

The hedge fund is also a large investor in Yahoo, though that position was trimmed in the last quarter of 2009, according to SEC filings.

By Pete Gallo

I'm not sure if any member of Ramius Advisors' investment team made it to the Vancouver Winter Olympics in February. But if so, the person would likely be upbeat about all the body-imaging scanners at the airport as well as the high-tech screening devices at event sites.

Why? Ramius is one of the largest shareholders of a tech company you've probably never heard of, called OSI Systems, which won the contract to provide security technology to the Vancouver Games.

Shares of OSI have been on a roll. The stock has doubled in value over the last six months, hitting $28 as of February 10. Filings with the Securities and Exchange Commission show the hedge fund owns some 555,500 shares of the company, swelling its stake to roughly $15.6 million.

The hedge fund has been a long-term investor in the company. With a market cap of just under a half-billion dollars, OSI, which has been around since 1987, is showing real traction, thanks to a recent spurt of buying of electronic screening equipment for passengers and cargo at airports.

Ramius shouldn't consider selling at this point. In addition to the contracts in Vancouver, the company since last year has been providing its branded Rapiscan Systems equipment through other transportation agencies at home and abroad. On February 1, the company announced a new $25 million U.S. government contract, helping push the stock $3 higher over the following week. Other deals were inked with NATO and international customs agencies in the United Kingdom.

Although a small cap stock, the company is well positioned because it focuses both on electronics and medical imaging, the very technologies being used at airports in the war on terrorism. Besides, if the contracts start to dry up, the company can rely on its pure medical technologies, a high-growth area on its own. And the company counts Lockheed Martin and Honeywell among its clients. That always helps.

Another long position in the Ramius portfolio is the Peabody, Mass.,-based Analogic, yet another medical imaging company that has been growing thanks to new security and defense industry applications for its technologies. Analogic was trading at $38 on February 10, gaining roughly $10 over 12 months. Ramius owns about 12,000 shares, according to the SEC.

Ramius may want to buy more. In late January, Analogic inked a deal with L-3 Communications' Security & Detection Systems division to upgrade the company's bomb detection systems used at airports. (The much larger L-3 placed an order for just a handful of detection systems as part of a $7 million contract with Analogic in early 2010.)

Analogic is also, separately, teaming up with Britain's Smiths Group, one of the world's largest bomb-detection equipment makers, with the intent of using an imaging technology called advanced tomography to compete with France's Safran group, which still employs older X-ray technologies to the same end.

But surely the Ramius investment team can recognize that MRI technologies aren't being used just at hospitals anymore? Big Brother has arrived, and he has a lot of discretionary cash earmarked for transportation security. (With MRIs being used to look for contraband, I suggest Ramius use its shareholder influence to get Analogic to screen for illnesses too, so that airline tickets might also become a health insurance deductible.)

Another medical-imaging security play in the portfolio is Actel. Ramius owns some 2.4 million shares in Actel, based on regulatory filings. At $11.15 per share (as of February 10), the hedge fund's stake weighed in at about $26.8 million. Ramius is the largest shareholder, though Renaissance Technologies is also onboard with some 1.5 million shares, according to SEC filings.

The company's president and chief executive, John East, announced in early February that he would step down. Actel recently reported a modest profit after seeing year-to-year revenues decline some $50 million in the final quarter of 2009.

The company is best known for its field-programmable gate arrays, a form of integrated circuit used in aviation and areospace electronics. Its microchips are also used for medical technologies, and the company produces flash storage hardware for computer systems. Just under half of revenues are from military purchases.