sevencornerscapitalsevencornerscapital Q1 2020 Portfolio Update]]>, 31 May 2020 21:39:27 +0000
The following is an update on Q1 earnings and other news for SCC's top-4 equity positions (PSHZF, SDI, MACK & CCUR), which currently constitute just over half of the value of the overall portfolio:
Pershing Square Holdings (PSHZF), 26% position: Up 22% on the year as of Friday's close, PSHZF is not only the largest, but has also been the 3rd-best performing, position in the SCC portfolio. YTD through 5/26, PSHZF's NAV had increased nearly 27% due mainly to portfolio manager Ackman's brilliant late February / early March CDS trade, which turned $27MM in premium payments into $2.6B in profits in approximately 2.5 weeks (see PSHZF's explanation of the trade here). This translates into a CAGR of something on the order of 190,000%(!) Rather than trying summarize PSHZF's portfolio's Q1 performance in this blog post, investors can check out the transcript of Pershing's recent conference call here. Below are the most recent NAV statistics:
Standard Diversified (SDI), 13% position: Down 13% on the year thus far, SDI was originally bought to obtain a derivative interest in Turning Point Brands (TPB) at a discount, since SDI owns approximately half of TPB's outstanding shares. It will shortly become a direct ownership interest in TPB, as each share of SDI's outstanding stock is expected to be exchanged for ~0.51 shares of TPB sometime next month at a valuation equal to 97% of TPB's prevailing market price (see PR announcing the merger here, as well as the preliminary merger proxy here). TPB, a leading U.S. provider of Other Tobacco Products and adult consumer alternatives, reported Q1 2020 earnings on April 28th (see full PR here):
Despite the coronavirus pandemic hitting the United States (TPB's sole market) with full force in March, and despite the fact that the momentum of its vaping operating segment had largely been stifled by government restrictions in Q3 & Q4 of 2019 owing to the supposed (mainly media-hyped) "vaping crisis", TPB's sales were only down 1% in Q1 2020 versus the prior year, an incredibly strong result for a consumer product company in such a challenging environment. Notably, due to the virus, the FDA has delayed the deadline for TPB and other manufacturers to submit their pre-marketing applications for e-cigarettes and similar devices until September 9, 2020. TPB expects to spend $15-18 million in total on this process, which hopefully should result in the approval of vaping products from TPB which are far safer from a public health perspective than traditional cigarettes (440,000 Americans die every year from tobacco exposure, mainly via cigarettes). Revenues at TPB have increased at a robust 13% CAGR (from $197MM to $362MM) over the past five years; if they receive FDA approval for multiple new products, one would expect TPB's growth to be super-charged going forward.
TPB projects the 2020 net sales to be $338 to $353 million and 2020 Adjusted EBITDA to be $69 to $75 million (with no upside assumed from the FDA's PMTA process in 2020), versus a current market cap of $469 million and EV of $637 million. Thus, TPB trades at the following forward multiples: EV/Revs = 1.85 (per company guidance); EV/EBITDA = 8.84 (same); and P/E = 12.7 (per single analyst estimate).
Merrimack Pharmaceuticals (MACK), 7% position: Up 5% during 2020 so far, MACK is a classic "discount to the sum-of-the-parts" play. It can be good to have one or more of these plays interspersed with one's general long holdings, since (theoretically, at least) investors should view them without regard to rises or falls in the overall market. With no debt and a cash runway which the company claims should last until 2027, and with underlying business operations at the company having basically ceased, MACK retains approximately $500MM of face value worth of contingent value rights (or CVRs) on its balance sheet, representing a maximum potential value to MACK holders of up to $37/share, compared to a recent stock price of $3.40. If the company fails to monetize the CVRs in the near term by selling them to a third party buyer, shareholders will likely have to wait 2 to 3 years for the underlying drug trials to read out in order to determine whether and how much the CVRs will pay out. Interestingly, insiders were buying fairly heavily in April (see here). According to MACK's 2020 proxy statement, however, the company has squandered literally millions of dollars of the shareholders' money on payouts to senior executives over the past 2 years (source):
This might explain why the voting results at last Thursday's annual meeting indicate that MACK investors appear to be increasingly fed up with the company's lack of progress in monetizing the CVRs (source):
CCUR Holdings (CCUR), 5% position: Down 22% thus far this year, we previously described CCUR as "alternative finance with an entrepreneurial bent" (see here). The company reported its Q1 2020 earnings on May 7th (source):
The company has now reported five straight profitable quarters, including the most recent one (despite the virus), which is significant given CCUR's prior history of relentlessly losing money. In addition, on March 9, 2020, CCUR paid a special one-time cash dividend of $0.50 per share. CCUR shares remain depressed, trading at a 43% discount to the company's $6/share book value. Eventually, one would assume that investors will bid CCUR back up to book value, given management's demonstrated skill at generating high returns on the company's assets (not to mention their other shareholder-friendly actions, such as paying out the large special dividend).
Conclusion: Buy & Hold is the only realistic way a so-called "value investor" (aka fundamental investor) can outperform the market: Generally speaking, "buy & hold" investing seems quaint in an era dominated by algorithmic and day trading. However, the above portfolio report shows why Warren Buffett's "Never Sell" approach (for which, see further below) is, in fact, the best method to use for a skilled fundamentally-oriented individual (i.e., non-computer) investor to achieve alpha. First, if one never sells winning positions, one's portfolio inevitably becomes weighted more and more over time towards one's highest quality holdings, which is precisely the goal of investing (Rule #1: Never forget what one is trying to do in the first place, namely concentrate your net worth in truly great businesses). For example, at the start of 2020, PSHZF was the 3rd largest position in the SCC portfolio, with a 14% weighting. Due to adding to the position in March, as well as its subsequent share price increase, PSHZF now represents over 26% of the overall portfolio. Thus, despite PSHZF constituting only ~1/3rd of the aggregate amount of equities added during Q1, its weighting in the overall portfolio has nearly doubled (the cream rises to the top). Meanwhile, those portfolio holdings which are not increasing their intrinsic value gradually become a smaller and smaller part of the portfolio, since stock prices inevitably track intrinsic value. (For a real-life example of this phenomenon playing out, see a retrospective "what could have been" analysis of Whitney Tilson's YE2011 portfolio here).
The end result of this practice is (1) a portfolio dominated by the highest quality companies and (2) consequent outperformance versus the indexes as time goes on. The only events that can interrupt things are either (A) the portfolio manager selling, or "trimming", winning positions, usually for illogical reasons such as that they "have gone up too fast", are "overweighted" or "overbought", etc, or (B) large positions being bought out (although at least in this scenario, one should theoretically be fully compensated by the control premiums paid by the acquirers). Too much of a good thing can be wonderful. Second, the "buy and hold forever" strategy is far more tax efficient than a "trading and trimming" strategy. Under prevailing tax law, (i) taxes on capital gains are only due upon selling, which means that $1 in taxes paid twenty years from now is the equivalent of paying half of that amount in taxes today ($1 due in 20 years, discounted at the risk-free rate of 3.5%, is the equivalent of $0.50 today), (ii) deferring these taxes allows an investor to compound the deferred amounts over time at high rates of return (due to the inevitable high-grading of the portfolio described above), and (iii) long-term capital gains are taxed at a lower rate than short-term capital gains (0-20% for long-term versus the regular income rate, i.e., 10-37% at the federal level, for short-term, respectively). SO STOP TRADING, PEOPLE - ALL IT WILL DO IS MINIMIZE YOUR GAINS (BOTH BEFORE AND AFTER TAXES).
Postscript: Warren Buffett, on when to sell winning holdings (source)...
DISCLOSURE: Long all of the above.
Turnarounds & Talent: Advice to Struggling Companies from Netscape Founder and VC Guru Marc Andreessen]]>, 23 May 2020 17:22:55 +0000
The following is some (IMHO) quite exceptional advice taken from Marc Andreessen's blog [PLEASE NOTE THAT HIS ENTIRE BLOG CAN BE DOWNLOADED AS AN E-BOOK AT HIS WEBSITE], which is as timely today as it was when initially published in 2007. So, without further ado we present...
Part 1: Turnaround!
Jun 20, 2007
So you've been hired/promoted/brought out of retirement to become CEO of and turn around your NASDAQ / NYSE / LSE-listed 5,000+ employee software / semiconductor / media company that's recently been getting trounced by competitors, brutalized by the press, and savaged in the stock market.
Here's your turnaround plan in 9 easy steps.
Step 1: Go dark and execute.
Your predecessor in the CEO job inevitably spent way too much time explaining to reporters, investors, analysts, and anyone else who would listen (that cute new Wall Street videoblogger?) why your company was actually doing just fine and how brighter times were just around the corner as your competitive position deteriorated and your financial results fell apart, and nobody believed it anyway.
Money talks, hype walks -- when you're hitting your numbers, everyone thinks you're a genius and believes everything you say, no matter how silly. When you're not hitting your numbers, everyone thinks you're a moron and won't believe anything you say, no matter how true.
So go dark, focus on the business, and don't talk publicly for at least six months.
Mark "Who?" Hurd sets the gold standard here.
Step 2: But first, throw your predecessor completely under the bus.
Can't forget this one! Tell Wall Street that your predecessor was such an incredibly dim bulb that in retrospect you can't even understand how he got past security and into the building, much less was picked to be CEO. He completely fouled the financials and sabotaged the business and as a result, earnings for the next several quarters are going to come in way below expectations.
The fun part about this one is that your stock won't even drop because everyone has already figured that out.
Step 3: Identify the 3-5 things that are working surprisingly well in your business, and double down on those.
Any big company, no matter how moribund and poorly run, has a number of products and projects that are going better than expected -- and usually come as a complete surprise.
Drawing on Peter Drucker's classic admonition to "focus on opportunities, not problems", figure out what these surprise successes are and double down on them.
Promote their general managers, elevate their business units in the organization, give them more funding, and get out of the way.
Step 4: Identify the 3-5 things that are consuming a lot of money and time and yet going nowhere, and kill those.
A good starting point is your predecessor's pet projects -- line 'em up and shoot 'em.
Frankly, they don't even have to be consuming that much money. They're almost certainly consuming time and management bandwidth, and they need to go.
You can also consider this a warmup exercise for Step 5.
Step 5: Lay off a third of the workforce.
Here's why:
History shows that you're going to have to ultimately do it anyway, either via death of a thousand cuts (or six to eight distinct rounds of layoffs), or all at once.
So do it all at once.
A company that requires a turnaround has, in all likelihood, hired too many people for the size of the business opportunity it actually has. This impairs profitability, driving away investors and submerging the stock price at precisely the time the company needs a healthy acquisition currency; this demotivates your great people by surrounding them by too many mediocre people and too much bureaucracy; and this slows everything in your company to a crawl because there are simply too many people running around who have to talk about everything before anything gets done.
Grit your teeth, offer the most generous severance and assistance packages you possibly can, and get it done.
Your ability to continue to employ the other two-thirds of your people is at stake.
Step 6: Reduce layers, then promote up and comers and put them clearly in charge.
A company that requires a turnaround has, in all likelihood, too many layers of management. Nuke as many of them as you can.
Then develop a list of your top 20 or 30 up and comers -- strong, sharp, aggressive, ambitious director- or VP-level managers who want to succeed and want your company to succeed. And promote them, and put them in sole charge of clearly identified teams and missions. (And give them big ol' fresh option packages.)
As CEO, you should only have at most one executive between you and these 20 or 30 up and comers once you are done promoting them and putting them in charge of their teams and missions.
If you don't know who those top 20 or 30 up and comers are, if you don't promote them, if you don't put them clearly in charge of the things that matter, or if you have more than one layer of management between you and them when you're done, you're probably doomed.
Step 7: Figure out the single most important thing your company has to win at, and put your single best person in charge of winning at it.
'Nuff said.
Step 8: Look at the market, figure out 3-5 new areas in which your company is not currently playing or winning, but are clearly going to grow a lot -- and acquire the best company in each of those areas.
Here you're looking for growth -- for products, trends, perhaps phenomena outside but adjacent to your current products and markets, that are going to grow a lot in the next few years.
You have to acquire, because if you're in a turnaround situation, you aren't going to have the time or bandwidth to build them in-house -- unless you're the very rare exception.
When you do acquire, you're going to have to pay up, because new things that are growing really fast in growth markets are always expensive -- whether private or public -- especially compared to the PE multiple of a big company in turnaround.
So here's hoping you did a great job at Step 5.
Step 9: In six months, relaunch the company with a single, crisp, coherent message and strategy.
Then go dark again and go right back to work.
Of course, there's more to being the CEO of a turnaround than these 9 steps. There are a thousand other things you're going to have to do. But these are the 9 most important.
To quote the great Tommy Lasorda: "This fucking job ain't that fucking easy."
Appendix for media companies only:
Step 10: For God's sake, stop suing your customers.
Part 2: Retaining great people
Jul 5, 2007
This post is about retaining great people, particularly at big companies in industries like technology, where stock options matter and where people can relatively easily move from one company to another.
Actually, I lied. This post isn't really about retention at all.
It's about winning.
Let me explain:
Companies that are winning -- even really big, old ones -- never have a retention problem. Everyone wants to stay, and when someone does leave, it's really easy to get someone great to take her place.
Companies that have a retention problem usually have a winning problem. Or rather, a "not winning" problem.
The typical case is a company that used to be a hot growth company, but the growth has flattened out, causing the stock to tank and everyone to be in a bad mood. Or, alternately, an older big company that did really well for a while but more recently hasn't been doing so well, causing the stock to tank and everyone to be in a bad mood.
In other words, a company in transition -- from winning at one point, to not winning now.
The only way a company in that situation can retain great people is to start winning again.
Great people want to work at a winner.
All the raises, perks, and HR-sponsored "company values" drafting sessions in the world won't help you retain great people if you're not winning -- not even the $6,000 heated Japanese toilets in all the restrooms, the $30,000 Olympic lap pool out back, and the free $4 bottles of organic orange juice in all the snack rooms.
This seems deeply unfair when you're going through it, because when you're not winning, that's exactly when you need all those great people the most!
Oh well. That's the price we pay for living in a society where jobs aren't for life anymore.
So the right question is, how can we start winning again?
In this post, I'm going to punt on large parts of the answer to that question, as follows:
I already discussed the big company turnaround scenario in my last post in this series, which describes how to take a big company that is no longer winning and set it up to win again.
A company that was a hot startup a few years ago and grew fast but is now seeing growth slow has a slightly different problem -- your original product cycle has peaked and you need to find a new product cycle. That's your big challenge, way beyond retention. But I'll talk about that in a future post.
Retention follows from the steps you are taking to orchestrate the turnaround and/or get to the next big product cycle.
Having adroitly sidestepped most of what you need to do, let me now address some things you can do to help the retention situation while you are addressing the deeper issues required to win again.
First, don't give up. I am particularly talking about the former hot startup that is now a large slow-growth company. It is easy to say, well, we're not a startup anymore, we're not a growth company anymore -- now we're a big company, and we need to change our culture and our methods to attract and retain the kinds of people who like to work at big companies.
Doing that will make your situation far worse, by causing the remaining great people you do have to abandon ship even faster. Who wants to work for a company that has given up on having energy and drive and ambition? And then you will end up with a staff that only knows how to be a big company -- that only knows how to maintain something that someone else has already built -- which is death in any industry where things change all the time.
Second, focus. In a technology company, focus on retaining the great architects and managers. In other kinds of companies, focus on retaining the equivalent people -- the people who are the magnets for retaining other great people and hiring more great people.
You have to retain the magnets -- or at least a critical mass of them -- because without them, you're going to lose everyone else.
If you bear down and focus on retaining the magnets, retaining everyone else -- for example, in a software company, the junior programmers, the product managers, the user interface designers, the salespeople, the sales engineers, the marketing staff, and so on -- will be much easier.
Third, clean house. Any company with a retention problem probably also has an overstaffing problem and a mediocrity problem and needs to fix both of those at the same time.
Identify and eliminate the jobs of the following categories of people:
People who are "vesting in peace" -- so called "VIPs". VIPs are a particular problem at the former hot startup that has plateaued. They suck the life out of their environment and have to go."Summertime soldiers" -- people who only joined in the first place because you were already successful and have no interest in really bearing down and applying themselves to a challenge. Again, a classic problem for the former hot startup. Look particularly hard at the people who joined in the two years following the IPO -- some of them are undoubtedly very hard working, but others are summertime soldiers and have to go.Mediocre performers -- every company has some, unless you have been routinely firing your bottom 10% every year, and even then you probably have some.
Taking out the people who fall into these categories will make your remaining great people feel better immediately, and will save you a lot of money and stock options that you can reallocate to better purposes -- such as new compensation packages for your remaining great people.
Fourth, promote your best people -- especially into the jobs vacated by the more senior of the people you just fired -- and give them very interesting challenges.
That is so fundamental that I'm not even going to discuss it further here.
Fifth, simplify and clarify your organizational structure to make sure that your best people have direct responsibility for their projects.
Companies coming off a period of significant success usually have grown a lot and/or bought a lot of other companies, and typically have messy or overly complex org structures. This is a great opportunity to clean that up -- and in particular, to move to an organizational model where each of your stars has clear, direct, and comprehensive responsibility for a critical mission.
Nuke all matrices. Nuke all dual reporting structures. And nuke as many shared services functions as you possibly can.
For example, in a software company, break up the centralized documentation group, QA group, build group, etc. and disperse those people into the individual product divisions. Give your product division heads complete responsibility for everything they need to ship great products -- except for sales. And then in sales, give your territory heads everything they need to kill their numbers.
A great general rule of thumb for this kind of organizational redesign is that you want to tolerate overlap. So each product division has its own QA team -- so what? Your division heads -- who are now your best people -- will be able to move so much faster that way that it's worth it. Plus, you saved so much money taking out the VIPs, summertime soldiers, and mediocre people that you're still ahead on headcount expense.
Remember, it's generally a good idea, once you do all of this restructuring, to end up with smaller team sizes than you had before. By reducing the size of a team, and increasing the average quality level within the team, you will usually speed things up, while saving money.
Finally, be sure to take out layers -- especially at the top of the company. The best people who are now running all the key projects and divisions should be no more than one layer away from the CEO, and usually that means you can take out at least one layer, maybe two, and (shudder) maybe even more.
Sixth, put the recruiters to work, aggressively -- but don't rely on them for everything.
Notably, for the really critical open jobs, go out and recruit the right person yourself, or better yet promote from within.
And here's a neat trick that actually works. Go out and re-recruit the best people who already left. Some of them have since discovered that the grass isn't actually greener at whatever mediocre startup they joined or whatever other big company they jumped to. Give them fat packages against the new mission and get them back.
Seventh, ramp up college recruiting. This will be very important for you over the next couple years. College recruiting is the best way to get a bunch of new fired up people into your company who are hungry and who don't realize quite how badly you suck. (That was a joke.)
Eighth, communicate within -- tell everyone in your company clearly and unambiguously, we are here to win and here's how we're going to do it. It won't be easy, but we can do it and we will do it, and we will have amazing stories to tell our grandchildren.
You don't need to be certain of all the answers! Colin Powell says, "You know you’re a good leader when people follow you, if only out of curiosity." So project boldness, and have that glint in your eye where people know you're up to something big.
Ninth, shake things up. Directly on Powell's curiosity point -- change the story to something new. Overhaul the organization, move people around, fire people, promote other people, cancel products, double down on other products, do some acquisitions, cut some big deals, do some spinoffs, whatever -- but change the story. Reintroduce curiosity.
When all else fails, do a "shake and bake" -- do a big transformative deal that you're not sure will work but which you think has a real shot. That will at the very least inject energy back into the situation.
I am being deliberately cavalier about this tactic, especially the "shake and bake" part. You can easily destroy your company with this kind of move.
But -- and this is a very important but -- a company in crisis often has a severe narrative or "story" problem that accompanies its business problems, and it can be hard to get people inside and outside the company motivated to reengage without you forcing a dramatic change to the story in some fundamental way.
Stories don't change by themselves. Change the story.
Next topic: how to talk a great person out of going to a startup.
I'm assuming based on all of the above that if you do the blocking and tackling right, you're going to be able to convince a lot of your great people to not go to a different big company.
Talking someone out of going to a startup is a separate challenge.
Someone usually wants to move from a big company to a startup for one or more of the following four reasons:
First, she wants to build a new company instead of being a caretaker in someone else's company.
You can talk someone out of this if you can show her how, if she stays with you for two more years, you are going to concretely better train and prepare her to kick butt at a startup when she does make such a move -- particularly if she is on the management track.
Give her a promotion, a big new job with a big new challenge, and clear responsibility. And tell her that if she kicks butt at this more significant challenge, she'll not only be better prepared to be out on her own, but you will personally give her glowing recommendations and help her find the perfect startup or the perfect VC for her -- in two years.
Then, two years later, you can do the same thing again.
I believe you are doing someone a huge favor when you do this. Most startups aren't very good and have no prospect of real success, and most big company people aren't very good at picking 'em, although they never believe that. And by staying, your great person is gaining incredibly valuable experience by taking on new challenges and new responsibilities at your company that will help her succeed and flourish down the road wherever she ultimately decides to go.
It's not that unusual to see a young superstar division head or senior vice president at a big company who has been promoted rapidly over the last several years who has also been periodically on the verge of going to a startup and stayed each time for a new challenge instead. And there she is, running 100 or 500 or 2,000 people and doing incredibly well in her career. Win/win.
Now, if you're not willing to promote 'em, that's another story.
Second, she has a killer idea for a startup, or has fallen in love with a startup's killer idea.
In this case, you're probably better off letting her go to the startup.
This isn't the case nearly as often as you'd think. Some of the startups I've seen great people join -- including very recently -- boggle my brain at how bad the ideas were.
Third, she wants the financial upside of a startup.
Visions of being the next Larry Page (Larriett Page?) are dancing in her head.
You can often defeat this by simply explaining the realities of the compensation package she's being offered.
Explain to her how her options will likely be worthless when the startup fails, how small a percentage of the company she's actually being offered, how much she's going to be diluted by future financing rounds, how far below market her package is overall, and how bad the medical and dental benefits are for her kids. And if she hasn't changed her mind by that point, tell her a cramdown round story.
Fourth, she can't function in a large environment. It's too frustrating, too boring, too many rules, too much management, whatever.
In this case, you are probably also better off letting her go to the startup.
Things not to do when trying to retain great people:
Now we're getting into personal opinion, but for what it's worth...
Don't create a new group or organization within your company whose job is "innovation". This takes various forms, but it happens reasonably often when a big company gets into product trouble, and it's hugely damaging.
Here's why:
First, you send the terrible message to the rest of the organization that they're not supposed to innovate.
Second, you send the terrible message to the rest of the organization that you think they're the B team.
That's a one-two punch that will seriously screw things up.
Instead, focus on boosting the innovation culture of the entire company.
Don't do arbitrary large spot bonuses or restricted stock grants to try to give a small number of people huge financial upside.
An example is the Google Founders' Awards program, which Google has largely stopped, and which didn't work anyway.
It sounds like a great idea at the time, but it causes a severe backlash among both the normal people who don't get it (who feel like they're the B team) and the great people who don't get it (who feel like they've been screwed).
Closing thought:
In general, the intangibles that keep great people are: the quality of the people they're working with, the interestingness level of their projects, and whether they are learning and growing.
The tangibles are: winning, and a high stock price.
As the leader, you have to really believe that you can get your company back to winning and therefore back to a high stock price.
If not, you should sell the company.
Seven Corners Publishes Open Letter to Shareholders of Merrimack Pharmaceuticals Regarding Annual Meeting]]>, 24 Apr 2020 18:51:27 +0000
Today Seven Corners Capital published an Open Letter to Shareholders of Merrimack Pharmaceuticals (ticker MACK) Regarding Proposals 4 & 5 Contained in MACK's Definitive Proxy Statement for its 2020 Annual Meeting (scheduled for May 28, 2020). THE LETTER ADVOCATES THAT MACK SHAREHOLDERS VOTE AGAINST PROPOSAL #4 AND FOR PROPOSAL #5 (I.E., IN EACH CASE AGAINST OUR BOARD’S RECOMMENDATIONS). For see a detailed discussion of each of these proposals, please see the PDF of our full letter, which has been posted in the Research Section of our website (see here).
Rite Aid - The Road Behind and The Road Ahead]]>, 04 Mar 2020 21:47:13 +0000
As a shareholder who has relentlessly (and, with a few other intrepid retail shareholders who took up the "Vote 'Em Out" standard along side us, nearly single-handedly) advocated for change at the upper echelons at Rite Aid (RAD) since October 2018--for example, see here and here--it is perhaps time to reflect on what has occurred at the company over the past 16+ months and look forward to the road ahead. First, the stock price (because it's usually, at the end of the day, "The Stock Price, Stupid!"):
At the time our initial RAD Seeking Alpha screed against the then-entrenched and atrociously-performing board and management appeared, RAD's share price had collapsed almost 90% from its early 2017 level to around $20/share (note that RAD effected an ill-advised 1-for-20 reverse split in 2019, which we strongly advocated against, as it sent a defeatist message to the market and was basically a green light for shorts to further attack the stock). Looking at the above chart, one might presume that not much has really changed at the company, as the share price is actually about 18.5% lower today than then, while the overall market is up. Just looking at the chart, in other words, one would presume that nothing material (in a positive sense) has changed at Rite Aid over the past year and a half.
The foregoing ("stock price, bro") view, however, misses certain tectonic shifts that have occurred recently at RAD, and which are the direct result of pressure put upon the board of directors and management by, principally, retail shareholders and people such as yours truly (in other words small time activists with big mouths/keyboards). This "soft activism" by non-13D filers has actually resulted in a substantial change in the trajectory of the company, we think for the better.
In our original RAD "Vote 'Em Out" SA article, we set forth the following three bullet points as the keys to our turnaround thesis for RAD:
Rite Aid's incumbent management and board of directors have failed shareholders repeatedly.Insanity is keeping the same people in power and expecting a different result.For Rite Aid's equity to ever have significant value, it needs to be entrusted to people who take stewardship seriously.
Given this thesis, it is quite inspiring to see how much progress has been made on this front since October 2018, when the article came out. At the time, the company was headed by (failed) CEO John Standley, (failed) COO Kermit Crawford and (meh) CFO Darren Karst, as well as a board composed of nine (failed) directors helmed by (failed) chairman Bruce Bodaken (the other incumbent directors were Joseph B. Anderson, Jr., David R. Jessick, Robert E. Knowling, Jr., Kevin E. Lofton, Myrtle Potter, Michael N. Regan, Frank A. Savage and Marcy Syms). Fast forward to today and the ENTIRE C-suite has been replaced with new leadership, while only 3 of the 9 legacy directors remain on the board.
RAD is now led by the following:
CEO - Heyward Donigan;
COO - Jim Peters; and
CFO - Matt Schroeder.
Six new directors, including a potential future board chairperson in Elizabeth "Busy" Burr.
(See full bios for all of the above here)
Importantly, per the stock chart above, RAD's share price bottomed right around the time that new CEO Donigan came aboard in mid-August 2019 (see PR for the appointment here). This backs up the adage "Success or failure begins at the top." If the top of the organization (the CEO) is a loser and a failure, inevitably the entire organization will take on this aspect, simply because a person attracts around him or her exactly what he or she is. Winners want to work with winners, losers and failures seek places to hide while clocking their undeserved paychecks (and what better place to hide than directly under a loser and failure of a CEO, who holds nobody accountable for actual performance). Winners expect to be pushed and challenged, while losers and failures want to take it easy and make endless excuses for their endless failure to achieve results--making excuses is a lot easier than accomplishing difficult goals.
The foregoing dynamic is compounded when the CEO is elevated to the board chairmanship, because then this person has nearly absolute power over the organization. When the CEO chairs the board, they also control who else gets/stays on the board, if & when board meetings are called and what the board's agenda will be. Thus, terrible CEOs tend to stock their boards with sycophantic non-entities who will act as rubber stamps for the CEO's agenda (which often involves making operational targets as flimsy as possible, so as to maximize their compensation). These directors only care about earning their low to mid six-figure director fees annually while doing minimal work. Never will they challenge the failing CEO on any substantive matter; otherwise, they risk losing access to these easy paychecks (gotta pay the rent on that summer home in the Adirondacks--priorities!). If the failing CEO farts during a board meeting, his (and it's usually a man) paid lemming directors will probably tell him it smells like roses. And so it goes on down the chain of command.
Conversely, a qualitatively great CEO not only tolerates strong directors around him or her, he or she actually embraces them with open arms. This type of CEO will not be afraid to put somebody on the board who is more knowledgeable regarding a particular topic that is germane to the company's business or more skilled at (for example) capital allocation (most CEOs are good at operations, but are not necessarily experts on how to effectively allocate capital). This species of CEO enjoys the thrust and parry of intelligent debate and pushback, because they know that, much like working out at the gym makes the body stronger, this debate makes them a much stronger, more competent executive. The result is corporate nirvana: an organization headed by a highly skilled CEO who can make correct decisions on important issues quickly (as both precision and speed are vital in business). In addition, those under the CEO similarly fall into the "A" Player category. Such an organization (think Apple under Steve Jobs and Amazon under Jeff Bezos) will inevitably dominate the competition in the marketplace and its stock will thus inevitably skyrocket (shareholder nirvana). Of course, the jury is still out on whether RAD's new CEO will meet the foregoing criteria, however early signs are promising and investors appear to be slowly catching on that she could be the real deal.
So, how does a company like RAD (or any other failing public company, for that matter) go from being captured by an entrenched, failing management and board to becoming (potentially) the next AAPL or AMZN? It's certainly not easy! There needs to be some outside influence that forces a comprehensive leadership overhaul, because one thing that never changes is that failing leaders at public companies almost always cling desperately to power to their last breath. In addition, failing organizations tend to reject change the way the human body naturally rejects transplanted organs.
The solution? The activist investor. This person is naturally free from the bias and groupthink that afflicts the failing organization. Because they are not complicit therein, they are free to point out exactly why and how things should change for the better. In addition, since they have actually skin in the game (their own money, which they exchanged for their shares), they have the incentive to fight for necessary regime change and their incentives are aligned with their fellow shareholders (usually the hapless incumbents have minimal skin in the game, resulting in misaligned incentives).
In RAD's case, there was no typical large activist investor involved, for example an Elliott or a Third Point, although they certainly would have been welcomed by shareholders with open arms. Rather, a (very) small group of shareholders holding relatively modest amounts of stock put constant pressure on the company to effect change. Even then it took eight long months to replace the CEO--but it happened.
Among the tools used by this group were the following:
Public pressure via Seeking Alpha and investment blog posts advocating for shareholder revolt at RAD and pointing out in excruciating detail the myriad ways the prior failed management and board had betrayed the owners of the company over and over (see our articles and posts linked above);
Public commentary via Twitter, tagging the new CEO and certain other board members on posts (don't think they don't read these, although if pressed they would inevitably deny this) (see our RAD tweets here);
Private communications between aggrieved yet defiant shareholders, coordinating strategy and sharing facts, as well as lobbying large activists to get involved so as to ramp up the pressure on the incumbent company insiders; and
The insertion of shareholder proposals in the company's proxy statement via the Rule 14a-8 route. This rule allows any shareholder who has held at least $2,000 worth of stock in a company for at least one year to make certain proposals (usually non-binding, advisory proposals) to be voted on at said company's annual meeting (see fuller explanation of the process here). In RAD's case, shareholders, by voting in favor of a 14a-8 proposal for an independent board chairman at the 2018 annual meeting (see here and here), were able to force the company to amend its bylaws to permanently separate the roles of CEO and board chairman. Stripping then-CEO Standley of his board chairmanship in late 2018/early 2019 was a key milestone in unlocking the floodgates of change, as Standley was the main person blocking executive and board turnover at the company (he held onto his power with a death grip until the last, even securing a ridiculous 6-month "consulting" gig as he was finally shown the door as CEO). Once he lost the board chairmanship, his days were inevitably numbered.
By employing the foregoing "soft activism" tools, even small-fry retail investors holding just a few hundred shares have the power to effect substantive change at a company--they just need to summon the energy to fight for it and master the techniques described above. Of course, at RAD things never went smoothly or perfectly during the process (for example, the new board members granted CEO Donigan a far too generous pay package; also, the board has yet to implement a Rule 14a-8 proposal that passed at last year's annual meeting which requested that the company grant shareholders holding at least 10% of the stock the right to call a special meeting). Overall, however, quite a bit has been accomplished, with more to come...
Which leads us to "The Road Ahead" for RAD. The future is always murky, as investors have recently discovered with the coronavirus panic. It is even more unclear at any individual company undergoing significant change, such as RAD. So much depends on the decision-making of the new leadership, yet we really haven't received the full roadmap the new leaders intend to use to chart the future for our company. Luckily, we will find out much more in just two weeks, when RAD holds its long-awaited Analyst Day on March 16th:
Speaking of the road ahead, one is reminded of the poem below, called "The Road Ahead or The Road Behind" by George Moriarty, which was often recited in public talks given by legendary UCLA basketball coach John Wooden, who won 10 NCAA basketball championships (by far a record) at the school, earning him the moniker "The Wizard of Westwood". Will CEO Donigan and her Rite Aid team denounce the Fates as the reason RAD can't win; or will they instead give all and save none until the game is really won? Shareholders will need to tune in on March 16th to find out!
Earnings Recap - Precision Optics (PEYE)]]>, 24 Feb 2020 03:20:10 +0000
We are long Precision Optics Corporation (ticker: PEYE), which on February 13th issued its earnings report for the 2nd quarter (12/31/19) of its fiscal 2020 (link here). PEYE is a leading developer and manufacturer of advanced optical instruments since 1982. Using proprietary optical technologies, PEYE designs and produces next generation medical instruments, Microprecision™ micro-optics with characteristic dimensions less than 1 millimeter, and other advanced optical systems for a broad range of customers including some of the largest global medical device companies. PEYE's innovative medical instrumentation line includes state-of-the-art endoscopes and endocouplers as well as custom illumination and imaging products for use in minimally invasive surgical procedures. We covered the thesis underlying this investment in a prior writeup (please see our 9/12/19 writeup ); PEYE's share price is up 13.4% since the issuance of this long thesis:
The quarter produced mixed results, with a large increase in revenues (mainly due to its acquisition of Ross Optical) but a concomitant increase in net loss (during 1H FY2020 PEYE experienced a $491,322 increase in compensation to existing and newly hired employees in its non-Ross operations). Below is the meat of the earnings PR:
Gross margins were higher due to the fact that Ross Optical's margins are typically in the 48-50% range, much higher than legacy Precision Optics. While PEYE's revenues for the 1st half of FY2020 were +77%, most of this was due to the Ross acquisition; on a pro forma organic basis (giving effect to the acquisition for the relevant periods), revenues still rose a respectable 7.5%. Provided PEYE can continue to find good acquisition targets while avoiding unnecessary dilution of its shareholders and taking on onerous debt, our original PEYE long thesis holds. The Ross acquisition increased PEYE's revenues about 70%, yet PEYE's shares outstanding only increased approximately 7% and the deal was not reliant on debt. One would, however, certain hope to see PEYE's losses decrease as a percentage of revenue over time (evidencing operating leverage in the business model).
