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A Little Update on my Payment Processor Position

I’ve had family commitments the last couple of weeks and that has led to a longer than usual radio silence.  I am due for a portfolio update, and I plan to get to that next week.

In the mean time I wanted to talk about one change I’ve made to my portfolio since I last wrote a month ago.

While my rule is generally is to not add to positions until they show a profit, I paradoxically only seem to accumulate larger positions in the stocks that go down.   I guess that once I break the rule, I might as well go whole hog.  As much as I try to add to my stocks that are working, I rarely do it meaningfully.  As such, my biggest winners have always been the stocks that have gone down significantly after I bought.

It doesn’t always work.  One name that comes to mind is Bellatrix, which in 2014 I bought and bought and it fell and fell.  My timing was terrible, and whether I was right about the Spirit River potential at the time or not, it was irrelevant – any upside was lost in the commodity collapse.  I eventually gave up and sold the lot of it for a loss, wiping out much of the gains I had earlier in the year in the ethanol trade.

I mention this as a warning.  Just because I have decided to break my rule it does not mean I am right.  It just means that I have an unusual amount of conviction.

Intelligent Systems

I had that unusual amount of conviction in Intelligent Systems as I added to it a few weeks ago.  I mentioned the stock in my last update and at the time it was my usual starter size.  In late April, as it dipped to the low $30s and high $20s I decided to increase the position.

Since then the stock has done well.  It reached the mid-$40s before appearing to take a breather.  In full disclosure I did take a few shares off the table, but only because my position was getting a little bigger than I was comfortable with, and it remains a fair bit larger now than when I first talked about it last month.

This move is the latest in a number of “steps” that the stock has taken to higher levels over the past 6 months.  The chart of Intelligent Systems is not typical for one of my investments.  It is clearly up and to the right.  I usually find stocks that are either down and to the right or just plain down.  I enjoy misery.

The valuation of Intelligent Systems is not typical for me either.  The stock trades at 16x trailing price to sales.  Twelve month trailing earnings are 70c, which puts the stock at a rather nose-bleed trailing PE.

So this isn’t the usual “cheap” story that compels me to take a larger than usual position.  At least on the surface.

But this is a company that has had a big inflection point.  I suspect we are still fairly early on along that road.

The reason the stock ran so far in the early part of the year is because the company “won” business from Goldman Sachs to create their back-end processing software that will drive the new Apple Card.

Of course with such a ridiculous move higher, the bearish point to be made would be that this is more than priced in.

I’m not so sure about that.  As well, I think there are reasons to believe that wins with other names are imminent.

More on that in a bit, but first lets talk about Goldman Sachs/Apple.  The win is a licensing contact for the Intelligent Systems software.  Intelligent Systems is delivering the processing software that Goldman Sachs will use to be the processor of the new Apple Card.  Goldman Sachs will be the processor of that card.  Intelligent Systems will be paid with license revenue, professional services for the work they are completing on the software development (much of this has been recognized) and maintenance revenue that will be a function of the number of licenses.

What is that worth to Intelligent Systems?  Potentially quite a bit.  Intelligent Systems licenses their processing tools by the user.  So what matters is how many Apple customers apply for a card.  While few brokerages have provided their estimates (so far Apple hasn’t really given any guidance – at least none that I can see), one that has is HSBC.

If HSBC is correct, Apple will onboard 14.6 million users to their card each year beginning in 2020.

Corroboration that this estimate is in the ballpark comes from the Intelligent Systems first quarter conference call where they said:

We’re working and helping a licensee build a world-class processing environment. It’s one that will process 5 million, 10 million, 20 million or more accounts.

We don’t know for sure what Intelligent Systems gets on a per user basis for their licenses.  It’s a bit of a theme with the company – they are light on investor relations and therefore light on details.  We do know that the license revenue they charge varies based on the complexity of the card.  The Apple Card, a supposedly revolutionary card, is likely to be fairly complex.

On one call the CEO of Intelligent Systems, Leyland Strange, gave a theoretical example that used a $1/license number.  So perhaps that is a good place to start.  There is some scuttle that has an existing licensing company with a very simple platform being charged in this range.

So if the Apple Card is more complicated maybe it would be a bit higher.  The number seems likely to be somewhere between $1-$2.  That would mean anywhere from $15 million to $30 million of annual revenue from licenses, at least over the next few years, if HSBC is correct.

Could I be wrong?  For sure.  The only other reference to what the Apple Card uptake might be is from this article, which suggests that Goldman is expecting 21 million accounts in 2020.  This is quite a bit higher than HSBC.  I don’t have access to Goldman research however, so I can’t verify the number directly.

On the calls the Intelligent Systems management, in particular Strange, has stated that license revenue is essentially 100% gross margin.  It is technically true, though they do a ton of professional services work upfront to develop the software, customize to the clients specifications, etc.  But that work is at its own profit and already done it is independent of license revenue, which means the important thing for investors is that the license revenue does fall in whole to the bottom-line.

On top of license revenue Intelligent Systems will continue to generate maintenance revenue and professional services revenue from Goldman Sachs.

The professional services revenue will come as Goldman or Apple ask for tweaks, new functionality or an expansion of what the software does.

On the last call management clarified that the maintenance revenue piece was tiered and based on the number of licenses.  While again I do not have enough information to equate a hard number to maintenance revenue, it seems that it will increase as Apple Card licenses are on-boarded.  Overall it is safe to assume there will be material recurring revenue from the relationship separate from the one-time license revenue.

While I don’t believe that it has ever been stated by anyone, I also think it is quite likely that the relationship between Intelligent Systems and Goldman is about more than just the Apple Card.  It seems likely that it began as work on Goldman’s new consumer platform called Marcus.

Goldman launched Marcus a couple of years ago.  It started off as a consumer digital deposit platform in the United States and last year expanded into loans.  They launched a similar digital deposit platform in the United Kingdom in September.  That platform in the UK has taken in $5 billion of deposits since then.  In the US and UK combined Marcus has taken $46 billion of deposits.

