|1Q 2018||2Q 2018||3Q 2018||4Q 2018||YTD|
|RC vs. S&P||7.92%||-2.53%||-4.54%||6.21%||7.06%|
|RC vs. Russell||8.75%||-7.03%||-0.60%||11.83%||12.95%|
The Inaugural year is in the books for Rockvue Capital, my paper investment fund. For the 4th quarter, the Fund returned -7.56% compared to the S&P 500 return of -13.77% and Russell 2000 of -19.39%. The Fund’s 2018 return came in at 2.20% compared to the S&P 500 return of -4.86% and Russell 2000 return of -10.75%. Although the Fund beat the S&P by a little over 700 basis points, one year is too small a time frame to judge the validity and robustness of a value investing strategy. Over a five-year time span I expect to beat the S&P by a satisfactory margin, and thus expect to be judged on that record. Nevertheless, we’ll take outperformance whenever we can. The portfolio is comprised of misunderstood, illiquid and cast-a-way securities. We will deviate from the broader market, sometimes to our favor, sometimes to our disgruntlement; as is value investing. A long-term time horizon is the Fund’s greatest competitive advantage.
Not All Buybacks Are Created Equal
Stock buybacks are back on the front pages of newspapers and investment websites. There are two main camps: The Good and The Bad. Those that claim stock buybacks are good cite investors such as Warren Buffett, a huge advocate for share buybacks, claiming them to be shareholder friendly and help a public company realize its higher intrinsic value relative to its current market position. The Good also suggests that buybacks are a more tax efficient way of increasing shareholder value (as opposed to dividends). The Bad camp yells that stock buybacks are simply another tool for C-suite executives to fatten their pockets through manipulating earnings to lock in any stock option rewards. Along with fattening C-Suite wallets, The Bad camp refuses to believe that buying back stock is the best form of capital allocation, preferring a company to issue dividends.
The reality is that (much like a lot of things in investing) there is a gray area to buybacks. Both camps have valid points, and both camps can learn a lot from each other. So where do I fit into this? I’m a huge fan of stock buybacks as long as they’re made strategically — i.e., when the company thinks their stock is massively undervalued.
When companies buy back stock for the sake of buying back stock (regardless of whether its under/over valued), it shows inefficiency in allocating capital. Unfortunately, that’s what the broader market has seen from majority of companies since 2007. An interesting paper written by James Montier of GMO suggests that close to 40% of EPS (Earnings-Per-Share) growth since 2007 has been due to share buybacks. Although real earnings growth in the corporate sector has been below GDP growth, the market stays propped up through these buybacks (Montier, The Late Cycle Lament: The Dual Economy, Minsky Moments, and Other Concerns). In general, I stray away from buybacks that are made at high valuations with no increased future growth projections. No tremendous undervaluation + no positive change in future growth prospects = sketchy time to buy back stock.
So when is a good time for management to buy back stock? When the company’s stock is significant undervalued. For instance, if a company normally trades around 11x EV/EBITDA and for whatever reason (not related to the core performance of the business) falls to 6x EV/EBITDA, I would be happy to see management buy back stock. You’ll see this in earnings transcripts as well, where management tells shareholders it will be doing a buyback program given how cheap the company appears to them. A second example would be in a company that truly believed in their growth story, and although quantitatively the stock may not seem like a tremendous bargain, insiders are buying in droves. Undervaluation, strong growth story and heavy insider purchasing is a great place to look for good buybacks. We’ll see an example of this later in the letter with a nano-cap company purchasing back a significant portion of its own stock at current levels that seem desirably cheap.
Top 3 Positions
The Fund was buoyed by high cash balances for the majority of 2018 which proved helpful during the downturn in October. December’s sell-off brought with it high volatility and ample investment opportunities. We started reducing our cash position from mid 60% to lower 40%. Most of the capital was spent purchasing shares of businesses we already owned at lower (more attractive) prices. The Fund did add a few new names, a couple of which will be touched upon in this letter. Expect longer form research pieces on the new names over the course of the month to hit the website — and subsequently — your inbox. The downturn in December caused my “Watch-list” to lengthen considerably. I’m now faced with the (albeit fortunate) problem of prioritizing which investments I want to focus on most. We currently have 15 positions in the Fund, right around the upper end of where I would like to be.