At a current equity valuation of approximately 2 times sales ($21 million market cap [with minimal debt, just a $500K potential earnout liability] versus $10.6MM revenue runrate for 1H FY2020), PEYE seems fairly reasonably valued by the market. In comparison, the S&P 500 trades at 2.4X P/S (PEYE probably deserves a bit of discount to the overall market due to its microcap status).
One important note of caution concerns the outbreak of the coronavirus in China and its effect on PEYE's supply chain--the following is from PEYE's most recent Form 10-Q filing:
We depend on the availability of certain key supplies and services that are available from only a few sources and we may experience difficulty with certain suppliers due to the recent coronavirus outbreak in China and we may have difficulty finding alternative sources of these supplies or services.
We source certain key supplies to develop and manufacture our products, particularly our precision grade optical glass, which is available from only a few sources, in China. Due to the recent coronavirus outbreak in China in December 2019, we may experience difficulties with certain suppliers. Our business could be affected if we become unable to procure these essential materials and services in adequate quantities and at acceptable prices. We are always evaluating our suppliers and alternative sources. If we experience a shortage of certain supplies and are unable to find an alternative source, our financial condition and results of operations could be adversely affected.
Earnings Recap - CCUR Holdings (CCUR)]]>, 20 Feb 2020 21:49:25 +0000
We are long CCUR Holdings (ticker: CCUR), which on February 5th issued its earnings report for the 2nd quarter (12/31/19) of its fiscal 2020 (link here). CCUR operates merchant cash advance (MCA) and real estate business segments through its subsidiaries Recur Holdings LLC and LM Capital Solutions, LLC and actively pursues other business opportunities to maximize the value of its assets through evaluation of additional operating businesses or assets for acquisition. We covered the thesis underlying this investment in a prior writeup and multiple blog posts (please see our 7/31/19 writeup in our Research section, as well as the SCC blog posts here).
The quarter produced very strong results, with $2.7MM of net income, or $0.31/share, on revenues of $1.8MM (earnings were higher than revenues due income on and appreciation of CCUR's large securities portfolio). Below is the meat of the earnings PR:
On a trailing-12-month (TTM) basis, CCUR has earned positive net income of $8.35MM, or $0.94/share, representing a huge earnings yield of 19.6% on the recent $4.80 stock price. In comparison, note that the earnings yield for the overall stock market is an anemic 4.1%--and this is based on *adjusted* earnings [aka earnings with certain negative items ignored so management teams so incentivized can claim higher earnings than actually exist in reality], rather than straight GAAP earnings (as in CCUR's case). In addition, this marked the fourth consecutive quarter of positive income for CCUR, which is notable given the seemingly endless losses that occurred at the company under CCUR's prior management & business model (aggregate losses for the period prior to FY2018, the fiscal year in which present management took over the company, totaled $165MM - see here). CCUR also has a hidden asset not appearing on the balance sheet, namely $58.4MM of federal NOL carryforwards and $42.6MM of state NOL carryforwards, which expire between now and 2037. Over the trailing four quarters under CCUR's new business model, book value per share has appreciated from $5.73 to $6.58, a 14.8% increase--yet the stock still trades well below this figure, reflecting apparent skepticism of market participants regarding the company and its management.
We think CCUR recently took a large step towards proving the doubters wrong by announcing a $0.50/share special dividend, payable to common stockholders of record on February 24, 2020, to be paid on March 9, 2020 (see PR here). We think this further indicates that CCUR's management intends to treat all shareholders (including, importantly, small ones) fairly. Why is this so significant? With companies dominated by a large shareholder (as CCUR, which has a 40%-holder), there is always the possibility that said large holder will take advantage of his position to disadvantage minority shareholders through economically lopsided & unfair related party transactions. However, when a large holder "sees the light" and treats small shareholders scrupulously fairly, a lollapalooza scenario can unfold, including (1) increasing overall investor confidence, translating into multiple expansion in the subject company's stock price (making it a better acquisition currency), (2) increasing confidence among business sellers that the subject company will be a good home for their businesses, leading more attractive acquisition opportunities, (3) increasing confidence among the pool of potential hires for the subject company, leading to a more motivated and talented workforce at the company, etc etc etc. All of these factors feed on and reinforce themselves in a virtuous self-fulfilling positive ecosystem, the end result of which can be truly astounding. We have seen exactly this scenario play out at Berkshire Hathaway over the past 55 years, leading to an aggregate increase in the stock price from the $12-$18 range in the mid-1960s (when Buffett took over the company) to $342,000+ today. We are certainly not predicting that CCUR's stock price will be six figures in a few decades like BRK-A, however we believe the necessary (but not sufficient) factor of treating all shareholders as true parters in the business is becoming increasingly proven through the actions of CCUR's management (the rest will obviously be up to the investment and business decisions they make over time).
Regarding CCUR's valuation, we previously stated that 1.25X book value would be appropriate for an alternative finance company this profitable (albeit small). Megacap ($430B) financial juggernaut JPMorgan (ticker: JPM), with a return on assets of a measly 1.3%, trades at a price/book ration of 1.8X (note that the only reason JPM can boast of a 13% return on equity (ROE) is because of its use of massive financial leverage). In contrast, on a TTM basis CCUR has earned 12% on assets, or almost 10X the ROA of JPM, and employs very little debt to generate its bottom-line returns. If CCUR traded at the same P/B as JPM, its stock price would be nearly $12, or ~150% higher than currently. Even at a comparatively modest P/B ratio of 1.25X, CCUR would trade over $8/share, indicating there remains room for substantial upward movement in the stock based merely on multiple expansion (never mind further increases in book value per share). If CCUR's management continues to earn a 12% ROA, we think it is only a matter of time until the stock re-rates significantly higher.
Earnings Recap - Orion Energy Systems (OESX)]]>, 18 Feb 2020 19:31:19 +0000
We are long Orion Energy Systems (Nasdaq: OESX), which on February 6th issued its earnings report for the 3rd quarter (12/31/19) of its fiscal 2020 (link here). OESX is a provider of LED lighting and turnkey energy project solutions designed to reduce energy consumption and enhance business performance and efficiency. Orion designs, manufactures, markets and manages the installation and maintenance of LED solid-state lighting systems, along with integrated smart controls. Overall financial performance for OESX remains in a strong uptrend, with revenues and earnings in the most recent quarter up *bigly* over the respective prior-year periods--below are the highlights:
The main driver of the recent outstanding performance for OESX was a large turnkey LED project win with a major national account, which has been responsible for over 70% of FY20's revenues YTD (and will likely be responsible for the vast majority of Q4's revenues as well). Our understanding is that this project is for the installation of lighting resembling the following:
The company has guided to full-year revenues of between $150 and $155 million, with "at least" a 10% EBITDA margin. This implies that at the absolute worst, Q4 of FY20 would be break-even on an EBITDA basis (since EBITDA for the 1st 9 months of FY20 was nearly $15MM). We certainly hope the company generates positive EBITDA (and is hopefully profitable) in Q4, however nothing in investing is certain, especially given the sourcing disruptions going on in China currently.
At a recent market cap of $184MM (31MM shares outstanding, $5.98 stock price at 2/14/20) and minimal debt, OESX trades at around 1.2X P/S, which would be considered extremely cheap *IF* its recent revenue trends were even remotely sustainable over the longer term. Much larger peer Acuity Brands (NYSE: AYI - $4.6B market cap, or 25X the size of OESX), for example, has a higher P/S ratio at ~1.3X (source), yet in its most recent quarter AYI's sales were actually down over 10% (versus up 110% for OESX) (source). The real question for OESX (and why people who are selling at current prices are doing so, despite the apparent P/S cheapness) is whether its recent contract wins will be exhausted in the near term, with little in the sales pipeline to replace them.
Admittedly (and this is an easy admission to make, admittedly) we bought in to OESX at prices far below the recent stock price of around $6/share--in fact, we bought our stake in late 2018 at an average price of $0.72/share. So why stay long after such a rise, especially given the uncertainty regarding the company's pipeline and the sustainability of its revenues? Two reasons: (A) leadership and (B) LED's secular growth story. On the first point, OESX has executed brilliantly ever since current CEO Mike Altschaefl took over in mid-2017 (see PR announcement here). Generally speaking, as an investor you want to ride a good horse as long as possible (think Buffett/BRK, Ellison/ORCL, Musk/TSLA, Hastings/NFLX, etc.) Here is the full bio for CEO Altschaefl (source):
Michael W. Altschaefl, 60, was appointed as OESX's chief executive officer on May 25, 2017 and has served as a director since October 2009. Mr. Altschaefl has served as OESX's board chair since August 2016. Mr. Altschaefl serves as the chairman of E-S Plastic Products LLC, a custom manufacturer of plastic injected molded parts and PanelTEK LLC, an electrical engineering services and custom manufacturer of electrical control panels. Mr. Altschaefl served as the president and chairman of Still Water Partners, Inc., a private investment firm, from August 2013 through December 2017 and as president of E-S Plastic Products LLC from November 2013 through May 2017. Previously, Mr. Altschaefl served as the vice president—strategy and business development of Shiloh Industries, Inc., a public company and leading independent manufacturer of advanced metal product solutions for high volume applications in the North American automotive, heavy truck, trailer and consumer markets from January 2013 until October 2013. Mr. Altschaefl was an owner and chief executive officer of Albany-Chicago Company LLC, a custom die cast and machined components company when Shiloh Industries purchased the company in December 2012. Mr. Altschaefl is a certified public accountant. Prior to acquiring Albany-Chicago Company LLC in 2008, Mr. Altschaefl worked for 27 years with two international independent registered public accounting firms, including 16 years as a partner.
Second, OESX's recent strength has followed the reorientation of its business model to focus on the sale of LED lighting and related IoT controls, as opposed to incandescent or fluorescent lighting. OESX's main products are the following (source):
The LED Troffer Door Retrofit (LDRTM): The LDRTM is designed to replace existing 4 foot by 2 foot and 2 foot by 2 foot fluorescent troffers that are frequently found in office or retail grid ceilings. Our LDRTM product is unique in that the LED optics and electronics are housed within the doorframe that allows for installation of the product in approximately one to two minutes. Our LDRTM product also provides reduced maintenance expenses based upon improved LED chips.
Interior LED High Bay Fixtures: Our LED interior high bay lighting products consist of our Harris high bay, ApolloTM high bay and ISON® high bay products. Our ISON® class of LED interior fixture offers a full package of premium features, including low total cost of ownership, optics that currently exceed competitors in terms of lumen package, delivered light, modularity and advanced thermal management. Our third generation of ISON® class of LED interior fixture delivers up to an exceptional 214 lumens per watt. This advancement means our customers can get more light with less energy, and sometimes fewer fixtures, compared to other products on the market. Our ApolloTM class of LED interior fixtures is designed for new construction and retrofit projects where initial cost is the largest factor in the purchase decision. Our Harris high bay is ideal for customers seeking a cost-effective solution to deliver energy savings and maintenance reductions. In addition, our LED interior lighting products are lightweight and easy to handle, which further reduces installation and maintenance costs and helps to build brand loyalty with electrical contractors and installers.
Smart Lighting Controls. We offer a broad array of smart building control systems that have either been developed by us under the InteLiteTM brand or procured from third parties. These control systems provide both lighting control options (such as occupancy, daylight, or schedule control) and data intelligence capabilities for building managers to log, monitor, and analyze use of space, energy savings, and provide physical security of the space.
LED lighting is currently in a secular growth trend, as per industry research and reports (source):
LED lighting is vastly superior to other forms of lighting, since LED bulbs only need to be replaced every 5 to 10 years (depending on usage) and use far less electricity per-hour used, meaning they save people serious money--see further discussion here. OESX's management has stated that customer pay-back periods for LED projects handled by the company can be as little as one year. This incentivizes the growing adoption of this type of lighting, which we think OESX should be able capitalize on robustly over the next 5-10 years and beyond. In addition, on the recent earnings conference call (link can be found at OESX's IR website) an analyst covering the company strongly implied that market leader AYI was panicking that OESX was on the verge of poaching one of AYI's top-5 customers. Thus, OESX seems poised to capture market share (in addition to simply participating in LED lighting's secular adoption curve). The recent on-boarding by OESX of four additional salespeople suggests that management is quite bullish about future contract wins.
If OESX can plateau over the near term at a net income level of ~$15-20MM/year (up slightly from FY20's expected level), this would justify a share price of ~$10.75 at the midpoint of this range (assuming a 20 P/E and minimal dilution). Therefore we see ~80% upside in the stock if a combination of market share gains plus general increased LED adoption puts a firm floor under OESX's FY2020 revenue run-rate going forward. Over the longer term, we think that under current management OESX can substantially increase earnings as more and more contract wins are obtained (the recent win with OESX's large national account and the satisfactory performance of this contract should set a precedent, as well as an advertisement for potential customers, in the marketplace). In either case, the future certainly looks bright (pun intended) at OESX.
P.S. - You can follow OESX on Twitter at the following account:
Disclosure: Long OESX.
Seachange International (SEAC) - Q3 2019 Earnings Report]]>, 17 Dec 2019 18:54:16 +0000
We've been following the progress of SEAC since investing in the company far too modestly in size :( earlier this year. At the time of purchase, SEAC fit our target profile of a small company undergoing rapid change due to exogenous events, creating a compelling risk-reward opportunity when the company's stock became (we believe temporarily) severely depressed due to investor uncertainty over operational challenges related to the transition of the company's business model from a license to a SaaS approach. To recap, an activist investor, Karen Singer / TAR Holdings LLC, came along took a large (16.6%) stake in the company towards the end of 2018 and into 2019 (see 13D filings here, here, here and here). As a result of this shareholder activism, the company's CEO resigned (in a huff BTW - see here) (PR link here)...
...and the company appointed several new directors at the behest of Singer & TAR Holdings (PR link here)...
Subsequently, the board was further reconstituted, new director Robert Pons was elevated to board chairman (see here) and Chief Commercial Officer Yossi Aloni was named new CEO (see here). Thus, virtually the entirety of SEAC's leadership has turned over, allowing for a fresh start for the company (obviously a good thing after years of underperformance [the stock was nearly $8/share as recently as March 2015]).
The company's business involves selling software products and services to facilitate the aggregation, licensing, management and distribution of video and advertising content for service providers, telecommunications companies, satellite operators and broadcasters (historically this was just applicable to television set-top boxes, however more recently SEAC has expanded its product offering to embrace PCs, tablets, smart phones and OTT streaming players). SEAC's customers include the following: operators, such as Liberty Global, plc, Altice NV, Cox Communications, Inc. and Rogers Communications, Inc.; telecommunications companies, such as Verizon Communications, Inc., AT&T, Inc. and Frontier Communications Corporation; satellite operators such as Direct TV and Dish Network Corporation; and broadcasters. SEAC historically sold and licensed its products and services on a standalone basis (i.e., a license model). Commencing February 2019, however, the company adopted a value-based selling approach as part of which SEAC offers customers the ability to license all of its product and services, including specified upgrades, for a fixed period of time for a fixed price which SEAC refers to as Framework deals (i.e., a SaaS model). The transition from a license model to a SaaS model caused a (seemingly) temporary downturn in revenue generation; however, as the SaaS model ramps up fully, we would expect revenues and cash generation to increase over time. The following is a schematic of SEAC's Framework solution (source):
In terms of recent operating performance, SEAC's new leadership seems to have steadied the ship. In Q1 of 2019, revenues fell 43% (from $14.9MM to $8.5MM), while in Q3 of 2019 revenues actually increased 10% (from $18.6MM to $20.5MM), as the company has finalized more and more of its Framework agreements with customers. On the expense side of the ledger, SEAC has engaged in restructuring which should yield annualized cost savings of approximately $12 million going forward. Overall, the company flipped to profitability in the most recently completed quarter, generating $2.15MM in net income in Q3 2019, after racking up an accumulated deficit of $193MM over its prior history (dating back to July 1993 [note that the company IPO'd in 1996]). The only real disappointment has been that the company's cash balance has not increased commensurately with the other metrics, as cash and marketable securities as of 10/31/19 were $5.9MM and $7.9MM, respectively (SEAC lowered its expectations for cash at the end of the fiscal year to $14-16 million, from the previous $22 – 25 million). The real question is whether CEO Alosi and his team can keep up the positive momentum. Below is a summary of SEAC's financial performance for the 3- and 9-months ended 10/31/19:
As to the future, SEAC's management reiterated its full-year revenue and operating income guidance of $70 to 80MM and $0.03 to 0.19 per share, respectively. Full guidance as of December 4th is as follows [source]:
Finally, we would be remiss not to include the performance of the stock recently (so far, so good, but nobody in the company, nor any shareholder, should declare victory so quickly--there a lot of tough work ahead to prove that SEAC has truly and permanently turned around):
Merrimack Pharmaceuticals (MACK) - Ipsen/Onivyde Pipeline Update]]>, 13 Dec 2019 19:11:10 +0000
Further to our previous coverage of MACK, this is a quick update blog to note that the trials for Onivyde by Ipsen for both pancreatic cancer and SSLC have advanced to Phase III. Below are Ipsen's pipeline flow charts from both the end of July 2019 (included in our blog post of that date, which can be found here) and currently (see source here):
Thus MACK shareholders are one step closer to receiving the CVR payouts for each of these trials (assuming they result in FDA approvals for either of the indications). Per one study regarding the 2006-2015 time period, drugs that advanced to Phase III studies had a 50% chance (58.1% X 85.3%) of receiving FDA approval (see source here), although the chances for Onivyde arguably should be a bit higher since the drug received approval back in 2015 for second-line treatment of pancreatic cancer (see here):
As a reminder, the payouts upon approval for Onivyde are as follows:
• $225 million for U.S. Food and Drug Administration (“FDA”) approval in first-line pancreatic cancer; • $150 million for FDA approval in small cell lung cancer (SSLC); and • $75 million for FDA approval in any third indication.
If we accept that there is a 50% probability that the first two of these payouts are received by MACK, then logically these should be worth $187.5 million on an undiscounted basis for MACK shareholders (375 million X 50%), or $14/share based on 13.363 million shares outstanding as of November 8, 2019 (per MACK's most recent 10-Q filing). Compare this to MACK's $3.85/share closing price as of December 13, 2019--quite a disconnect. Note that the $14/share figure does not give any value to (1) any other Onivyde approvals that might be obtained down the line, or (2) the potential $54.5 million in CVR payments pursuant to the 14ner Oncology asset sale which closed in July 2019 (see pages 6-7 of the 10-Q filing).
CCUR Holdings - More Good News For Shareholders]]>, 10 Dec 2019 18:27:36 +0000
Continuing our coverage of CCUR Holdings (see prior blog posts, as well as our writeup in our Research section), the company today announced in a press release (see full PR here) that it has "initiated further review of capital allocation alternatives to maximize stockholder value, including a potential limited return of capital to stockholders through a special distribution" (emphasis added). It's worth noting that, as of the most recent quarter end, CCUR had $15.8 million in cash, cash equivalents and equity securities on its balance sheet, worth approximately $1.80/share (see balance sheet here). In addition, as of 9/30/18 CCUR had $22.8 million in available-for-sale debt securities, worth another $2.60/share. Having just $1.6 million in long-term debt outstanding, there appears to be ample room for the company to return cash and/or equity or debt securities to its shareholders in the most tax efficient manner possible (in cash or in kind). It is even possible that the company might conceivably lever up a bit and use some of the proceeds to return capital to shareholders (currently CCUR is under-levered).
Below is the full 9/30 CCUR balance sheet:
It is refreshing to see a company in CCUR's position, with a dominant (~40%) shareholder, publicly signaling that it intends to reward all shareholders, not just controlling ones. This kind of thinking engenders goodwill that normally ends up providing long-term benefits to those running the company, as well as stock outperformance over time (think Buffett and Berkshire Hathaway). The press release also indicates that CEO Wayne Barr and the board are intelligent capital allocators, as they appear to realize that when asset prices are historically high, excess funds should be returned to a company's owners rather than reinvested at exorbitant, unappealing multiples (i.e., at cash flow yields which are below CCUR's cost of capital). Thus, while we await the board's final determination, we render a provisional "Kudos, gents!" verdict on the latest development at CCUR.
The market apparently agrees, as shares were up 7.5% on the news at last check:
Rite Aid - Customer-Centric? A Forensic Analysis of RAD's Press Releases vs AMZN's]]>, 07 Dec 2019 17:53:14 +0000
We did a quick and dirty analysis of the last year's worth of Rite Aid's (RAD) press releases (see links to RAD's PRs here), in order to determine how much RAD's senior management (i.e., those putting out the PRs) prioritizes improving the customer experience, versus (for example) addressing the interests of investors, employees or charities. What we found was quite interesting. Out of the approximately 60 PRs issued by RAD over the past year, only 11 were PRs announcing how RAD planned to make the customer experience better (these are highlighted in yellow at the end of this post). Some of these were generic announcements, such as the August 19th PR regarding the availability of flu shots for the winter season and the April 23rd PR regarding the cessation of the sale of smoking products to adults under age 21. Such PRs don't do much to move the sales needle, however useful they are generally. Others were of a preferable variety, trumpeting a new product or service (e.g., the PR from July 1st regarding Thrifty ice cream's introduction to the Northeast--better late during the summer season than never!) Sadly, there were far more PRs issued regarding the Rite Aid Foundation's activities than customer-facing products or initiatives. For any retailer, a "hit ratio" of just 18% (11/60) is pretty anemic and indicates that not enough attention is being paid to what really counts--the customer experience.
***BLOG INTERRUPTION: As an aside regarding the Rite Aid Foundation, please note our tweet below:***
In comparison, consider the PR strategy of a best-in-class retailer like Amazon [see links to full AMZN PRs here]. First, note that a long time ago Jeff Bezos instituted a company-wide practice regarding product development; namely, that teams had to structure their proposals for new initiatives in the form of a press release (as a thought exercise, he wanted them to imagine themselves announcing these publicly--how would they describe them in that context?). Here is a fuller description of the rationale from an ex-AMZN insider [source]:
Notice in particular the requirement that the new product or initiative must "blow away existing solutions" (aka move the needle for the customer). Also note that because AMZN has this practice in place, they (1) carefully consider whether projects are worthwhile from the customer's perspective prior to expending a significant amount of time and money on them, (2) have a roadmap to follow if the projects get greenlighted, and (3) have rudimentary PRs already drafted if and when the time comes to make actual announcements to the public.
So, moving on to the forensic analysis of AMZN's PRs vis-a-vis RAD's, we initially note just how many PRs AMZN puts out. Thus far in 2019, they have released over 200, or more than 3X the number for RAD. Granted, AMZN is a much larger company than RAD, however AMZN has always been fairly hyper about communicating with the public even when they were much smaller (in 2005, for example, they issued nearly 90 PRs). In addition, AMZN's "hit rate" appears much higher than RAD's pathetic 18%. Focusing on AMZN's PRs since the beginning of October, we calculate that their hit rate was around 55% (37/67). Thus, it appears that AMZN is far more focused than RAD on alerting the people who truly count over the long term, the customers, regarding all of the great things AMZN is creating for them. Not surprisingly, RAD distantly trails AMZN on virtually every relevant metric one could think of (including number and percentage of satisfied customers).
Below are the full results for RAD's 2019 PRs:
CCUR Holdings - Q1 FY2020 Earnings Report]]>, 04 Dec 2019 19:06:07 +0000
In this post we quickly examine the most recent earnings report from CCUR Holdings (ticker CCUR), issued on November 1st (yes, we are very late, apologies!). For reference, please see (A) the company's Q1 FY 2020 earnings press release here and Form 10-Q filing here for a much more in-depth review and (B) a chart showing the recent performance of the company's shares immediately below:
CCUR reported positive net income of $3.4 million in the quarter, which might not sound like too much in the abstract, however this amount is close to 10% of the company's current market cap. Not bad for 90 days' work. In addition, CCUR's book value now stands at $6.40/share, meaning that there is still 58% appreciation potential in the stock just to "get back to even", as it were. While one shouldn't necessarily expect this level of net income quarterly going forward (especially since the most recent quarter included slightly over $1 million in realized gains, which are dependent to some degree on overall stock market movements), it does seem that CCUR is moving steadily towards sustainable profitability. Should a sustainably profitable diversified alternative finance company really trade at less than 2/3 of book value when interest rates are at rock bottom levels? We don't think so. At our longer term target of 1.25X book value, CCUR would trade at $8, about double the recent price.
In effect, the past year at CCUR has been an ongoing process of standing-up a brand new business model (MCA funding, real estate investment and a portfolio of equity and bond investments managed by significant shareholder Julian Singer [please see our prior blogs and research write-ups on the company on this website]). So it's not a surprise that the financials have bounced around significantly on a quarterly basis. In the most recent quarter, all aspects of the business contributed positively to results.
Investors seem to be missing the forest for the trees here (in our humble opinion). Rather than looking at how the company performed 2 or 3 quarters ago, shouldn't the rational investor try to project forward the trend in the company's results? Here is what the trend looks like currently (CCUR quarterly net income in $000s):
[Source: Barron's, company filings.]
And if we zoom out a bit in time and take another look at the long-term stock chart, this is what we think is going on with CCUR:
Our takeaway from all of this?
Rome wasn't built in a day. CCUR's stock won't return to double digits in a week or a month either. Investors (perhaps wisely) discount the "green shoots" of any new business model and wait to see if it's truly sustainable before bidding up shares. Yet, as Warren Buffett has said, "If you wait for robins, Spring will be over." And if you wait until a turnaround has fully turned around, you will miss out on most of the share gains. Thus, we plan to hold CCUR indefinitely as a core part of our portfolio, despite the obvious risks involved in turnarounds generally (as Buffett also famously remarked, "Most turnarounds don't"!).
CCUR Holdings: 2019 Annual Meeting Trip Report]]>, 11 Nov 2019 21:22:55 +0000
Having written previously about CCUR Holdings (ticker CCUR), including a full investment writeup posted in July 2019 in SCC's Research section, this is a follow-up post regarding the company's recent annual meeting. [In a subsequent blog post, I will review CCUR's Q2 FY2020 quarterly earnings--for those who just can't or won't wait, please see the company's earnings press release and Form 10-Q filing.]
For reference, below is the YTD performance for CCUR, showing that shares are up about 19% (note that, despite what is set forth immediately below, the company does not currently pay a regular dividend):
The annual meeting [see proxy statement here] was held on October 24th in an industrial park located in gorgeous Duluth, GA, a suburb of Atlanta (shout out to my three Lyft drivers: Katherine, Yolanda and Emily, you ladies rock!). It was tough wading through the hordes of rabid CCUR shareholders attending the meeting at CCUR's palatial HQ (think Versailles, only nicer), many of whom had elaborate lists of multi-part questions they wanted to ask management regarding their company, however somehow I managed to snag the last available chair in the house. (Actually, out of several thousand beneficial owners of CCUR stock, I was the only non-insider shareholder to appear at the annual meeting - "yay" me...or, rather, "boo" other shareholders [especially those located in the greater Atlanta area]--why so lazy, guys? Also, CCUR's offices are--thankfully, from a shareholder perspective--far from palatial [think "modern cubical"]). Also at the meeting were CCUR Chairman & CEO Wayne Barr, CCUR directors Steven Singer and David Nicol, CCUR's CFO and general counsel and the company's auditors from Marcum LLP (don't forget the auditors!). Chairman Barr expeditiously dispensed with the formalities of the meeting itself and then the spotlight was on me to ask some penetrating questions. After all, I didn't travel all the way from New York to Atlanta just to hear in person that the directors had been re-elected and Marcum LLP approved as auditor for another year. Thus, for the benefit of any other CCUR shareholder who may happen upon this blog post (perhaps a vain hope), I present a few key takeaways from the meeting:
1. As an initial matter, Chairman Barr was extremely welcoming of shareholder participation at the meeting and answered everything I threw at him (indeed, the other directors were equally cordial towards me after the meeting, when we enjoyed some pleasant informal conversation). This is not the norm at tiny pubic companies, in my experience, where minority shareholders are viewed by insiders with a mixture of suspicion and disdain ("what the heck do these guys want?"). Indeed, I attended another not-to-be-named micro-cap company's annual meeting just the the week prior to CCUR's, and the CEO, while polite, made it obvious that my questions were not entirely appreciated. [Note to other CCUR shareholders: PLEASE SHOW UP NEXT YEAR, IT'S WORTH IT.]
2. The company does not plan to do earnings conference calls anytime soon. I guess this makes sense, since it does not appear that any analysts (other than yours truly) cover CCUR right now, so there's little point in having a call where the CEO and/or CFO simply reads off of a script. Eventually, once the business model is fully developed, I hope the company will get analyst coverage and do regular quarterly calls (in addition, a few other long-term goals would be to hire an investor relations firm to assist with PR matters, etc, and to uplist the stock to a major exchange; both of which should make shares more marketable and appealing to institutional holders).
3. The company will not disclose additional information regarding performance metrics, etc, under the JDS1 management agreement. To refresh the reader's recollection, Julian Singer, a ~40% CCUR shareholder, manages the company's assets pursuant to an external management agreement between CCUR and JDS1, LLC (wholly-owned by Mr Singer). Mr Singer receives a 2% management fee (paid in SARs and only realizable upon certain changes of control of the company), $200K per year in expense reimbursement and an incentive fee equal to 20% of the annual increase in the company's NAV (subject to certain adjustments), to the extent NAV is above the then-current high-water mark. My main ask of CCUR here would be something similar to what Pershing Square Holdings provides its holders, i.e., periodic NAV calculations and disclosure of the NAV high-water mark as of any particular date (see PSHZF's regular disclosures here and here). Weekly NAV reports seem unnecessary in CCUR's case, however it would be nice if they could (eventually) disclose the following in their quarterly earnings press releases: (1) NAV/share at quarter end, (2) current NAV high-water mark under the JDS1 management agreement and (3) relevant calculations regarding the quarterly fees accrued under the JDS1 management agreement.
The main fly in the ointment with the CCUR long case in my view (and likely why the stock trades below book) has been the foregoing fee structure. If an investor has a threshold goal of making 8% per annum on average (on a pre-tax basis) investing in stocks over the long term, CCUR's underlying assets will need to appreciate at a much higher intrinsic rate to beat this bogey. If, for example, the company generates a 14% annual NAV return and 2% is taken immediately for the management fee and an additional 2.8% (14/5) is paid out to JDS1 as an incentive fee, the return for shareholders is reduced to just 9.2% (14% minus 4.8%). At a 12% annual NAV return, after management fees the company is effectively generating less than its cost of capital (which I have arbitrarily pegged at 8%). Berkshire Hathaway has generated a ~20% annual NAV return over the past 50 years, so 14% or higher off of a comparably tiny asset base (currently just $66 million) is certainly doable (as Buffett says, size is the enemy of outperformance). Essentially, CCUR investors like me are betting that Mr Singer and Mr Barr can together generate much higher returns on equity and assets (at least in the low teens annually) than would a "normal" executive team. In light of this fact, more disclosure would be better for shareholders, because with it they can better understand what they own and price the stock accurately (if pre-fee NAV is increasing at a low teens rate or greater, the stock should appreciate substantially; if not, it is likely accurately priced at less than book value).
In this context, I would also reissue the admonition (included in my original investment writeup) that the company treat its minority shareholders scrupulously fairly, for several reasons. First, it is highly unlikely that CCUR's stock price will ever rise if only certain large shareholders benefit from the company's assets (i.e., JDS1), because the investing community will catch on and bid the price down accordingly (probably permanently). One glaring example of this phenomenon is Biglari Holdings (ticker BH); here the CEO, Sardar Biglari, once hailed as the next Warren Buffett, took the reins in mid-2008 and saw BH's stock shoot up from $115 to $415 (split adjusted) in just 2.5 years (i.e., January 2011); thereafter, unfortunately, he engaged in numerous egregious related-party transactions that benefited only himself and the stock has sunk 60% in the nearly 9 years since, despite a near constant bull market. If Julian Singer truly wants to see his net worth skyrocket, clearly the quickest (although not the easiest, admittedly) path would be to have CCUR's stock price skyrocket. A re-rating of CCUR shares to just 1.5X book value would equate to a ~$20 million increase in the market value of Mr Singer's CCUR position from prevailing levels (over 16 years worth of the current annual management fee). Thus, over the long run it is actually in Mr Singer's own financial best interest to protect the rights of the rest of the other shareholders.
The second reason to err on the side of protecting minority shareholders is because the resulting reputational benefits should make future deal-making much easier and more lucrative, as (1) a richly-valued stock is the best acquisition currency and (2) sellers of businesses will trust CCUR to treat their stakeholders fairly following a change of control. Just look at the many sweetheart deals Warren Buffett has received over the years, often based primarily on reputation rather than access to funds (his 2011 Bank of America bathtub deal will go down in financial history as particularly glorious). Conversely, one seriously doubts that Mr Biglari can now effect any major acquisition using anything other than cash, and many sellers likely won't even consider him at all as a prospective buyer due to his reputational baggage. [Side note: At the annual meeting, CCUR's CEO Barr stated that while he definitely wants to see the stock go up, using it as a potential acquisition currency will be restricted for awhile (for tax reasons, due to the need to protect the company's NOLs).]
Luckily, my interaction with Mr Barr and the other directors lead me to believe that minority shareholders will be looked out for and protected from Biglari-esque conflicts of interest and self-dealing. If so, there is every reason to think that the stock price should appreciate over time to above book value (assuming CCUR's assets generate high returns on capital). The CEO's recent open market purchase of CCUR stock (albeit small) seems to be one clue that he shares my opinion. At the meeting I mentioned that one way to promote CCUR within the investment community as a "good actor" would be for the company to pay a regular dividend. Paying out just $1 million per year (<1/60th of the company's assets; CCUR is close to debt-free, so can freely make restricted payments) translates to a ~3% dividend yield at the current stock price. This would have a two-fold benefit: it would indicate that (1) management confidently expects long-term prosperity and profitability (otherwise, the company would hoard cash) and (2) all shareholders will be treated fairly by insiders.