Consumer deposits and unsecured loans were just the first step of Goldman’s vision with Marcus.  The following is from a presentation Goldman gave in early-2018:

The credit card piece has perhaps been clarified with the Apple Card.

Here is what Goldman has said about the Marcus platform.  This is from their second quarter conference call:

Importantly, I want to turn your attention to the key elements of this project as they represent the same drivers that underscore a range of major strategic growth initiatives underway at the firm. These elements include: re-imagined projects that address pain points for corporations, institutions and consumers; new technology unburdened by legacy systems that often slow down innovation; digital delivery mechanisms that produce scale and efficiency; and access to large customer populations. These elements are critical to our key growth platforms, including: Marcus and mass affluent wealth, where we will pursue partnerships to access large numbers of consumers; Marquee, our digital institutional platform with the ability to innovate can help us engage its other institutional client base; and corporate cash management, where we can serve existing clients for the firm and offer differentiated products on a digital platform.

In my opinion, the key points as they might relate to Intelligent Systems role, is the excerpt I highlighted.  It gives an idea of what Intelligent Systems is delivering.

But this is just me guessing.  I don’t know what role Intelligent Systems has in Marcus.  I assume that Marcus is the engine driving the Apple Card processing.  I also assume that Goldman’s vision with Marcus is not going to stop with Apple.  On Intelligent Systems first quarter call, in a comment where he was referring to their “world-class licensee”, Leyland Strange said that Intelligent Systems was a “key contributor to the main system of record that requires a highly scalable and high availability infrastructure”.

With all that in mind, it is important to note that on completion of the Goldman platform Intelligent Systems will retain the IP.

It surprises me a little that Goldman is so willing to let the IP of one of their next, big growth engines to remain in a relatively small company in Atlanta.  But maybe I don’t understand the risks and they are less than I think.

At any rate that IP will be a key to future growth at Intelligent Systems as it will be the basis of their own processing business.  On the last conference call:

The fact is that we cannot take on a new 5 million account client in our own infrastructure and environment at this point in time.  So it’s better for we ourselves to say not ready rather than customer due diligence come back with, you’re not ready…

We’re working and helping a licensee build a world-class processing environment. It’s one that will process 5 million, 10 million, 20 million or more accounts. We’re the key contributors to the main system of record that requires a highly scalable and high availability infrastructure.

 We will then add the elements that we have brought to them as well as lessons learned from their smart people to our own environment and have a good, valid reason to then claim we are a world-class processor. I hope we do it by the end of this year. It could drag on if we are tied up with them a whole lot longer.

Intelligent Systems has a processing business already, but not one of the scale they are describing above (processing and maintenance revenue was about $1.8 million last quarter).

Where are these (large) processing clients going to come from?  There is reason to believe that Intelligent Systems is working with a few large operators already.

The one that is likely closest to launch is Sallie Mae.

No one has said that Intelligent Systems is working with Sallie Mae.  Yet I think they are.  Here is my reasoning.  We know that Sallie Mae is working with a company called Deserve on the new credit card they are about to launch.  Sallie Mae has mentioned Deserve by name on a number of their conference calls.  This reference is from their third quarter call (SLM CEO Raymond Quinlan talking):

Deserve is a west coast, very modern, integrated native app purveyor of credit cards. And when we looked at our entry into the card business, several things guided us: One is that the card business is filled with very capable competitors, many of whom have excess capacity, while we’re sitting here; two is that we did not want to build an infrastructure that had high fixed costs associated with it; three is that we wanted to be modern and we thought that we would have an advantage over existing players who frequently are bound by their old unintegrated and not fair consumer-friendly systems. And so as we surveyed who would be a potential partner, we looked at multiple potential capabilities. We hit upon the Deserve folks because they are modern, they are dedicated to us and — but they are a relatively new company, and so we made a small investment in them.

A little bit of digging turns up that the Deserve platform is powered by Corecard, which is the brand that Intelligent Systems markets their processing solution under.  From the Deserve Privacy Policy (a h/t to Hiddensmallcaps for finding this link):

There are a few other indications of the Sallie Mae connection that I’ve discovered but won’t get into here.

What is the Sallie Mae business worth?  Well first of all, this is a different model than what Intelligent Systems is delivering to Goldman/Apple.  Sallie Mae (if I am right and it is indeed them that Intelligent Systems is working with) is almost certainly the processing client that was delayed last year and it now being ramped up.  This is something Intelligent Systems has discussed a number of times on the last few calls.

As a processing customer, the revenue model is more traditionally recurring.  Intelligent Systems will generate revenue on a monthly basis as a function of the number of accounts processed for the card holders.  So again it’s a function of accounts – but this time it is not a one-time fee and maintenance.

How much is that fee?  I can only make an intelligent guess.  I dug up some information from First Data that is very old (2003) that suggested at the time they generated $4/year/card holder on processing.  I can also infer from 3Pea International disclosures (they are now called Paysign) that they generate $8/year/card holder for their processing platform, though they also provide a more end-to-end solution than Intelligent Systems.

How many users will take up a Sallie Mae card?  Again, tough to say with any certainty.  Sallie Mae has over 1 million customers and originated almost $6 billion in loans last year (I had previously written 25 million customers but I didn’t realize that came from a disclosure before the spin-off of Navient).  How many of those customers take a card?  Your guess is as good as mine here.

Now again, nothing has been officially announced with Sallie Mae. This is my speculation based on the information I have dug up.

What lies beyond Goldman and Sallie Mae?  Another big question. We know there are two processing customers they are working with.  We have talked about the first likely being Sallie Mae.

I can’t say for sure who the second is.  My only guess is that it may be Greensky.  Greensky partners with merchants to provide point of sale credit.  They primarily derive their business from home improvement stores (Home Depot makes up 5% of sales while Renewel by Anderson is a sponsor for another 19%).

Why Greensky?  Well its more of a stretch than Sallie Mae so take this with a grain of salt: First and circumstantially Leyland Strange has made point-of-sale credit comments on the conference calls a couple of times (there is a long example of POS credit scenario at Bass Pro Shops that he says only Intelligent Systems could handle on the fourth quarter call).  Second, there is a striking similarity between the credit card service portal of Final, which is a Corecard client, and Greensky (though I have to say I am comparing the screens second hand as my IP is in Canada and I am blocked when I try to access this Greensky portal – a h/t again to @hiddensmallcaps here).  Third, if you do a Google search with the terms ‘mygreensky.com corecard’, oddly this is the only result that appears.