Discovery Communications (DISCA) – Discovery remains the largest position in the Fund at around 11% of assets. We started buying shares in August of this year and quickly saw prices rise from $27 to $33. A missed quarterly earnings season sent the stock falling to where it currently stands around $24, below our original purchase price. Taking a closer look at the business, we decided the long – term thesis was still very much in tact. Listening to the most recent quarterly earnings call reinforced my confidence that DISCA was doing everything right to create long-term value for its shareholder.
Discovery’s acquisition of Scripps Network solidified the company as the leader in women’s entertainment with shows such as HGTV, Food Network, TLC and OWN. This creates an incredible advertising opportunity for companies looking to target women, as they can now go to Discovery’s network of channels instead of blasting ads to national events such as NFL games. Along with the improved competitive position, the acquisition is expected to realize $600M in cost synergies (which management claims are ahead of schedule). These synergies have bolstered operating margins to a leading 40%, which in turn helped the company realize $900M in free cash flow. This cash flow paid off nearly $1 Billion in debt, reducing the company’s net debt from 6x to 5x, also ahead of management’s expectations. Finally, 50% of the company’s revenues come from longer-term pay-TV distributors, we like our contracted revenues.
DISCA is trading at roughly 8.5x 2019 EBITDA. Since the cable industry has seen a string of acquisitions in recent years, we can get an idea on how much Discovery could go for should as an acquisition target. For comparison, Time Warner Cable was bought at 13x EBITDA and Disney acquired all of Fox’s assets for 15.5x EBITDA. So here’s a company (DISCA) that’s trading at a discount to other acquisition multiples that generates $3B in FCF, reducing its leverage at a faster than anticipated rate and sports industry leading operating margins.
The company seems to be pulling all the right levers yet share prices aren’t reflecting this underlying improvement of the business. They continue to own and produce all of their own content, enabling them to take it anywhere they want. The subscription deal with Hulu and Sling TV should provide additional tailwinds that weren’t expected when doing the initial valuation of the company. We bought shares as prices fell and are looking to continue purchasing as long as our thesis remains in tact.
inTest Corp, Inc. (INTT) – inTest was another company which reported solid Q3 earnings. Bookings grew 13% YoY, revenues came in above management’s upper bound guidance and 16% YoY. The company’s acquisition of Ambrell is paying dividends, especially in their thermal equipment segment — achieving record quarterly revenues of $6.8M — with overall company revenues reaching levels management hadn’t seen in 15 years. Management reinforced optimism that long-term economic drivers are still in place to help achieve business growth. Looking ahead, the company expects to further capture customers in the IoT, semiconductors, automotive and defense / aerospace industries.
The company guided lower Q4 revenues citing softer industry conditions, which sent shares tumbling roughly 30% during the quarter. The entire semiconductor industry had a bumpy end to the year. Q4 of 2018 and Q1 of 2019 are expected to be the softest quarters before the industry picks up again. The company is still cheap; trading at 4x 2019 EV/EBITDA and 10x FCF (industry average being 20x). With no debt on the balance sheet, 50% gross margins and free cash flow coming in, I’ve added to this position and it sits around 10% of the Fund’s capital.
Garrett Motion, Inc. (GTX) – I wrote a lengthy piece on Garrett back in early November (which can be found here) and started building my position to where it is today, close to 6% of the Fund. Share prices dropped around 30% since being spun-off from its parent Honeywell. I initiated my position at the $13 price point, and steadily added as prices fell towards $11-$12. I wouldn’t be surprised to see this position reach close to 10% of the Fund.