Following the annual meeting I managed to squeeze in a quick visit to the World of Coca Cola in downtown Atlanta prior to my flight back to NYC. [Warning: Don't try to bring in Pepsi products, such as Mountain Dew. They will get out the knives! (To remove the label, of course).] Below is a view of the facility:
Of interest (and as a warning) to investors, they had an exhibit regarding the corporate history of Coca Cola. In 1888, the founder, an Atlantan named John Pemberton, sold the entire business to the Candler family for $1,750 just two years after starting it, at least in part in order to fund his morphine addiction (he would die shortly thereafter). Suffice it to say, from an investment perspective this was a decidedly bad decision, given that the company's overall equity value has appreciated by 127 million times [sic] since then. Lesson for investors: The best time to sell your interest in a demonstrably great business is NEVER. Below is an 1887 document from the exhibit whereby Pemberton grants the right to sell Coca-Cola to a third party:
Disclosure: Long CCUR.
A New Dawn at Rite Aid? Part 3 of 3]]>, 15 Oct 2019 22:50:31 +0000
In our prior two blog posts from this month regarding Rite Aid Corporation (RAD) [for which, see here and here], we first examined the recent board and senior executive leadership changes at the company and then looked at RAD's recent Q2 FY2020 earnings report and the current state of the company's finances and operations. In this (3rd and final) post, we set forth four (4) immediate action items for RAD to pursue, namely:
(1) Repurchase more debt;
(2) Link up with a Goliath;
(3) Cut the corporate fat; and
(4) Change the company culture.
So, without further ado, below are our marching orders for RAD's revamped executive team and refreshed Board of Directors...
Clearly, RAD's leverage, most recently clocking in at ~6.8X (using the company's self-graded "Adjusted" EBITDA metric) is a major problem which potentially imperils the company. Leverage needs to come down--and fast. Thus, it was refreshing to see in today's Form 8-K filing that RAD is actively buying back its senior notes, both via negotiated purchases and private transactions. The company is tendering for up to $100 million aggregate principal amount of its outstanding 7.70% Senior Notes due 2027 and 6.875% Senior Notes due 2028 at just 61% of par value. Moreover, RAD bought back $84 million of these notes at the same price in a private transaction recently. Why might noteholders agree to this? Simple--these bonds were recently trading in the low 50s, so RAD is offering about 20% above the open market price (source here and here):
All told, the announced repurchases could eliminate $184 million of senior debt for just $112 million of cash, a gain of $72 million (over $1.30/share in value accretion to the shareholders). We applaud these moves by the company and believe RAD should repurchase the maximum permissible (under the revolver) amount of bonds at these depressed levels.
In order to prosper in the long run, RAD cannot really pursue a "go it alone" strategy, in our view. It is simply too small to compete with large-scale players like CVS and Walgreens. Yes, occasionally a David such as the 1970s era Walmart (WMT) comes along and defeats Goliath (at the time, K-Mart). One can also look at mid-1990s era Amazon (AMZN) as a good example of this phenomenon. However, the number of tiny players in the retail and/or pharmacy spaces that have floundered over the decades in the face of established competition dwarfs the number that have conquered like WMT and AMZN (see, e.g., this list of dead and dying retailers). One need only look at the downfall of pharmacy chain Fred's Inc. last month to see what the most likely final outcome of "go it alone" looks like:
So what is the solution for RAD? Link up with a Goliath. We believe that a logical fit would be any of AMZN, WMT or Target (TGT), each of which has both retail and pharmacy operations and could benefit from acquiring RAD's stores/pharmacies. Does AMZN really want to disrupt the pharma and drug space, following its $753 million PillPack acquisition, which is now facing competitive pressure and pushback from WBA and CVS? Perhaps some or all of RAD's ~2,400 pharmacy network could be the key for them to achieve the necessary scale. Does AMZN want its cashierless store strategy, currently apparently mired in mud, to ramp up quickly? One journalist has noted that AMZN's slow rollout "might just be [attributable to lack of] good store locations. According to the documents, Amazon’s cashierless stores need high ceilings so the company can mount the cameras and sensors they use to detect which items a customer is buying. They also need to be near Amazon depots that carry fresh food, and they need to have decent foot traffic so customers are likely to stop by." Well, what company has leases in place for plenty of high-ceiling stores located along both coasts (i.e., near AMZN distribution centers)?
Yep, that would be Rite Aid [source here]:
Compare this to Amazon's distribution center map [source here]:
In fact, the two states that have the largest RAD store presence (post-WBA asset sale) are California (577 stores) and Pennsylvania (535 stores)...which also just happen to be the two states with the most AMZN distribution centers (18 and 12, respectively). Sounds like a match made in heaven--or, at least, capitalism.
We recommend that RAD's senior executive team IMMEDIATELY AND SIMULTANEOUSLY reach out to each of AMZN, WMT and TGT to begin discussions of a potential 50/50 joint venture into which RAD would contribute certain of its stores and pharmacies and in return would receive a commitment from the applicable deep-pocketed JV partner (whichever of these three offers the most compelling package to RAD) to fund the technological investments needed to go "cashierless" (note that adding RAD's network to any of these three would likely make their online, direct shipment offerings more compelling as well). If during negotiations AMZN tries to drive a hard bargain, simply give WMT or TGT the opportunity to steal a march on their juggernaut rival by outbidding AMZN. In other words, RAD executives will need to channel their inner Elon Musk in the negotiations, to wit: "
'Do the impossible' is one of Tesla’s slogans, and Musk set out to make it happen [during the Gigafactory negotiations with various states]. He looked to spread the costs, seeking a mammoth package of incentives from states for the right to be the factory’s home. He succeeded—and then some. Musk landed a stunning $1.4 billion in tax breaks, free land, and other beneficence from Nevada to build the factory outside Reno. It’s one of the biggest gift baskets in history... Musk played an Oz-like role as master orchestrator, sending signals through earnings calls and blog postings, while keeping the states in the dark and playing on their fears of losing out. The combination of his strategy, the electric Musk factor, and the lure of 6,500 jobs inspired excited bidding among seven states and staggering leaps of faith. States were willing to move mountains (or highways, as the case may be) for a chance to have the factory
". Great negotiations are not based on luck, as this example proves--negotiating well is an extremely valuable skill.
Importantly, for RAD shareholders to participate in the potential upside of such a link-up, the deal must be done in a JV format rather than a buyout of the entire company (unless a truly mind-boggling takeover proposal were advanced for all of RAD's equity--and by mind-boggling we mean triple digits). Even announcing a pilot program involving, perhaps, 20 or 30 RAD stores would be worthwhile to get the ball rolling and would likely cause RAD stock to quickly re-rate much higher. All of the foregoing might seem like a pipe dream to RAD shareholders today, given the relentless negativity surrounding the stock and the company in recent years, but often the proper long-term strategy for an upstart or "comeback kid" enterprise (RAD falls in the latter category) is to aim for a (nearly) impossible goal and push relentlessly to get there, the massive payoff justifying the effort. In other words, it's time to employ the "reality distortion field" at RAD (for once).
In order to prosper (either in its current state or post-JV), RAD clearly needs to reduce its level of corporate SG&A. We believe that several decades of stagnation, combined with a lack of accountability and efficiency, has resulted in a bloated and unappealing (for new hires as well as existing employees) corporate culture at Rite Aid. To cite Musk once more, RAD needs to scrape off the barnacles. Remember, the prior (failed) senior executive regime ran the company for most of the past 20 years, so it is no surprise that excessive sclerosis may have set in over that period. The stock price tells the sad tale, down 96% during this century (with zero dividends paid out) [note that AMZN is up over 2,000% during the same time period--or to put it more starkly, $10,000 invested in RAD on January 1, 2000 is now worth $393, enough to buy half of a men's suit at Hugo Boss, while the same amount invested in AMZN would now be worth $216,463, enough to buy a brand new, 3-bed 2-bath house in Austin, TX):
If we look at competitors WBA and CVS, for example, we find that RAD's SG&A line as a percentage of revenue is around 21%, whereas WBA's is at 18%. On $21.7 billion of revenue (RAD's guidance for FY 2020), an extra 3% means $650 million less flowing to the bottom line. Moreover, RAD disclosed that the 400 "corporate and field organization" employees laid off in early 2019 constituted just 20% of the total number of this category of employee, implying that pre-restructuring, RAD had a total of 2,000 "corporate and field organization" employees [source]:
A hallmark of a great company is maintaining a lean structure. While RAD sold approximately half of its stores to WBA, it has only reduced the number of corporate employees by 20%. Surely there is more fat to trim here. The new CEO should immediately prioritize further leaning out of the corporate overhead structure in order to get RAD's SG&A much closer to WBA's 18% of revenues.
Having great role models is incredibly important in life, as they can determine one's character ("character is destiny"). Even corporations can use a good role model or two to emulate. In our prior RAD Seeking Alpha article entitled "A MultiStep Rx For Rite Aid's Woes" [see full article & comments here], we argued that "now is a perfect time to refresh [RAD]'s staid corporate culture [by copying a] few examples of best practices from two demonstrably great companies, Amazon and Netflix". We specifically cited Bezos's 2016 AMZN shareholder letter, in which he said the following:
I work in an Amazon building named Day 1, and when I moved buildings, I took the name with me. I spend time thinking about this topic.
“Day 2 is stasis. Followed by irrelevance. Followed by excruciating, painful decline. Followed by death. And that is why it is always Day 1.”
To be sure, this kind of decline would happen in extreme slow motion. An established company might harvest Day 2 for decades, but the final result would still come.
I’m interested in the question, how do you fend off Day 2? What are the techniques and tactics? How do you keep the vitality of Day 1, even inside a large organization?
Such a question can’t have a simple answer. There will be many elements, multiple paths, and many traps. I don’t know the whole answer, but I may know bits of it. Here’s a starter pack of essentials for Day 1 defense: customer obsession, a skeptical view of proxies, the eager adoption of external trends, and high-velocity decision making.
. NOW. PLEASE. DO IT. It will be by far the most important and rewarding thing you do all day.
[All of his other shareholder letters should also be read--for which, see here.] To further expand on the AMZN example, take Bezos on hiring:
One sign that RAD's corporate HQ folks simply haven't been working hard enough comes from our friends at Google. They handily allow us to get a glimpse of what is going on at HQ, located at 30 Hunter Lane, Camp Hill PA. First, take a look at ground level views of the campus from 2016 and 2017:
All seems relatively normal, cars are everywhere, people are seemingly working hard (or, at least, people are at work). But what happens when we look at a satellite view from 2019 (apparently taken on a weekend)? We find that virtually nobody can be bothered to put in any weekend overtime at this company (including the senior executives, who seem to have the prime parking spaces in the semi-circular driveway near the front entrance [third photo below]). We count a grand total of 5 cars in these shots, showing how minimal the "extra effort" is at RAD's Camp Hill HQ:
We are reminded of the old investment banker adage: "If you aren't coming in on Saturday, don't even think of coming in on Sunday". Except at Rite Aid HQ they apparently take this literally! Sorry, guys, but when you are a company in peril, with a large debt load coming due in a few short years, you need to bite the bullet and start working some (make that, most) weekends--even if you live in Camp Hill, PA. If it is good enough for AMZN, it's good enough for RAD. MEMO TO THE NEW CEO: CHANGE THE RITE AID CORPORATE CULTURE IMMEDIATELY TO ONE THAT DEMANDS ACCOUNTABILITY, PERFORMANCE, RELENTLESS EFFORT AND EMPHASIZES INTEGRITY FROM EVERY TEAM MEMBER, FROM ITS TOP LEADERS TO ITS STORE-LEVEL EMPLOYEES (NO EXCEPTIONS!).
We could cite many more items to put on RAD's senior leadership "to do" list, such as (1) schedule an Investor Day, (2) institute self-checkout kiosks in stores, (3) get a new board chairman, (4) institute a fundamentally re-thought and re-worked senior executive compensation system (that actually motivates executives to produce results rather than excuses [no more so-called "retention bonuses"!!!]), etc. However, we think intense focus is required of RAD's new CEO and COO, and their immediate reports, on a few key goals to get the company back on track after two decades of fairly continuous downward drift. We therefore recommend these folks focus 70-80% of their energy in the near term on the above four action items.
Disclosure: Long RAD.
A New Dawn at Rite Aid? Part 2 of 3]]>, 10 Oct 2019 17:05:19 +0000
In our prior Rite Aid Corporation (RAD) blog post [for which, see here], we examined the recent changes to the company's board of directors and senior executive leadership. In a subsequent post, we will lay out a blueprint for these folks to follow to achieve Rite Aid 2.0 (success over the long haul). In this post, however, we will examine RAD's recent Q2 FY2020 earnings report, the current state of the company's finances and operations and how a turnaround scenario might look for RAD investors.
On September 26th, RAD issued its earnings press release for the second quarter of its fiscal year 2020, along with its earnings slides. First, the headlines:
While the growth in same-store prescriptions is encouraging, the company is still cash flow negative and mired in red ink, losing $79 million in the quarter on a GAAP basis and racking up negative $358 million of cash flow (although, in fairness, all of this negative cash flow came from working capital changes rather than from operations). These outflows were offset by $375 million of revolver borrowings. Here is the statement of cash flows for the first half of FY 2020, evidencing that RAD's financial performance has not materially improved from the prior year (an optimist might note that it hasn't gotten worse either):
Below are RAD's leverage calculations, evidencing an unsustainable net debt to AEBITDA ratio of 6.84X:
Note that, if we measured the leverage ratio on Q2's run rate basis and used EBITDA instead of "adjusted" EBITDA, this metric would have been far worse, at 8.8X [source: SCC calculations].
RAD is currently stuck in a negative feedback loop, owing to its $3.9 billion of debt and overall poor operating performance. Servicing the debt costs ~$240 million per year, which in turn means the company cannot generate positive free cash flow, which means it also cannot pay down the debt. Just over two years ago, former CEO Standley orchestrated the sale of about half of RAD's stores to Walgreen's for $5.175 billion. At the time, the former CEO claimed that "[t]he transaction offers clear solutions to assist us in addressing our pharmacy margin challenges and allows us to significantly reduce debt, resulting in a strong balance sheet and improved financial flexibility moving forward" (emphasis added). At the time, RAD's leverage ratio stood at 6.80X (see slide 20 here). Two years later we find that, despite the former CEO's optimistic assertions, RAD's leverage ratio in fact remains just about the same following the asset sale as prior to it--in other words, no deleveraging progress has been achieved (mainly due to continued declining EBITDA). Despite receiving approximately $4.4 billion in proceeds from Walgreen's in a tax-free transaction, RAD's net debt has been reduced only $3.5 billion (from $7.1 billion as of June 3, 2017 to $3.6 billion as of August 31, 2019), resulting in $900 million of "leakage".
On the positive side, the aforementioned bad news is now mostly priced in to the stock, which is down 86% since the WBA asset sale was announced in mid-2017:
In addition, RAD's operations do appear to be stabilizing around the current (low) level, evidenced by the following trends:
The prescription sales side of RAD's business is experiencing a bit of a resurgence over the past 10 quarters (all evidencing year-over-year growth), which is important since this segment accounts for almost half of RAD's overall revenues (48%, to be precise; front end sales constitute 24% and EnvisionRx accounts for 28% of aggregate revenues). If the Rx side of the ledger can continue to rebound, logically revenues and EBITDA should increase over time, especially if the PBM business, EnvisionRx, can fulfill its potential under new leader Ben Bulkley. Here is a comparison of the trends over the past 4.5 years (18 quarters) showing the correlation between Rx Sales (YoY quarterly %age change) and EBITDA (YoY quarterly %age change)--in both charts the low point appears to have occurred in Q1 of FY 2018:
If the recent Rx sales and EBITDA uptrend continues, how might a bullish scenario play out in terms of future financial metrics? We present one below:
In the above turnaround scenario, we assume a 3% annual increase in shares outstanding due to stock compensation grants (i.e., insider dilution) and that YoY EBITDA grow on the upside (during 2021-2023, positive 20-25%) is a bit less robust than it was on the downside (2017-2018, negative 25-30%). Importantly, however, given how levered RAD's stock price is to EBITDA, if we assume RAD's enterprise value remains constant at 7.5X EBITDA, this would imply a stock price of over $50/share by early 2023 (~6X the current share price), representing a CAGR of 68%. Not too shabby...ASSUMING the bullish scenario actually plays out as modeled above (a major assumption). In addition, by the end of FY 2023 in our model, due mainly to the growth in TTM EBITDA over time, the leverage ratio finally falls below 4X in early 2023 (all FCF assumed to be used to pay down down), allowing the debt to be refinanced on reasonable terms. Of course, this is a bit of a rosy scenario in light of the recent relentless downtrend in RAD's EBITDA, however we think it possible if (A) reimbursement rate pressures are ameliorated (the current governmental deadlock will help in this respect) and (B) RAD's new leadership takes emphatic measures to materially reduce RAD's bloated cost structure while revitalizing underlying operations with an entrepreneurial ethos which was sorely lacking (to put it mildly) under the Standley regime.
RAD's current financial state is quite precarious, due to its significant debt level combined with negative cash flows--6.8X leverage is not sustainable over the long run. On the positive side, we find that comparable pharmacy revenues and script counts have been growing recently, which is important given that nearly half of RAD's revenues are from prescriptions. Given the aging of the Boomer generation, these positive trends seem likely continue over the next few years and drive increased demand for prescription medication (by 2024 all of the Boomers, who currently number over 76 million individuals in the United States, will be in their 60s and 70s). Under the rebound scenario above, we think that RAD's stock price could climb back to $50+ per share over the next four years, up massively from the current ~$8 level. While this might seem incredible, it would actually only be a return to the $2.50 per share range on a split-adjusted basis (RAD performed a 1-for-20 reverse stock split earlier this year). The proof will be in the pudding, at least with respect to those areas under RAD's management's control: i.e., expense management (there appears much fat at RAD to be trimmed), crisp execution of the business plan and effective communication of the rebound story to investors. We will have more to share on these three topics in our final "Rite Aid 2.0" be continued.
A New Dawn at Rite Aid? Part 1 of 3]]>, 07 Oct 2019 16:29:05 +0000
Recent developments at Rite Aid Corporation (RAD) are worth noting and perhaps give some hope to its long-suffering shareholders that the era of seemingly interminable value destruction may perhaps be ending and a new dawn approaching (yes, we dare to dream). First, among other leadership changes, the company finally announced the hiring of a new chief executive in mid-August and a new COO just a few days ago. In addition, on September 26th the company announced earnings for its Q2 of FY 2020. We examine the first of these developments (leadership rotation) in detail in this blog post; in the next two parts, we will look more closely at the recent earnings report, and then provide our in depth recommendations regarding how new leadership at the company can successfully engineer a Rite Aid 2.0 that can compete in the marketplace over the long haul.
Regarding RAD's leadership changes, it should initially be noted that the company's highly compensated yet often inept board of directors [see full analysis here] waited far too long to replace its former failed executive leadership team. While it was obvious to any rational observer by mid-2018 that ex-CEO Standley and certain of his cronies in the C-suite needed to go (Kermit Crawford, we're looking at you), RAD's board (then and now headed by a shareholder-unfriendly chairman Bruce Bodaken) inexplicably endorsed Standley in September 2018 as the best possible option to continue to lead the company forward (at the time, RAD shares were trading at just a small fraction of where they were when Standley first became RAD's CFO approximately 20 years ago). It took a subsequent nearly 50% further destruction of the stock price before the Bodaken-led board finally bowed to the inevitable in mid-March of this year and announced Standley's termination as CEO, at the time rubbing more salt in shareholders' wounds by stating "[w]e thank John for his outstanding leadership [sic] in guiding the Company over the past several years". Yet, much like one of the ghouls in Michael Jackson's Thriller video, Standley would not die, as Bodaken & crew allowed him to remain in his CEO role an additional five months(!) until the appointment of his successor. Even when he was at long last replaced two months ago with the appointment of a new CEO, Heyward Donigan (at which point the stock had DECLINED ANOTHER 50%+ from March's already anemic level), Bodaken's board decided to give shareholders one final kick in the teeth by gifting the departing CEO with a six-month "consulting" deal at $7,500 per week on top of his already enormous severance payments (certainly good work if you can find it--the "consulting" agreement limits the ex-CEO's efforts to a maximum of ten hours per week--perhaps so as not to unduly interfere with whatever golf matches or other leisure activities he has scheduled). How Mr. Bodaken remains RAD's board chairman after all of the shareholder value destruction and terrible board-level decisions that have occurred on his watch (as of last Friday, October 4th, the stock price was down 86% since he joined the board and 64% since he became chairman) is truly a mystery wrapped in an enigma.
Fortunately, despite intense pushback and foot-dragging at every step of the way by certain (and, thankfully in many instances, now replaced) individuals in RAD's upper echelons, significant and desperately needed change in leadership has come to this troubled company as a result of relentless shareholder pressure. Including new CEO Donigan, 6 out of 9 of RAD's directors, each of whom has been appointed to the board over the past year, are not wholly implicated in the many failings of the Standley/Bodaken era. These six are Donigan, Elizabeth Burr, Robert Knowling, Louis Miramontes, Arun Nayar and Katherine Quinn (see bios for all here). Two of the new board members have significant relevant healthcare experience: (1) Burr most recently served as the chief innovation officer and vice president of healthcare trend and innovation at Humana, while (2) Quinn previously served as senior vice president and chief marketing officer at Anthem (and prior to that worked at CIGNA and PacifiCare Health Systems).Thus, only 1/3rd of RAD's board remains wholly "tainted" by past incompetence (directors Bodaken, Marcy Syms and Kevin Lofton). We can only hope that these three lingering directors, all of whom have been on the board far too long (since 2013, 2005 and 2013, respectively), will finally be shown the door by shareholders at the 2020 annual meeting.
On a more positive note, let's examine RAD's newly appointed CEO Heyward Donigan. She has the following resume [per her LinkedIn profile]:
Dates Employed: Aug 2019 – Present
Employment Duration: 3 mos
Location: Harrisburg, Pennsylvania Area
President and CEO
President and CEO- Sapphire Digital
Dates Employed: Mar 2015 – Aug 2019
Employment Duration: 4 yrs 8 mos
Location: Lyndhurst, NJ
(formerly Vitals)
Leading Consumer Transparency Company--providing Consumers, Health plans, National Accounts and Providers with a full suite of tools, including Provider Selection/Provider Reviews and Cost Calculators. Enabling consumers to make smart health decisions.
President and CEO - Value Options
Dates Employed: Sep 2010 – Jan 2015
Employment Duration: 4 yrs 5 mos
Behavioral Health Improvement
Executive Vice President, Chief Marketing Executive - Premera Blue Cross
Dates Employed: Apr 2003 – Sep 2010
Employment Duration: 7 yrs 6 mos
SVP, Operations - CIGNA Healthcare
Dates Employed: Sep 2001 – Oct 2002
Employment Duration: 1 yr 2 mos
President, Southeast Region - CIGNA Healthcare
Dates Employed: 1999 – 2000
Employment Duration: 1 yr
Senior Vice President - Empire Blue Cross Blue Shield
Dates Employed: 1994 – 1997
Employment Duration: 3 yrs
New York University
Degree Name: MPA
Field Of Study: Health Finance
Dates attended: 1987 – 1992
University of Virginia
Degree Name: BA
Field Of Study: English
Date of graduation: 1983
Although in perusing the above we note a few unexplained blank periods (was Donigan employed between 1997 and 1999, as well as from 2000 to September 2001?), on the whole she presents a compelling resume to be a CEO of Rite Aid (which generates over 2/3rds of its revenue directly from the healthcare system). Not only did Donigan receive a master's in health finance from NYU, she's has been in the health care field consistently over the past 25 years, including nine years (and counting) as a CEO. Her most recent company, Sapphire Digital (fka Vitals), is described as follows [source: February 2019 company PR]:
Sapphire Digital is a mission-driven company that drives competition in health care to lower cost and improve quality for all. The omni-channel engagement and shopping platform, available through health plans and employers, empowers members to shop with confidence for high-quality and lower cost medical services. Sapphire Digital’s platform achieves measurable and sustainable savings for consumers, employers and health plans and results in system-wide cost savings. Over 95 million people each year rely on Sapphire Digital to help them decide on their care with confidence.
One of the key business lines apparently developed under Donigan's leadership at Sapphire is a sort of healthcare comparison shopping service called SmartShopper where patients receive small cash bonuses from their employers or health insurers in return for choosing cheaper service providers, which is meant to reduce overall healthcare costs by encouraging competition. A Boston Globe article from April described it thusly:
[Note: The Globe adds that "[d]octors and hospital systems generally don’t like patients shopping around for tests and procedures based only on price" (color us shocked)]
So we find that RAD's new CEO Donigan's background includes encouraging evidence that she brings to the company fresh, "out-of-the-box" thinking and entrepreneurism regarding health care, which traits were unfortunately severely lacking (indeed, virtually non-existent) in the prior Standley regime. Donigan's prior stint was as CEO of Value Options, which acted as a vendor for administering behavioral health benefits on behalf of major health insurers. On a note of caution, we found that shortly after Donigan left Value Options in early 2015, the company was hit with a $900,000 fine by disgraced former New York AG Eric Schneiderman for "allegations of widespread violations of mental health parity laws by the company... An investigation by the Attorney General’s Health Care Bureau found that ValueOptions issued denials [of coverage] twice as often for behavioral health claims as insurers did for other medical or surgical claims and four times as often for addiction recovery services" [see full PR here]. Per the settlement agreement [available here], the allegations against Value Options concern the period during which Donigan was CEO, although the agreement states that Value Options "neither admits nor denies the Attorney General’s findings". One interesting side note: the settlement agreement states that "[i]n 2013, ValueOptions had revenues of approximately $1.3 billion nationally".
In addition, just days ago Donigan tapped a new Chief Operating Officer to be her right-hand man at RAD, namely Jim Peters [see PR here]. Peters has the following bio:
Jim Peters is a recognized leader with 25 years’ of broad healthcare and industry experience. Most recently, Peters served as chief executive officer of Skyward Health, a strategic healthcare advisory firm. Prior to Skyward, Peters was a 12-year senior executive at Geisinger Health System, helping establish Geisenger’s national reputation for healthcare innovation. At Geisinger, Peters held roles including chief executive officer of Geisinger Medical Management Corporation, managing partner of Geisinger Ventures and senior vice president, chief strategic partnerships officer. Prior to Geisinger, Peters served as principal at Updata Capital, a venture capital firm focused on software, data analytics and health IT.
Peters is a member of the American College of Corporate Directors and, until its recent acquisition, an independent director of NxStage Medical, Inc. (NASDAQ: NXTM). He is also an independent director of Special Olympics PA. Peters serves as an adjunct lecturer at Lehigh University and has been a guest lecturer for the Wharton School at the University of Pennsylvania. Peters holds an MBA in finance from the Wharton School at the University of Pennsylvania. He graduated with a Bachelor of Arts in architecture from Lehigh University.
Per its LinkedIn profile, Skyward Health is an extremely small company (11 to 50 employees, with no jobs or people listed on LinkedIn [other than Mr Peters]) which has a minimal footprint on the Internet (only a bare bones website). Frankly, we don't know what to make of it. Perhaps it was just a convenient resting spot for Peters after leaving Geisenger before moving on to bigger and better things. More encouragingly regarding his prior position: per Wikipedia, "Geisinger Health System (GHS) is a regional health care provider to central, south-central and northeastern Pennsylvania and southern New Jersey. Headquartered in Danville, Pennsylvania, Geisinger services over 3 million patients in 45 counties. It has been widely recognized for delivering high-quality care at low cost through an integrated delivery system model of healthcare."
RAD's executive leadership team therefore now consists of the following individuals:
Heyward Donigan, chief executive officer;Jim Peters, chief operating officer;Matt Schroeder, chief financial officer;Jim Comitale, general counsel and secretary;Jessica Kazmaier, chief human resources officer;Jocelyn Konrad, chief pharmacy officer;Justin Mennen, chief information officer; andBen Bulkley, chief executive officer, EnvisionRxOptions.
What investors need from the aforementioned management team is a presentation of their 30,000-foot long-term vision for the company (think something along the lines of Bezos's 1997 letter to Amazon shareholders here). Without such a vision, the stock price will likely continue to stagnate around current low levels. We would recommend that (1) the CEO puts out a "State of the Company" letter presenting her view on where RAD needs to go and how she plans to get it there, and (2) the new executive team organizes an Investor Day, so each senior team member can review their particular line of business, etc. In each case these action items need to occur in the near term (by the end of 2019 would be ideal). We will also have further thoughts on "Rite Aid 2.0" in a subsequent blog post...stay tuned.
CCUR and SEAC Earnings Reports]]>, 19 Sep 2019 19:25:02 +0000
Just a quick blog post to update our previously posted long thesis on CCUR (and, consequently, one of its main portfolio holdings, SEAC, which we are also long separately). Both CCUR and SEAC reported earnings in late August (see here and here). First, the headlines for CCUR:
CCUR turned in a profitable final quarter for its 2019 fiscal year (ending June 30th), with revenues growing a massive 72% sequentially and 3,300%(!) year over year. In addition, Q4 of FY 2019 represented the second consecutive profitable quarter for the company, with CCUR recording a total of $2.2 million, or $0.25/share, in profits over the past two quarters. Not too shabby for a stock that was trading at just $3.43 as of the date of the earnings release. The Merchant Cash Advance (or MCA) business, acquired just 7 months ago, certainly seems to be paying dividends for the company, as the company noted that "[CCUR] recorded an expense of $730,000 representing the change in fair value of contingent consideration due to the seller of the LuxeMark [MCA] assets...given better than expected performance since the LuxeMark acquisition earlier in calendar year 2019."
In our original writeup, we pegged CCUR's fair value at 1.25X book value, implying a target price of $7.47/share (or double the then market price). Since then, book value per share has declined ever so slightly from $5.98/share to $5.87/share due a decline in other comprehensive income (i.e., changes in unrealized gains and losses with respect to CCUR's investment portfolio during Q4 of FY 2019). Thus, our target price is now $7.33/share (versus $7.47/share in the writeup), or 101% above the current market price of $3.65/share. In short, we still major upside potential for CCUR shares.
Next, the headlines for SEAC:
As a reminder, as of June 2019, CCUR owned 1.285 million shares of SEAC, whose stock has appreciated 50% (from $2/share to $3/share) since the above earnings release. In the release, the company announced that revenues for Q2 of FY 2020 (ending July 31st) reached $18.8 million, up from just $8.5 million in the prior quarter, representing sequentially growth of over 120% (and year over year growth of 58%). More importantly, SEAC narrowed its quarterly loss to almost breakeven (negative $174K, to be precise) from a massive $9 million loss in the prior year quarter. The promotion of Yossi Aloni to the permanent President and Chief Executive Officer role seems to bode well for SEAC shares, as he has primarily orchestrated the current turnaround. Management is targeting "a business model that could result in sustainable double-digit revenue growth and non-GAAP operating income growth of 12-15% in 2 to 3 years". While it is too early in the turnaround process to render a verdict on SEAC yet, recent results appear promising.
Both CCUR and SEAC also have active stock repurchase programs: (x) CCUR repurchased a total of 188,510 shares during the fiscal third quarter for a total of $703,000; a total of 414,607 shares under the authorized program remain available for repurchase as of March 31, 2019; and (y) SEAC initiated a $5 million share repurchase program in June 2019, subsequently purchasing 100,000 shares for a total consideration of approximately $140,000 in the quarter.
Below is the tale of the tape (or tale of the charts, as it were) for both stocks in 2019:
Scrutinizing MACK's Board's Flimsy Proxy Fight Assertions; VOTE BLUE, SHAREHOLDERS!]]>, 16 Sep 2019 20:27:10 +0000
In mid-July, Seven Corners published its long thesis on Merrimack Pharmaceuticals (MACK). [Please see our full writeup in our .] We also published a follow-up blog post entitled "Merrimack Pharmaceuticals - Long Thesis UPDATE" [for which, please see here]. Since then MACK's board of directors and activist investors JFL Management and 22NW Fund have been trading rhetorical blows in a proxy fight [see full SEC filings here]. As a reminder, MACK delayed the annual meeting from its originally scheduled date of September 11th, apparently lacking votes for their candidates' re-election; now it is expected to occur on October 17th [per company proxy statement here].
We recently received in the mail a "Dear Fellow Shareholders" brochure from the company pitching their director slate and, frankly, we were disgusted by what we read [see full text here]. Thus, we decided to point out a few of the more egregious items contained therein, so "fellow shareholders" can see the level of weak spin MACK's board is resorting to in order to win votes in the proxy fight:
MACK's board claims that "...the Company and its financial advisor, a leading healthcare industry bank, MTS Health Partners, L.P., contacted more than 100 potential companies regarding transaction opportunities – ranging from reverse mergers with private companies to an outright sale of Merrimack. Unfortunately, none of these potential transaction partners offered sufficient near-term value for Merrimack shareholders. Furthermore, none of these potential partners were able or willing to assume responsibility for capturing and distributing the potential long-term ONIVYDE milestones to the Company’s pre-transaction shareholders."
MACK's board brags that they "reduced the Company’s workforce by 100 percent since the initiation of the strategic review, including the Company’s entire senior management. The Company currently has no full-time employees and has engaged experienced consultants to manage day-to-day operations."
MACK's board crows that they "Announced an anticipated reduction in the size of the Board from seven to four".
MACK's board states that "Since the announcement of the Company’s restructuring and strategic process on November 7, 2018 Merrimack’s stock price has increased by approximately 55 percent – reflecting the overall positive reception by shareholders of the significant steps Merrimack has taken".
The above points are, in our opinion, just a few of the many where MACK's board is engaging in intellectually dishonest and disingenuous arguments out of desperation to win a proxy fight they clearly deserve to lose. Let's face it, Board Chairman Gary L. Crocker is simply a failure and must be removed. Per the company's proxy, he has served as a member of MACK's board of directors since 2004, as Chairman of the Board since 2005 and as President and Treasurer since June 2019--and he has failed to create shareholder value during that entire period. In just the past 4.5 years alone, MACK's stock price has cratered ~95% under Crocker's supposed "leadership"(!!!) THUS, DESPITE A DECADE AND A HALF OF FUTILITY UNDER CROCKER, HE AND MACK'S BOARD ARE ASKING MACK SHAREHOLDERS TO KEEP THEM IN OFFICE. Why should we oblige?
Enough is enough, fellow MACK shareholders. Let's end the incumbent board's reign of financial terror and take back our company. The REAL reason the stock is up and the board is scrambling to appease us is because JFL & 22NW have been putting pressure on them. If we side with the incumbents now, all that leverage will be gone for another year (if not for many more years) and the value of our investment in MACK will likely plummet.