So those are my guesses at the immediate two processors that are in the wings.  There is reason to believe that they have another large processing customer that is still a year or more away.  There is scuttle on this that truly is scuttle and so I’m not going to speculate on who.  There was mention of this on the last call, though Strange was quick to say that this customer is not in any “pipeline” – so take that for what its worth.  Either its not a done deal or Strange is being his usual understated self.

More broadly, I believe that Intelligent Systems had a unique processing platform and through Goldman/Apple has been paid to develop an even better one.  I suspect the platform is geared towards real-time processing, which from what I gather from listening to panel discussions and the calls of larger processing players, is really the shift that is beginning to take place – replacing ACH batch processing with immediate transfers has many use cases.  Real-time processing offers speed, transparency and 24/7/365 capabilities that give it advantages to merchants and consumers.

It is my sense that the processing industry is quite a hodge-podge of solutions.  Companies like Fiserv, Total System Services and First Data have a number of different brands and versions of payment solutions that they have acquired over the years and from what I can tell they are all quite distinct from one another and are difficult to combine.  Case and point is that as Fiserv has made a bid to acquire First Data, they listed a host of synergies between the two companies but were clear that the product lines would see limited or no integration.

It’s an industry that is ripe for disruption.

So that’s story and why I was willing to add to the stock as it dipped, rather than following my usual strategy where I do not add until I see begin to see a profit.

Going forward I think the stock can move higher, but the time frame is less certain.  This company does very little to promote itself (there is no corporate presentation and no IR to speak of), so there almost assuredly will be no press releases between now and the second quarter results.  Those second quarter results might be a catalyst; there may be an uptick in license revenue from Apple/Goldman – but there also may not.  I can only guess when the licenses will begin to be recognized or how fast it will be recognized.  The Apple Card is not launching until the summer.

The two processing customers will begin to generate revenue in the second half of the year.  But this will likely be a small base at the beginning.

Could the company be taken over?  I think that is a possibility.  On more than one occasion Leyland Strange has said that they are a “very opportunistic” company.  He said this specifically in response to questions about being acquired.  He is also 76 years old and owns over 25% of the company (two holders, Strange and Weitz Investment Management, own over 50%).

As well, Goldman themselves said on their own third quarter call that while they did not plan to make any large acquisitions, they were looking at ways to “consolidate their technology”, particularly on the consumer (Marcus) platform.  They said that such acquisitions would be small for Goldman and not require share issuance.

The short interest in the stock has risen, which is interesting.  I imagine there is a simple thesis around valuation.  On a trailing basis the company looks very expensive.  I also wonder whether the inclusion on the board of a prominent executive that has been in the cross-hairs of short sellers (I will not mention his name because I have no interest in this blog being listed in Google searches with respect to this individual – I have come to dislike publicity in general and specifically of this nature!) who you can look up easily enough in their filings.  My thoughts on this board member are – it is what it is.  He’s been there forever, there is a relationship there and if you want to make something of it that is yours to do.  I have seen no reason to myself.

That short interest could be negative but could also be positive.  The float is actually quite small here as between Strange, Weitz and a few other individuals and funds own over 60% of the shares.

Either way I don’t care much about that.  I plan to stick with this name as long as it continues to execute.  I’m hoping that, barring a takeover, that will be a very long time.

 

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Update on a Few Stocks

Here are some of the changes I made to my portfolio in the last two weeks.

Liqtech

I sold out of Liqtech after reviewing their fourth quarter results.  I did so a couple of reasons.

First, their guidance for the first quarter was okay but not as strong as I would have hoped.  The company said they expected $7 million of revenue in the first quarter.  Assuming diesel particulate filters rebound back to historic levels, that implies 10-15 filters, depending on the price.

That’s not as many sales as I would have hoped for at this point.  We’re less than a year away from IMO 2020.  I would have liked to see twice that.

Second, the company decided to stop reporting its backlog.  As a rule, companies don’t stop reporting items that have positive implications for the stock price.  Which leads me to wonder if and why the backlog is not be increasing as quickly as hoped?

One of my worries with Liqtech has always been that shippers go with “hybrid-ready” scrubbers that are designed to use a filter some day, but not right now.  I follow the announcements on Ship & Bunker and other sites and I’ve noticed most of the large scrubber orders are described as hybrid-ready.

Gregory Vousvonis made interesting comments on SeekingAlpha yesterday saying:

Although closed loop and hybrid scrubbers make sense there is a legit counter-case to be made that the overwhelming economic benefit can be collected with a cheaper open-loop model and thus avoiding the more expensive and complicated closed loop / hybrid scrubbers. Which also have the disadvantage of having to dispose the solid residue from the wastewater management system.

Liqtech is still going to get a lot of filter orders, but the pace of these order may be more stretched out than I had hoped.  And order may lag until there is a more general ban on open-loop scrubbers everywhere

This is all just guessing.  Maybe the company has completely unrelated reasons for not reporting backlog.  The stock price has actually held up quite well since the earnings release which makes me wonder if I am wrong.  Nevertheless I decided to do my guessing from the sidelines.

Product Tanker Stocks

In his comment on SeekingAlpha Vousvonis says he was researching Scorpio Tankers when he came upon the insights about open-loop scrubbers.  It’s a coincidence because I have been researching tankers myself.

I’ve known for a while that product tankers (the one’s carrying gasoline, diesel and other clean fuels) are expecting an uptick in demand from IMO 2020.  Gasoil and low-sulfur bunker fuels will need to be transported to the bunkering hubs.  As well longer shipping routes will be required as low sulphur fuels now need to travel further (refineries that are most able to produce low sulphur fuel are in North America and Europe whereas the demand will increase in ports across the world in particular in developing nations).

With that in mind I found this panel discussion with four product tanker companies, which was tweeted by @20slots, to be really interesting.