GTX designs, manufactures and sells turbocharger and electric-boosting engines and engine technologies for Original Equipment Manufacturer (OEM’s) as well as aftermarket. The company is a global leader in technologically advanced turbos and boosters, delivering products across gasoline, diesel, natural gas and electric power-trains, hitting every market from small cars to commercial equipment. This investment was a case of trying to buy shares from sellers that weren’t focused on the core operating business. Forced selling can happen for a variety of reasons: institutional mandates, lack of desire to research the spun-off company or simply not wanting an extra stock in a portfolio. Those that bought Honeywell bought it for the parent and they might not have a desire to own an offshoot of its existing shares. Multiply this thought process by thousands (if not millions) of times and you get a stock falling 30% with no change in the underlying business.
So here we have an industry leading business trading at 4x 2019 EV/EBITDA with annual revenues of over $3B and 2017 FCF of close to $450M. Garrett has deep relationships with major customers such as Caterpillar, Volkswagen, Mercedes-Benz, BMW and Ford. The average length of those relationships is 41.2 years, that presents sustainable competitive advantages given the economics of a turbocharger business. Once customers choose Garrett to develop their turbocharger engines for their cars, that relationship is pretty much locked in for the next 1-2 years.
The optimistic scenario for this business is a share price close to $30. How does one get to $30? The company is estimating $640M in EBITDA for 2018, $601M in 2019 and $605M in 2020. If we assume 5% growth for the remaining two years we’re left with a 5 year average growth rate of 4% and a 2022 EBITDA of $667M. Subtracting taxes, adding back D&A and changes in NWC as well as subtracting CapEx leaves us with $296M in 2022 unlevered FCF. Holding long-term growth rates constant we get a terminal value in 2022 of $4,276M and an enterprise value of $3,390M, or 5.08x EV/EBITDA. In this scenario we’re going to assume GTX is able to pay down its debt a bit faster, reducing its net-debt level to $1,261M. From here we get an intrinsic value per share of around $30, representing a potential upside close to 100%. Applying our EV/EBITDA competitor multiple of 6.2x gets us an Enterprise Value of $3,603M and equity per share value of around $30.
I want to take some time to talk about two new investments into the Fund. These aren’t the only new additions to the Fund, the other businesses will be written about on the blog over the next month (as I am building my full position). The two businesses are Construction Partners, Inc. (ROAD) and Qualstar, Inc. (QBAK).
Boring Can Be Beautiful – Construction Partners (ROAD)
I’ve probably said this sentence too many times, but it’s worth repeating in this letter: Boring businesses can be fertile places to find great investments. What makes boring businesses so exciting? They never go away no matter the economic condition. This doesn’t mean that share prices of these businesses won’t falter if an entire economy declines; but it does mean that the company’s services will still be in high demand despite a downturn.
Scott Miller, manager of Greenhaven Road Capital, alluded to a conversation he had with a home repair professional regarding the stock market in one of his quarterly letters. Miller — and I’m paraphrasing — asked the man something along the lines of, “If the market drops 600 points, how does that affect your business?”. The story goes that the home repair person laughed in confusion as he didn’t understand how the stock market affects the day-to-day valuation of his underlying repair business. This is important. Although the market may gyrate wildly day in and day out, it doesn’t mean the value of the underlying business fluctuates that rapidly. In fact, it’s almost impossible for a businesses value to change as fast as the market makes it look. With that, let’s dive into Construction Partners (ROAD).
Double Digit Growth & Differentiated Drivers
ROAD operates in the large, growing highway and road construction industry. The company specializes in asphalt paving/servicing and is the market leader in the five Southeastern states it serves (NC, SC, GA, AL and FL). The company sports double digit revenue growth and double digit EBITDA margins. ROAD generated $680M in Revenues for 2018 and is projecting 2019 Revenues to be between $760 – $810M with $1B in Revenues by 2022. The company offers three major differentiators to its business that pose as competitive advantages: vertically integrated operations, leading choice for acquisitions and enhanced tailwinds from location.