Seven Corners Publishes Precision Optics (PEYE) Long Thesis--$2.85/Share Target Price (101% Potential Upside)]]>, 12 Sep 2019 13:20:45 +0000
Please note that Seven Corners published its long investment thesis on Precision Optics Corporation (ticker PEYE) today, September 12, 2019, with the following high-level bullet points:
Expected Value vs. $1.42 Market Price (as of 9/11/19) = $2.85/share101% Upside To PEYE’s Price Target, Which Reflects a P/S Multiple of 3.7XComparable Companies Trade at an Average 5.7X Revenue Multiple, Versus Just 1.7X for PEYE
To find a PDF containing our full PEYE writeup, please visit our Research section (link here).
Seven Corners Publishes CCUR Holdings Long Thesis--$7.47/Share Target Price (102% Potential Upside)]]>, 31 Jul 2019 19:23:25 +0000
Please note that Seven Corners published its long investment thesis on CCUR Holdings (ticker CCUR) today, July 31, 2019, with the following high-level bullet points:
Expected Value vs. $3.70 Market Price (as of 7/31/19) = $7.47/share102% Upside To Our Price Target (Could Be Higher Pending Recent Repurchase Activity) Company Trades at Just 62% of Book Value Despite Potential for Significant Profitability
To find a PDF containing our full CCUR writeup, please visit our Research section (link here).
Merrimack Pharmaceuticals - Long Thesis UPDATE]]>, 29 Jul 2019 18:44:47 +0000
Approximately two weeks ago, Seven Corners published its long thesis on Merrimack Pharmaceuticals (MACK). [Please see our full writeup in our Research section here.] Since then several material events have transpired, giving a bit more clarity to the MACK investment thesis, as follows:
On July 25th the company announced that it will be returning half of its cash to shareholders in the form of a $20 million special dividend, equaling $1.50/share (see full PR here). The special dividend is payable on September 5, 2019 to stockholders of record as of the close of business on August 28, 2019. Note that, due to the size of the dividend versus the market cap, the ex-dividend date for the special dividend will be September 6, 2019, the first trading day following the payment date [see explanation of rules for large dividends here]. In our original writeup, we noted that a special dividend was expected in Q3 2019 (the actual $1.50/share amount exceeded our estimate of a range of $1.27 to 1.42 per share) and that this would de-risk the MACK investment. Importantly, in the special dividend PR, MACK's management reaffirmed that "[o]ur remaining cash balance is anticipated to support operations into 2027, when we estimate the longest-term potential Ipsen milestone may be achieved."This implies that MACK's expected cash burn for the next eight years is just ~$2.5MM/year ($20MM current cash divided by 8), much lower than our prior estimates. It is nice to see the foregoing aspects of the long thesis playing out so quickly (and favorably to expectations).
The company issued its Q2 2019 Form 10-Q on July 17th without any earnings press release. The takeaway here is the balance sheet (since MACK has now completely ceased operations and, per page 6 of the 10-Q, has no current employees):
As noted above, MACK ended Q2 with $40MM in cash and cash equivalents and minimal long-term liabilities. The cash/CE figure was about $9MM below our prior estimate principally because the company reduced its payables more than we had expected. Although MACK's current book value per share is just $3, this figure excludes the value attributable to $455MM in potential CVR payments from Ipsen and another $54.5MM in potential CVR payments from 14ner Oncology (discussed in our original writeup). Investors should also bear in mind the company's nearly $250MM in NOLs, which are yet another "hidden asset", as they are excluded from the balance sheet due to a valuation allowance against the full amount.
Below we present our updated valuation calculations for MACK, showing that despite the recent uptick in the stock price, shares still have significant upside to our fair value estimates of $9.36/share (excluding any value for the NOLs) and $10.86/share (ascribing a conservative $1.51/share value to the NOLs):
Overall, MACK shares have appreciated about 14% since we released our long thesis on July 16th:
The activist investor group headed by JFL Capital Management and 22NW Fund recently filed an update to their previously filed Form 13D [see here for full filing]. Collectively, this group owns an aggregate of 2,500,526 MACK shares, constituting approximately 18.7% of the shares outstanding. In the amended 13D, the group states that "JFL Partners resubmitted its nomination of [Jason M. Aryeh, Aron R. English, Joseph F. Lawler, M.D., Ph.D., and Kenneth Lin, M.D. as] Nominees for election to the Board at the Annual Meeting following the Issuer’s disclosure that the Annual Meeting will be held on September 11, 2019". Given that there are no significant MACK shareholders represented on the board of directors other than chairman Gary Crocker (if one excludes unexercised stock options from the ownership amounts listed on page 16 of the Form 10-K/A filed in late April), we believe that the activist group deserves significant representation on the board.
We hope the incumbent board will realize that it is in the interests of all of MACK's owners, i.e., the shareholders, to have more (rather than less) true shareholders on the board (as opposed to board members who expect endless free grants of stock courtesy of the shareholders, but who are unwilling to put any real skin in the game via significant open market stock purchases), and will act accordingly by offering the activists a sufficient number of seats to avoid a full-on proxy contest, which would be a completely avoidable and unnecessary waste of company assets. One logical solution would be for MACK to expand it board from 6 to 10 directors, allowing all four of the activists' nominees to join the board, while not giving full control of the board to a group currently owning less than 20% of the stock.
One factor that may be restraining MACK's shares from reaching our fair value estimates is the contingent nature of the CVRs MACK owns. Investors are normally skeptical of ascribing value to payments that may or may not occur and which appear to lie far into the future (it could be a number of years before any of the Ipsen Onivyde drug trials reach the FDA approval stage, triggering the largest CVR payments). Why pay up today for something that won't happen for 3 or 4 years (if at all)?
Investors should bear in mind, however, that an alternative monetization scenario exists to simply waiting many years for the Onivyde trials to conclude: namely, selling the CVRs back to Ipsen or to another financial buyer. Ipsen's stock has appreciated significantly during the current bull market and its market capitalization now stands at a robust EUR 8.64B (USD 9.6B) [source]:
We think it not unreasonable to believe that Ipsen might be willing to repurchase the MACK Onivyde CVRs for, say, 20-30% of their face value (which would equate to a payment of between $90MM to $135MM, or $6.75 to $10 per MACK share). By using its stock as currency, Ipsen could effect this repurchase for just 1% to 1.4% of its current market cap, thereby avoiding taking on debt while simultaneously removing a large contingent liability from its balance sheet. Note that Ipsen obviously believes in Onivyde, otherwise they wouldn't be spending significant amounts of capital on the two currently-running drug trials (for first-line treatment of pancreatic cancer and small cell lung cancer). For MACK, accepting payment for the CVRs in Ipsen stock could potentially avoid a large tax bill, thereby preserving all of MACK's NOLs for future use. Most importantly from the perspective of MACK shareholders, such a transaction could occur at any time (assuming agreement on a purchase price, form of consideration, etc.), significantly advancing the date of monetization and thus removing the lingering uncertainly about the timing and realizability of the CVR payments. Quite literally, we think such a transaction this could present a "win-win" scenario for everyone involved. In addition, if Ipsen were unwilling to negotiate, there is no reason MACK could not monetize the CVRs by selling them to another financial buyer for cash for some agreed-upon percentage of face value.
If the Onivyde CVRs were sold back to Ipsen, MACK would be left as a debt-free, cash-rich, publicly-traded shell with significant tax assets (note that we assume that most, if not all, of any payment received from Ipsen would be distributed to MACK shareholders as a special dividend). While we have only ascribed $1.51/share for MACK's tax assets in our valuation above, there is a very attractive upside scenario possible if the JFL / 22NW activist group gains a meaningful number of board seats in the pending proxy contest. We note that one of the activists' director nominees, Jason M. Aryeh [see full bio here], has been on the board of Ligand Pharmaceuticals (LGND) since late 2006. While Aryeh was on its board, LGND significantly overhauled its prior business model around the time of the 2008/2009 financial crisis, acquiring new drug assets and utilizing its ample NOLs. LGND shares have appreciated from single digits in 2010 to triple digits currently, beating the overall stock market handily. Could a similar situation play out with respect to MACK over the next decade? Obviously, it is far too early to tell, however at the current trading price of MACK stock we think investors are getting an extremely cheap (if not outright free) option on such a upside bonanza.
In our original MACK writeup, we stated that "no trials are currently active" for Onivyde other than for the two key CVR payments (SSLC and pancreatic cancer). However, a reader helpfully pointed out that Ispen is actually currently running a Phase 1 trial for Onivyde for breast cancer--see the 6th box in the "Phase I" column below [source here]:
Seven Corners Capital Scorecard: Results of Four Years of Public Picks]]>, 17 Jul 2019 20:29:24 +0000
As an investor is only as good as his or her actual bottom-line results over time ("You are what your results say you are"), we herewith provide the aggregate results for the stock picks (longs, shorts and special situations) which we publicly posted on our Research page on this website during the 4-year period from July 1, 2015 through June 30, 2019. Please note: all stock prices (x) for open picks are as of July 17, 2019 and (y) for closed picks are as of the date of closure. Please also note that we have never removed a publicly posted stock thesis from the Research page for any reason--all of our crappy picks are still there for anyone to read in all of their glory.
Both the average pick and the average CAGR were approximately 12% (the latter was high due to a single short-term arb play throwing off the numbers somewhat). Out of the sixteen picks, 12 have returned positively, while 4 have returned negatively (resulting in a respectable enough 75% batting average). One side note: When we recommended or covered a stock on multiple occasions (such as with RAD, GM, TSLA, etc.), we only included it once in the above table, as of the date we first recommended it. RAD is listed twice because it was initially recommended in August 2016 as a short-term arbitrage play (which position was closed out when the stock subsequently hit the $8.25/share target price), and then again in early 2019 as a generic long play (the two RAD writeups posted in 2018 did not recommend that investors buy the stock, rather they recommended that investors throw out the board of directors due to incompetence [a recommendation which still stands]). The GNW arbitrage was closed out in early 2019 when the stock hit our $4.93 target price (see our real-time notification of this fact here).
Overall, the results of our public picks should be considered respectable, perhaps slightly above mediocre. We give ourselves a B-minus. The main issue is the glaring lack of multi-baggers--there is not a single one, in fact, in the group. Realistically, multi-baggers are the only way to outperform the market (anyone holding NFLX over the past 8 years knows this all too well). One 20-bagger makes up for a lot of dud picks. Going forward, we intend to focus on these types of investments (extremely high potential upside versus medium to low potential downside) than on the GM's and the Viacom's of the world (low downside risk , but not much upside reward either--similar to a bond). Please be on the lookout for these type of picks from SCC in due course.
Market Musings - March 25, 2019]]>, 25 Mar 2019 17:04:27 +0000
We continue our blog series: Market Musings, Volume 3, Edition 2, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present UPDATED
: Whitney Tilson Vindicated (Sort Of).
Everybody loves to mock Whitney Tilson. Or, at least, used to love mocking him prior to the demise of his hedge fund Kase Capital (fka T2 Partners). Witness, for example, the following snark-infested Tilson-related news items from recent years:
Regarding the last Tilson snark item, bashing him for underperforming the S&P for the 2004-2011 period, it is interesting to take a refreshed look at Tilson's YE 2011 portfolio and partner letter after the passage of 7+ years. First, take the partner letter (link here):
Tilson notes that 2011 was a "dreadful year", during which T2 underperformed the S&P by a whopping 27%. Yes, that is truly dreadful, inexcusable really. Tilson goes on in the letter to state that his grade for the year is still TBD, however, because it was too soon to tell whether he was wrong about his stock picks or right but early:
Tilson invokes the famous Ben Graham dictum that the market is here to serve, not instruct you, that it is imperative to ignore the "noise" of the market when assessing one's stock holdings, and that he continued to believe in the long-term prospects of his portfolio:
Note particularly the statement that "the real money is made betting against the herd when it's wrong".
Now with the passage of over seven years we can judge whether Tilson was correct or not regarding his YE 2011 holdings. First, below we show the top 12 holdings in T2's portfolio as of December 31, 2011 (source here) [both BRK-B and NFLX are listed twice because T2 owned common shares plus call options (and these were listed separately in the 13-F filing); for the sake of our analysis we've assumed that all call options were converted to the underlying common shares as of 12/31/2011]:
Overall, the portfolio was worth $325 million (again, assuming T2 had enough funds to convert all call options to common shares; note that the actual portfolio was only valued at $296 million in the 13-F, so T2 would have needed at least $29 million of cash to convert all of the options to common stock). The top 12 positions comprised about 65% of the total portfolio.
Below we present how this portfolio would have looked had Tilson simply gone on an extended vacation for the past 7+ years, completely ignored the stock market and not made a single change to the portfolio from December 31, 2011 to today (again, we present the top 12 holdings, some of which are listed twice for the reasons described above):
Overall, the portfolio would have increased in value from $325 million to $1.167 billion today. In addition, $31.6 million of dividends would have been received. This means that the YE 2011 T2 Portfolio would have generated a total return of 269% including dividends, versus 146% including dividends for the S&P 500, from December 31, 2011 to the present. And this despite the fact that Tilson's second largest holding in 2011, J.C. Penney (JCP), would actually have fallen 96% since then.
The much-maligned Tilson--if he had simply stood pat following his disastrous 2011--would have outperformed the S&P by a total of 123% over the past 7.25 years and would now be running well over $1 billion!
(Note: This assumes no redemptions from or flows into the fund since 12/31/11.) With respect to annual returns, the T2 portfolio CAGR would have been 19.7% while the S&P CAGR would have been 13.2%, meaning T2's alpha would have been ~650 basis points per year.
What's amazing about Tilson's portfolio is that a single stock, which was a 4.3% position as of YE 2011, i.e., Netflix (NFLX), would have been responsible for $509 million of the $874 million total portfolio gains, or 58% of ALL GAINS for the entire portfolio during the past 7 years and 3 months, and would today be responsible for over 45% of the portfolio value today. Without that one insane growth stock, Tilson's portfolio would actually have underperformed the S&P slightly. Amazingly, Tilson had previously been short NFLX before reversing course and going long (see the short thesis here and the about-face long thesis here).
Of course, we have omitted any analysis of T2's short book, which is described in the 2011 T2 letter as follows:
Some of these would have worked out well (ITT Educational filed for bankruptcy in 2011), however others would have blown up in Tilson's face (GMCRand CRM, for example). But this would have been the result of running a short book far too early in a nascent bull market (Tilson's decision to run a short book just two years following the greatest financial crisis since 1929-1932 is questionable at best).
What to make of all of the foregoing?
Well, first we can confirm that Ben Graham was correct--the market is here to serve us, not instruct us. The pessimism surrounding many of Tilson's YE 2011 holdings was unwarranted, given the subsequent massive share price appreciation of many of these issues. So it pays to stick to one's guns if one has a firm conviction about an investment thesis, regardless of what the market may think at any given time. Paradoxically, however, one must retain enough flexibility and humility to be willing to admit mistakes. The one decision that would have made all of the difference between being a hero and being a zero for Tilson since 2011 would have been the key choice to drop the NFLX short and instead go long.
Second, buy and hold works. Generally speaking, letting your winners run (NFLX and IRDM) and avoiding putting more money into hopeless cases (JCP) is the best long-term strategy to outperform the market. This lets your best ideas grow until they reach a size that dominates your portfolio, while your worst ideas shrink into obscurity (it doesn't matter whether JCP falls another 50% tomorrow, because even though it represented 7% of the portfolio as of YE2011, it now represents just 1/25th of 1% of the overall portfolio).
Third, avoid short selling. Every minute spent focusing on short candidates or short theses is a minute not spent trying to find the next 35-bagger (NFLX), which can make or break your performance over time. Moreover, when you short, you are betting against the house (stocks go up over time), and the house normally wins. Ironically, Tilson has expounded at length on the dangers of short selling (see here, for example), but in our view by far the worst aspect of shorting goes unmentioned in his list (namely, that it needlessly distracts you from your primary goal of finding multi-baggers). Therefore, holding cash or bonds is the best hedge against a market decline, as these can be harvested quickly to put into new long positions just as easily as shorts.
Of course, Tilson only came to put on his NFLX long position after first examining it as a short, so one might argue that shorting in this case "worked". However, shorting NFLX in late 2010 was clearly an error, no matter what the eventual outcome of Tilson's NFLX long investment. Thus, one should logically conclude that it is perfectly fine to *examine* a short thesis, but only to determine whether to go long (if the short thesis is flawed) or not (if the short thesis is convincing). Some of the very best investments can be found when a flawed short thesis temporarily crushes the stock of a promising long (see, e.g., Herbalife (HLF) in late 2012 [see here] or Chemours (CC) in mid-2016 [see here]).
Market Musings - March 2, 2019]]>, 02 Mar 2019 21:01:39 +0000
After a bit of a hiatus, we continue our blog series: Market Musings, Volume 3, Edition 1, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Dell, Tesla, Netflix and the Rule of 2X".
Back in 1999, Dell Computer Company was the toast of the stock market, with shares exploding upwards during the Tech Bubble. Below we show the growth in Dell's stock price, adjusted for splits, from its 1989 IPO until it was taken private in 2013 (see source data here):
The torrid 50X appreciation in the stock from the beginning of 1996 to the end of 1999, which resulted in a market cap at the height of the bubble of ~$120B, fascinates. Obviously in late 1999 investors were pricing in massive profits for Dell over the ensuing decade or two. As of Christmas 1999, only 29 companies in the world had a higher market cap than this hyper-growth computer manufacturer:
(source here)
Interestingly, Dell ended up delivering huge profits by the time it was taken private 14 years later, namely ~$30B over that span. Unfortunately, this amount of aggregate net income was a mere 1/4th of the company's market cap back in its halcyon days. Predictably, on a split-adjusted basis the stock fell almost 75% over that period despite the fact that the company was immensely profitable (just not as profitable as 1999's investors hoped). By the time founder Michael Dell and P/E firm Silver Lake bought public shareholders out, Dell's once massive equity capitalization had shrunk to a much more reasonable $23B.
This brings us to a simple rule of thumb for sensible investing in the stock market: Never buy a company unless you rationally believe that said company will deliver aggregate profits over the ensuing decade equal to at least twice its then-current market cap (the "Rule of 2X"). We know from the Rule of 72 that if an investor doubles his or her money over a decade, said investor will make a compounded return of 7.2% per year. Thus, if we logically conclude that a company can deliver profits equal to double it current market cap over the ensuing 10 years, an investor buying shares at such a valuation should earn a return at least equal to 7.2% (and probably 3-5% above that bogey, since they will still own the company at the end of the decade). Thus, if (for example) the market cap of a company is $10B, a rational investor (i.e., one not using "pie-in-the-sky" assumptions regarding future growth, lack of competition, the vagaries of chance, etc.) should buy if prospects reasonably appear favorable for the company to deliver $20B in profits over the following 10 years; moreover, the company probably should have earned at least 5% of this amount (or $1B) in the fiscal year immediately preceding the purchase.
Now consider two current market darlings: Netflix (NFLX) and Tesla (TSLA). In order for an investor to rationally purchase NFLX and TSLA at their current market valuations, one would need (per our Rule of 2X) to pencil in (A) $312B in profits for NFLX for the period from 2019-2028 and (B) $102B in profits for TSLA for the period from 2019-2028. If one cannot reasonably do this, one should not expect outstanding (10% or more annually) investment returns from these two stocks going forward. And if one cannot reasonably pencil in anything remotely close to such profit figures, then the investment will likely resemble Dell's 1999-2013 performance outlined above (down massively).
So, is it reasonable to assume that NFLX will deliver $312B in profits over the next decade? Here is NFLX's trailing 5-year profitability track record (source):
Likewise, is it reasonable to assume that TSLA will deliver $102B in profits over the next decade? Here is TSLA's trailing 5-year profitability track record:
Caveat emptor...
Genworth: Updated SotP Calculation = $9.58/Share]]>, 18 Feb 2019 19:00:32 +0000
Just a quick blog post to update our Genworth Financial (ticker GNW) (SECs here) sum-of-the-parts valuation (SotP), in light of the fact that the company recently extended (yet again) the deadline for the China Oceanwide merger (this time, to March 15, 2019 - source here):
Although we sold out of our GNW position late last month at close to $5/share due to the upside being currently capped at $5.43/share... remains firmly on our radar screen for a potential re-entry if the price and circumstances are right.
We last presented a GNW SotP calculation in early November 2018 in our Seeking Alpha article entitled "Genworth: Stakeholder Incentives And Facts On The Ground Point To Ultimate Approval Of China Oceanwide Merger". At the time, the SotP was $4.31B, or $8.58/share based on 502.6 million GNW shares outstanding.
Since then, the company announced its Q4 2018 financial results (see PR here), thus we have updated info to plug into the equations, as follows:
Genworth Sum-of-the-Parts Valuation (ex-L&A businesses) as of February 18, 2019 = $4.80B, or $9.58/share based on 500.8 million GNW shares outstanding, calculated as follows:
Value of GNW Canada equity @ 2/15/19 = 57.2% X C$3.75B X 0.76 f/x = $1.63B; plusValue of GNW Australia equity @ 2/15/19 = 52.0% X A$1.05B X 0.71 f/x = $0.39B; plusValue of U.S. M.I. @ 12/31/18 = 12X $490MM LTM Operating Income = $5.88B; minusEstimated Net Holdco Debt @ 12/31/18 = $3.10B;Equals Total of $4.80 billion.
(Source: GNW earnings releases and SEC filings; Yahoo! Finance)
Since early November 2018, the SotP has increased by exactly $1/share (or 11.7%) to $9.58/share, yet the stock currently trades for just $4.55/share--shockingly, down about 13% from the date immediately preceding the October 23, 2016 Oceanwide merger announcement--resulting in (theoretical, at least) upside of 110%(!):
The main driver of the recent increase in intrinsic value is the outstanding performance of GNW's U.S. Mortgage Insurance operations, which recorded $490MM of adjusted operating income in 2018, versus $311MM in 2017 (up 58% yoy). Even if one were to assign just a 10X multiple to USMI's adjusted operating income, the SotP would still be $7.63/share, far above the merger price. The main frustration/problem with any GNW SotP long thesis is, of course, the fact that GNW's board and management irrationally decided to give away all upside in excess of $5.43/share [which currently stands at ~$4/share, per the SotP above] to Oceanwide by agreeing to sell the company for that amount in cash.
What is even more frustrating for investors (such as us) on the outside looking in is that GNW's BoD/management have repeatedly extended the merger deadline without requiring Oceanwide to pay any kind of ticking fee to compensate GNW shareholders for the delay and the time value of having their funds locked up for such a long period with a capped $5.43 upside price. Of course, GNW's directors receive ever more directors' fees while they wait and GNW's CEO and upper management continue to collect their seven-figure salaries during the deal delays (it is actually convenient for these parties to drag out the process as long as possible, provided they face no challenge from an activist). Oceanwide gets a free call option on all of GNW's equity while they attempt to get their funds in order and the remaining regulatory merger approvals in hand. And the shareholders? Well, they get precisely squadoosh. Thanks a lot, CEO Tom McInerney...
Market Musings - December 16, 2018]]>, 18 Feb 2019 17:03:33 +0000
[NOTE: This blog entry was drafted on December 16, 2018 but not published until February 18, 2019. Due to procrastination, we never acted on the long thesis, missing out on ~44% appreciation (to date).]
We continue our blog series: Market Musings, Volume 2, Edition 24, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Merrimack Pharmaceuticals--Break Up Play?".
Merrimack Pharmaceuticals (MACK) (SEC filings here), a cancer drug developer, has been a dreadful dog of a stock over the past few years, falling 97% from its April 2015 top, mainly due to drug trial and other commercial failures (note that MACK effected a 1-for-10 reverse split in August 2017):
The CEO was fired back in October 2016...
...following which most of the company's commercial assets were sold to Ipsen S.A. (IPSEY) for $1.04 billion, resulting in the company downsizing its employee base by 80% and its drug pipeline to just three molecules (MM-121, MM-141 and MM-310)...
...a new CEO was appointed in early 2017...
...following which $140 million of the Ipsen asset sale proceeds were returned to shareholders as a special dividend ($1.06/share)...
As a result of the foregoing, as of mid-2017 the company had a refocused pipeline, new leadership and the following balance sheet:
Normally, one would presume that the bleeding would slow significantly following these actions, but no, the stock has continued to plummet throughout 2018:
The most recent debacle occurred in late June, when the company announced yet another drug trial failure...
...thereby reducing its pipeline to just two drugs, MM-121 and MM-310, as follows:
MM-121 (seribantumab), a monoclonal antibody targeting the HER3 (ErbB3) receptor, is being tested in combination with standard-of-care treatment in two randomized Phase 2 studies: SHERLOC, in patients with non-small cell lung cancer, and SHERBOC in patients with metastatic breast cancer. Both studies are enrolling patients with high tumor expression of heregulin, the signal for the HER3 receptor. Top-line results from the SHERLOC study are expected in 2H 2018.MM-310, an antibody-directed nanotherapeutic targeting the EphA2 receptor, is currently being tested in a Phase 1 study in solid tumors, with safety data and the maximum tolerated dose expected in 2H 2018.
Enter An Activist
Fortunately, one of the positive aspects of a 97% stock price decline is that following such a drawdown a company is much more susceptible to shareholder pressure via activist investors. Such is the case with MACK, as in early November a Form 13D was filed JFL Capital Management (SECs here), reporting ownership of 941,502 MACK shares (about 7.1% of the company's outstanding stock). Judging by its SEC filings, JFL Capital appears to be a small (and relatively new) hedge fund, founded by Dr. Joseph Lawler:
The 13D states that "[JFL Capital] have engaged, and intend to continue to engage, in communications with [MACK]’s management team and Board of Directors (the “Board”) regarding means to enhance stockholder value." Interestingly, shortly after this 13D filing, MACK's board and management suddenly "got religion" and decided to drastically reduce company spending, as well as pursue a strategic alternatives process,as they stated currently with announcing Q3 2018 financial results:
Is a Break-Up In Store for MACK?
We think that shareholder value could be maximized by breaking MACK up. The company's assets now reside in two distinct buckets, which could be separated: First, MM-310, the remaining pipeline asset which MACK intends to develop itself (note that the company also has several preclinical pipeline assets), and second, approximately $450 million in potential future milestone payments from Ipsen related to the ONIVYDE asset sale, as follows:
Both of the larger milestones (totaling $375 million) depend on the success of drug trials currently in Phase 2 at Ipsen (see here), so it will likely be several years before either come up for FDA approval. Nevertheless, this asset could be monetized immediately for MACK shareholders by spinning it off as a contingent value right, or CVR. CVRs are routinely used in pharma M&A transactions as a way to obtain value today for drugs that won't be approved for years (if ever).
With MACK's market capitalization now sitting at an anemic $54.4MM (based on 13.34MM shares outstanding, as of the most recent Form 10-Q filing on November 1, 2018) and an enterprise value of a minuscule $24.4MM ($54.4MM less $30MM of net cash as of 9/30/18), the company is clearly valued by the market at far less than the sum of its parts. Assuming just a 10% likelihood of obtaining the full Ipsen milestone payments yields $45MM in expected value, almost twice the current enterprise value. Moreover, the company stated just over a month ago in its Q3 earnings release that its current cash position (specifically excluding future milestone payments, but including further possible cost saving measures) could allow it to continue operations without additional equity dilution until "at least the second half of 2022". Thus we think that the milestone payments plus the option value of MI-310 should easily be worth at least $100MM, or $7.50/share (84% above the recent market price), with much higher possible upside should any of the milestones actually be hit (if all were fulfilled, MACK would receive almost $34/share in payments from Ipsen).
The Agency Problem
Of course, all of this should make eminent logical sense to the MACK shareholder, but not necessarily to an empire-building management team who don't actually have to pay for any of their stock on the open market (there have been zero insider purchases of MACK stocksince Q1 of 2016). For the latter, shareholder dilution is usually a wholly acceptable price to pay to guarantee the large salaries and bonuses that come with running a big(ger) pharma company (and the dilution incurred can easily be offset--for insiders, not outside shareholders--through additional insider option and RSU grants at lower and lower prices). When in doubt, bigger is almost always better for these folks. Thus, it is vitally important to have an activist involved (as MACK currently enjoys) holding management's feet to the fire, thus preventing unnecessary destruction of shareholder value by faithless agents.
This is especially true given that most of the MACK directors have very little skin in the game (and thus little reason to block management overreach). Per the 2018 Proxy Statement, as of April 2018 the non-executive members of the board of directors owned just 441K shares of MACK stock outright (or 3.3% of the outstanding shares), the vast majority of which are owned by MACK "lifer director" (on the board since 2004, chairman since 2005) Gary Crocker:
While Crocker has a relatively impressive track record of insider purchases, the other five non-executive directors decidedly do not. The fact that the company spent nearly $1 million on directors' compensation in 2017 (or 1.8% of the current market cap) is not encouraging.
Potential Roadblocks to Realizing Intrinsic Value
1. Management / insiders - as discussed above;
2. Tax leakage - One important consideration with respect to separating assets is tax leakage that MACK might incur upon the receipt of future milestone payments. As of December 31, 2017, MACK had federal net operating loss carryforwards of $138.1 million, which begin to expire in 2034, and state net operating loss carryforwards of $223.4 million, which begin to expire in 2028 (see page 30 of the company's
Q3 2018 10-Q filing). It would be vital to insure that these NOLs continue to be available to offset tax gains attributable to milestone payments if these were spun off to shareholders via a CVR.
3. Debt facility with Hercules Capital - In Q3 2018, MACK borrowed $15 million under a new debt facility, described in the Q3 2017 10-Q as follows:
On July 2, 2018, the Company entered into a Loan and Security Agreement (the “Loan Agreement”) by and among the Company, certain subsidiaries of the Company from time to time party thereto, the several banks and other financial institutions or entities from time to time parties thereto (collectively referred to as “Lender”) and Hercules Capital, Inc., in its capacity as administrative agent and collateral agent for itself and Lender (in such capacity, “Agent”) pursuant to which a term loan of up to an aggregate principal amount of $25.0 million is available to the Company. The Loan Agreement provides for an initial term loan advance of $15.0 million, which closed on July 2, 2018, and, at the Company’s option, two additional term loan advances of $5.0 million each upon the occurrence of certain funding conditions prior to December 31, 2018 and December 31, 2019, respectively.
A copy of the Hercules loan and security agreement can be found here. Section 7.8 of the loan agreement states that "[e]xcept for Permitted Transfers, Permitted Investments and Permitted Liens, [MACK] shall not, and shall not allow any Subsidiary to, voluntarily or involuntarily transfer, sell, lease, license, lend or in any other manner convey any equitable, beneficial or legal interest in any material portion of its assets (including cash)." Section 7.7 of the loan agreement also prevents the payment of dividends to shareholders. Thus, this facility would need to be paid off (or an appropriate waiver received) prior to any distribution to shareholders of the Ipsen milestone payment rights via a CVR or of the cash received pursuant thereto via a dividend.
Market Musings - August 12, 2018]]>, 12 Aug 2018 18:04:56 +0000
We continue our blog series: Market Musings, Volume 2, Edition 23, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Money For Nothin': Arbitrage Play Updates".
Back on October 27, 2017, we presented the blog entitled "Money For Nothing--Four Arbitrage Plays" (for which see here). As close to 10 months have elapsed since this blog post, it seems a quick update is in order:
1. Standard Diversified Inc. (ticker SDI; formerly ticker SDOIA; SEC filings here), our first presented play, was then trading at $10.50/share. Today it is close to $16:
As per our October blog post, the vast majority of SDI's value is attributable to its 51% ownership interest in Turning Point Brands (ticker TPB) [SECs here]. Fortunately TPB's stock has nearly doubled since last October, as shown below (causing a consequent rise of 50% in SDI's stock price):
On the negative side, the arbitrage spread has now widened from 11% then to approximately 26% today. So if one had shorted TPB as a hedge, the arb would have had a large negative return. Fortunately, we simply went long SDOIA (now SDI), so have had significant unrealized gains in the investment. We would expect the spread to narrow back to the 10% to 15% range, either by TPB decreasing or SDI increasing (or a combo thereof).
Target price for SDI = $19/share, or an 11% discount to current NAV.
2. Viacom Inc. "B" Shares (ticker VIAB; see their SEC filings here), our second arb play, was then trading at $25.67/share: Viacom's "B" shares have the same economic rights as the company's "A" shares, which were
trading at $31.96, meaning that the B shares traded at a 20% discount to NAV. Today the B shares are at $30.34 while the A shares trade for $35.85, so the spread has dropped to 15%. Simply going long the B shares would have returned 18% since the date of the initial blog.
Target price for VIAB = indeterminate; depends on the outcome of the Viacom / National Amusements / CBS litigation.
3. Pershing Square Holdings (ticker PSHZF), our third play, was trading at $13.45/share as of October 27, 2017, while the PSHZF NAV as of October 24th was $17.92, meaning that PSHZF traded at a 24% discount to NAV. Fast forward to today and we have the following state of play:
With a $15.30 PPS and a $19.62 recent NAV, PSHZF trades at about a 22% discount to fair value. So things have marginally improved on the PPS-to-NAV front, however if one had simply taken the long side of this trade (as we have), such an investor would be up 14% since the original post.
Target price for PSHZF = $17/share, or a 13% discount to NAV.
4. Lastly, we recommended Softbank ADRs (ticker SFTBY; see IR site here), then trading at $44.90/share. We noted that these shares traded at a huge 36% discount to NAV. Today a huge discount still exists and, while we aren't going to recalculate the NAV (since it is a painstaking process), we note that one hedge fund recently pegged the upside to NAV at about 100%, meaning the spread has (in their view) widened from 36% to about 50% since our original post:
SFTBY shares trade today at $45.34, so since our initial blog post they have gained 1% plus about another 1/3 of 1% via dividends, or about 1.3% overall.
Target price for SFTBY = $70/share, or a 22% discount to NAV.
So, to sum up, if one had gone long each of our four arb plays (unhedged) last October and held through today, one would have gained 50%, 18%, 14% and 1.33%, respectively (including dividends), or an average of 21%, versus up about 11.3% holding the S&P 500 (including dividends). Therefore, the outperformance of our "long arbitrage portfolio" versus the S&P 500 would have been almost 10%. Sounds good. However, the outcome would have been significantly worse if one had attempted to hedge out the market risk of these plays by shorting the underlying assets, such as TPB (in the case of SDI) or BABA (in the case of SFTBY). Which goes to show that in arbitrage there is very rarely a free lunch (and often a costly one).
But, occasionally, one can find for nothin' (that's the way you do it)...
Market Musings - July 18, 2018]]>, 18 Jul 2018 17:56:31 +0000
We continue our blog series: Market Musings, Volume 2, Edition 22, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "The Internet Never Forgets: Tesla Edition".
First, a quick stroll down memory lane...(see full video here). Gotta love that Elon bro, to wit:
"A series of calls and the [$50 million] is there""I mean, those are just a large number of Ben Franklins”"I do not fit the picture of a banker", etc.