Each participant is very bullish.  Of course it could be said that shipping companies are always bullish.  But I don’t know – not like this.

The most interesting argument made is that product tankers have been in a bear market for 11 years.  The companies cannot respond to the coming demand from IMO 2020 because they are too levered already and their share prices are too depressed.  This sets up a scenario of an extended cycle.

I took equal positions in 2 of the panelists: Ardmore Shipping and Scorpio Tankers.  I took a smaller position in Pyxis Tankers.  Of the 3 I am inclined to think Scorpio might fair the best.  Why?  Because they have been the most proactive with scrubbers.

Scrubbers could potentially be quite lucrative to the shippers that install them.  An old article from last year:

The estimates in the article are for VLCCs so the absolute margin increases will be lower for MR and LR tankers, but you get the idea.

Speaking of selling scrubbers to Scorpio, @FBuschek found an obscure little company to play scrubber installations with.  Pacific Green Technologies has scrubbers orders with Scorpio Tankers, Scorpio Bulkers and a couple of other tanker firms.

Pacific Green is an illiquid little OTC company, so I took a very, very small position in it.  Really its more just for curiosity than anything else.  They have a partnership with a Chinese company called Power China, which makes me a little wary.  They also split gross margins with Power China 50/50, and with no guidance from the company on what margins might be, its difficult to put together any kind of financial model

Nevertheless scrubber orders of nearly $200 million on a stock with a $135 million market cap makes this an interesting one to watch.

Oil stocks – Athabasca Oil and Gas and Crescent Point

I made a couple bets on oil stocks.  The price of oil has risen and the stocks so far have not followed.  This happened last year.  At the time it was frustrating to watch until it wasn’t.  In April of last year oil stocks decided to join the rally and some of them rose 75-100% in the matter of a month.

Will that happen again?  Who knows.  But its worth a small gamble I think.  I added Athabasca Oil and Gas and Crescent Point.   I did a rough model on Athabasca, essentially replicating the company’s own guidance, and it’s quite stark how levered the company is to each $1 increase in the price of WCS at these price levels.

Athabasca is guiding to CAPEX of between $95 million and $110 million for 2019.  So you can see how the free cash flow begins to add up.  WCS prices were USD$56/bbl yesterday.  Athabasca has a market capitalization a little under $500 million.

HyreCar

I owned HyreCar earlier this year and briefly mentioned it in one of my portfolio updates.  I didn’t talk about it extensively because I didn’t know how long I would hold onto the stock.  I was worried about their ability to add dealer inventory to their rental car platform.  As it turns out I sold it after a month but missed much of the run-up to $7.

Well the company reported their fourth quarter earnings and the stock responded poorly.  To be fair I think the stock moved more on the Lyft IPO than anything to do with its own results.  The same could be said for the prior move to almost $8 per share.

I thought HyreCar’s results were actually pretty decent.   As it turns out Hycar was pretty successful adding dealers to the network.

In our third quarter call, we noted that we had 25 dealerships representing an estimated 250 cars on our platform. A number we expected to double in the fourth quarter of 2018. Today I am proud to report, we listed our 100th auto dealership today, of which, 1200 cars have been listed to the platform.

HyreCar had 10% growth sequentially in the quarter which is pretty good.  But I think the headline number may underestimate the underlying growth.

If you look at the 10-K there is a table showing gross billings and rental days.  Both increased around 20% sequentially in the fourth quarter.

But HyreCar didn’t fully participate in the growth of gross billings and rental days because owners took a higher percentage of profits in the quarter (the tables are in weekly and daily respectively so you have to convert one of the two to see the apples to apples comparison).

Third quarter margins per vehicle:

Fourth Quarter margins per vehicle:

I’m not surprised that owner margins went up because HyreCar had to entice dealers to deliver cars to the network.  The success of that initiative is more important to the long-term viability of the business than the lost margin in the short term.

My hope would be that margins stabilize and HyreCar more-fully participates in margin growth going forward.

Also in the 10-K is a note that HyreCar should be realizing better margins on insurance in the second quarter:

American Business Insurance Services (“ABI”) is our insurance broker and Y Risk is our mobility-focused managing general underwriter. Y Risk was sold by our incumbent insurance company American International Group (NYSE: AIG) to The Hartford (NYSE: HIG) in December 2018, and we are in the process of moving our annual car insurance policy with The Hartford for the plan year from April 2019 to March 2020 under superior pricing and term

Together these positive data points made it worthwhile for me to add back the stock.

Aehr Test Systems

I’ve been watching Aehr flounder the last few quarters after selling it last year.  But it looks like they may be turning the business around here.  It was a pretty positive conference call, and I haven’t known the management team to be all that bullish unless there is reason to be.

On the call management made the following points:

  • Evidence of a ramp in orders – $6.9 million backlog at the end of fiscal third quarter plus recently announced orders means they have a $10 million plus backlog
  • Currently actively engaged with 12 customers
  • Expect to see a significant increase in bookings in the fiscal fourth quarter
  • Expect a return to profitability in the fiscal fourth quarter

If I understood what they were saying on the call, it sounds like the low-end products they’ve introduced have been successful in bringing on new engagements and initial orders.  As well maybe, just maybe, the technology of smaller dies is finally beginning to require a solution like the FOX family of systems as CEO Gayn Erickson said “our solutions stand alone as the only way to cost effectively scale to meet the demands of these devices that are used in 5G infrastructure build out, 2D and 3D sensors, and enterprise and datacenter server and storage applications.”

So we’ll see.  I took a starter.  I mean my biggest worry here is that the semi-conductor industry is strong enough to support the growth, but I guess I’ve been totally wrong about my assessment of the economy in general (or at least that is what the market has told me!) so I’ll try to keep that concern locked away in the back of my head for the time being.

 

 

A few updates and a new position

I’ve been harping on my lack of risk tolerance for about 9 months now.  The same goes for the leash I keep my positions on.  I sold a couple of stocks already this week: Overstock and Evolus.

In the case of Overstock, my conviction is just not high enough to handle the volatility.  I sold out earlier this week, getting spooked out on the first dip in the $17’s on Monday.  I felt dumb a few hours later but I feel better about it today.