Vertically Integrated Operations
ROAD covers virtually every aspect of road construction from Aggregate to manufacturing of HMA (hot mixed asphalt). The company has the capability to provide nearly every service required to build the final product from clearing & grading, setting roadway base, paving, storm drainage and curbs. The only services the company subcontracts are signage and roadway markers, guardrails / barriers and line striping / painting. To support this robust integration, ROAD deploys 30 HMA plants and 9 Aggregate Facilities. These HMA plants are located throughout their Southeastern region and provide tremendous competitive advantages. As it turns out, HMA plants can’t be transported long distances very quickly (shocking — I know). These plants enable ROAD to get all the HMA they need regardless of where they are in the Southeastern region, providing a huge advantage to the local competition which is mostly small to mid-sized “family run” construction companies.
Strong Record of Bolt-on Acquisitions
At the time of its IPO in May of this year, ROAD successfully completed 15 acquisitions, enabling them to expand markets and geographic footprint. The company’s been able to add rather frequently while keeping their debt burden in check. In fact, ROAD is net-cash positive with a Debt-to-Equity ratio of 0.21. How is management able to keep leverage minimal while making nearly an acquisition a year? Decentralized command.
Management’s philosophy is simple at its core and extremely effective. On page 3 of the company’s 424B (public filing for new IPOs) management presents a clear case for their acquisition strategy. The company keeps local management in place and maintains all operational decisions at the local level. Upper management comes in only to provide strategic insights and leadership. The only part of the business that gets standardized at the local level is the implementation of ROAD’s bidding and management information systems. This level of decentralized command enables ROAD to acquire great, local businesses without having to make costly personnel changes. Plus, who better to understand the local market than the best asphalt company in that local area?
Enhanced Geographic Tailwinds
Improving road conditions might very well be the one and only issue that both sides of the political spectrum agree on in the current environment. Both Democrats and Republicans support an increased spending bill for infrastructure repair to our nation’s roads, bridges and airports. This increased effort was first seen in 2015 with the passing of the FAST Act, which allocated $305B for transportation infrastructure spending through 2020. 2019 will see around $900M more dollars in infrastructure spending than 2018, and the current administration appears equally excited to get a spending deal done on road construction.
ROAD is located in the heart of some of the worst road conditions in the United States. According to the American Society of Civil Engineers, the states in which ROAD does business score extremely low on the grading scale. North Carolina: C, Georgia: C-, Alabama: D-, and Florida: C. Although the road conditions currently resemble that of an Amy Schumer Netflix special, each state is investing heavily into improvements. The average state in ROAD’s jurisdiction has committed over $1.1B in spending on road infrastructure. Back-dropping all of this spending is a region of the US that is growing faster than the national average in both GDP and population (2.7% GDP growth and 1.1% population growth). There is an estimated $836B in backlogs for projects to repair deteriorating bridges and highways throughout the US. ROAD is well positioned to take some of that pie.
The company has grown revenues, cash flows and EBITDA each of the last three years. Looking out to 2019, management is expecting EBITDA to be in the range of $85 – $91.5M. If management is able to to achieve even the low end of their EBITDA figure, that would imply an EV/EBITDA multiple of 5.3x at current prices. Industry average multiples are around 9x EV/EBITDA. Applying that multiple to the company’s most recent EBITDA figures gets us an EV of $612.9M. Adding back cash and backing out debt gets us to a market cap of $618M. Dividing the market cap by total shares outstanding (51.4) gets us an equity value per share of $12. So here’s a business that’s growing through strategic acquisitions while staying both net cash positive and low debt-to-equity. Industry tailwinds are well in place and the company is positioned in one of the higher-need areas for road improvement.
ROAD faces a few major risks to its continued revenue and EBITDA expansion. Reduced spending on public infrastructure, inability to successfully bid on DoT projects, sustained adverse weather conditions and taking on too much leverage for acquisitions seem to be the highest potential risks that could reduce the company’s outlook and shrink their runway. While I do not see those playing a huge role in the next 3 – 5 years, they are good reminders for me should any of them pop up. If I had to choose the one risk that I’m worried about the most right now, it would be leverage. The company is in an excellent position balance sheet wise. I don’t want them to take on more and more debt for the sake of acquisitions. A strong balance sheet will be crucial during an economic downturn and will make ROAD able to acquire more businesses at cheaper prices.