Now, back to reality (i.e., present day). Tesla CEO Elon Musk had a rather eventful last weekend, kicked off on Friday the 13th (an omen?) with a mysterious tweet about a cat:
Then on Saturday news broke that Musk had been in bed with many...REPUBLICANS (yikes, definitely NOT good PR for a clean tech company like Tesla):
Well, never one to rest on his laurels (side note: Elon denies he's a big backer of the Repubs), Musk on Sunday accused one of the Thai cave rescuers of pedophilia (again, not exactly a great PR move--except that it certainly DID get folks to stop talking about how Musk is backing the GOP to retain control of Congress--so maybe it was a smart PR move after all):
Frankly, all of this stuff is rather immaterial long as it doesn't affect Tesla's vehicle sales (who knows what the fall out there will be).
What's interesting is that Musk deleted the offending "pedo guy" tweets from his Twitter timeline. But as everyone now knows, the Internet NEVER FORGETS. Once it's posted, it's permanent (via screen grabs, retweets, etc.). (Witness this very blog post, as further proof.) Ten and a half years ago Tesla had an analogous Internet controversy concerning a blog entry by Martin Eberhard, the actual founder of Tesla (Musk was not the founder, he came into the picture a year or so after it was set up and was initially just a financial backer). At the time, Eberhard had been ousted by Musk, who had taken control of Tesla's board of directors, for general mismanagement of the company's operations. Tesla then instituted a widespread purge of personnel in order to cut costs. Well, this did NOT sit well with the ex-CEO and founder Eberhard. In fact, he was so mad that he posted the following entry on his personal blog, then located at
Lo and behold, the post and the comments appended thereto were so incendiary, they were quickly thereafter taken down and replaced with the following blog entry:
Fortunately (or unfortunately, depending on your viewpoint), since the Internet never forgets, the original blog post with its full set of comments can be found in all their respective glory by searching for "" at this link. (Thank you, Wayback Machine.) Another reminder to every CEO--be very careful what you say (as Papa John's CEO recently discovered), but be especially careful if you say it on the Internet.
Note that Musk had his own contemporary blog post addressing the late 2007 layoffs entitled "The Song Remains the Same":
The final paragraph of Musk's post included the statement that "Tesla needs to be profitable to be viable and grow". So, a full 10.5 years ago Musk was talking about Tesla needing to achieve profitability "to be viable and grow"(!!!) Huh. The song indeed remains the same, Elon...
Market Musings - July 10, 2018]]>, 11 Jul 2018 02:57:44 +0000
We continue our blog series: Market Musings, Volume 2, Edition 21, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "General Motors: Time for Activist Involvement".
Common shares of General Motors (GM) (SEC filings here) have chronically underperformed the market since their November 2010 IPO, rising just ~16% plus dividends in almost 8 years versus the S&P 500 being up 130% plus dividends during same period, for a total underperformance of approximately 114% (the difference is even greater after dividends, or +155% for the S&P versus +33% for GM, since GM did not initiate a dividend until 2014). Shockingly, were GM shares to reach our $64 target price immediately (or 10X 2018E earnings), they would still have underperformed the S&P since their IPO, evidencing just how poorly the owners of the company have fared during the current bull market. Below is the tale of the disappointing tape from November 2010 to the present:
One might ascribe various reasons to explain this poor performance. Perhaps GM simply has a bad business model and thus value never compounds for its shareholders. We note, however, that competitors Toyota (TM) (SECs here) and Fiat Chrysler (FCAU) (SECs here) have not suffered despite having highly similar business models, as TM stock is up more than 60% since GM's IPO, while FCAU stock has more than tripled since late 2014, outgaining GM by 170% during that timeframe:
So GM's share price laggardness cannot be explained by the fact that it manufactures and sells autos. Nor can it rationally be explained by the threat of tariffs by the Trump administration or (in retaliation) by the Chinese government, since the vast majority of GM's GAAP profitability is generated within North America (and is therefore not dependent on vehicle exports). Moreover, GM China is composed of joint ventures with domestic Chinese companies such as SAIC Motors and Wuling Motors, which one would expect to be impacted minimally by any China-imposed retaliatory tariffs.
We also note that there are not even any headwinds evident in GM's 2018 financial performance that could logically explain the share price malaise. For example, GM recently reported domestic sales numbers for the April-June period, which showed an increase in deliveries of 5% year over year, resulting in a half percentage point uptick in market share (see here). In addition, the company announced last week that first half sales in China were up 4.4% (see here). So growth in GM's two largest and most profitable markets has been strong lately.
Could it be that GM has squandered massive amounts of money on unwise acquisitions since 2010? That does not seem to be the case either, as GM has not engaged in any large scale M&A transactions; rather, it has made apparently smart bolt-on deals. For example, in 2010 GM paid $3.5 billion for AmeriCredit (now GM Financial) (see here), in 2012 they paid $4.2 billion for Ally Financial's international operations (see here), and in 2015 they bought a 35% stake in Ally's China operations for $700 million (see here). All of these were logical additions to the core business model of selling vehicles to retail customers. In addition, GM paid $500 million for a stake in Lyft in early 2016 (see here) and paid around $1 billion for Cruise Automation in March 2016 (see here). Softbank recently committed to invest $2.25 billion in Cruise in exchange for 19.6% of the entity's equity, giving Cruise an implied valuation of $11.5 billion (see here). Concurrently, GM invested an additional $1.1 billion into Cruise. Thus if we assume that GM has sunk an aggregate of $2.1 billion into the company for its 80% stake (now valued at approximately $9.2 billion), on paper GM shareholders should be enjoying about $7 billion, or ~$5/share, in Cruise-related profits thus far. Meanwhile, Lyft's valuation has supposedly doubled over just the past year (see here), so GM's 2016 investment in the company should be firmly in the black. Yet GM's stock price is only up about $7/share since these investments were made, despite the company recording recording over $12/share in adjusted EPS since that time.
Could GM's share price doldrums be a result of stagnant earnings during this bull market? Again, no. Below are GM's 2009 through 2017 financial results, showing rising earnings from 2009 through 2016 and minimal 2017 earnings due solely to tax charges (without which earnings would have come in at $6.60/share) (sources here and here, respectively):
If we adjust for certain one-time tax charges and pencil in $6.60/share in earnings for 2017, below is a chart showing 2009-2018E earnings trends for GM:
This hardly resembles a company whose business model is collapsing or about to collapse, in fact just the opposite appears to be the case. Yet GM ranks close to the bottom of the entire S&P 500 with respect to P/E ratios. So we conclude that neither GM's business model nor its financial performance nor acquisition track record logically explains why the company's shares have massively underperformed peers as well as the overall market since late 2010.
So what is the real reason for the long-term underperformance? We believe that investors refuse to bid up GM shares because they believe that the interests of the board and management are not aligned with those of the shareholders and that therefore most of the economic benefits of GM's business model will never fully filter down to the true owners of the company. Why do we think shareholders believe this? Look at the following facts:
First, there is no true shareholder representative on the Board of Directors, so the owners of the company lack an advocate for their interests in the key decision-making body of the organization. Board members historically have bought only token quantities of stock on the open market and CEO Barra has only bought a minuscule 800 shares with her own money since 2010 (grand total spent: $26,400), despite receiving tens of millions of dollars in cash compensation (salary plus cash bonuses) since then. The following is the ONLY open market purchase of GM stock Barra has EVER made (source):
Barra is Chairman of the Board--by far the most important director--yet is not financially aligned with shareholders and in our opinion runs the board to benefit primarily the members of the C-suite, not the shareholders (see corporate governance section below). GM attempts to claim the contrary in its 2018 Proxy Statement, stating that "Your board holds management accountable" (see excerpt below); yet how can this possibly be when the board itself is chaired--and therefore basically controlled--by management (i.e., the CEO)???
The company further states above that "GM's performance under [Barra's] leadership demonstrates that [having her also serve as Board Chairman] is the most efficient create value for shareholders". Does this statement make any sense at all given the fact that since Barra became chairman in early January 2016 (1) GM stock has vastly underperformed the S&P 500 and (2) the company has only raised the dividend by $0.02/share per quarter (with zero increases since shortly after Barra assumed the chairman's seat)?
In addition, below we can see that the non-executive directors on GM's board (who supposedly are looking out for the shareholders' interests and overseeing management's activities) collectively own just 107,088 shares outright, or about one-thirteen thousandth (1/13,000th) of all outstanding shares (source):
Second, GM's board and management have consistently refused to take actions to benefit shareholders except under the duress of a proxy fight:
1. FCAU merger proposal - Back in 2015 Fiat Chrysler chairman Sergio Marchionne proposed a potential merger between FCAU and GM. However, instead of pursuing a combination that could have brought with it many billions of dollars in synergies (most of which would flow to the shareholders of the respective companies), GM CEO Barra rejected the idea out of hand. According to contemporary news accounts (sources here and here):
"Marchionne sent an email to GM CEO Mary Barra in March [2015] suggesting that the two companies that a combination of the two automakers could cut billions of dollars in costs.... Barra discussed the pros and cons of a GM-FCA merger with her key staff and board members. However, in fairly short order, she sent Marchionne a rejection letter, denying his request for a face-to-face meeting on the matter."
So Barra would not even discuss the matter with Marchionne, indicating a close-minded attitude toward any outside influence that could potentially threaten her entrenched CEO/Chairman position (letting Marchionne get a foot in the GM door was clearly a threat). Since rejecting the FCAU proposal out-of-hand for no apparent reason, FCAU's share price has almost doubled, meaning Barra potentially left billions in value on the table that could have accrued to GM shareholders, assuming the two entities had combined in a stock-for-stock merger. No doubt Barra is not losing any sleep about such a missed opportunity, since her bureaucratic mentality naturally resists any external M&A advances, regardless of whether shareholders might prosper from them.
2. Proxy Fights - In addition, CEO & Chairman Barra et al. have now been the subject of two separate proxy fights in just the past 3 years. The first was in early 2015 when Harry Wilson acted on behalf of a group of hedge funds advocating for better capital allocation at GM, which contest GM settled by agreeing to a large buyback (source):
"General Motors agreed Monday to buy back $5 billion in stock and put forth a new capital allocation plan, which offers investors a more transparent view of GM's cash investment proposals than previously disclosed. In exchange, Wilson dropped his bid to get a seat on GM's board."
The second was waged by Greenlight Capital last year. Greenlight proposed an ingenious dual-share structure for GM that would likely have raised the share price significantly. GM, in its infinite bureaucratic wisdom, decided to sabotage any hope that the plan could come to fruition by trashing it with the rating agencies. We discussed this debacle in detail in a previous article (see here). However, the impending threat of Greenlight's proxy fight was sufficient to spur GM management into finally divesting GM Europe after $20 billion in losses over the previous 17 years, so at least it had one beneficial result for the owners of the company (note that the troubled European car market is once again stagnating).
Frankly, we are a bit tired of hearing apologists for Barra & Co. who insist the stock price doesn't matter, that it's all about the long term, etc. Firstly, if it's "all about the long term", why do the C-suite members get annual incentive bonuses based on achieving short-term (yearly) metrics (aka, the STIP)? If it's "all about the long term", why do GM's illustrious C-suite denizens constantly exercise and dump their shares on the open market as soon as they legally can (see, e.g., here, here, here and here)? But more than that, why the stock price matters is because the stock price determines what a company's cost of capital is--and the lower the cost of capital, the better able said company is to compete in the marketplace.
For example, what company would have a greater advantage in selling cars: Company A, whose stock trades at a P/E multiple of 5X (or an earnings yield of 20%), or Company B, whose stock trades at a P/E multiple of 200X (or an earnings yield of 0.5%)? Obviously, other things being equal, Company B will have a great advantage over Company A because it will be able to raise equity capital with a yield of just 0.5% (far below the yield on, say, 30-year Treasuries). Moreover, a company that can raise cheap equity capital will also likely be able to issue cheap debt, since debtholders will take comfort in the company's strong "equity cushion".
Or, to put it another way, a company generates value of its owners only if its ROIC exceeds its cost of capital. Thus, the lower the cost of capital, the more value accrues to the shareholders at any given ROIC. By permitting its cost of capital to be abnormally high (due to the conflicts of interest addressed herein), GM's board of directors are in effect robbing the true owners of the company of a portion of the economic gains that would otherwise flow to them. Simply because they can't be bothered to address the fact that the board is controlled by management instead of the shareholders. This is an obvious problem--but one that fortunately can be fixed.
Today an activist in GM has great opportunity to make billions in profits by forcing board of directors to act in the shareholders’ interests (rather than management’s). If GM's board of directors were chaired and/or represented by directors who actually prioritized the interests of the shareholders (as the true owners of the company) and took the steps we outline below to increase shareholder worth in GM, we believe that GM's stock could re-rate upwards to as high as $64/share, or 10X 2018's estimated EPS of $6.40 (indicating shares could have up to 60% upside). Thus, an activist who amassed a 10% stake in GM (meaning 140MM shares) could make up to a $3.36B profit on a $5.6B initial investment. To repeat, that is a profit of $3,360,000,000--not exactly chump change for large activist hedge funds or investors.
We note that in the past 6 months of trading, more than the entire share count has changed hands (see here). Thus, in order to acquire 140MM shares, an activist would only need to buy about 10% of the daily trading volume to build such a stake in half a year (or about 20% of the volume over a three-month period). Who could be potential activists? The following:
Greenlight Capital - as noted above, Greenlight ran a proxy contest against GM just last year and as of the end of Q1 2018 owned 22.6 million shares, or about 1.6% of the outstanding stock (source);
Elliott Management - probably the top activist hedge fund, Elliott has around $34 billion in AUM (source), so could easily amass a large enough GM stake to make a proxy contest worthwhile;
Appaloosa - Appaloosa Management, founded by David Tepper, is one of the most successful hedge funds of recent decades (source); Appaloosa was involved as an activist in the 2015 proxy contest and could potentially go for a second round of activism in light of GM's recent sagging stock performance since then;
Jana - Jana Partners had a 1.3 million share position in GM at the end of Q1 2018 (source) and is a noted activist investor in major companies such as Whole Foods (see here);
Starboard Value - Starboard is a large and successful activist hedge fund with AUM of around $5 billion; they take concentrated positions and advocate aggressively for change at their investee companies. In addition, Starboard has experience in the auto / industrial manufacturing space, with recent positions in Advance Auto Parts and (see here) and prior activist campaigns involving Wausau Paper Corp (see here) and ;
Pershing Square - Pershing Square is a well-know activist outfit which is now apparently on the rebound from several investment misfires; chief investment officer Bill Ackman tends to focus on alignment of incentives, which is clearly the biggest problem at GM. Note that Pershing held a significant position in GM as of the end of 2010, so they are familiar with the company (source);
Trian - Trian, headed by Nelson Peltz, has activist experience with industrial companies such as General Electric (currently holding over 70 million shares, source here), thus they could be a future activist with respect to GM;
Carl Icahn - Carl Icahn currently has an entire auto-related business segment under the aegis of his holding company Icahn Enterprises, consisting of the following (thus being an activist in GM could make logical sense for him) (source):
The following are steps we believe an activist must make GM's board take:
1. Increase the dividend - the current payout ratio, at ~25%, is far too low. The dividend should be increased to $2/share per year, representing a payout ratio of approximately 33% (which is still conservative). GM shares would yield a healthy 5% at current price levels.
1a. Buy back stock based on share price & P/E ratio (buy more when lower, less when higher) - we think it was a questionable decision in March of this year to buy $1.59 billion worth of shares owned by the UAW Retiree Medical Benefits Trust at nearly $40/share (see here), when GM could have bought a similar amount of stock 10% or so lower in price on the open market. As a general rule, however, when the company's forward P/E is under 8X, repurchasing shares makes a lot of sense.
2. Tracking Stocks - GM should issue tracking stocks for GM China and GM's New Ventures (Cruise Automation and its Lyft stake). If this were done, GM would be much more likely to trade according to the sum of its constituent parts, meaning the respective parts should accurately reflect their underlying cost of capital. Why, for example, should Cruise Automation, clearly a tech business, suffer from the suboptimal cost of capital attributed to an auto manufacturer, a capital-intensive industrial business? In addition, compensation of GM employees could be much better targeted, since individuals assigned to work for a tracking-stock entity could be paid with the currency of that entity instead of the overall company, while tracking-stock entities that need capital could raise the same via tracking stock issuances.
3. Fix GM's corporate governance - GM should allow for proxy access for holders of a 1.5% stake (which currently would amount to about $840 million worth) + 2 year hold period; in addition, the company must split the CEO and chairman roles and onboard as the new chairman a representative of a large shareholder.
4. Fix GM's senior executive compensation system - we outlined the flaws in GM's compensation system in our last GM Seeking Alpha article (see here). The current system is in dire need of reform, which changes an activist would be primed to effect.
5. Additional Items - an activist would be able to draw upon their own prior experience in proposing additional shareholder-friendly changes at GM. Perfection should always be the goal, therefore pressure constantly needs to be on the board and management to improve and perfect things over time.
Note that many activists operate behind the scenes as the most effective way to influence boards and management. Thus, just because a Greenlight or a Jana may not be attempting in public view to effect one or more of the above-outlined steps to increase shareholder value doesn't mean that they are not doing so privately.
Market Musings - June 27, 2018]]>, 27 Jun 2018 18:28:41 +0000
We continue our blog series: Market Musings, Volume 2, Edition 20, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Investors Who Forget History..."
In these somewhat frothy days (from a market valuation perspective, at least), it is worth remembering what investors were thinking at certain times in the past...and what happened to stocks subsequently. First, let's look at how the market looked to investors as of exactly 89 years ago today (June 27, 1929), as shown from the pages of the Reading (PA) Eagle for June 28, 1929:
"Stock Prices Move Upward...Bullish operations were conducted at a vigorous pace in today's stock market, which completely disregarded the increase of $122,000,000 in brokers' loans last week... Closing Strong...New favorites sprang up in the latter part of the stock market session...":
General Electic (yes, THAT General Electric) hit an all-time high of $322/share, while IBM (yes, THAT IBM) reached a new record high of $210/share (and even U.S. Steel (yes, THAT U.S. Steel) got a shout out at over $191/share):
So things were looking mighty good for investors GE, IBM and X in late-June of 1929. Nothing but blue skies did they see. Similarly, investors in love today with Netflix (around $400/share), Tesla (around $345/share) and Amazon ($1,680/share) see endless riches ahead for these favored companies, who are "disrupting" the incumbents in media, autos and retail, respectively. The future is so bright, NFLX, TSLA and AMZN shareholders need to wear shades, baby!
Fast forward to the financial news for July 8, 1932, as per the financial headlines from the Reading (PA) Eagle for July 9th of that year:
"Market 'Placid' dwindled to around the lowest levels of the past eight years..."
The market that day reached its Great Depression low of just 41 for the Dow Industrials (for comparison's sake, today the Dow stands at 24,246, or 591X higher). And what happened to high-fliers GE, IBM and U.S. Steel from June 27, 1929 to July 8, 1932? The following:
GE fell from $322 to $9.50, an overall drop of 97%; IBM fell from $210 to $55, an overall drop of 74%; andU.S. Steel fell from $191 and change to $21.75, an overall drop of 89%.
In fairness, during the same period the overall market (as measured by the Dow Industrial Index) fell approximately 87%, so in the context of this broader perspective the returns for GE, IBM and U.S. Steel are not that terrible (as a group, they approximately matched the index). Then again, to a significant extent these behemoths (along with similar investor favorites of the day) were the index at the time (all three companies were Dow components in 1932, while GE and U.S. Steel were also members in 1929) [for the yearly list of Dow Companies, see here]. What really matters when times get frothy is not necessarily "keeping up with the index", but rather "protecting one's capital from incineration" when investors stampede out of stocks. None of this is to say that a market collapse is imminent, because nothing on the horizon seems to imply such a downturn. Then again, nothing on the horizon in late June of 1929 seemed to spook investors then either.
So, Will history rhyme with respect to NFLX, TSLA and AMZN? We think it likely. The real question is not if, but when...
Market Musings - June 23, 2018]]>, 23 Jun 2018 18:39:13 +0000
We continue our blog series: Market Musings, Volume 2, Edition 19, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Start of Summer Activist Plays".
1. ICON Activist - recently we have witnessed some activist SEC filings by Sports Direct International (SEC filings here) with respect to Iconix Brands (ICON) (SECs here). Sports Direct is headed by the relatively reclusive British billionaire Mike Ashley:
Suffice it to say that ICON, a brand licensing vehicle (chief current licenses held are for Candie’s ®, Bongo ®, Joe Boxer ® , Rampage ® , Mudd ® , London Fog ® , Mossimo ® , Ocean Pacific/OP ® , Danskin/Danskin Now ® and Rocawear ® /Roc Nation ®), has been an absolute disaster for investors in recent years, with a once nearly $3 billion market cap shriveled to just under $50MM currently:
The problem? The ICON business model just doesn't seem to be sustainable. Unless a company reinvests in a brand, the brand stagnates and then slowly dies. ICON seems to have been guilty of such underinvestment, relying on retail partners to pay for promotional costs; however, this gravy train has apparently petered out. The other problem? ICON bought most of its licenses using borrowed money and now staggers under a mountain of debt (as of March 31, 2018: $711.8 million in long-term and $46.5 million of currently-due debt to be exact, versus $95.7 million of cash and CE). Below we present the end of Q1 2018 balance sheet:
Meanwhile, the company generated just $12.9 million in cash from continuing operations in FY 2017, versus $134.8 million in cash from continuing operations in FY 2016 and $188.7 million in cash from continuing operations in FY 2015. So things have gone seriously downhill on the operating cash front. And to add insult to injury, stockholders' equity is negative and numerous licensing deals with large retailers are set to expire shortly (Target Corporation is not renewing the existing Mossimo license agreement following its expiration in October 2018 and Walmart, Inc. is not renewing the existing Danskin Now license agreement following its expiration in January 2019).
Sports Direct has launched a proxy fight regarding ICON, as per the following PR from the beginning of this month (source):
- Iconix’s Current Board has Overseen Drastic Drops in Company’s Share Price – With the Stock Currently Trading Below $0.70 – and an Increasingly Unsustainable Debt Load, along with Alarming Losses of Significant Licensing Agreements –
- Sports Direct’s Four Highly-Qualified Nominees – Ron McPherson, Howard Moher, Mark Hunter and Daniel Dienst – Possess Extensive Operational Expertise and Industry Experience and Will Help Reverse Trend of Underperformance and Value Destruction at Iconix –
Shirebrook, England – June 1, 2018 – Sports Direct International plc (LON: SPD) (“Sports Direct”), one of the United Kingdom's largest sports-goods retailers which holds 9% of Iconix Brand Group, Inc. (Nasdaq: ICON) ("Iconix" or the “Company”), today announced that it has nominated four highly-qualified individuals – Ron McPherson, Howard Moher, Mark Hunter and Daniel Dienst – for election to the Iconix Board of Directors (the “Board”) at the Company’s 2018 Annual Meeting. This is in line with Sports Direct’s commitment to actively participate in its strategic investments.
Sports Direct issued the following statement:
“As significant and long-term Iconix stockholders, we have seen first-hand how the numerous operational and strategic decisions initiated by the Company have resulted in severe value destruction for its investors. The Company’s stark drop in share price (currently trading at under $0.701), substantial debt load relative to revenues (with more than $800 million in outstanding principal obligations as of Q1 20182) and the loss of major direct-to-retail licensing agreements with major retailers all demonstrate the failures of the current Board and management.”
“Given these serious concerns, we have made a number of attempts to engage constructively with Iconix, but this has unfortunately led nowhere. We can no longer stand by while Iconix’s Board and management continue along this unsustainable path. We have nominated four highly-qualified individuals for election as directors. These nominees have an in-depth understanding of the operational challenges facing the Company – three of the four are seasoned executives affiliated with Sports Direct and all four of our nominees are veterans of the retail and brand licensing industries. We believe that reorganizing the Board with highly-qualified experts is a critical first step to unlocking the Company’s latent value.”
“Our nominees are fully committed to undertaking a strategic evaluation of the current business and opportunities that exist with the goal of driving significant value for all stockholders and improving governance and transparency – which the incumbent Board has failed to do over a number of years. Iconix’s history of underperformance and its lack of a coherent strategy to reverse this recent unacceptable loss of stockholder value illustrates the need for significant change at the Board level.”
Sports Direct’s nominees for Iconix’s Board of Directors are:
· Ronald McPherson, President and CEO of The Antigua Group, Inc., an affiliate of Sports Direct International plc. Mr. McPherson has been an employee of Antigua for nearly four decades as it has grown into a leading designer and marketer of men’s, women’s and children’s lifestyle apparel and sportswear. He has also served as a board member for the Golf Manufacturers and Distributors Association, and for The Samaritan Foundation/Banner Health Foundation.
· Howard Moher, CEO of SDI USA LLC, SDI Stores USA LLC, Mountain Sports LLC and Bobs Stores USA LLC, ultimate subsidiaries of Sports Direct International plc and operators of the Bobs Stores and Eastern Mountain Sports retail and web businesses. Mr. Moher took on the role of CEO after leading the successful transaction by Sports Direct International plc to purchase the Bobs Stores and Eastern Mountain Sports from Versa Capital in 2017. Under his leadership, Mr. Moher is successfully managing their restructuring and turnaround. Prior to taking on his role as CEO, Mr. Moher worked in various capacities for Sports Direct International plc for over a decade. He is also the Chairman of the Board of Leisurewear International Ltd., owners of the Minoti brand. Mr. Moher is a non-executive director of Technology Rentals Ltd, a leading UK leaser of IT equipment to the education sector.
· Mark Hunter, Acting CEO and CFO of Everlast Worldwide, Inc., an affiliate of Sport Direct International plc. Everlast is the world’s leading manufacturer, marketer and licensor of boxing, MMA and fitness equipment. Prior to taking on this role in 2017, Mr. Hunter served as Executive Vice President of Finance, Supply Chain, Planning & Ecommerce at Everlast from 2012 to 2017. Mr. Hunter is also an officer of both SDI Holdings USA Inc. and SDI Sports Group America, Inc., affiliates of Sport Direct International plc.
· Daniel Dienst, founder and managing member of D2Quared LLC and former director and CEO of Martha Stewart Living Omnimedia Inc., where he led the turnaround of the famous brand and orchestrated its successful sale in 2015 to Sequential Brands, Inc. for $353 million. Mr. Dienst is a Director of Knoll, Inc. (NYSE: KNL) and Matlin & Partners Acquisition Corporation (NASDAQ: MPACU). He was the Group CEO of Sims Metal Management, Ltd., having founded and served as the Chairman and CEO of Metal Management, Inc. before the company was sold to Sims for $1.7 billion in 2008. Mr. Dienst is experienced in the financial markets, having served as a Managing Director of Corporate and Leveraged Finance at CIBC World Markets Corp. He also was recently a Director of 1st Dibs, Inc., a venture-backed e-commerce business, from 2014 to 2015.
In response, ICON has shaken up its C-suite, appointing a "turnaround expert" as the new CEO (source):
Iconix Brand Group Announces Leadership Transition
Peter Cuneo Named Interim Chief Executive Officer Effective Immediately;
John Haugh Resigns as Chief Executive Officer and President
Board Search for Permanent CEO Underway
NEW YORK – June 15, 2018 – Iconix Brand Group, Inc. (Nasdaq: ICON) (“Iconix” or the “Company”) today announced that Peter Cuneo, Executive Chairman of the Board of Directors, will serve as Interim CEO, effective immediately. John Haugh has resigned as Chief Executive Officer, President and a member of the Board to pursue other opportunities, also effective immediately.
The Board has retained an executive search firm to assist with the process to identify a permanent CEO.
Drew Cohen, Lead Independent Director of the Iconix Board, said, “The Iconix Board regularly evaluates leadership to ensure that we have the right mix of skills and experience in place to drive growth and value creation for all of our stockholders. Iconix has made steady progress on a range of financial initiatives, including strengthening our balance sheet and addressing near-term debt obligations. As we continue to work diligently to build a platform for sustainable growth that fully capitalizes on the strength of our global brand portfolio, the Board is committed to putting in place a strong leadership team that is able to successfully execute on these goals.
“We are fortunate to have someone of Peter’s caliber, with an extensive track record of revitalizing leading consumer brands and direct experience leading Iconix as Interim CEO from August 2015 to April 2016, to step in as Interim CEO while we identify a permanent successor. We are grateful to John for his service to Iconix during his years as CEO and for the contributions he has made in positioning the Company for the future. We wish him well in his future endeavors,” Mr. Cohen continued.
Mr. Cuneo, said, “I am committed to helping Iconix as Interim CEO at this important time in the Company’s history. We are addressing the challenges facing the Company head on, and are moving forward with focus and a sense of urgency. I look forward to working closely with the Board and management team as we search for a permanent CEO and best position Iconix to deliver growth and stockholder value creation.”
About Peter Cuneo - Peter Cuneo is a recognized leader in business turnarounds. Since 1983, he has completed seven turnarounds of distressed branded businesses in the global media and consumer products sectors. From 1999 to 2009, Peter played a lead role in the turnaround of Marvel Entertainment Inc. (MVL). As President and CEO, he led Marvel, post-bankruptcy, to a prominent position in the entertainment industry. He then served as Vice Chairman of the Board, providing active strategic leadership as Marvel continues to grow into one of the world’s leading entertainment brands. This culminated in its $4.4 billion sale to Disney at the end of 2009. Previously, Peter was President and CEO of Remington Products Company. He joined the company as it was near bankruptcy and, in less than four years, executed a successful turnaround of the business and facilitated its sale to private equity investors. Peter has also served as President of the Security Hardware Group of the Black & Decker Corporation, President of Bristol-Myers Squibb Pharmaceutical Group in Canada and President of the Clairol Personal Care Division. Peter is currently the Managing Principal of Cuneo & Company, LLC, a private investment and management company.
Peter currently sits on the Board of the Foundation for the National Archives in Washington, DC as Co-Head of the Development Committee. Peter served two tours as a Lieutenant in the U.S. Navy in the Vietnam War. He received his MBA from Harvard Business School and holds a Bachelor of Science in Glass Science (Ceramic Engineering) from Alfred University, where he has served on the Board of Trustees since 1990. Peter recently completed six years as Chairman of Alfred’s Board and was awarded an honorary doctorate degree in 2013.
It will be interesting indeed to see if this seemingly impossible turnaround actually can turn. As Buffett is fond of remarking, "Turnarounds seldom do." ICON has been a battleground stock on the message boards, with a recent SA article garnering over 1,300 comments:
Below are major holders of ICON stock as of April 20, 2018, the date of filing of the form of 2018 Proxy Statement:
In all, it seems as though either ICON equity is a value trap with assets the value of which can never repay ICON's accumulated debt (as the bears argue) or possibly a mispriced option with massive potential upside if the company can somehow reignite growth within its license portfolio (as the bulls contest). Anecdotally, we saw a teenager in Soho several days ago sporting a Pony T-shirt, so perhaps this is a small clue that ICON is on the comeback trail.
2. DFIN Activist - similar to ICON, Donnelly Financial Solutions (DFIN) (SECs here) has come under activist pressure recently. In this case, the activists want the company to put itself up for sale. Denali Investors sent out the following PR on June 6, 2018 with respect to DFIN:
Denali Investors Sends Letter to the Donnelley Financial Solutions (DFIN) Board of Directors Urging Formation of Special Committee to Pursue Strategic Alternatives
NEW YORK, June 6, 2018 /PRNewswire/ -- The following is a letter from Denali Investors to the Donnelley Financial Solutions (DFIN) Board of Directors urging the formation of a special committee to pursue strategic alternatives.
June 5, 2018
The Board of Directors Donnelley Financial Solutions, Inc. 35 West Wacker Drive Chicago, IL 60601
RE: Shareholder request for special committee to seek strategic alternatives for Donnelley Financial Solutions (the "Company")
Dear Members of the Board:
We appreciate the recent investor day you held in New York. However, as evident in the continued decline of your stock, the market and shareholders are not impressed with the progress or management's ability to communicate a clear path forward. The Board must be proactive in evaluating management and holding them accountable on their ability to navigate this valuable business and communicate effectively with the investment community.
The two year mark for the Company's spinoff is rapidly approaching, and the stock is now down more than 47% over this period during which time the S&P 500 Index is up over 26%. The stock is valued at approximately 5x EV/EBITDA and 0.5x Price to Revenue, which is a massive disconnect from your competitors that range from 11x to 17x EV/EBITDA and 3.3x - 5x Price to Revenue. We believe the Board must consider next steps for unlocking value, as the current plan is clearly not working.
As we have stated before, we believe Donnelley is worth considerably more than the current price and multiples imply, and that additional steps are needed to surface this value. As such, we urge the Board to voluntarily form a special committee to seek strategic alternatives and commence a formal solicitation process that includes all potential strategic and financial suitors.
Sincerely, H. Kevin Byun Denali Investors, LLC
DFIN shareholders have indeed very little to show for the nearly two years that the company has been publicly traded:
DFIN's business model is to help create, manage and deliver financial communications to investors and regulators. DFIN provides capital market and investment market clients with communication tools and services to allow them to comply with their ongoing regulatory filings. In addition, DFIN's U.S. segment provides clients with communications services to create, manage and deliver registration statements, prospectuses, proxies and other communications to regulators and investors. The U.S. segment also includes language solutions and commercial printing capabilities. DFIN's International segment includes operations in Asia, Europe, Canada and Latin America. The international business is primarily focused on working with international capital markets clients on capital markets offerings and regulatory compliance related activities within the United States. In addition, the International segment provides services to international investment market clients to allow them to comply with applicable SEC regulations, as well as language solutions to international clients.
Below we reproduce DFIN's 2013 to 2017 financial results from DFIN's 2017 Form 10-K filing; revenues and earnings have trended down, while debt levels are up (not a good combo):
First quarter 2018 earnings were uninspiring as well, as shown by the following summary from the Q1 2018 DFIN earnings PR:
DFIN's large holders as of March 29, 2018 were as follows (from the 2018 DFIN Proxy Statement):
The jury is out right now on DFIN, however activists tend to light a fire under the behinds of underperforming management teams (losing one's job tends to focus the mind on getting results), so perhaps the financials are due for a turn to the better.
Market Musings - June 10, 2018]]>, 10 Jun 2018 16:31:27 +0000
We continue our blog series: Market Musings, Volume 2, Edition 18, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Ackman's Back; Time to Back Ackman".