With Evolus, the final straw was the prospectus for selling shareholders.  Now I don’t know the motive, why these guys are putting up their stake for sale and whether they actually intend to sell their shares at all.  But whenever I see this kind of thing I know the stock is likely to be under pressure (and it has been!).   So I’m out.

A couple of other updates.

Digital Turbine got clobbered on Monday (Monday was not a great day for me) on news that Google is reviewing their Chrome ad policy.  That this is negative for Digital Turbine made about zero sense to me.

First, all of Digital Turbine’s revenue currently comes from their pre-install product that has nothing to do with Chrome and nothing to do with cookies or user derived data for that matter.

Second, Digital Turbine doesn’t sell advertising.  In fact the only product that is remotely related to the news is Single-Tap, which even then is not an ad-product itself, it’s something an advertiser or app developer would embed in an existing ad.

Third, I can’t imagine Chrome is that important to Single-Tap because Single-Tap is for mobile and users get most of their mobile content via apps, not a browser.

Anyway I think for these reasons that Digital Turbine got pulled down in error and so I added a little.

I took a new position in Intelligent Systems.  This is the company that won the right to be the back end tech on the Apple/Goldman Sachs credit card.  I’m still digging into the stock and so I could be wrong, but after having read through the 10-K, some transcripts and having dug a little into the technology advantage I have to say it looks like a pretty good bet.

I wish I would have caught it sooner, I mean its run up like crazy since the Bloomberg article I linked to and I have no one to blame there but myself.  Buying here exposes me to all sorts of risk because its way over-bought and probably due for a pullback.  Now that I have a position I fully expect it to see the $20’s.

Nevertheless I decided to take a position because it really doesn’t look as expensive as it appears on the surface (they were profitable last year and generated over $6 million of free cash), the Apple/Goldman revenue should mean a lot of growth in 2019 and there are some indications there are other big customers in the wings.

What’s more, I just like what I hear from the management team.   Their CEO Leland Strange seems like a straight shooter.  I also just love that they doubled their revenue last year while actually showing a decline in operating expense.

I also added back Gran Colombia Gold, Roxgold and added to Wesdome.  I just couldn’t stay away from the gold space, especially now that the Federal Reserve is being stacked with money-printing yes-men.

Finally while I never talk about any of my shorts I do have to say that in my opinion the Canadian banks look pretty weak here.   I’m biased living in Alberta (where the economy remains moribund and us citizens depressed) but even so I have to wonder how the banks can withstand what appears to be an accelerating housing slump and an inverted yield curve all at the same time.

Week 401: Treading Along

Portfolio Performance

Thoughts and Review

Treading water might be the best way to describe my portfolio performance.  I haven’t participated much in the rally we’ve had over the past 7 weeks. My stocks got the initial bump in early January but since then its been only a little bit up.

In fact the tracking portfolio looks better than my actual portfolio because I don’t hedge the Canadian dollar here.  That has helped the numbers by about 2-3% since my last update.

But what are you going to do?  I said last update that I didn’t feel comfortable buying heavily into the rally and therefore I wouldn’t be chasing it.  And I haven’t.  The lack of performance is a consequence.

Nevertheless I am happy with the stocks I own.  I think there are some that could turn out to be decent winners.  Digital Turbine looks good.  No one cares about Mynd Analytics but there is every indication that the merger with Emmaus is going to happen.    Smith-Micro, Mission Ready and Evolus,  all of which I will discuss below, give me plenty to be excited about.

Smith Micro

Smith-Micro had a great quarter.  I added to the stock at $2.30 last week and added again Monday (which won’t show up in the portfolio totals below) as I think it could really turn out well if things continue in this direction.  BTW, a thanks to Mark Gomes for his video on Smith-Micro, which helped give me some insight on the quarter.

I am told that the subscriber count, which is expected to see a doubling of between the third quarter and the end of the first quarter, was not a surprise, but to me it was, and I saw this as very positive news.  Those subs should ramp to over $2 million in quarterly revenue over the next few quarters. That’s a pretty big jump from the $1.2 million of SafePath revenue that we had in the fourth quarter (which itself was up from $1 million sequentially).

Speaking in maximum double negatives, there seemed like there was not much not to like here.  The fourth quarter revenue was really good ($7.4 million which was up from $6.5 million the previous quarter).  They had positive earnings (3c EPS) and positive cash flow.  Smith-Micro forecast another tier-1 win for SafePath in the first half and suggested they could have more than one new tier-1 by year end.

And the valuation is still not expensive at all.

The average estimate here pegs growth in 2019 at 30%.  While that number could be higher or lower depending on how the Sprint ramp continues and the other Tier-1’s materialize, let’s take it at face value for now.  I believe there is about 34 million shares outstanding including the warrants that are in the money again.  So the market capitalization is $85 million.  I realize there is cash with the warrants and on the balance sheet but I’m going to ignore that.  At an $85 million market capitalization Smith-Micro trades at 2.5x forward revenue.  If I didn’t tell you this was Smith-Micro and I just said I had a 30% grower with 80%+ gross margins and recurring revenue at 2.5x sales… I think you’d have to say that sounds like a deal.

Now I realize its never quite that simple and you can go down the road of why Sprint still hasn’t sunset the legacy software, why they didn’t Smith get a Tier-1 by year end like they had suggested they might, why are reviews still mixed on GooglePlay.  There are always questions.  But after these results and with the color they gave on the call I felt comfortable adding.

Mission Ready Solutions

One of the more interesting positions in my portfolio right now is Mission Ready Solutions.  It is a stock I’ve held for a year and a half.  For most of that time I have been flat to underwater on it.  The original thesis I invested on is busted – there was an LOI with a distributor for purchases of their BCS armor vest (called Flex9Armor) from a foreign military.  It never amounted to anything and the LOI was eventually dissolved at year end.

When orders from the LOI didn’t materialize many investors lost interest and were rightfully ticked off.