Revenue and EBITDA growth in the low double digits should command a higher multiple. If we look even further down the road — pun intended — we can approximate a roughly right 2020 EBITDA figure of $100M (based on 2020 target of $1B in revenues). A median multiple of 7.5x puts ROAD’s EV at $750M. If we take the three-year cash and debt averages, we arrive at a market cap of around $740M. Dividing by the current number of shares gets us a share price of $14. Current cost basis of my acquired position is around $8.50. Management buying shares as the price declined from $12 to $8 increased my confidence in effective capital allocation, and helps me sleep at night knowing interests are aligned.
Nano-Cap Data Storage Company Aggressively Reducing Costs and Shares (QBAK)
Qualstar, Inc. (QBAK) is the smallest company in the Fund. Sitting at just $10M, QBAK remains untouchable for most of the investing landscape, making it a perfect place to look for a bargain. Qualstar delivers storage archiving, data and power solutions to its global customer base. The company’s data management and storage products have been industry leading for the last 20 years. For instance, the company has some of the most competitive prices with no hidden licensing fees. Along with competitive prices, QBAK institutes a standard 3-year no-cost warranty, no other company can come close to that kind of protection. Finally, all of QBAK’s products are optimized for low-power consumption, saving its customers more money.
Moving on to the Power Solutions, the company sells its power supplies under the subsidiary N2Power. These highly efficient, ultra-small power solutions reduce energy consumption, generate less waste heat, all while requiring little to no forced air cooling. All of these features translate into decreased AC loads, increased reliability and low operating costs for the customers. The markets N2Power serves range from Transportation to Broadcast to Gaming.
Industry tailwinds are well in place as more data than ever is being created each day. Over 90% of the world’s data was generated in just the last two years. Increased regulations on data storage and backup systems provide QBAk a runway for generating cash for at least the next 3 – 5 years.
Net-Cash & Buying Operations For Cheap
What made me interested in this company isn’t necessarily the products it sells — although they sell competitive products and great prices — it was their balance sheet and insider ownership. QBAK has close to $5M in cash on the balance with zero debt. With 2M shares outstanding it gives us over $2 per share in cash. This means we get the operations of the business for ~$3 per share. So what does $3/share get us in terms of earnings and cash flow? Latest quarterly report shows $12M in revenues, EBITDA of $2.3M, Net Income of $2.1M and $1.05 in earnings. In 2017 the company earned around $800K in FCF with virtually zero capital expenditures. We’re effectively buying the core business for roughly 3x earnings, 0.6x EV/Revenues and 3x EV/EBITDA.
Management is working aggressively to reduce operating costs and its showing in the margins. Gross Margins have grown from 23% in 2014 to 40% in 2017. EBITDA Margins from -51% to 7.7%, and Net Income Margin of 6% in 2017 versus -51.4% in 2014. These improvements lead to improved returns on capital (which currently stand at 7.7%) from -30% in 2014. Despite this turnaround, the company has actually shrunk in size from its 2014 market cap of $16.2M.
As long as the core operating business continues to churn out EBIT, QBAK appears to have completed its turnaround project and is headed for further revenue and multiple expansion. What’s the quickest way for the stock price to revert to its intrinsic value? Share buybacks.
Management’s Recent Share Buyback Program
Management approved its share repurchase program on the heels of another successful quarter. This is a major share repurchase program as it gives management the ability to purchase up to $2.4M in stock. If management elects to purchase all of the $2.4M allowed, that would represent a little over 20% of the company. This isn’t out of the ordinary as Steve Bronson, CEO, owns over 30% of the company. A full $2.4M buyback at (lets say) $5 per share reduces the share count by 480K, leaving us with 1.62M shares outstanding. With a full buyback complete, share prices would be around $7.30 per share, or around 35% higher from current prices.