When celebrity hedge fund manager Bill Ackman appeared on the cover of Forbes in May 2015 as "Baby Buffett" (above), in retrospect it marked his "Sports Illustrated Curse" moment. Over the past three years, Ackman's perfect billionaire life has seemingly imploded, marred by a huge ($1 billion) short bet gone awry (HLF, for which see here), a massive (>$3 billion) long bet gone spectacularly wrong (i.e., VRX, for which see here), gigantic overall underperformance versus the market for his hedge fund Pershing Square (see here) and even a divorce from his wife after a 25-year marriage (see here). Below are a few choice quotes from Ackman's supposed "peers", evidencing the fact that Ackman schadenfreude has reached peak levels in recent years:
"I think he hits a brick wall at about 197 miles an hour. I think he’s done. I think he’s a dead man walking and he’s completely un-investable.""I think he’s proven himself incapable of managing risks. I think that’s kind of obvious at this point.""I don’t think that it’s particularly fair, but there is some glee."
(What a classy industry, by the way, where the moment you are down all of your peers jump on top of you and try to stomp you into oblivion, at least verbally).
In any event, we humbly submit that now may be the opportune moment to place a bet on Ackman by buying shares of Pershing Square Holdings (ticker PSHZF). Really...for the following reasons:
a. Ackman-as-a-Service is Available at a Firesale Price - Ackman is an investment manager. Every day he wakes up thinking about how to make his clients money. This is a service; one which we could label "Ackman-as-a-Service" (AaaS). Normally, a high-quality service is priced accordingly. In the investment world, depending on the context, one refers to either book value (or BV) or net asset value (or NAV) as a benchmark. For example, buying "Buffett-as-a-Service" (BaaS) will cost one about a 40% premium to the book value of the net assets Warren Buffett oversees at Berkshire Hathaway, BRK-A (source); similarly, "Icahn-as-a-Service" (IaaS) will cost close to 25% to 30% above the NAV of the assets Icahn manages via Icahn Enterprises, IEP (per slide 25 in this investor presentation). Quite reasonably given their respective stellar long-term track records, investors are willing to pay a premium to have Buffett or Icahn manage their assets. Yet, due to Ackman's recent underperformance, Ackman-as-a-Service is currently available at a discount of 21.4% (or 1-(14.70/18.71)) to the June 5th NAV of the assets that Ackman and his team currently manage at PSHZF--or a discount of 60% versus Buffett and 50% versus Icahn--as evidenced by the following (sources here and here, respectively):
Clearly, investors have given up on Ackman's abilities as a manager due to his struggles over the past three years. Yet if we look at his entire Pershing Square track record (not just the most recent 3-year snapshot), it is clear that Ackman is an outstanding investor. Below is Pershing Square's gross performance by year since inception versus (1) the S&P 500 (including dividends) and (2) Berkshire Hathaway (BRK-A) (note that 2017 and 2018 YTD returns are for PSHZF rather than Ackman's hedge fund; Pershing Square 2004-2016 historical performance can be found on slide 9 of this presentation):
From this table we can see that, purely looking at Ackman as a long / short investor (and therefore ignoring management and incentive fees for the moment), he has outperformed both the S&P 500 and Berkshire over past 14.5 years by over 770% cumulatively(!), while his long-only portfolio has outperformed the S&P 500 and Berkshire by 9.5% and 9.2% per year, respectively. Clearly, a large chunk of this outperformance would not have reached Ackman's hedge fund investors due to the notorious 2-and-20 fee structure that such funds typically employ. However, for an investor today in PSHZF this drawback is limited due to fee waivers and the $26.37 NAV high-water mark, as noted in the last bullet point from the following 2017 PSHZF annual report excerpt:
In essence, the next 40% of NAV appreciation (26.37/18.71) will be nearly fee-free for the PSHZF long.
Obviously, the time to invest in a distressed asset is when it is still considered distressed, not after the recovery has already occurred (by definition, such an asset would no longer be considered "distressed" at that point). If there was ever a time to view Ackman as a distressed asset, now is it. As shown above, Ackman-hate in the investment world is about as strong as it could possibly be. If one waits for Ackman's comeback to become an obvious success before placing one's bet on PSHZF, "betting on Ackman" will have much less upside potential.
b. Interests Aligned - Significantly, Ackman has been putting his own money where his mouth is by buying a large number of PSHZF shares on the open market (source):
When a manager mouths platitudes about their optimism for the future, shares being undervalued, etc., these words should typically be taken with a large grain of salt. However, when a manager backs up bullish words with huge amounts of their own money, investors should pay close attention. In short, by putting $160,000,000 of his own money into PSHZF over the past two weeks, Ackman has in effect gone "all-in" betting on himself. Whether he succeeds or fails for PSHZF unitholders in the future, the outcome will not be negatively affected by any conflict of interest. Ackman's interests and the interests of minority PSHZF holders now appear fully aligned.
Signs Point to Ackman's Comeback Being Firmly Underway -
Lastly, recent signs point to Ackman's comeback as a premier investment manager being firmly underway. The most obvious sign is the dramatic reversal in PSHZF's NAV over the past month, going from from negative 5.5% as of May 3rd to positive 7.5% as of June 5th, a positive 13% swing in total:
Suddenly all the Ackman haters (who shall remain nameless) appear a bit flummoxed. However, this positive trend should not be surprising for several reasons. First, one would expect that Ackman's performance should eventually mean-revert. The 2015-2017 period of underperformance should clearly be considered the exception rather than the rule, given Ackman's overall excellent track record since 2004 (as shown above). Second, for better or worse Ackman is probably one of the most persistent investment managers alive. Witness his five-year battle against HLF, which one noted fund manager likened to the Siege of Stalingrad. In our view, Ackman is the type of person who simply will not tolerate permanent failure; thus, setbacks such as Ackman has recently experienced should only fuel his fire for redemption, which should eventually be reflected in his investment results. A humbled Ackman is hungry Ackman. Third, the fact that Pershing's assets have declined drastically since mid-2015, while painful for Ackman personally, is actually bullish for PSHZF holders. As Buffett is fond of stating, "size is the enemy of performance" in investing. Ackman's AUM is now much smaller, meaning the universe of potential investments he can make is now much larger than it was three years ago. Finally, Ackman has stated that he is going back to basics as an activist investor and will be avoiding the limelight going forward (see here). So there should be no more public shorts like HLF, no more passive investments made at a full price a la VRX and no more distractions like engaging in a CNBC-broadcast food fight with Carl Icahn. Thus, all signs look good prospectively for an investor betting on Ackman via PSHZF.
Conclusion - An investor seeking an alternative to ETFs and index and mutual funds, yet still wanting to outsource the stock-picking aspect of investing, has just a few options. One could buy shares of BRK-A or IEP and pay a large large premium to the value of the respective underlying investment holdings for the privilege of coattail-riding an Icahn or a Buffett. Conversely, one could buy PSHZF at a massive 20+% discount to NAV and cede the decision making to Bill Ackman, who appears poised for a comeback and has put nine-figures of his own money in said investment vehicle, evidencing clear financial alignment with the rest of PSHZF's unitholders. Additionally, Ackman just turned 52 and manages around $8 billion, while Icahn is 82 (managing over $20 billion) and Buffett is about to turn 88 (overseeing about $400 billion). If age and size are the enemy of future performance, the advantage lies with a (relatively) young, hungry and more nimble Ackman, who still has decades of investing ahead of him and has recommitted to the activist investing style that first brought him to prominence. If Ackman regains a significant measure of prior stock-picking glory (which we think he will), PSHZF is likely the vehicle by which he achieves this end. And enterprising investors can currently get aboard for the ride at enviable prices before the train leaves the station. All aboard!
Market Musings - June 6, 2018]]>, 06 Jun 2018 19:00:05 +0000
We continue our blog series: Market Musings, Volume 2, Edition 17, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Value in Supervalu? Blackwells' SVU Activist Campaign".
A new activist has emerged on the scene: Blackwells Capital. Blackwells is run by Jason Aintabi, whose bio can be found here. On March 22, 2018, Blackwells announced that they are running a proxy contest to place six of their nominee directors on the BoD at Supervalu (SVU) - SEC filings here:
Blackwells' 5% stake is currently worth about $37MM. SVU has been an unmitigated disaster for shareholders over the past 10 years, dropping over 90% during that timeframe:
Enough is enough, say the activists; to spread their message they have created their own Save Supervalue website. Basically, Blackwells is urging the company to focus its energy on the company's valuable wholesale business (with the view of eventually selling it to the highest bidder) and ending the distractions involved in running the smaller (negative EBIT) retail operation (by separating it from the remainder of the company). Thus, Blackwells is advocating for the following actions at SVU:
Multiple strategic initiatives to drive growth and margins, and reduce Supervalu’s significant valuation discount;A sale-leaseback of Supervalu’s wholesale distribution center real estate to reduce net leverage and significantly boost share price;A sale or spin-off of the retail segment, transforming Supervalu into a pure-play wholesale business, which would be accretive to EPS and improve valuation multiples; andA sale or merger of Supervalu’s strategically attractive wholesale business to or with one of multiple potential competitors.
The bios of Blackwells' six director nominees are as follows:
In addition, we have excerpted below a few of the more interesting slides from Blackwells main Powerpoint presentation regarding SVU, which indicates that there may be 110% to 125% upside in the stock from the current $20 level:
Blackwells' arguments appear quite persuasive (in our humble opinion). Unfortunately, instead of doing the logical thing (for shareholders) and engaging with Blackwells to try to get out of the massive hole SVU has fallen into, SVU's BoD and management have predictably responded to the activists with the following "circle-the-wagons"/ "we've got this, thanks anyway guys" kiss off (in other words, the usual empty C-suite PR spin):
"The Board and management team already have SUPERVALU’s transformation strategy well underway, and do not believe the changes to the Board proposed by Blackwells are necessary to ensure the continued execution of the Company’s initiatives to create stockholder value. As previously disclosed, members of our Board and management team have had several discussions and meetings with representatives of Blackwells over the last several months to discuss overlapping objectives and attempt to reach a constructive path forward. Nonetheless, Blackwells has chosen to respond with a public campaign and an attempt to take effective control of the Company. However, and as previously announced, we are committed to Board refreshment and will consider Blackwells’ candidates as we would any other potential directors to assess their ability to add value to the Board and the Company for the benefit of all stockholders."
(Note that SVU conveniently omits to mention the fact that the current BoD already has "effective control" of the company and never paid shareholders a dime for this.) With SVU's stock price down 27% over the past year, it seems as if Blackwells may have a decent chance in this proxy contest. Although SVU's directors last year received only de minimis number of "No" votes at the annual meeting, close to 17% of the shares were not even voted (see full meeting voting results here). Thus, shareholder apathy with the current board seems high, indicating the time may be ripe for an activist campaign.
Finally, there is encouraging precedent for a "separate the retail and wholesale segments / monetize the real estate assets" activist campaign in the food space. Bob Evans Farms (BOBE) - SEC filings here - came under scrutiny from activist Sandell Asset Management in early 2014. A copy of Sandell's initial presentation on BOBE can be found here. Similar to Blackwells' message to SVU, Sandell encouraged BOBE to split their retail restaurant operations (Bob Evans Restaurants) from their packaged food wholesale business with grocers (BEF Foods) (although in this case, the initial emphasis of the activist was on maximizing value on the retail side and divesting the wholesale operations); in addition, Sandell urged BOBE to monetize their real estate:
At the time Sandell initiated its proxy fight, BOBE stock was trading around $44/share, while Sandell estimated shares could potentially be worth between $76 and $91, or approximately double their then current value:
So how did things work out for BOBE shareholders in the end? Sandell won four BoD seats at the 2014 annual meeting (see here), the imperial CEO was forced to give up his Board Chairmanship (see here) and eventually forced out as chief executive (see here), the company moved to monetize several hundred million dollars in corporate real estate assets to free up funds to repurchase shares (see here), as well as entered into sale-leaseback transactions regarding its restaurants, freeing up hundreds of millions more in capital to return to sharheolders (see here), the company announced the sale of its retail restaurant business to Golden Gate Capital for net proceeds of approximately $480MM and consequently declared a $7.50/share special dividend (see here), and finally the remaining public company (i.e., the wholesale business) was sold to Post Holdings for $77/share (see here).
Thus, without even counting regular dividends, BOBE shareholders realized an aggregate return between April 2014 (when Sandell announced their activist campaign) and January 2018 (when the sale of BOBE to POST was completed) of $40.50/share (i.e., $33 in capital gains plus the $7.50 special dividend) on a $44/share cost basis, representing a CAGR of 19% for that holding period. Including regular BOBE dividends, the CAGR was nearly 21%. Not too shabby...
Readers should also note that somewhat similar activist campaigns involving Starboard Value commenced in February 2014 against Darden Restaurants (DRI) (for which see here), as well as Biglari Holdings in September 2011 against Cracker Barrel (CBRL) (for which see here), both of which resulted in huge gains for shareholders--food for thought:
Market Musings - June 4, 2018]]>, 04 Jun 2018 17:46:55 +0000
We continue our blog series: Market Musings, Volume 2, Edition 16, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Shots Fired At David Einhorn".
Back on April 23, 2018, David Einhorn gave a presentation at the Sohn Investment Conference on Assured Guaranty (AGO) - SEC filings here - wherein he basically stated that the insurer was massively under-reserved. The full presentation can be found here. Based on a cursory review, Einhorn makes some good points on AGO's below-investment-grade (or BIG) portfolio, especially concerning the company's Puerto Rico exposure. However, as can be seen from the chart below, Einhorn's late April presentation has had minimal to zero impact on AGO's stock price to date:
In any event, following Einhorn's AGO presentation another investment fund named Sunesis Capital apparently took umbrage with Einhorn (as they seem to be long AGO) and went on a full-blown attack against Einhorn's reinsurance vehicle Greenlight Re (GLRE) - SEC filings here. The full Sunesis presentation on GLRE can be found here. Sunesis makes several interesting arguments about GLRE, as follows:
a. PFIC Rules - Sunesis claims that GLRE is in jeopardy of violating the PFIC rules, which basically tax disadvantage a publicly-traded entity that qualifies as a passive foreign investment company. As per Wikipedia, "For purposes of income tax in the United States, U.S. persons owning shares of a passive foreign investment company (PFIC) may choose between (i) current taxation on the income of the PFIC or (ii) deferral of such income subject to a deemed tax and interest regime. The provision was enacted as part of the Tax Reform Act of 1986 as a way of placing owners of offshore investment funds on a similar footing to owners of U.S. investment funds (regulated investment companies)."
Below are a few excerpts from Sunesis' presentation on the PFIC issue as it relates to GLRE (note particularly the point Sunesis identifies about Trump's tax bill's effect on GLRE's ability to continue to claim its PFIC exemption):
The interesting thing here is that GLRE has basically admitted that the tax changes have caused them a PFIC problem, since in GLRE's response to the publication of the Sunesis short thesis, the company (while rejecting the overall thrust of the thesis) stated that it will need to "restructure its activities" (whatever that means) in order to retain its PFIC exemption:
"The (Sunesis) Report questions whether the Company 'should be classified as a PFIC'. As Greenlight Re has stated publicly in its annual report on form 10-K for the period ended December 31, 2017, management believes Greenlight Re should not be classified as a PFIC. Under the existing rules prior to the Tax Cuts and Jobs Act, Greenlight Re annually conducted an assessment and determined that in 2017 and in prior years it should not be deemed a PFIC. The Company’s reinsurance activities and risk profile do not support the PFIC designation, but the law change has put more emphasis on balance sheet arithmetic than a qualitative assessment. Greenlight Re intends not to be treated as a PFIC and is in the process of restructuring its activities to ensure that it meets the bright-line applicable insurance liabilities test. Greenlight Re will not need “to increase insurance liabilities in a market that has terrible pricing” or deviate from its underwriting discipline."
b. Incentivized to Lose Money? There is clearly some negative effect from the tax bill on GLRE's PFIC status, although GLRE claims that it will remedy this through "restructuring". So let's assume that is the case (although it is interesting that GLRE provides no specifics on how this "restructuring" will occur) and that the PFIC exemption problem will go away. In our view the more salient point is the subsequent one that Sunesis makes about GLRE, namely that it operates as a reinsurer not for the purpose of making profits, but rather solely to fit under the PFIC exemption safe harbor. In other words, Sunesis claims that GLRE has no real intention of operating a profitable reinsurer with sound underwriting practices; rather, GLRE will underwrite uneconomic reinsurance business simply to retain the tax deferral benefits of the PFIC-exemption for GLRE's investment operations (the fees for which are obviously lucrative for Mr. Einhorn's hedge fund in its role as GLRE's designated investment advisor):
In fairness to Einhorn and GLRE, they claim that Sunesis's "assessment of the Company, its business and strategy is fundamentally flawed". Perhaps so. But it does seem as though GLRE has an incentive to underwrite business regardless of profitability in order to keep the stream of tax-deferred management fees flowing to Mr. Einhorn's hedge fund. Moreover, these fees appear even more attractive than normal hedge fund fees, since they are earned on what looks to be permanent capital, due to Mr. Einhorn's voting and other influence at GLRE (in other words, Greenlight Capital is highly unlikely to fired by GLRE as its investment advisor even if its performance is sub-par, as it has been in recent years). If that is the case (that GLRE is incentivized to underwrite uneconomic business, if necessary, to preserve its PFIC exemption), the long-term outlook for GLRE stock would indeed be quite dire. Using history as a judge, it does appear that GLRE exists for some purpose other than rewarding shareholders, as the stock has massively underperformed the S&P 500 since its IPO eleven years ago:
It should also be noted that the same negative dynamics identified by Sunesis with respect to GLRE (if Sunesis is correct in its analysis) would presumably also be at play for Dan Loeb's offshore reinsurer Third Point Re (TPRE) - SEC filings here. TPRE has done a bit better against the S&P 500 since its public flotation than GLRE, yet has hardly impressed:
Granted, outstanding investment performance by Einhorn and Loeb could prospectively mitigate the negative incentive effects on their respective reinsurers and their underwriting practices. Yet the drag from high investment management fees, as well as apparently perverse incentives related to PFIC and the reinsurance-cum-hedge fun business model, may perpetually doom GLRE and TPRE to underperform the S&P going forward.
Market Musings - June 2, 2018]]>, 02 Jun 2018 19:42:58 +0000
We continue our blog series: Market Musings, Volume 2, Edition 15, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Market Musings of the Day for June 2nd".
Back after a bit of a hiatus, we resume our random musings. Here is a list of items we are keeping tabs on in the market:
1. Newell Brands (NWL) - SEC filings here - this company has been the subject of activist proxy campaigns by not one, but two, big names: Starboard Value and Carl Icahn. The proxy fights were amicably settled and the CEO got to keep his job, yet the share price keeps falling. Of course, other things being equal the lower the share price, the better the buy, so maybe there is an opportunity here. The shares now yield just over 4% and trade at forward P/E of just 8.7X (representing an earnings yield of 11.5%).
Note that the company just announced that the CFO is quitting, sorry make that (ahem) "retiring", usually not a good sign:
"Newell Brands Announces Chief Financial Officer Ralph Nicoletti toRetire at the End of 2018. HOBOKEN, June 1, 2018 – Newell Brands Inc. announced today that Executive Vice President and Chief Financial Officer Ralph Nicoletti will retire at the close of 2018.“On behalf of Newell Brands, I want to extend my thanks to Ralph for his partnership over the last two years,” said Michael Polk, Newell Brands President and Chief Executive Officer. “Ralph and his team have put in place a set of information management processes that will increase the analytic capabilities of the company, positioning us to strengthen our operational and financial performance. Ralph has agreed to stay on through the end of the year to help with the succession process and to continue to drive our transformation work as a key member of the Management Committee.”Newell Brands will begin a search for Nicoletti’s successor. Both internal and external candidates will be considered."
2. More Carl Icahn Proxy Fights - Speaking of Carl Icahn, at 82 he is not apparently slowing with age. He is currently embroiled in two other proxy fights, as follows:
a. Amtrust Financial (AFSI) - SEC filings - Icahn is challenging the management & P/E going private transaction at $13.50/share:
As can be seen below, management cherry-picked multi-year lows on the stock price in early January 2018 as the point at which they entered into the going-private deal with their hand-selected P/E firm:
However, unbeknownst to most of the market until early May (when the proxy statement for the merger was finally filed), AFSI management determined that April 5th would be the record date for voting on the merger (and Icahn purchased most of his shares after the record date). Now AFSI claims this was all done in accordance with Nasdaq's rules:
So the real questions are the following: Will Icahn and others who bought shares after April 5th but before the proxy was filed (May 4th) get to vote on the merger; and, if so, will they be able to block the merger? Since the stock price is now trading below the $13.50/share buyout price, it appears that the market has concluded "no" on these two questions. (For what it's worth, Glass Lewis is backing the merger, while ISS recommends shareholders vote against it.) Only time will tell.
Also note that yesterday Icahn asserted he will exercise appraisal rights for his stock (see here). Perhaps this indicates his backup plan if he loses in court on the record date issue. Below is an excerpt from the definitive proxy (full filing here) on availability of appraisal rights in connection with this merger (it does not appear that the merger is contingent on the absence of a specified percentage of shareholders exercising such rights, as is sometimes the case in cash-out mergers):
b. Sandridge Energy (SD) - SEC filings - This is another situation where incumbent management, when confronted with activists, engaged in truly obscene entrenchment tactics, such as attempting an uneconomic (and since terminated) merger with Bonanza Creek Energy (BCEI) (in order to dilute the activists' voting stakes), instituting an egregious poison pill under the guise of it being a "shareholder rights" plan (for the same reason), approving absurdly lucrative severance packages for upper management, etc etc etc. It is actually surprising that corporate executives do not end up in legal jeopardy for these kinds of things--welcome to corporate America.
In any event, Icahn and other activists managed somehow to override most of the entrenchment devices employed by the SD CEO and captive board of directors. Indeed, the CEO was jettisoned by the board, who are now in full-blown self preservation mode. Icahn wants 7 director seats for his slate, while the entrenched board has offered him just 2 slots. Icahn has also indicated he may make an offer for the entire company. SD shares appear quite undervalued, as Icahn has indicated they trade at a measly 2.5X EBITDA and well below the PV-10 value of the underlying O&G assets. Shares trade well below their 52-highs from the beginning of 2018, despite rising oil prices:
3. Snap Inc (SNAP) - SEC filings here - noted short seller Citron Research decided to come out with a long thesis on Snap:
Apparently Citron's thesis is that "the bad news is priced in". Usually we hear that from bag-holding longs who are in denial. No doubt holders of Sears Holdings (SHLD) also thought many times over the years that "it's all priced in, guys!", yet the stock has continued to sink relentlessly (including being down 17% today). Being short SNAP, we think that the company is likely terminal. Facebook's Instagram has made SNAP obsolete. In addition, the company has borderline contempt for its shareholders, denying them even a token voting right in their IPO:
Per SNAP's 2017 Form 10-K filing, page 31:"Class A common stockholders have no voting rights, unless required by Delaware law. As a result, all matters submitted to stockholders will be decided by the vote of holders of Class B common stock and Class C common stock. As of December 31, 2017, Mr. Spiegel and Mr. Murphy control approximately 95.2% of our voting power, and potentially either one of them alone have the ability to control the outcome of all matters submitted to our stockholders for approval. In addition, because our Class A common stock carries no voting rights (except as required by Delaware law), the issuance of the Class A common stock in future offerings, in future stock-based acquisition transactions, or to fund employee equity incentive programs could prolong the duration of Mr. Spiegel’s and Mr. Murphy’s current relative ownership of our voting power and their ability to elect certain directors and to determine the outcome of all matters submitted to a vote of our stockholders. This concentrated control eliminates other stockholders’ ability to influence corporate matters and, as a result, we may take actions that our stockholders do not view as beneficial. As a result, the market price of our Class A common stock could be adversely affected."
And let's not forget that SNAP is still run by the same CEO who gave himself $636.6 million in stock compensation just before said IPO:
In short, SNAP's corporate governance is abysmal (unsurprisingly, the company pays no dividend). So good luck to Citron, you will need it!
Separated At Birth - Tesla Edition]]>, 15 May 2018 16:13:42 +0000
Presented without comment...
Market Musings - April 10, 2018]]>, 10 Apr 2018 18:22:43 +0000
We continue our blog series: Market Musings, Volume 2, Edition 14, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Ties that Bind: Interesting Parallels and Connections Among Elon Musk, Eddie Lampert & Donald Trump".
Without further ado, we present the following interesting connections between Musk, Trump and Lampert:
1. EDUCATION: Sears CEO Eddie Lampert and President Donald Trump's Treasury Secretary Steve Mnuchin were roommates as undergrads at Yale in the mid-1980s. (In addition, Mnuchin has invested in Lampert's hedge fund, ESL, and served as a director on Sears' board for 12 years according to his Senate confirmation testimony (source).) Trump and Elon Musk both attended the University of Pennsylvania for their undergraduate degrees (although, obviously, they were separated by many years). Thus, all three are bona fide Ivy Leaguers.
2. VISIONARY STATUS: Eddie Lampert was in the mid-to-late 2000s considered the next great market whiz, a visionary who combined Sears and Kmart into one entity, with the result being its stock price soaring from $10.50/share in May 2003 to $133/share in April 2007, or a 12.7X increase in just under 4 years (a CAGR of around 90%). Meanwhile, Elon Musk in the mid-to-late 2010s was considered a real-life "Iron Man", a visionary who combined Tesla Motors and Solar City into one entity, with the result being its stock price soaring from $32/share in May 2012 to $305/share in April 2018, or a 9.5X increase in just under 6 years (a CAGR of around 45%). [Contra: Eddie Lampert was considered an iconoclast at the time for refusing to reinvest capex in his stores, while Elon Musk was considered an iconoclast at the time for spending like a drunken sailor on capex in his factories, while Trump has been considered an iconoclast for spending like a drunken sailor on pretty much everything.] Finally, in the mid-to-late 1980s, Trump was considered a visionary in the real estate field, especially following the publication of his bestselling book The Art of the Deal. (Note that Trump even has a painting of himself on the wall at Mar-a-Lago which is entitled "The Visionary"...)
3. REALITY DISTORTION FIELD: Lampert, Trump and Musk all appear to have employed some form of "reality distortion field" (made famous by Steve Jobs) in their professional careers. Lampert has been in denial about the economic decline of Sears for the past decade and consistently refuses to acknowledge reality, stating each year when announcing record annual losses and cash burn that the "transformation" of Sears is making progress and just about to take hold (it never is). Trump is legendary for his denial of reality, apparent losses and defeat (namely, business failures and bankruptcies [he called his near brush with personal bankruptcy in the early 1990s as his "blip"], "grab them by the -----" tapes, defying long odds of becoming the nation's 45th chief executive, his hairline, etc); he has seemingly perfected the art of positive thinking (that if you repeat something enough to yourself and others, it will eventually become reality). Finally, Musk has made a career out of staring down the naysayers, constantly engaging in reckless financial gambits and massive risks (note that Tesla almost went bankrupt in 2008 and again in 2013), with his companies living far beyond their financial means. Perhaps being a "visionary" means that one simply cannot accept at a fundamental level the mundane "reality" that normal people take for granted. In any event, reality distortion has worked wonders for both Musk and Trump professionally. (Contra: It has been a disaster for Lampert, although he remains incredibly wealthy nonetheless. Does this presage the future downfall of either Musk or Trump?)
4. IMMENSE WEALTH: Lampert, Trump and Musk are all billionaires, worth (according to Google) and $1.6B, $3.1B and 19.5B, respectively (note that that odds of becoming a billionaire in the United States is over 600,000 to 1). Below is a picture of Lampert's Florida mansion:
5. FEEDING AT THE GOVERNMENT TROUGH: Trump and Musk each made their fortunes by exploiting funding and tax breaks from the government. Trump's real estate empire was largely due to government-financed housing projects in the 1960s and 1970s and tax abatements in the 1970s and 1980s. Musk likewise has relentlessly exploited government tax breaks, loans and credits for electric vehicles and other renewable energy projects; in addition, SpaceX is largely financially reliant on government contracts to launch satellites. (Contra: Lampert has apparently foregone such government largesse.)
6. FAMILY: Trump and Musk have each have been married three times and each have five children. (Contra: Lampert has only been married once and has three kids.) Below is Musk with his offspring (sans ex-Wife #1, aka "The Starter Wife", who is the mother of all five):
7. IT'S GOTTA BE THE HAIR. Trump and Musk have miraculously managed to re-grow their hair since appearing to go mostly bald in early adulthood (more reality distortion?) (Contra: Lampert appears to be slowly yet surely going bald over time.) Should we take some insight from this? Namely, that men who can re-grow their hair clearly possess superpowers?
CONCLUSION: We are not quite sure what to make of the foregoing parallels and connections between these illustrious three gentlemen, Musk, Trump and Lampert. Something's clearly up, though...
Market Musings - March 10, 2018]]>, 10 Mar 2018 18:57:48 +0000
We continue our blog series: Market Musings, Volume 2, Edition 13, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Instant Analysis - Allergan 2017 Form 10-K Filing".
On February 16, 2018, Allergan Plc (AGN) filed with the SEC its 2017 Form 10-K filing. This blog will perform an instant analysis the risk factors section of the document (each excerpt is redlined against the respective text from Allergan's 2016 Form 10-K filing).
As an initial matter, it should be noted that AGN's total shares outstanding decreased from 335,224,713 as of February 17, 2017 to 330,320,420 as of February 13, 2018, or 1.5% lower year over year. AGN's stock price as of the former date was $247 and as of the latter date was $159, or 36% lower year over year. AGN's market capitalization thus declined from $82.8B to $52.5B, a total loss in value for shareholders of $30.3B. AGN's TTM stock chart is below:
Instant Analysis: A new risk factor has been inserted into AGN's 10-K specifically referencing the potential loss of revenues due to "problems", such as losses of exclusivity (or LOEs) for drugs that individually produced more than $500MM in 2017 revenues for the company. AGN here calls out major revenue drivers such as Botox and Restasis and warns investors that the revenues derived from these drugs could be in jeopardy. Restasis, which produced $1.47B in 2017 revenues, may soon be subject to generic competition, for instance--typically drugs that go generic will see drastic (~80% or more) revenues declines.
Instant Analysis: AGN here specifically calls out potential trade restrictions on their drug manufacturing capabilities. This is interesting in light of the Trump Administration's recent ratcheting up of tariffs on goods entering the United States. If a full-blown trade war were to erupt due to U.S. protectionism, AGN's ability to manufacture its drugs effectively could be negatively impacted.
Instant Analysis: AGN adds a new risk factor specifically highlighting potential weaknesses in its R&D program. Over the past year AGN has had numerous pipeline setbacks, most recently having their PDUFA date for Esmya for uterine fybroids delayed by the FDA until August 2018 (see here). In addition, note the Refusal to File letter from the FDA regarding Vraylar in September 2017 (see here).
Instant Analysis: AGN adds language to a risk factor specifying that it may suffer liability due to the explosion of opioid-related lawsuits that have been filed recently by state and local governments in the U.S. For example, in January 2018, New York City named AGN (along with seven other pharma companies) as a defendant in a $500MM opioid lawsuit (source here):
Instant Analysis: AGN effects some word-smithing with respect to a risk factor regarding share repurchases. The key is not the changes made, but rather the fact that this risk factor has proven prescient in light of AGN blowing over $15B of available cash over the past couple years on repurchases of company shares at prices far higher than the current market price, generating little to no value for shareholders. For example, note the following regarding 2016-2017 repurchase programs, which were completed at levels in the $190 to $250 range (versus a current share price of $157); it clearly would have been a much wiser use of capital to instead reduce AGN's net debt, which currently is a massive $24,000,000,000 (source here):
Instant Analysis: New language in a tax risk factor specifies that the Trump Tax Bill may "adversely impact [AGN's] effective tax rate or operating cash flows going forward" for various reasons. So much for the benefits of being a tax inverted company, one of AGN's previous talking points as to why their business model was superior to traditional U.S. pharma companies.
AGN Investors should also carefully review the section in the 10-K that discusses patent challenges to AGN's drug portfolio, which runs from pages F-87 to F-106 in the filing. While this is seriously dry reading, AGN investors would have saved a pretty penny if they had absorbed all of this information when it appeared in the 2017 10-K a year ago, as it would likely have warned them of the looming LOEs for Restasis and other major AGN revenue generators.
Given the drastic decline in AGN's share price over the past few years (shares are down over 50% since mid-2015), it will be interesting to see how much the senior executives at the company will receive in compensation for 2017. The 2018 proxy statement should be out in about two weeks. For the record, below is the Summary Compensation Table from the 2017 Proxy Statement (don't worry, these folks will not be going hungry anytime soon, although their shareholders might):
Market Musings - March 2, 2018]]>, 02 Mar 2018 19:36:11 +0000
We continue our blog series: Market Musings, Volume 2, Edition 12, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Instant Analysis - Tesla 2017 Form 10-K Filing".
Last Friday Tesla (TSLA) filed its 2017 Form 10-K filing. This blog will perform an instant analysis the risk factors section of the document (each excerpt is redlined against the respective text from the 2016 10-K).
Instant Analysis: Tesla admits that its Model 3 production is still not fully automated as of the date the 10-K was filed, i.e., February 23, 2018 (see reference to "semi-automated manufacturing lines"). This appears to refer to the press reports that some aspects of the Model 3 production were being performed by hand (see here, for example). So "Production Hell" in Fremont appears to be continuing.
Instant Analysis: Tesla here expands on the issues regarding "Production Hell" at the Gigafactory. The main issue holding up Model 3 production appears to be issues with Panasonic and its battery pack production lines. Note that Tesla states that Panasonic has never previously attempted such an ambitious production ramp in the U.S. The statement that Tesla expects to "continue to experience challenges" indicates that the Model 3 production problems are ongoing and apparently difficult to solve.
Instant Analysis: Note the reference at the end regarding "cost and volume targets" being in jeopardy. Tesla seems to be admitting that its previously stated gross margin goals for the Model 3 are potentially no longer feasible, at least in the near to mid-term.
Instant Analysis: Mainly word-smithing here, but note added references to battery production (in addition to solar) being impacted by increased competition.
Instant Analysis: Tesla states that the recent Trump tax cuts will likely reduce the tax efficiency of their solar products, thus negatively impacting the company's ability to receive financing for solar systems from tax equity investors.
Instant Analysis: Tesla hints that some of the tooling installed in its factories (especially, presumably, the Gigafactory) may be written down and/or obsolete. It is not clear whether this specifically relates to "Production Hell", but it is reasonable to assume that the rush to get Model 3 production underway may have resulted in ill-advised / sloppy procurement of equipment, necessitating the referenced accelerated depreciation.
Instant Analysis: Tesla states that Musk has acquired some of his TSLA shares on margin, increasing the risk that he may make short-term oriented decisions to support the stock price (at the risk of long-term company success). To see an example of how this type of stock pledging can produce bad outcomes, see the saga of Mike Pearson's margin call on his Valeant (VRX) shares.