I stuck with the stock because… well, I don’t know exactly why.  Probably some hope mixed in there. Also their lead product, the Flex9Armor vest, always appeared to be a legitimate product to me, maybe the best ballistic combat shirt out there.  Same for the team at their subsidiary, Protect the Force, which on all indications is a premier R&D firm for tactical gear and body armor.  I kinda took the opinion (and this is purely my opinion) that Mission Ready was likely given the run around by the distributor on the foreign military LOI.  Also, the price of the shares remained surprisingly resilient through the first half of last year, a period of basically zero news and few positives to speak of, which made me wonder why that might be the case.

It turned out that Mission Ready was about to sign a merger deal with Unifire.

Unifire is a manufacturer and distributor of fire, military, emergency, and law enforcement equipment.  The following are their own manufactured products, but in addition they distribute over 1.5 million products from a whole pile of different vendors.

In the first half of 2018 Unifire had $18 million USD of revenue (that number comes from Mission Ready’s original press release on the acquisition).   We don’t have a lot of information yet on revenues prior to that.  Government data shows that Unifire had $31 million of revenue via Federal Government contracts in 2017.

The interesting part, and I wrote about this before in this blog post back in September but will give an update here, is that Unifire is one of six participating vendors in Defense Logistics Agency contracts (DLA).

The most recent awards for two DLA contracts came out in February. Unifire is still one of six vendors for the “$4,000,000,000 bridge contract under solicitation SPM8EJ-13-R-0001 for special operations equipment” and one of six vendors for “$90,000,000 bridge contract under solicitation SPM8EH-12-R-0009 for fire and emergency services equipment”.

These are big numbers but before we get carried away there are lots of unknowns here.  The biggest one is what piece of the pie Unifire will get.  Historically it’s been small.  Like I said, in 2017 Unifire received $31 million of government revenue.  In 2018 that appears to be down to more like $6 million (which may or may not be because they have been tied up with this merger with Mission Ready over that period).

The story behind the merger is that Unifire has been capital constrained and that has prevented them from bidding on higher volumes.  A $20 million available credit line was announced by Mission Ready a few weeks ago and with it in hand Unifire/Mission Ready should be able to bid on (and presumably win) more product.  It makes sense, but we’ll just have to see how it plays out.

At any rate I don’t think it is any coincidence that Mission Ready announced a private placement after these DLA awards were announced.   Literally the next day a $2 million private placement was announced.  Likely a lot of investors had been hesitant to participate in anything until they knew for sure that Unifire was still on the DLA go-to list.

Today they announced that the PP was over-subscribed and would be increased to $3 million.  A good sign as it means they at least have the original $2 million.  It’s certainly better than the alternative.

A successful private placement is good news because it will mean we can finally get closure on the merger.  After being halted for 7 months (maybe it was more? I lost track…), in February Mission Ready announced they had an escrowed close on the merger that still required approval by the TSX Venture to close (this is the first time I’ve ever heard of an exchange escrowed merger close?).  So the merger has so far been a kind-of-mostly-done-deal.  Once the money from the private placement is in hand I suspect it will become a fully done deal.

I added to my position in Mission Ready.  While there is still a lot I don’t know, I do like the direction the story is going.  Finally.

Overstock

Overstock announced fourth quarter results on Monday morning.

While the results missed estimates, disappointed many, and so on, I have to say I actually thought the retail business was in better shape than I had expected.  I mean the fourth quarter wasn’t ideal but that wasn’t really a surprise.

Apart from the fact that I firmly believe that I cannot take anything Patrick Byrne says at face value, the thing that has most kept me from getting behind Overstock again over the last 9 months or so has been this retail traffic problem.

Overstock has had a problem for about two years.  Their search engine optimization (SEO) traffic had been collapsing.  I’m no online retail guru but even I can figure out that if your free traffic is declining precipitously you are probably in big trouble.

I’m pretty sure Byrne knew they were in big trouble too.  In fact I would hazard to guess that the crazy marketing spending spree that Overstock did in Q1/Q2 of last year was a smoke screen to cover for the disaster that was SEO.

Byrne saw that the numbers were going to continue to get worse so he ramped marketing spend to cover for it.  This created a false bump in revenue and allowed him to play the market with his growth schtick. You can even get hints of what they were really up to on the third quarter conference call, where they admit that they spent a lot of that money on testing and R&D. I have my doubts that the spend had much to do with competing against Wayfair.  I think it was about ploughing money into a collapsing retail business in a last ditch attempt to right the ship.

Like many of the things Byrne does, while you can’t take it at face value you can have some confidence there is some legitimate plan behind it.  Just probably not the one stated.  And this time it appears to have worked.

The fact they are off that train and on the conference call said they would bring ad spend back down implies to me that they have some confidence that they will right the ship.   I would be willing to bet that if Byrne didn’t think they could do it he’d come up with some new sleight of hand to get the market to look elsewhere.

There are two pieces of good news here.

The first good news is they did turn around their contribution dollars.  And they are saying they can keep that going.  The first quarter number they gave is quite good.  The fourth quarter number wasn’t terrible either.

The better news is that there is a definitive turn in SEO.  It’s not exactly a hockey stick but at least the collapse appears to be in the past.

I have struggled to see why an acquirer would be willing to buy retail for anything other than a very low-ball offer while SEO was in free fall.   Any acquirer would see the pre-Q4 numbers as part of their due diligence and realize the business is likely doomed.  Even if they were interested in Overstock’s logistics and back-end platform, I doubt they’d be willing to pay much given the negotiating position Overstock would be in.  But the numbers above suggest this is changing.

The final bit of news is that while the first quarter revenue comp looks ugly it is bogus IMO because the marketing spend deluge that was done Q1/Q2 of last year.

Putting this all together, my wild guess would be that they might actually be able to sell retail once they show a couple quarters of solid contribution number and get above that break-even EBITDA number.

Meanwhile on the blockchain front in August tZero opens up to retail investors.  This seems like a big deal to me and I like the idea of holding the stock heading into that.  Its a tiny position but will be interesting to watch.

Evolus

Not much to say here as the stock treads water in the mid-$20’s, I hold my position and wait. Evolus released their fourth quarter results Monday night.  Everything is going fine with the upcoming launch.