This investment seems to be a case of what Mohnish Pabrai calls Dhandho Investing: Heads, I win! Tails, I don’t lose much! Our downside is captured at around $2 per share (its net cash balance), and our upside can come from either share buybacks or continued revenue and multiple increases in the underlying core business. It is currently a 5% position.
The Fund has small short positions in Tesla, Inc. (TSLA) and Alibaba Group, Ltd. (BABA). One short is a story of a cash burning enterprise trying to survive in a gut-wrenching industry for newcomers. The other is a company loved by American investors and institutions yet one that I believe is an outright fraud. Tesla’s bear case has been publicized countless times that I will not bore you with a drawn-out bear thesis. In short, the company is burning through cash and trading at multiples that do not justify the underlying condition of the operating business.
In the case of Alibaba, I recommend anyone interested to learn more about why I am shorting to read the fantastic report from the blog Deep Throat, which you can find here. The author does an incredible job at diving into the 20-F (annual report) exploiting all the wonky accounting principles the company takes advantage of (sneak preview: Alibaba creates wealth out of thin air — hooray for Chinese accounting!).
Two New “Tracking Positions”
I forget off the top of my head which investors letter I saw this “tracking position” phrase being mentioned, but that’s exactly what the Fund has done for two new positions. These two investments will have deeper dive posts on the blog at some point in the near future — but let’s offer a sneak peak.
One company will be going public via a SPAC double-merger. This company specializes in rental accomodations for oil & gas, industrial and government projects. The company will IPO at 8x 2019 EV/EBITDA with its closest competitors trading at 10 – 12x. This company has better margins, cash flow and scale than its competitors making me believe it will eventually trade in-line (if not higher) than its peers. Free cash flow conversion is close to 90% and the IRR (Internal Rate of Return) for each new “bed” they add is over 30%. Both the SPAC and management of the company have elected to keep their founders shares – -going so far as to lock them up until share prices reach a certain threshold.
The second investment is a small company disrupting a niche market with 11 straight quarters of growth driven by massive industry tailwinds that will continue for the next 3 – 5 years. The company has close to 900 customers and 6 (moat-generating) patents. The company is a SaaS (Software-as-a-Service) model which makes current financials hard to interpret for a couple reasons. First, gross margins actually improve over the life of a contract. Like many SaaS companies, all costs associated with acquiring a customer are expensed upfront, yet the company gets paid over the duration of the contract. For example, the average gross margin across their customer base is 81% after year 3 of the contract. If you backup to the first year of the contract, average gross margins get reduced to mid-50%. Average contract lengths have grown for both its direct and indirect customers, and the company sports a 95% Retention Rate. The company is currently the only End-to-End SaaS offering in their space. So here we have beautiful business economics coupled with strong top-line growth thats plowing into acquiring new customers. Once this company reaches scale, all they have to do is simply turn the switch from “acquisition” to “cash generation”. There is a good chance of both cash flow and multiple expansion over the next 3 – 5 years.
As I have mentioned in previous letters, I am getting closer to having a full base of starting capital to run my real money investment account. Once that happens, I will switch my letters to tracking the real money portfolio. It has been a humbling experience tracking my investments, thought processes and losers in the “public eye” of my email lists members and readers of the blog. The list has grown quite a bit since the beginning of the year, which isn’t a hard hurdle given the first people to read these letters were my parents. The end of 2018 brought forth tremendous volatility and market declines. A long-term time horizon is the Fund’s greatest competitive advantage. We continue to look for great businesses trading at ridiculously cheap prices. Shares are ownership stakes in physical companies. Staying focused on the process of identifying great businesses at cheap prices keeps us from worrying about short-term negative fluctuations in share prices. We will have down months, quarters and years. Value investing works over the long-run because it doesn’t work all the time. In the case for long-term thinking, I leave you with one quote from Michael Burry (one of my favorite investors):
“What should strike the intelligent investor is that 76.8% of the true intrinsic value of the company today is in the company’s earnings after 10 years from now. To look at it another way, just 5.7% of a company’s intrinsic value is represented by its earnings over the next three years. This of course implies that the company must continue to operate for a very long time, facing many obstacles as its industry matures.”