Market Musings - February 21, 2018]]>, 21 Feb 2018 13:48:04 +0000
We continue our blog series: Market Musings, Volume 2, Edition 11, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Buffett on Inflation".
Back in May 1977 Warren Buffett wrote an article for Fortune magazine (full article linked here) entitled "How Inflation Swindles the Equity Investor". Given that we now appear to be heading into an era of higher inflation, it pays to take a look back at Buffett's thoughts on the subject from 41 years ago.
First we should note that the 30-year Treasury bond yield has jumped up recently, appreciating about 40 bps over the past 6 months to the ~3.16% level (source):
Granted, we are not even remotely close today to the ~15% level of the early 1980s, however for equity investors we appear to be moving in the "wrong" direction, at least if you buy in to Buffett's thesis, explained further below. But first the long, long-term bond view, showing that the ~35-year bond bull market may finally be ending (source):
So how does Buffett view the relationship between inflation and equities? First, he refutes the previously accepted view that equities act as a hedge against inflation:
There is no mystery at all about the problems of bondholders in an era of inflation. When the value of the dollar deteriorates month after month, a security with income and principal payments denominated in those dollars isn’t going to be a big winner. You hardly need a Ph.D. in economics to figure that one out. It was long assumed that stocks were something else. For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities. These, investors believed, would retain their value in real terms, let the politicians print money as they might. And why didn’t it turn out that way? The main reason, I believe, is that stocks, in economic substance, are really very similar to bonds. I know that this belief will seem eccentric to many investors. They will immediately observe that the return on a bond (the coupon) is fixed, while the return on an equity investment (the company’s earnings) can vary substantially from one year to another. True enough. But anyone who examines the aggregate returns that have been earned by companies during the postwar years will discover something extraordinary: the returns on equity have in fact not varied much at all.
Basically, Buffett takes the view that equities are disguised bonds that pay around 12% on par value (i.e., book value, or shareholders' equity). Thus, stocks are hurt just as much as bonds when inflation rises because the price-to-book ratio for stocks must decrease just as a bond's price decreases in inflationary times. Conversely, the lower the relative level of inflation, the higher bond prices rise and the more P/E multiples expand (all other things being equal).
We can see this evidenced currently, as stocks trade around 3.4X book value (source). Recently, however, S&P 500 companies have averaged around a 14% return on equity, which looks to have been bumped up by the recent tax cuts to perhaps 16% (source). At a 16% ROE, this means that investors are receiving an earnings "coupon" of 4.7% (16/3.4) on the S&P 500, or about 1.5% higher than the risk-free 30-year Treasury rate (note that this equates to a trailing P/E ratio of about 21X). However, if the 30-year bond rate were to increase to, for example, 7%, then one would expect the earnings yield on the S&P 500 to rise from 4.7% to about 8.5%, implying a P/E ratio of around 12X. With investors anticipating around $150/share in 2018 S&P earnings (source), this would mean that the S&P should drop to the 1830 level or so (12X150), which is about 33% lower than the current trading level. Obviously, we are nowhere near a 7% long bond rate, but it is interesting to see how things would likely shake out in such a scenario.
Buffett goes on to identify a key characteristic of low inflationary environments: they favor companies that reinvest their earnings (versus paying them out via dividends). Why? Because when stocks are trading at 3.4X book value, every $1 of cash from operations that gets reinvested in said book value should translate into an incremental $3.40 in market value for the shareholder (versus worth just $1 when paid out as a dividend, or even less after payment of taxes thereon). Buffett explains further:
This characteristic of stocks — the reinvestment of part of the coupon — can be good or bad news, depending on the relative attractiveness of that 12%. The news was very good indeed in the 1950s and early 1960s. With bonds yielding only 3 or 4%, the right to reinvest automatically a portion of the equity coupon at 12% was of enormous value. Note that investors could not just invest their own money and get that 12% return. Stock prices in this period ranged far above book value, and investors were prevented by the premium prices they had to pay from directly extracting out of the underlying corporate universe whatever rate that universe was earning. You can’t pay far above par for a 12% bond and earn 12% for yourself.
But on their retained earnings, investors could earn 12%. In effect, earnings retention allowed investors to buy at book value part of an enterprise that, in the economic environment then existing, was worth a great deal more than book value.
It was a situation that left very little to be said for cash dividends and a lot to be said for earnings retention. Indeed, the more money that investors thought likely to be reinvested at the 12% rate, the more valuable they considered their reinvestment privilege, and the more they were willing to pay for it. In the early 1960s, investors eagerly paid top-scale prices for electric utilities situated in growth areas, knowing that these companies had the ability to re-invest very large proportions of their earnings. Utilities whose operating environment dictated a larger cash payout rated lower prices.
No wonder investors recently have been in love with so-called "growth" companies--they tend not to pay dividends, but rather reinvest all their cashflows into existing or new operating businesses. Think about Amazon (AMZN) for a moment. All operating cashflow is plowed back by Jeff Bezos either into the existing retail business or in new businesses such as AWS. Unfortunately, the higher interest rates rise, the lower the relatively benefit of the reinvested dollar for shareholders, and the less attractive "growth" stocks will look relative to stodgy dividend payers like AT&T (T) or General Motors (GM) (again, other things being equal). Buffett notes that this exact "reversal" phenomenon took hold in the mid-to-late 1960s just after major institutional investors had stampeded into growth stocks at nosebleed valuations:
This heaven-on-earth situation finally was “discovered” in the mid-1960s by many major investing institutions. But just as these financial elephants began trampling on one another in their rush to equities, we entered an era of accelerating inflation and higher interest rates. Quite logically, the marking-up process began to reverse itself. Rising interest rates ruthlessly reduced the value of all existing fixed-coupon investments. And as long-term corporate bond rates began moving up (eventually reaching the 10% area), both the equity return of 12% and the reinvestment “privilege” began to look different.
Buffett goes on to note that there are 5 ways companies can increase their ROE, namely (1) an increase in turnover, i.e., in the ratio between sales and total assets employed in the business; (2) cheaper leverage; (3) more leverage; (4) lower income taxes; (5) wider operating margins on sales. Obviously, #4 has recently come into play with the cut in the domestic corporate tax rate from 35% to 21%. However, tax cuts leads to higher deficits, which logically would lead to higher inflation and higher interest rates (so, regarding #2, leverage should become more expensive, rather than cheaper). What the tax cut giveth, higher interest rates may take away. Note also that higher interest rates may lead companies or their lenders to reduce leverage (see #3). So, overall, the recent corporate tax cut package might be a wash as far as equity valuations are concerned (although no doubt CEOs across the country will bonus themselves to the hilt in the aftermath of it). But those who have been happily long certain "profitless growth", high price-to-book companies during the current bull market may be in for a rude surprise if rates continue to rise.
Market Musings - February 16, 2018]]>, 16 Feb 2018 20:13:42 +0000
We continue our blog series: Market Musings, Volume 2, Edition 10, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Echoes of Bull Markets Past".
"It was an era of peace and prosperity. A pro-business, pro-tariff (one might label him "America first") Republican President was in charge in Washington, DC. The last economic downturn, which had been extremely painful but fortunately fairly brief, was over eight years in the rearview mirror, basically forgotten. It was indeed a new era for America and its economy, with low unemployment, high economic growth, a massive bull market and exciting new technologies titillating the public."
On the surface, it might appear that we talking about how the current era will be remembered years hence. After all, the 2008-09 financial crisis is long gone and faintly remembered today. Other than a blip in 2011 when the U.S. lost its "AAA" credit rating, the stock market has been in an almost continuous uptrend since March 2009. Market darlings Amazon (AMZN), Facebook (FB), Netflix (NFLX) and Tesla (TSLA), as well as A.I., virtual reality, self-driving cars, etc., have seemingly heralded a new era of amazing technologies which promise to revolutionize people's lives. Happy days are indeed here again.
In fact, though, what we have described in the quotation above was the state of affairs in America as of early 1929. Republican President Hoover had been elected at the end of 1928, replacing laissez-faire Republican Calvin Coolidge. Hoover, a former businessman and ex-Commerce Secretary, generally favored tariffs to protect American industry from deleterious competition. Below is a Hoover campaign brochure linking his policies with prosperity:
In early 1929 the economy was roaring along in a sustained upturn since the business depression of 1920-21. GDP increased over 40% during the period from 1922-1929, representing a strong ~5% CAGR (source). The stock market was likewise roaring. Below is a chart of the Dow's relentless progress from the trough represented by the 1920-21 depression to March 1929, showing a virtually uninterrupted climb from around 70 in mid-1921 to over 300, an aggregate rise of 325% (not dissimilar to our recent bull market, where we have seen the S&P 500 increase from 666 in March 2009 to 2,745 today, a total rise of 312%) (source):
As for technology, it truly seemed as if nirvana had arrived for Americans, promising unlimited future prosperity. Automobiles, radio and motion pictures had been invented and were taking the country by storm. Not to mention airplanes, refrigerators and washing machines, as well as (ho hum) mass electrification of large cities.In 1920, just 35 percent of American households had electricity; by 1929, nearly 68 percent of American homes were electrified. Unemployment was to bottom out in December 1929 at just 3.2% (source). To Americans alive at the end of Roaring Twenties, the future looked intensely bright.
Yet in early 1929 the first cracks appeared, presaging the massive market and economic downturn that was to hit beginning in late 1929 and continuing into the early 1930s. The market started 1929 strongly, up over 6% in January (sound familiar?). However, in early February stocks began to sell off sharply following the Federal Reserve's tightening of credit (sound familiar?). Below is an excerpt from an AP story that appeared on February 8th (source):
A week later, on February 15, 1929, another steep market selloff occurred, which was also attributed to Fed tightening (source):
The following day traders continued to liquidate their holdings and market news reports spoke of "sharp confusion of opinion on Wall Street" and "Favorites [Being] Dumped" (for example, shares of Radio Corporation of America, or RCA, which might be labelled the Tesla or Netflix of its era, was specifically mentioned) (source):
At the time these market stumbles seemed temporary and a general "buy the dip" mentality held firm. And why not? This philosophy had always worked during the previous eight-year bull market. Indeed, despite its February gyrations the Dow would rocket much higher during the summer of 1929, eventually reaching a maximum of 381 in early September. We all know what happened next (spoiler alert: it's very bad).
It is interesting to look a bit more closely at RCA, since its fate could hold clues as to how things may play out for the likes of FB, AMZN, NFLX and TSLA. Below is a synopsis of RCA's run up to the great market crash of October 1929, written back in the 1990s when Microsoft (MSFT) was dominant in personal computing (source):
Dominant leading-edge "monopoly" tech player--check. No serious competition in sight--check. Skyrocketing stock price--check. No dividends paid, ever--check. Millionaire longs swooning at the mere sight of the ticker symbol--check. No doubt any idiot who tried to tell a holder of RCA in 1928 or 1929 that it could be fool's gold would have been met with a quick "You just don't get it" and/or "This time it's different" retort.
So...let's see how RCA stock fared after the massive run to $114/share ($570/share pre-split) from 1924 to September 1929 (source):
So we know how this particular story ends--not well for RCA longs, who saw their investment crash 95% during the 2+ years from late 1929 until early 1932 (RCA shares closed at just $5.63 on January 2, 1932--source). [Note that the Depression did not spell the permanent demise for RCA or its vanguard technology; the company eventually became the National Broadcasting Company, more familiarly known as NBC, and is now part of the conglomerate Comcast (CMCSA)].
Now it's highly unlikely that we are on the precipice of another Great Depression. However, history will inevitably rhyme with the past. Importantly, just as with the conditions prevailing in early 1929, today's economy seems to be firing on all cylinders--thus, what 1929 proves is that the future is never clear. While economic conditions might not (and hopefully won't) become as bad as 1929-1932, the economy will inevitably slow (and perhaps even go into reverse for a time), simply because the economy always operates in cycles. And when it does the high flyers of today's market will be remorselessly cut to shreds by investors.
One last thought on FB, NFLX, AMZN and TSLA. Before turning out the lights, would somebody please fill this gentleman in on the ending too (hint: this time it's NOT different)? Thanks.
Market Musings - February 13, 2018]]>, 13 Feb 2018 20:24:04 +0000
We continue our blog series: Market Musings, Volume 2, Edition 9, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Clash of The (Wannabe) Titans: LGND versus INVA".
In this installment of Clash of the (Wannabe) Titans, we compare two pharma royalty companies, Innoviva, Inc. (ticker INVA) and Ligand Pharmaceuticals (ticker LGND). Below is the tale of the tape for these two entities as of 2:30 p.m. on February 12, 2018, as well as a brief description of each company's business from its respective SEC filings:
Description of INVA: Innoviva is focused on bringing compelling new medicines to patients in areas of unmet need by leveraging its significant expertise in the development, commercialization and financial management of bio-pharmaceuticals. Innoviva’s portfolio is anchored by the respiratory assets partnered with Glaxo Group Limited (GSK), including RELVAR®/BREO® ELLIPTA®, ANORO® ELLIPTA® and TRELEGY® ELLIPTA®, which were jointly developed by Innoviva and GSK. Under the agreement with GSK, Innoviva is eligible to receive associated royalty revenues from RELVAR®/BREO® ELLIPTA® and ANORO® ELLIPTA®. In addition, Innoviva retains a 15 percent economic interest in royalty payments made by GSK for TRELEGY® ELLIPTA® and earlier-stage programs partnered with Theravance BioPharma, Inc. For more information, please visit Innoviva’s website at
Description of LGND: Ligand is a biopharmaceutical company focused on developing or acquiring technologies that help pharmaceutical companies discover and develop medicines. Our business model creates value for stockholders by providing a diversified portfolio of biotech and pharmaceutical product revenue streams that are supported by an efficient and low corporate cost structure. Our goal is to offer investors an opportunity to participate in the promise of the biotech industry in a profitable, diversified and lower-risk business than a typical biotech company. Our business model is based on doing what we do best: drug discovery, early-stage drug development, product reformulation and partnering. We partner with other pharmaceutical companies to leverage what they do best (late-stage development, regulatory affairs and commercialization) to ultimately generate our revenue. Ligand’s Captisol® platform technology is a patent-protected, chemically modified cyclodextrin with a structure designed to optimize the solubility and stability of drugs. OmniAb® is a patent-protected transgenic animal platform used in the discovery of fully human mono- and bispecific therapeutic antibodies. Ligand has established multiple alliances, licenses and other business relationships with the world's leading pharmaceutical companies including Novartis, Amgen, Merck, Pfizer, Celgene, Gilead, Janssen, Baxter International and Eli Lilly.
As we can see from the charts above, INVA's share price has remained relatively flat over the past 10 years, while LGND's has skyrocketed. LGND consequently has double the market cap of INVA. Neither company pays a dividend. On the surface, then, LGND looks to be the clear victor in this matchup. Below please find the most recent earnings results for the two rivals:
Looking at the respective income statements, we find that despite having approximately half of the market cap of LGND, INVA is actually the far more profitable of the two, even on a per share basis (despite having just ~1/10th of the stock price of LGND). In its most recent quarter reported for each entity, for example, INVA recorded net income of $58.4 million versus just $8.43 million for LGND. For all of 2017, INVA garnered $134.1 million in profits; in comparison, LGND registered just $19.6 million in earnings in the first 9 months of FY2017 and is expected to report $26.8 million in earnings in Q4'17, meaning that LGND's 2017 total profits should be $46.4 million, or just 35% of INVA's level. On a forward basis, LGND is supposed to earn $4.42/share in 2018 (source), or $104 million total, while INVA is expected to earn $2.28/share in 2018 (source), or $272 million total.
Thus, we find that LGND trades at a forward P/E of 35X, while INVA trades at just 7.7X. Does this make any sense at all? What could explain the disparity? If LGND were on a much faster growth trajectory than INVA, this could explain it. Looking at analysts' current estimates, however, we find that LGND is expected to grow earnings in 2018 by 43.5% ($4.42 versus $3.08 for 2017) while INVA is expected to grow earnings in 2018 by 43.6% ($2.01 versus $1.40 for 2017). So the earnings growth rates are virtually the same. Will LGND grow revenues much faster in 2018 than INVA? Not according to the analysts. LGND is expected to grow revenues from $139MM in 2017 to $167MM in 2018, a healthy growth rate of 20%. In comparison, INVA is expected to see its revenues expand from $217MM in 2017 to $289MM in 2018 (and further to $322MM in 2019), meaning that at 33% its forward revenue growth rate is actually much higher than LGND's. So based on a forward earnings and revenues analysis, there does not appear to be any reason why LGND is currently a market darling while INVA is seemingly a dud.
Perhaps INVA has much higher debt levels than LGND; if so, this could explain why the market ascribes a much higher comparative valuation to LGND's equity. Below please find the most recent respective balance sheets for the companies:
Here we find that INVA has a total of $599MM in convertible notes and term loans versus $129MM in cash, for a total of $470MM in net debt. In contrast, LGND has $222MM in convertible notes plus $5MM in other long-term contingent liabilities (for a total of $227MM) versus $202MM in cash, meaning LGND has just $20MM in net debt. Thus, to make an apples to apples enterprise level (or EV) comparison, we will need to add $470MM to INVA's market cap versus just $20MM to LGND's. Doing so, we see that, on an EV basis, INVA clocks in at $2.12B, or $1.65B for its equity (106.2MM diluted shares O/S as of 12/31/17 and a $15.50 stock price) plus $470MM of net debt. In comparison, LGND's EV is $3.23B, or $3.25B for its equity (21.1MM diluted shares O/S as of 10/31/17 and a $153.30 stock price) plus $20MM of net debt. This demonstrates that the market still values LGND at a 52% premium to INVA on an EV basis, despite their key financial metrics (revenues and earnings) being quite comparable.
Based on our limited diligence, we are stumped so far--there does not appear to be any clear reason why the market would ascribe a 35% discount to INVA's assets versus LGND's. Could it possibly be because INVA has poor corporate governance while LGND's is stellar? Looking at this issue, we note that INVA faced a proxy contest from Sarissa Capital in 2017, near the conclusion of which the company apparently reneged on an orally-agreed settlement with Sarissa, resulting in Sarissa temporarily losing out on 2 BoD seats (source):
Sarissa was eventually able to claim these seats, however, by winning a court ruling in December to this effect (source):
The court ruling enabled Mssrs. Bickerstaff and Kostas (the Sarissa nominees) to take their seats on the BoD in late December 2017 (source):
INVA's CEO's position was no longer tenable once the foregoing had occurred and he was shown the door just last week (source):
So we find that Sarissa appears to be firmly in control of INVA's BoD, meaning that the BoD should now be aligned with the interests of shareholders (note that Sarissa owned about 3.6 million shares as of the end of Q3 2017, the most recently reported quarter end portfolio - source). In other words, while corporate governance at INVA last year during the proxy contest was clearly an "F", it now appears to be at least a "B+" in our opinion. Meanwhile, LGND insiders have been selling their shares at a rapid clip recently, indicating that they believe shares are richly priced. For example, below see recent sales by the CEO, John Higgins (source):
Similarly, former large holder and director Jason Ayreh's position has shrunk dramatically due to recent share sales (source). Thus, it appears that those on the inside at LGND, through the selling down of their respective ownership stakes, are increasingly not aligned with the interests of the shareholders.
It should also be noted that LGND's internal controls have been weak in the relatively recent past, as per the following risk factors (taken from the company's most recent Form 10-Q filing):
We have restated prior consolidated financial statements, which may lead to possible additional risks and uncertainties, including possible loss of investor confidence.
We have restated our consolidated financial statements as of and for the year ended December 31, 2015 (including the third quarter within that year) and for the first and second quarters of fiscal year 2016 in order to correct certain accounting errors... As a result of the Restatement, we have become subject to possible additional costs and risks, including (a) accounting and legal fees incurred in connection with the Restatement and (b) a possible loss of investor confidence. Further, we were subject to a shareholder lawsuit related to the Restatement which, if ratified, may be costly to defend and divert our management's attention from other operating matters.
We have identified material weakness in our internal control over financial reporting that, if not remediated, could result in additional material misstatements in our financial statements.
As described in “Item 9A Controls and Procedures” of the Form 10-K filed with SEC on February 28, 2017, management concluded a control deficiency that represents a material weakness was not remediated at December 31, 2016. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. As a result of the unremediated material weaknesses, management has concluded that we did not maintain effective internal control over financial reporting as of December 31, 2016. Although management has since implemented new controls and process to remediate the material weakness, we do not believe these new controls have been in place for sufficient time for management to conclude the material weakness has been fully remediated at June 30, 2017.
We continue to refine and implement our remediation plan to address the material weakness. If our remediation efforts are insufficient or if additional material weaknesses in our internal control over financial reporting are discovered or occur in the future, our consolidated financial statements may contain material misstatements and we could be required to restate our financial results, which could materially and adversely affect our business, results of operations and financial condition, restrict our ability to access the capital markets, require us to expend significant resources to correct the material weakness, subject us to fines, penalties or judgments, harm our reputation or otherwise cause a decline in investor confidence.
As far as we can tell, INVA has had no such internal control problems. Buyer (of LGND) beware...
Market Musings - February 8, 2018]]>, 08 Feb 2018 20:33:06 +0000
We continue our blog series: Market Musings, Volume 2, Edition 8, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "The Question of Conservatism (in Investing)".
Back in the Stone Ages, or in January 1962 to be more precise, a manager of a small investment partnership sent his limited partners an update on the performance of their partnership for 1961 (for those curious, it was up 46% versus up 22% for the Dow Industrials). The manager had recently turned 31, yet professionally was wise far beyond his years. Indeed, those lucky enough to buy into his investment partnership early on became rich beyond their wildest dreams and, decades later, the manager would become one of the world's wealthiest people. Of course, we are talking about none other than the Oracle of Omaha, Warren E. Buffett (the above picture shows him teaching an investment class for adults at the University of Nebraska at Omaha around the referenced time period). In the 1961 partnership letter, Buffett included a section headed "The Question of Conservatism", which contains the following paragraphs:
Conscious, perhaps overly conscious, of inflation, many people now feel that they are behaving in a conservative manner by buying blue chip securities almost regardless of price-earnings ratios, dividend yields, etc. Without the benefit of hindsight, I feel this course of action is fraught with danger. There is nothing at all conservative, in my opinion, about speculating as to just how high a multiplier a greedy and capricious public will put on earnings.
You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you. In many quarters the simultaneous occurrence of the two above factors is enough to make a course of action meet the test of conservatism. You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.
I might add that in no way does the fact that our portfolio is not conventional prove that we are more conservative or less conservative than standard methods of investing. This can only be determined by examining the methods or examining the results.
The more things change, the more they stay the same. Recently in markets we have again seen many investors bid securities up to absurd levels "regardless of price-earnings ratios, dividend yields, etc." Indeed, in many instances investors are attempting to justify higher stock prices based on the amount of money the company loses (not earns). Yes, that's correct, in this bizarro investment world the more losses a company generates and the more cash a company burns, the higher its stock price deserves to be, based on the dubious assumption that burning more cash means that management expects more "growth" ahead. "Growth" has been the market's mantra over the past few years: growth, growth, growth--not necessarily growth in earnings, mind you, but above all growth in revenues and, oftentimes, cash burn and losses (hey, it's still "growth").
Below we present recent earnings (using that term loosely) results for two companies that aptly exemplify this strange phenomenon (all amounts in $000):
Company A managed to lose $350MM in Q4 of 2017 and a grand total of $3.445 billion (yes, with a "b") for the year. Both amounts were far worse than the corresponding 2016 figures. Taking a look at the statement of cash flows, this was likewise atrocious:
Company A burned through $735MM in cash from operations in 2017, over $120MM worse than the prior year. It also spent far more on capex and acquisitions than in 2016.
Using any traditional investment measuring stick, the foregoing numbers would be considered truly horrific results. Yet when Company A reported these figures to the market several days ago, its shares skyrocketed nearly 50%. Was Company A's equity previously valued by the market at a de minimus amount, which perhaps might justify a brief, but minor, price spike upon reporting higher revenues year over year? Hardly. Before the 50% explosion in the share price, the fully-diluted market cap of Company A was over $17,000,000,000. For some strange reason, the market in its infinite wisdom upon receiving these amazingly dismal (to us) results, decided to mark Company A's already steep market cap up by over $8,000,000,000(!). Why, you ask? Well, Company A increased its number of product customers (aka "active users") more than expected, and thus "growth" (there's that word again) has supposedly been "reignited". (Note that the market does not appear to care at all about that the fact that expense growth has likewise been reignited.)
Company B managed to grow net losses by over $550 million in Q4 2017 versus the prior year's fourth quarter. For all of 2017, Company B managed to lose close to $2 billion for its shareholders, or nearly 400% the amount of 2016's annual losses. Below is the statement of cash flows for Company B:
While on the surface it appears that Company B's operating cashflow improved immensely in Q4 2017 versus prior quarters, almost all of the improvement was due to the "Changes in operating assets and liabilities" category, which is not indicative of underlying operating performance. For 2017 overall, despite working capital improvements generating nearly $500MM in cash, Company B still managed to burn cash on an operating basis and consumed an incremental $4 billion in cash from investing activities versus the prior year. Again, these results should hardly make a normal, sane investor rush out to buy shares. Yet, Company B inexplicably sports a fully-diluted market cap of over $55,000,000,000(!). Much as with Company A, the market has been relentlessly cheering Company B's "growth" (in revenues), while completely ignoring the massive recent growth in losses and negative cashflow (ex-working capital changes).
So, what is the identity of each of these market darlings? Company A is Snap Inc. (SNAP) and Company B is Tesla Inc. (TSLA). Interestingly, today both companies appear to be out of favor with the market, indicating that maybe, just maybe, our long national nightmare of bizarro market behavior--where up is down, black is white, night is day and terrible earnings and cashflow are bullish--may finally be nearing an end (and, if so, when it comes to investing Buffett will be proven right for about the 1,846th consecutive time):
Market Musings - February 2, 2018]]>, 02 Feb 2018 14:43:04 +0000
"Blue skies
Smiling at me
Nothing but blue skies
Do I see"
--Irving Berlin, "Blue Skies" (1926)
We continue our blog series: Market Musings, Volume 2, Edition 7, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Netflix: Priced For (and Beyond?) Perfection".
Netflix stock (NFLX) has lately gone parabolic, increasing from the $187 level just 2 months ago to $265 as of close of trading on February 1st, or up a massive 42% in just the past 60 days. The rapid rise in the stock price naturally begs the question, "Too much too soon?" We believe the answer is a resounding "yes", based on the analysis set forth below.
First, take the actual dollar amount of the increase in NFLX's valuation over the past two months, leading up to and immediately following the release of Q4 2017 results on January 22nd (see earnings PR here). With a $78 rise in the share price and 447 million diluted shares outstanding (per the company's 2017 10-K filing), simple math tells us that approximately $35,000,000,000 has been added to the diluted market capitalization in the past 60 days, or almost $600,000,000 per day during that period. Note below the parabolic move in the stock during this period:
Now $35 billion is a seriously big number, with lots of zeros (nine, in fact). Something must have fundamentally changed with the company to account for such a massive increase in capitalization, correct? Did NFLX just introduce a revolutionary new product? Nope, they have the same products they had two months (streaming Internet TV and DVDs by mail). Did NFLX announce expansion into a huge number of new territories? No, they still operate in the same ~190 countries that they operated in as of a year ago. Did NFLX add a gazillion new customers unexpectedly when they reported Q4 2017 results? Not really. In fact, according to Credit Suisse, domestic paying customer count at 52.8 million was just 700,000 higher than expected and international paying customer count at 57.8 million was also 700,000 higher than expected. So NFLX exited 2017 with 1.4 million customers, or about 1.27%, more paying customers than expected. Should a 1.27% "beat" in terms of paying subs really translate into an extra $35 billion added to the market cap (note that this equates to $25,000 in additional market cap per "unexpectedly added" customer)? No, this surely cannot account for the stock price explosion, as no customer has a net present value to NFLX of anything remotely close to $25,000. What about total sub adds during the quarter? According to a Seeking Alpha news summary, "Total streamings adds were 8.33M for the quarter vs. 6.34M consensus". Yet this number includes free subscriptions, which logically should be less valuable than the 1.4 million extra paying additions (versus expectations) referenced above. Again, can one really believe that two million unanticipated incremental customers in Q4 justifies $35 billion in market cap (or $17,500 per customer)?
Perhaps Q4 2017 financial results were massively more impressive than expected, however. Did NFLX record a huge EPS beat in Q4? Negative; at $0.41/share, NFLX actually just met consensus (source here). What about revenues? Again, no. While clearly impressive at up 33% yoy, NFLX's $3.29 billion in revenue only beat expectations by a mere $10 million (at three-tenths of 1%, a rounding error). Did free cash flow numbers overly impress? Once again, highly unlikely. In Q4, NFLX had negative free cash flow of $524 million, which was actually in line with the average negative free cash flow of the four immediate preceding quarters, so there was no marked improvement in this metric.
Apparently, the recent bullishness of NFLX longs boils down to rampant optimistic speculation regarding "the future". Management's guidance for Q1 2018 net additions of 6.35 million subscribers and revenues of $3.69 billion lit the fuse that resulted in a stock price explosion up to a recent high of $286.81/share. Longs have apparently decided to focus solely on subscriber counts and pay no heed to the fact that free cash flow for 2018 is now expected to sink to a negative $3 to $4 billion (far worse than 2017's negative $2 billion), based on increased content spending. Nor do they seem the least bit concerned with very real risks regarding their investment, such as increased streaming video competition from the likes of behemoths Amazon (AMZN) [see here], Apple (AAPL) [see here] and Disney (DIS) [see here] and the recent repeal of the net neutrality rules by the FTC [see here]. Right now NFLX longs see "nothing but blue skies".
For the sake of argument, however, let us assume that none of the known risks (or, rather, "known (but ignored)" risks) actually materialize over the short to medium term (say, the next five years through the end of 2022). Let us further assume there are no "known unknown" risks to fret about either during this period (even though these always lurk). In other words, let's just be blindly bullish for the moment. Can we justify NFLX's $118,455,000,000 market valuation, and if so, how? First, we start with the proposition that a company is properly valued today if it trades at a stable earnings yield of 3.85% (which is the inverse of the S&P 500's current 26X P/E ratio--see source here). This means that NFLX would be properly valued at its current market cap if it had produced $4.56 billion in earnings in 2017 ($118.455 billion divided by 26). Obviously, we know that this did not happen, as NFLX only registered $558 million in income last year. But what really matters is free cash flow, because at the end of the day only cold, hard cash can be returned to shareholders. Yet, free cash flow in 2017 was negative $2 billion, far worse than net income. So no help there either.
There is a ray of hope for longs, though. If one desires a 10% return on one's investment, the Rule of 72 tells us that such person's investment must double every 7.2 years; if one desires a 20% return, it must double every 3.6 years, etc. Given the inherent uncertainty in NFLX's business model and the massive stock gains NFLX longs have enjoyed recently, assume for the sake of argument that a NFLX long asks for a meager 15% return annually going forward on his or her investment. NFLX's current market valuation could then be justified if we could conclude that the company trades at a 13X multiple based on earnings and cashflow 4.8 years from now (72/15 = 4.8), or by the end of 2022. In other words, if we believe that at $265/share we are today buying NFLX at 13X its 2022 earnings/cashflow, we can expect a 15% CAGR between now and then, since the market cap should double by YE 2022. So if we could somehow determine that in 2022 earnings and cashflow will reach twice the $4.56 billion amount referenced above (or $9.12 billion), then NFLX's current stock price could make sense from an ROI perspective.
How likely is this? First consider GAAP net income. Analysts currently expect 2018 earnings of $2.69/share, or $1.283 billion based on 477 million diluted shares outstanding (source here). Thus, to get to $9.12 billion in 4.8 years, earnings would need to increase at a 50% clip over that period (assuming no net issuance of shares, which is highly unlikely). However, we must keep in mind that analysts are an extremely optimistic lot and 2018 earnings estimates will probably come down as the year progresses, in which case the required CAGR will be higher than 50% (perhaps substantially higher). Moreover, NFLX is now capitalizing huge amounts of content costs, most of which will be amortized over the next five years. Even if earnings somehow double in 2018, increased content amortization should put a serious drag on earnings growth thereafter (put another way, current GAAP earnings are being flattered by the fact that NFLX has been capitalizing more and more of their recent spending, but the effect of this should reverse as these costs begin to flow through the P&L statement). Maybe NFLX bulls feel comfortable penciling in well over 50% earnings growth for each of the next five years with no further questions asked, but this seems quite optimistic given the foreboding competitive landscape ahead (NFLX bulls should perhaps recall Jeff Bezos's famous dictum, "Your margin is my opportunity"), as well as the amortization dynamic we have just described.
Next let's look at cash flow. Per the Q4 earnings conference call (link here), we already know from management that free cash flow should be in the negative $3 to $4 billion range in 2018. Taking the midpoint of negative $3.5 billion, NFLX will need to either cut spending or increase revenues (or a combination thereof) by an aggregate amount equal to $12.62 billion by YE 2022 ($9.12 billion plus $3.5 billion) in order to justify a reasonable return for NFLX investors over the next five years from today's stock price. Is this achievable? Looking at costs, it seems pretty unlikely given anticipated continued inflation in content costs (demand for streaming content should exceed supply for the foreseeable future, considering all of the deep pockets moving heavily into the streaming game). As far as revenues are concerned, management has previously targeted a mid-single digit CAGR subscriber pricing increases, as per the following exchange from the Q2 2017 earnings call (source here):
Therefore, assuming we trust management's prediction, we can expect that 2017's $11.7 billion in revenues attributable to NFLX's current subscriber base to go up about 5% per year. This supplies $3.1 billion of additional revenue in 2022 ((1.05^4.8)-1 X $11.7 billion), which could go a long way towards closing the current year's $3 to $4 billion negative cashflow runrate. Then there are, of course, net new subscribers. Assuming NFLX can add an average of 15 million new paying customers per year going forward, this would generate a total of 75 million additional paying subs by YE 2022, most of which should be foreign-based. If we further assume that each of these new subs pays the equivalent of $12/month in 2022 (up 27% from the $9.43/month average for all subs and up 39% from the $8.66/month average for all foreign subs in 2017), then the incremental sub base should generate $10.8 billion in revenue for NFLX (75 million X $12 X 12). Even assuming that 50% of this new sub revenue falls straight to the bottom line, this $5.4 billion plus the additional $3.1 billion from pricing increases on existing subs still falls over $4 billion short of our $12.6 billion incremental cash bogey described above. If we bump the 15 million annual sub growth figure up to 20 million, we still fall $2.3 billion short of our $12.6 billion target. And the foregoing further ignores the fact that content costs should continue to rise if NFLX adds another 100 million paying subs.