The most positive news was that they alluded that they already have the head-to-head data with botox and that the results are thumbs up. That should be a big positive as they will release those results in conjunction with the launch.

The second most positive news was that they received $100 million of debt financing.  This reduces the worry of dilution.

Nevertheless I’m not increasing the size of my position.

Its still going to be a few quarters before we really understand the uptake.  They said that the second and third quarters will be full of trials and free samples as they try to gain traction and take share.

I also need to understand the competition better.  There was a discussion on the call last night about a longer acting toxin that will hit the market in a few years:

Irina Rivkind Koffler, Mizuho Securities: how do you contemplate the market entry of a long-acting toxin sometime maybe towards the end of next year or middle of next year? Does that change the #2 positioning? And can you stay at #2 beyond 24 months?

This toxin, called RT002, is owned by Revance Therapeutics.  They had a Phase 3 study completed and plan to submit a Biologics License Application in the first half of 2019.  A longer acting toxin, if the results are comparable, will likely be tough competition.  Just how tough?  I don’t know.

So I’m not sure yet how I should expect this all to play out.  I’ll keep my position small.

A few comments on stocks I sold

Gran Colombia – it remains cheap and after I sold they changed the offering from shares and warrants to debentures.  Had it been debentures in the first place I’m not sure I would have sold.  I might have though.  The small, worrisome piece of the story that always had me a little on edge is that if you read through the technical report on Segovia the grades are expected to start to decline after 2019.  Now the veins they are chasing have been around forever and have always been high grade so there is every possibility that they find more high grade gold and this is not a problem.  Still, it was the other contributing factor to me selling.

Golden Star – I’d like to see some sign that Prestea is straightening out. It feels like its been a year and the results at Prestea are getting worse if anything.  The stock price has held up really well since I sold and so I am left to wonder if maybe this is the quarter where that happens and I will be kicking myself in a couple of months.

HyreCar – I mentioned in my last post that I had bought and sold HyreCar.  The buying was a great idea, the selling not so much.  I don’t see any news to account for the rise.  I’m guessing that this $2 move since I sold (ugh) is because of the Lyft IPO?  You know I always underestimate things like that.   I mentioned the Lyft and Uber IPO’s as potential catalysts in my notes on HyreCar, but I didn’t really give that much weight to them.  Turns out its the overriding factor.

Superior Drilling – I sold a bit of this.  Nothing is really wrong with the stock but nothing is particularly exciting either.  If I had to give a single reason for reducing my position it would be that their OPEX spend in 2019 is going to be higher than I had thought, so the company will grow, but they won’t be delivering as much free cash as I had hope for.

Liqtech – I have continued to reduce my position in Liqtech, which may turn out to be a mistake.  Why sell the stock?  Well it was a pretty big position and it is also a binary one.  There still are a lot of assumptions in any of the calcs I run.  So its really just a matter of risk management.

Portfolio Composition

Click here for the last seven weeks of trades.  Note that I found a problem with my spreadsheet in the last update.  From December 12th 2018 until my January 2019 update I had double counted my Smith-Micro shares (6,000 instead of 3,000).  Therefore the totals for my portfolio during that time were roughly $7,000 (~1%) too high.  I corrected all my tables and charts in this update.

A Bit of an Update and Kindred Biosciences

In the month since I last wrote I have mostly stayed the course that I laid out in my last portfolio update.  I took a couple of small positions which I have subsequently sold (HyreCar, which worked out, Graftech International, which didn’t).  I sold out of Gran Colombia, Atlantic Gold and Golden Star Resources, all of which had risen quite a bit over the last 2 months.  I sold out of C21 Investments just this week.  And I also reduced my position in Liqtech as it has appreciated.

Add it all up and I have an even larger cash position now than I had in the fall.  I have only a couple of positions that are more than 1% in size.  I’m close to net short in my account after including index shorts.

My plan is to mostly wait patiently in cash.  I’ve said it before a few times: if the market keeps going up for reasons that I don’t really understand, I’m okay with it doing it without me.

But I’m still on the look out for stocks that aren’t too economically sensitive and offer some upside.

I thought I had found a decent one with Kindred Biosciences.  But my timing was horrible.

I got the idea from @FBuschek who pointed me to this podcast where former hedge fund manager Steve Kuhn says he has 10% of his portfolio in the stock.

I took a 1% position in the stock early this week.  Then the company released earnings last night and the stock tanked today, down 15% at one point.  I’ll get into why, but first a brief overview of the company.

Kindred has a market capitalization of $370 million (39 million shares) and $125 million of cash.  They are mostly a clinical stage biotech – they are only starting to generate revenue from one approved product (Mirataz) and are burning cash at about a rate of $45 million a year.

The twist is that Kindred Biosciences focuses on animal pharmaceuticals.  They develop drugs for companion animals, which means house pets like cats and dogs but also horses.

The high level idea here is that Kindred says they can be much more efficient with capital than your run of the mill biotech.  The line they use at conference calls is that the addressable market for an animal drug is typically one-tenth that of a human drug, but the costs of development are one one-hundredth.

It’s a compelling catch line and I think there is some truth to it, though it remains to be seen whether the incremental value of an animal drug is to the extent Kindred suggests.  After all, Kindred is spending enough on their operating expenses ($53 million in 2018 including $26 million on R&D) that it’s clearly not free.

The other twist on the business is that veterinarians that prescribe the drugs are generally also effectively the pharmacists.  They sell the drugs they prescribe.  So they  have an economic interest in prescribing new drugs that they can sell to their patients.

Kindred’s first drug, Mirataz, was approved last spring and started selling in the third quarter.  Sales in Q3 were $600,000 and that rose to $1.4 million in the fourth quarter.

Mirataz is for managing weight loss in cats.  Preventing weight loss in cats, particularly old one’s, is necessary. Cats that lose 10% of their weight are at significant risk of liver failure and death.  “If you’ve owned a cat, often at the end of their life, what happens is they get sick for some reason, they stop eating and they get sicker and sicker and sicker.”  The trick is to find a way to get them to eat again.