Thus, the NFLX long, even if using our optimistic assumptions and blindly ignoring clear known and "known unknown" risks, cannot find remotely enough incremental cash flow between now and the end of 2022 to support a 15% CAGR for NFLX shares going forward, boding ill for further share price appreciation in the medium term. Moreover, all of the foregoing assumes that the S&P's historically high 26X multiple does not contract over the next five years due to higher interest rates (yet another risk factor for the long case).
Reed Hastings and his team at NFLX have done an admirable job growing the company's streaming business over the past 10 years and will likely enjoy continued momentum for the foreseeable future. However, most (if not all) of this success is now baked into the company's $118 billion fully-diluted market capitalization. Indeed, according to our calculations and despite using extremely optimistic assumptions (little competition ahead, moderate content cost increases, large continued sub growth, no contraction in general market multiples, no further shareholder dilution despite massively negative near-term cashflow, etc.) we still cannot find enough growth in earnings or cashflow over the next five years to justify underwriting even a 15% CAGR on NFLX shares through the end of 2022. Clearly the easy money has already been banked for NFLX shareholders.
Market Musings - January 29, 2018]]>, 29 Jan 2018 21:33:47 +0000
We continue our blog series: Market Musings, Volume 2, Edition 6, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present
Whitney Tilson Vindicated (Sort Of).
Everybody loves to mock Whitney Tilson. Or, at least, used to love mocking him prior to the demise of his hedge fund Kase Capital (fka T2 Partners). Witness, for example, the following snark-infested Tilson-related news items from recent years:
Regarding the last Tilson snark item, bashing him for underperforming the S&P for the 2004-2011 period, it is interesting to take a refreshed look at Tilson's YE 2011 portfolio and partner letter after the passage of 6+ years. First, take the partner letter (link here):
Tilson notes that 2011 was a "dreadful year", during which T2 underperformed the S&P by a whopping 27%. Yes, that is truly dreadful, inexcusable really. Tilson goes on in the letter to state that his grade for the year is still TBD, however, because it was too soon to tell whether he was wrong about his stock picks or right but early:
Tilson invokes the famous Ben Graham dictum that the market is here to serve, not instruct you, that it is imperative to ignore the "noise" of the market when assessing one's stock holdings, and that he continued to believe in the long-term prospects of his portfolio:
Note particularly the statement that "the real money is made betting against the herd when it's wrong".
Now with the passage of over six years we can judge whether Tilson was correct or not regarding his YE 2011 holdings. First, below we show the top 12 holdings in T2's portfolio as of December 31, 2011 (source here) [both BRK-B and NFLX are listed twice because T2 owned common shares plus call options (and these were listed separately in the 13-F filing); for the sake of our analysis we've assumed that all call options were converted to the underlying common shares as of 12/31/2011]:
Overall, the portfolio was worth $325 million (again, assuming T2 had enough funds to convert all call options to common shares; note that the actual portfolio was only valued at $296 million in the 13-F, so T2 would have needed at least $29 million of cash to convert all of the options to common stock). The top 12 positions comprised about 65% of the total portfolio.
Below we present how this portfolio would have looked had Tilson simply gone on an extended vacation for the past 6+ years and not made a single change to the portfolio from December 31, 2011 to today (again, we present the top 12 holdings, some of which are listed twice for the reasons described above):
Overall, the portfolio would have increased in value from $325 million to $999 million today. In addition, $27.6 million of dividends would have been received. This means that the YE 2011 T2 Portfolio would have generated a total return of 216% including dividends, versus 148% including dividends for the S&P 500, from December 31, 2011 to the present. And this despite the fact that Tilson's second largest holding in 2011, J.C. Penney (JCP), would actually have fallen 90% since then. The much-maligned Tilson--if he had simply stood pat following his disastrous 2011--would have outperformed the S&P by a total of 68% over the past 6+ years and would now be running $1 billion (and probably more, since he would likely have received inflows given his outperfomance)! With respect to CAGR, the T2 portfolio CAGR would have been 17.6% while the S&P CAGR would have been 13.7%.
What's amazing about Tilson's portfolio is that a single stock, which was a 4.3% position as of YE 2011, i.e., Netflix (NFLX), would have been responsible for $394 million of the $702 million total portfolio gains, or 56% of ALL GAINS for the entire portfolio during the past 6 years and 1 month, and would today be responsible for over 40% of the portfolio value today. Without that one insane growth stock, Tilson's portfolio would actually have underperformed the S&P by 53% (+95% for Tilson versus +148% for the S&P). Amazingly, Tilson had previously been short NFLX before reversing course and going long (see the short thesis here and the about-face long thesis here).
Of course, we have omitted any analysis of T2's short book, which is described in the 2011 T2 letter as follows:
Some of these would have worked out well (ITT Educational filed for bankruptcy in 2011), however others would have blown up in Tilson's face (GMCR, PVH and CRM, for example). But this would have been the result of running a short book far too early in a nascent bull market (Tilson's decision to run a short book just two years following the greatest financial crisis since 1929-1932 is questionable at best).
What to make of all of the foregoing? Well, first we can confirm that Ben Graham was correct--the market is here to serve us, not instruct us. The pessimism surrounding many of Tilson's YE 2011 holdings was unwarranted, given the subsequent massive share price appreciation of many of these issues. So it pays to stick to one's guns if one has a firm conviction about an investment thesis, regardless of what the market may think at any given time. Paradoxically, however, one must retain enough flexibility and humility to be willing to admit mistakes. The one decision that would have made all of the difference between being a hero and being a zero for Tilson since 2011 would have been the key choice to drop the NFLX short and instead go long. That single decision represented the difference between triumph and disaster in our hypothetical.
"If you can meet with Triumph and Disaster, And treat those two impostors just the same" --Rudyard Kipling, "If"
Market Musings - January 25, 2017]]>, 25 Jan 2018 17:59:10 +0000
We continue our blog series: Market Musings, Volume 2, Edition 5, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present
Drive-By Analysis: Walter Investment Management Edition.
In this edition of Market Musings, we take a quick look at Walter Investment Management Corp (WAC). WAC was originally established in 1958 by homebuilder-cum-industrialist (and later billionaire) Jim Walter. WAC operated as the captive financing business of Walter Energy, originating and purchasing residential loans and servicing these loans to maturity. In April 2009, WAC was spun off from Walter Energy; merged with Hanover Capital Mortgage Holdings; qualified as a REIT; and began to operate as an independent, publicly-traded company. After the spin-off, in 2010 WAC acquired Marix, a high-touch specialty mortgage servicer, and in 2011 WAC acquired Green Tree, a leading independent mortgage loan servicer providing high-touch servicing of GSE, government agency and third-party mortgage loans. As a result of the Green Tree acquisition, WAC no longer qualified as a REIT. Since then, WAC grew its servicing and originations businesses both organically and through a number of acquisitions, including the acquisition of a national originations platform in 2013 from ResCap and significant bulk servicing right acquisitions in 2013 and 2014.
Sadly for shareholders, in November 2017 WAC filed for Chapter 11 bankruptcy reorganization, per the following (source):
(Interestingly, Walter Energy also filed for Chapter 11 back in 2015 and has since re-emerged as a public company under the name Warrior Met Coal (HCC), regarding which see our Market Musings blogs dated November 3, 2017 and November 13, 2017, respectively).
WAC's demise appears to have been caused by a combination of low interest rates (which can exacerbate portfolio runoff as borrowers refinance their mortgages) and an unfortunate foray into reverse mortgage lending. However, none of WAC's prior issues really matter that much to prospective shareholders, who look to the future rather than the past. Despite filing for Chapter 11, WAC's shares currently trade in the mid-70s cent range:
Why not zero? Well, WAC's existing shareholders will not be wiped out by the bankruptcy filing, as is normally the case. Instead, shareholders will own a combination of stock and warrants in the reorganized entity. The stock portion should comprise approximately 8.5% equity ownership of the new entity. We arrive at this 8.5% figure by deducting from the total reorganized equity value (1) 73% allocable to the convertible preferred holders and (2) 10% allocable to management pursuant to an incentive compensation plan, and multiplying the resulting figure (i.e., 17%) by 50% (for which, see the excerpt from WAC's Form 10-Q below). Shareholders will also be entitled to half of the 10-year warrants to buy common shares which are expected to be issued in connection with the reorganization (details of which are described in the Plan of Reorganization located here). Additional details regarding the foregoing are included in WAC's most recent 10-Q filing, as follows:
A week ago, the reorganization plan was approved by the bankruptcy court (source):
What could the 8.5% equity interest for existing WAC shareholders be worth? According to the most recent Monthly Operating Report (or MOR) filed with the bankruptcy court (source), WAC (at the holdco level) had shareholder equity as of December 31, 2017 of negative $440 million:
As noted in the reorganization press release included above, though, $800 million of WAC's debt will be wiped out. Thus, on a pro forma basis, we should expect shareholder equity to be around $350 million or so ($800 million minus $440 million), with minimal intangible or goodwill assets included. As the existing common shares will receive 8.5% of the reorganized equity, book value for these holders on a pro forma basis will be approximately $30 million ($350 X 8.5%). With 37.4 million common shares outstanding as of November 2017 (per the Q3 2017 10-Q), this means that pro forma book value per share attributable to existing holders will be about $0.80/share, higher than where the shares currently trade.
Moreover, long-term interest rates are finally rising, boding well for the value of WAC's mortgage servicing assets. Below we see that the 10-year Treasury yield has appreciated approximately 60 bps over the past five months, from slightly over 2% in early September 2017 to 2.64% currently (source):
Finally, we need to ascertain the value of the warrants. Admittedly, we have not yet done the necessary diligence to reach a conclusion regarding this number, so this item is still TBD.
Market Musings - January 17, 2018]]>, 18 Jan 2018 04:19:57 +0000
We continue our blog series: Market Musings, Volume 2, Edition 4, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present
Zais Group Holdings Buyout--An Offer Shareholders (Literally) Cannot Refuse.
Zais Group Holdings (ticker ZAIS) is an investment advisory and asset management firm focused on specialized credit strategies with approximately $4.144 billion of assets under management as of the end of Q3 2017. In September 2017 the company received a $4/share buyout offer from its founder, chief investment officer and board chairman, Christian Zugel. The price represented over a 100% premium to the prevailing trading level for the stock. As can be seen from the above chart, to that point in its life ZAIS had been an unmitigated disaster for shareholders. The company went public through a merger in 2015 with a special acquisition company (or SPAC) called HF2 Financial Management Inc. (from 2013 to 2015 the stock traded at the $10.50/share SPAC cash redemption value). Since the merger with HF2, ZAIS shares fell over 80% to below $2 by the time the Chairman made his buyout offer.
Why did ZAIS's share price collapse? Mainly due to plain old conflicts of interest and egregious disregard for shareholder rights. First, while Chairman Zugel held 1,131,000 of the Class A shares (or 7.7% of the outstanding Class A shares) at the time of the buyout offer (see details regarding original offer here), following the HF2 / ZAIS combination he also retained (and still retains) control over 20,000,000 (noneconomic) Class B shares. Since each Class B share has 10X the voting power of a Class A share, this means that Zugel has about 93% of the overall voting power despite holding just 7.7% of the economic rights. When such a disparity exists, a dominant (in terms of voting power) shareholder has the ability to siphon off all of the economic benefits of the enterprise with impunity. In ZAIS's case, there are conflicts of interest and various related party transactions which take almost 10 pages in the proxy statement to describe (link here).
Unsurprisingly, the company has never paid shareholders a dime in dividends. In contrast, insiders (including the aforementioned Zugel) been paid quite handsomely while ZAIS's share price has plummeted (note that these amounts are just for 2014 & 2015; in yet another "thumbing of the nose" to shareholders, the company did not even bother to put out a proxy statement during 2017, presumably because Chairman Zugel knew it would be superfluous given his buyout intentions):
Meanwhile, a different shareholder, Neil A. Ramsey, owns 9.6 million Class A shares, representing 69% of the economic rights for ZAIS. Normally, one would think that Mr. Ramsey would be outraged at the fact that Zugel could apparently drive ZAIS's stock price into the ground through his super-voting control and unfortunate stewardship of the company. That is, one would think that except for the fact that Ramsey seems to have paid a grand total of just $25,000 for 5.4 million of his 9.6 million shares, or about one-quarter of one cent per share for these shares(!!!) (source):
Since March 9, 2015, the date of filing of Amendment No. 1, the Reporting Persons engaged in the following transactions in shares of Class A Common Stock:
· On March 17, 2015, upon the closing of the Issuer’s initial business combination with ZAIS, SpecOps purchased an aggregate of 3,492,745 Founders’ Shares at a price of $0.0005875 per share (or an aggregate of $20,519.88) in a private transaction pursuant to the Allocation Agreement described in the Existing Schedule 13D. SpecOps used its working capital to fund the purchase of such shares.
· On March 17, 2015, upon the closing of the Issuer’s initial business combination with ZAIS, NAR acquired beneficial ownership of 1,135,973 shares of Class A Common Stock, including 796,973 Founders’ Shares. Voting and dispositive control over these shares had been transferred to Randall S. Yanker until the closing of the business combination. NAR did not use any funds for the acquisition of such shares.
· On March 17, 2015, upon the closing of the Issuer’s initial business combination with ZAIS, NAR sold an aggregate of 757,742 Founders’ Shares at a price of $0.0005875 per share (or an aggregate of $4,451.73) in a private transaction pursuant to the Allocation Agreement described in the Existing Schedule 13D.
How is this possible? Well, Ramsey seems to have been a principal organizer of the SPAC and received "founder shares" for his role (basically free shares). It makes one a lot more accepting of conflicts of interest by insiders when one pays virtually nothing for one's stock. Welcome to the oftentimes scummy world of SPACs, where the sponsors and insiders can confiscate all of the economic benefits of a business enterprise for themselves while leaving the helpless third-party shareholders holding the bag (of course, these shareholders have the opportunity to "opt out" at the time of the original merger and receive back their $10.50 (or, more often, $10.00) subscription price (but with no interest paid), but once this period has passed, they are at the often at the mercy of insiders).
In connection with the proposed merger, Zugel will purchase 6.5 million of Ramsey's Class A shares for $4.10/share, the same price being offered to the unaffiliated third-party shareholders. (Yes, that's correct, between the September 2017 original offer and the signing in January 2018 of a definitive agreement, the supposedly "independent" board members managed to convince Zugel to raise the offer price a whole 10 cents, or 2.5%, from $4 to $4.10--well done, special committee, give yourselves a round of applause!)
Below are the specific terms of the definitive buyout agreement, from the company's press release (source):
Red Bank, NJ – January 12, 2018 – ZAIS Group Holdings, Inc. (NASDAQ: ZAIS) (“ZAIS” or the “Company”) today announced that it has signed a definitive merger agreement with Z Acquisition LLC, a Delaware limited liability company (“Z Acquisition”), and ZGH Merger Sub, Inc., a wholly-owned subsidiary of ZAIS. Christian Zugel, the founder of ZAIS Group, LLC, the Company’s operating subsidiary, and the Company’s Chairman and Chief Investment Officer, is the sole managing member of Z Acquisition. Pursuant to the merger agreement, all of the outstanding common stock of ZAIS that is not (i) beneficially owned by (A) Z Acquisition, the members of Z Acquisition (including Mr. Zugel and Daniel Curry, the Company’s President and Chief Executive Officer), certain trusts for members of Mr. Zugel’s family, and Mr. Zugel’s current spouse (collectively, “Purchaser Group”), or (B) any person who, after the date hereof, acquires common stock of ZAIS through certain issuances pursuant to an exercise of exchange rights, or (ii) owned by certain stockholders who agree with Z Acquisition to retain certain of their common stock in connection with the merger, will be converted into the right to receive $4.10 per share in cash, less any required withholding taxes (the “Merger”).
The $4.10 per share price represents a premium of more than 138% to the closing price of the Company’s shares of Class A common stock (“Class A Common Stock”) on September 5, 2017, the last trading day before the initial proposal from Mr. Zugel and Z Acquisition was publicly disclosed. The majority of the funding for payments required to be made to stockholders of the Company in the Merger will be provided by existing cash of the Company, but a portion of the funding for such payments will be provided by Z Acquisition by means of an acquisition of Class A Units of the Company’s majority-owned subsidiary, ZAIS Group Parent, LLC (“ZGP”).
As previously disclosed on September 5, 2017, Z Acquisition and Mr. Zugel entered into a Share Purchase Agreement (as amended, the “Share Purchase Agreement”) with Ramguard LLC (“Ramguard”) to purchase from Ramguard 6,500,000 shares of Class A Common Stock at $4.00 per share. That agreement has been amended and restated to provide that the purchase price for the Ramguard shares will be the same $4.10 per share price to be paid in the Merger. Once this share purchase is completed, Z Acquisition will own, before consummation of the Merger, approximately 44.66% of the Company’s currently outstanding Class A Common Stock and Purchaser Group overall will own approximately 48.01% of the currently outstanding Class A Common Stock.
The Company’s Board of Directors, acting on the unanimous recommendation of the special committee formed by the Board of Directors (the “Special Committee”), approved the merger agreement and the transactions contemplated by the merger agreement and resolved to recommend that the Company’s stockholders adopt the merger agreement and the transactions contemplated by the merger agreement. The Special Committee, which is comprised solely of independent and disinterested directors of the Company who are unaffiliated with Purchaser Group and management of the Company, negotiated the terms of the merger agreement with Purchaser Group, with the assistance of its legal and financial advisors.
Paul Guenther, Chairman of the Special Committee, said, “We are confident that we have negotiated a fair price and that this merger is in the best interest of our minority stockholders. The price of $4.10 is an approximately 138% premium over the last trading day before the offer.”
Mr. Zugel said, “On behalf of Z Acquisition, we are pleased to have reached this agreement, which we believe is in the best interests of unaffiliated stockholders of the Company.”
Unbelievably, Zugel is offering to pay shareholders with their own money ("The majority of the funding for payments required to be made to stockholders of the Company in the Merger will be provided by existing cash of the Company"). The chutzpah of it all! Not only that, the "Special Committee" (indeed, they are very "special") has the arrogance to claim that the merger is in the best interests of shareholders because the buyout price represents a large premium over the rock bottom price the company's shares had fallen to due to the apparent incompetence and abysmal leadership of the very person making the offer, Mr. Zugel (while ZAIS has a separate CEO, it is clear that Zugel as board chairman ultimately calls the shots at the company).
Moreover, while the merger is subject to a "majority of the minority" vote, shareholders are completely in a Catch-22, because if they vote against the deal the stock price will likely go right back to sub-$2 again (possibly on its way even lower). So ZAIS shareholders have been screwed at every turn. Not only did they see 80% of their wealth vaporized in just two and a half years following ZAIS going public, they are now faced the unenviable choice of either (A) voting for the merger, thereby giving up their ownership of ZAIS at a bargain basement valuation (book value at 9/30/17 was $6.36/share) in return for receiving back their own money (currently being held hostage by the company on its balance sheet) or (B) voting against the merger and suffering a likely 50% or more immediate drop in the share price and a return to the disastrous status quo ante. Thus, it seems that Chairman Zugel has made the Class A shareholders of ZAIS an offer they (literally) cannot refuse.
Market Musings - January 12, 2018]]>, 12 Jan 2018 18:11:28 +0000
We continue our blog series: Market Musings, Volume 2, Edition 3, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present Et tu, Mangrove (Crypto Edition)?
In a sign of the times, we noticed an interesting nugget in a recent SEC filing by hedge fund Mangrove Partners (company website here). By way of background, Mangrove is an extremely successful fund run by a late 30-something named Nathaniel August. Below is an excerpt from a 2015 Barron's article regarding Mr. August and Mangrove (link to full article here - note: may be behind paywall):
There's no doubt that Mangrove Partners' returns have been quite stellar. As the Barron's article notes: "Since the fund’s launch in April 2010, it has returned more than 28% a year with relatively subdued volatility. Mangrove, which typically has 100 to 150 positions, has never had more than three consecutive down months". Below is a summary of Mangrove's top-15 disclosed U.S. long portfolio holdings as of September 30, 2017 (the most recent data available; source here)
So why do we mention all of the foregoing? Take a look at the #7 holding above, Atlantic Power Corporation (ticker AT), which was a 4.5% position for Mangrove as of 9/30/17. Note that AT has been a relative dud investment since Mangrove initially acquired it in early 2016, as the average price Mangrove paid for its 11.5 million shares was ~$2.25/share, exactly where the stock traded several days ago (i.e., just prior to the most recent Schedule 13D/A filing (for which, see further below; link to filing here); nor does the company pay a dividend):
With respect said Schedule 13D/A by Mangrove on AT, filed this morning, notice the highlighted text from Section 4 therein, excerpted below:
"Item 4. Purpose of Transaction. Item 4 is hereby amended to add the following: The Reporting Persons have had discussions with the President and Chief Executive Officer of the Issuer regarding alternative uses for the Issuer’s power plants that have expired or expiring power purchase agreements. On January 10, 2018, the Reporting Persons had a telephonic meeting with the President and Chief Executive Officer of the Issuer to discuss plans to develop and supply power to collocated data centers as well as to explore utilizing surplus power for cryptocurrency mining and other blockchain applications. The Reporting Persons also expressed interest in providing co-investment capital for such projects. These discussions are continuing."
To which which reply, Et tu, Mangrove? When mainstream hedge funds like Mangrove are urging management at their laggard investees to "explore...crytpocurrency mining and other blockchain applications" in order to get the stock up, you know for sure we are in the midst of a full-blown crypto mania. Hey, if it works, why not? Pay no attention to the man behind the curtain or the doubting Buffetts on the sidelines.
( guessed it, the stock is up 11% today. Well played, sir.)
Market Musings - January 5, 2018]]>, 05 Jan 2018 22:05:11 +0000
We continue our blog series: Market Musings, Volume 2, Edition 2, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present Book Review: No More Champagne - Churchill and His Money.
OK, so technically this post doesn't directly concern "recent goings-on in the markets", yet it covers finances generally and we have just read most of the book (only have about a quarter remaining), so...let's review it, shall we? (Link here for the book on Amazon.)
Winston Churchill is an endlessly fascinating character. We recently saw the movie Darkest Hour, which is sort of "Churchill's Greatest Hits" summarized on film, and quite well acted with Gary Oldman in the lead role. This led to the discovery of "No More Champagne", which was published a few years ago by Englishman David Lough, who was a private banker professionally before becoming an author (see his background here). The book meticulously documents Churchill's personal finances over the course of his life, based mainly on Churchill's own private papers. What is amazing about Sir Winston was that he never--literally never--lived within his means financially during the first 65 years of his life, despite consistently ranking among the top 1% of wage earners in Britain during that period. If he earned 10,000 pounds in a year (around $1 million in modern money), he was sure to spend 13,000 pounds; and if he earned 15,000 pounds, he would consequently spend 20,000 pounds, almost as if it were some kind of perverse financial strategy to get into as much debt as possible. What is amazing is that Churchill could pull off this relentless spending-beyond-his-means act for decades on end without ever going bankrupt (it helps in this respect to be the Prime Minister and not Joe Sixpack).
Churchill was an insanely prolific individual and something of an adrenaline junkie. Not only did he occupy ministerial level offices for the vast majority of his adult life (from the age of 36 to 81, he consistently held positions in the highest levels of the UK government), which for a normal person would leave time for little else, but he actually engaged in massive amounts of journalism and historical writing, as well as found ample time for leisure activities such as painting, bricklaying(!) and gambling. He even won the Nobel Prize for literature for his writing in 1953. And, unlike JFK with "Profiles In Courage" (ghostwritten by Theodore Sorensen), Churchill actually wrote the vast majority of his articles and books personally (admittedly he received ample help from secretaries and researchers, and in a pinch would have an article or particular section of a book ghosted).
[Above: Churchill working at an upright desk that had once belonged to Benjamin Disraeli]
Why and how was he such a prolific writer? For the simple reason that he had no choice--writing was his main source of income (being a cabinet minister paid well but, being dependent on the electorate, was not a secure source of income). Churchill was constantly wheeling and dealing with various newspapers and book publishers, and later movie producers, to try to make money. Five articles for 100 pounds apiece here; a 12,000 pound book deal for a life of his ancestor the Duke Marlborough there; 3,000 pounds for a collection of wartime speeches; 50 pounds for the U.S. syndication of each article he wrote; 50,000 pounds for the film rights to Marlborough; etc etc etc, the deals never stopped.
Churchill had to write like mad because he lived like mad: he had many expensive hobbies (gambling and stock speculation), tastes (champagne and cigars) and financial sinkholes (Chartwell, his wife Clementine's shopping habits) in his life. An aristocrat by blood and at heart (although with a relatively modest inheritance, since his father was the 2nd son of a Duke--the 1st son, Churchill's uncle, inherited the mother load including Blenheim Palace), Churchill loved to live large--the lists of his expenditures detailed in "No More Champagne" is mind-boggling. He would spend the equivalent of around $50,000 in a year just on champagne and spirits, and perhaps $20,000 per year on cigars (Churchill was in a sense the P. Diddy of his era, albeit a much tamer version in his romantic life). He would visit the French Riviera for a month-long winter holiday and consistently throw money away gambling (despite his wife's constant pleading to avoid casinos). Then he would try to make back his losses with quick forays in the stock market based on tips received from the likes of Bernard Baruch, invariably losing large amounts of money (Churchill lost a fortune being long the stock of Simmons and Montgomery Ward in the 1929-32 bear market). [Interesting side note, Baruch actually made $2 million in 1929, despite being long stocks during the stock market crash that year.] He constantly was taken out one loan to pay off an existing loan, borrowing from his future inheritance, mortgaging other assets, and trying to find loopholes by which he could avoid paying tax on his income (during WWII the top income tax bracket in England was 97.5%). During the 1940s he actually received loans and payments from various businessmen, as well as preferential treatment from the U.K. Inland Revenue Service, that by today's would be considered outright corruption (perhaps he deserved this, though, as he DID save the world from Nazi domination).
Below is a list of just the non-fiction books Churchill authored, quite a few of which were multi-volume works (source):
The Story of the Malakand Field Force 1898 [free ebook here]
The River War 1899 [free ebook here]
London to Ladysmith via Pretoria 1900 [free ebook here]
Ian Hamilton's March 1900 [free ebook here]
Lord Randolph Churchill 1906 [free ebook here]
My African Journey 1908 [free ebook here]
The World Crisis 1923-31
My Early Life 1930
Thoughts and Adventures 1932
Marlborough: His Life and Times 1933-38
Great Contemporaries 1937
The Second World War 1948-53
Painting as a Pastime 1948
A History of the English-Speaking Peoples 1956-58
He also penned a novel, Savrola (published in 1900 - free ebook here), published 28 books of his speeches, and was credited with various miscellaneous works that were published under his name.
[Above: Churchill painting "Near Breccles", 1920s]
Reading "No More Champagne" is somewhat exhausting (albeit fascinating). One can only imagine how exhausting it must have been for Churchill to actually live such a frantic hand-to-mouth 90-year-long life crammed with activity (and the book, by design, doesn't even cover the main bulk of his professional life, his political career, which Randolph Churchill and Martin Gilbert have covered in no less than eight bulging volumes!). The cool thing about Churchill's personal peccadilloes is that, because of them, we can now enjoy the significant amounts of great literature which he authored in the exact same manner as his contemporaries, by reading it ourselves (unlike musical recordings, film and TV, a book is from 1898 still reads exactly the way it did the year it was published). And in certain instances we can do this for free, since the copyrights for many of his works have now expired and these are available on the Internet (see, e.g., the "free ebook" links above).
So thank you Winston for being so prolifgate and—consequently—so prolific!
Market Musings - January 1, 2018]]>, 01 Jan 2018 17:25:45 +0000
We continue our blog series: Market Musings, Volume 2, Edition 1, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present 2017 in Review and 2018 Resolutions.
At the end of one year and the beginning of another, people usually pause to "take stock" (pun intended) of the year that has passed and make firm resolutions regarding the one ahead. Hope springs eternal (the future WILL BE BETTER, goshdurnit)...until early January resolutions fall by the wayside around mid-February (at the latest). But it is nevertheless a useful exercise to engage in, and, who knows, maybe we will be the exception that proves the rule in actually following all of our 2018 resolutions.
1. Year in Review: 2017: First, a look back at the year that was. For us here at SCC, 2017 was a year of promise and frustration. We performed relatively in line with the S&P 500, with funds invested (i.e., everything excluding cash, which averaged around 35% of total assets) up approximately 23% (pending a full accounting). In comparison, the S&P advanced 19.4% plus ~2% in dividends, or ~21.5% overall. While beating the S&P is always a positive, there were many obvious (in hindsight) missed opportunities we should have capitalized on. For example, there was Celadon Group (ticker CGI), a trucking and logistics company, the shares of which were were eyeing in early May after they plummeted to the $1.55/share level following disclosure of accounting irregularities:
Sadly, we let this opportunity pass without pulling the trigger (paralysis by over-analysis, perhaps), which in retrospect was an extremely large error of omission, as the stock is up over 300% since then. We should have bought a small (~3%) position, given the perceived riskiness of the company from a financial perspective--but in any event, this riskiness was obviously more than priced in when the stock was in the mid-$1 range (note that, at the time, book value per share was over $12). Had we done so, our 2017 overall performance would have improved by around 9% (to ~32% versus ~23% actual).
In addition, RMR Group (ticker RMR) was another no-brainer whiff on our part. This botch of ours actually dates back to early 2016, when the company was spun off from the various infamous Portnoy-controlled REITs (for more info, see Seeking Alpha article here). We should have capitalized on this opportunity shortly after the spinoff in 2016, when RMR traded in the low teens. But even if we had waited until the end of 2016, we still would have seen our investment appreciate 50% plus dividends over the past year:
RMR seems like the prototypical sure thing, since its income stream is almost completely protected (it consists of management fees from REITs that are basically controlled by the principal RMR shareholders). In effect, the captive REIT shareholders subsidize the RMR shareholders via egregious (one-sided) management fee contracts. Below is a summary of the bull case from the above-linked SA article:
RMR Inc. is a holding company of RMR Group LLC (RMR LLC), the company's operating subsidiary. RMR LLC was founded in 1986, so it's got quite a history. Its primary business activity consists of providing business and property management services to real estate companies (e.g. REITs).
RMR LLC currently has four REITs (Managed REITs) and real estate operating companies (Managed Operators) as clients. The majority of the revenue is derived from service provided to REITs (80.5%). This is important because the revenue from REITs is supported by a "perpetual" 20-year agreement, in that the agreement is automatically extended every year so that the agreement will end on the twentieth anniversary of every year. In the event of termination without cause, RMR LLC will be entitled to the present value of the payments.
Also worth noting is that the management fee scales with the growth of the REITs. The management fee is calculated based on either total market cap (equity and debt) or the historical cost of real estate properties, whichever is less. The rate is 0.7% for the first $250 million and 0.5% for any amount beyond that.
In addition to the management fee, RMR LLC is also entitled to incentive payments, which is based on the total return (i.e. including dividends) over a selected SNL index. What's great about the incentive payment is that there is no high-water mark.
To protect themselves, the REITs can also terminate the agreement for performance. However, the definition of poor performance is rather lax. The REIT in question must underperform the SNL index by 5% for three consecutive years and have a total shareholder return that is in the bottom tercile (bottom third) of the SNL index. Furthermore, even if the agreement is cancelled for performance, the REIT would still have to pay the present value of the management fee for 10 years.
So how/why did we miss this no-brainer opportunity? First, it simply escaped our initial due diligence filter. In other words, we were totally unaware the spinoff had occurred until it was "too late" (by the time we caught on in mid-2016 and examined the company, shares had already appreciated into the low $30s). Proving that we were still fully capable at that time of turning a mid-sized mountain into a molehill, we far-too-quickly decided that most of the juice had already been squeezed out of RMR shares and moved on. Whoops! After missing the initial double and more through inexcusable cluelessness, we have since missed nearly another double on top of that through inexcusable lazy analysis. *Sigh*
Regarding effort expended in 2017, yours truly put in a total of 4,332 hours for the year, or an average of 11.86 hours worked per day (in keeping with our lawyerly billable hour background, we keep track of this metric on a daily basis). This number was actually down 410 hours from the 4,742 hours worked in 2016 (an average of 13/day). We made a conscious decision to try to dial back on the hours in order to achieve a bit better work/life balance. Perhaps those 410 fewer hours cost us missing out on a Celadon or RMR, although the 13th hour worked in any day is likely a lower value hour due to the law of diminishing returns. Quality in hours worked is clearly as important as quantity, although it is much harder to measure. In addition, we published around 75 blog entries in 2017, or about 6 per month, and 9 Seeking Alpha articles.
2. Year Ahead: 2018: Looking forward to 2018, we have adopted the following professional New Year's Resolutions:
A. Hours Worked: Given that there are 16 non-sleeping hours in a day, it is not unreasonable to budget 12.5 of these hours for work and 3.5 for personal business (ratio of 78% business to 22% personal). This equates to 4,562 work hours total for the year, or up 230 from 2017's level. 230 more hours should be enough to account for additional expected administrative work anticipated in 2018 versus 2017 (per B below).
B. Investment Fund: 2018 will be (knock on wood) the year SCC becomes a full-fledged investment operation, complete with third-party funds under management via an official fund (rather than consisting of informal third-party advice and personal funds managed). In short order, we need to get all of the administrative apparatus assembled and completed (legal entities, management and operating agreement(s), investment advisor registration, etc.) and complete our marketing materials...and then market the heck out of SCC! Any marathon begins with the first stride--and this needs to occur ASAP.
C. Blogs and SA Writeups: Our 2018 blogging goal is to continue with our Market Musings series, publishing about 8 installments per month (~2 per week). Using our Market Musings as initial "rough drafts", we plan to prepare and publish one Seeking Alpha article per week in order to establish a more fulsome track record of investment calls and gain additional followers (and hopefully prospective investors). Thus, if all goes according to plan, 2018 should see us publish about 100 blogs and 50 SA articles.
D. Aggregate and Relative Investment Returns: If only aggregate returns could be dialed up upon request for any period during which the Earth fully circles the sun! Alas, it is not that simple, as any year's returns largely depend on the direction of the overall market. However, our main (and heretofore elusive) goal remains beating the S&P by 10% per year, including all dividends and interest payments received (incidentally, we fell about 8% short of this goal in 2017). So if the market were (theoretically)to drop 15% in 2018, we would consider being down 5% a "win", even though it would mean losing money. Conversely, if we were (theoretically) up 25% and the market were up 20% in 2018, that would be a "loss". Clearly, beating the S&P by 10% is an ambitious goal, but if one is going to participate in the investment game, why not aim high?