Mirataz is based on a human generic drug called mirtazapine.  The problem with using mirtazapine directly in cats is that its sold in pill form.  The cat owner has to break up the little pill into 8 and then manage to get the cat to swallow it.  Compliance is low.

Mirataz puts mirtazapine into a transdermal delivery system, which means its an ointment, this case applied inside the cats ear, that seeps in through the skin.  Compliance is expected to be much higher. Mirataz was approved by the FDA in May 2018.

It’s a legitimate use case and the transdermal delivery system makes a lot of sense.

Where will sales go?  Well here is where we get into today’s collapse.

There are 9 million cats in the United States with this problem.  3 million of them are being treated right now.  About half of those are considered chronic and will need treatment for months or years.  A tube of Mirataz goes for $15. That is a 2 week supply.  The veterinarians are expected to mark it up to $30.

The big opportunity with Mirataz is on the chronic side – if the 1.5 million chronic cases require 6 months of supply every year that’s an addressable market of $585 million.  That’s a pretty big TAM.   If the other 1.5 million cats being currently treated require a 2 week treatment that is $22.5 million. So the 2-week treatment is much smaller.  The 6 million cats that aren’t being treated are additional upside if the owners bring them in now that there is an option with better compliance.

Putting this all together, the TAM looks quite large.  But how accurate that TAM is and how it translates into revenue remains to be seen.  It’s early. What we are seeing today in the share price is a consequence of that uncertainty.

The stock is selling off today because Lake Street reduced their target significantly (from $30 to $12), on concerns that Mirataz revenue will be lower than modeled.

Kindred Biosciences price target lowered to $12 from $30 at Lake Street Lake Street analyst Brooks O’Neil lowered his price target for Kindred Biosciences to $12 following the company’s Q4 results while affirming a Buy rating on the shares. The analyst says that while Mirataz, Kindred’s first approved drug, is off to a solid start, he now believes revenue from the drug will be lower than modeled previously. However, the company has a “deep pipeline of attractive drug candidates for the large and growing companion animal medicines space,” O’Neil tells investors in a research note.

I don’t have access to Lake Streets research so I don’t know how much they reduced their sales estimate by.

Reading over the conference call it looks like this was probably the key exchange that led to their reduced expectations (my italics):

Brooks Gregory O’Neil, Lake Street Capital Markets, LLC, Research Division – Senior Research Analyst [43]

Sure. It makes sense. In the past, you guys have talked about 9 million cats having inappetence and big percentage, perhaps as many as 50%, being chronic. What have you seen in the U.S. market so far in that regard? And can you say if you see any big differences between the international opportunity for Mirataz and what you’re seeing domestically?

Denise M. Bevers, Kindred Biosciences, Inc. – Co-Founder, President, COO & Director [44]

Sure, Brooks. So again, I’ll just reiterate that our product is labeled for 2 weeks, and that’s what we’re marketing toward. The challenge we have, of course, as I’m sure you understand, is getting down to patient-level data. The way to do this is through market research. We have ongoing market research initiative. What we do know is that unintended weight loss impacts many chronic conditions, cancer, chronic kidney disease, hypothyroidism, diabetes. How the veterinarian chooses to use the product is obviously up to his or her clinical discretion. So we will continue to collect market research and report on that accordingly. As far as opportunity, as I said, it’s about 2/3 typically is about the opportunity in Europe versus the U.S. And we suspect that veterinarians will be treating the same host of cats with these conditions, chronic and acute.

I’m thinking that Lake Street took the response to mean that Kindred was backing off of their expectations for the chronic market.  Is it also noteworthy that Lake Street was not part of the last financing?

So I don’t know.  I was thinking Mirataz could do $50 million of revenue once sales matured.  Is that too high?  Reading through a couple of the analysts I have managed to get research from, I was seeing peak numbers around the $75 million range.  This was prior to today’s call though.   What’s realistic?  Tough to say.  There’s really not a lot of information to go on here, which I guess is the problem.

But I’m still pretty interested in the idea, which is why I didn’t just cut and run this morning (I did do a whole lot of waffling however).  The pipeline is big.  In addition to Mirataz, Kindred Biosciences expects 2 drug approvals and 3 more pivotal studies in 2019.

The nearest term opportunity is with a drug called Zimeta.  It controls fever in horses.  Kindred showed positive results in a pivotal study of 139 horses.  The FDA has done most of its due diligence and all that seems to be left is a last manufacturing inspection before it is approved.  The market for fever in horses isn’t huge, but it looks like the drug should be able to get $10-$20 million of revenue once it ramps up.

Kindred announced positive data on its pilot field effectiveness study for the drug epoCat in January.  epoCat is intended to control anemia in cats.  The results from the study looked to be very good (albeit to my untrained eye).  The next step is a more extensive pivotal study that will take place in 2019 with a read out either in late 2019 or early 2020.  If successful the drug could launch late in 2020.  Based on the analyst estimates I’ve seen the revenue from epoCat could be in the $75-$100 million range.

Stepping even further out Kindred has a couple of drug candidates for atopic dermatitis in dogs.  This is a big problem in dogs and there are already a few other drugs on the market.  There are two drugs sold (Apoquel and Cytopoint) by the very large animal health company Zoetis.  The market size of atopic dermatitis is $500 million plus and growing so there is a lot of opportunity.  It’s possible these candidates, if successful and if they prove more effective than the atopic dermatitis options available right now, the estimates I’ve seen suggest the revenue opportunity is over $100 million.

So there appears to be lots of ways for Kindred to win.  Nevertheless, getting smacked on my purchase only a couple days after I bought makes me wonder if there is too much I don’t know here.  One of the things Kindred has said themselves is that animal health is not very well followed or understood – the research on market potential and on chances of success are not as well defined as in human biosciences.  So we are all kind of flying in the dark.

Looking at the competitive landscape, these animal health companies get big multiples.  Zoetis trades at 8.1x EV/Sales.  Idexx Laboratories trades at 8x EV/Sales.  Elanco, which is not really growing, still trades at 4.3x EV/Sales.

So if I spit-ball it and say that Kindred should trade at 7x EV/sales, then the current stock level is pricing in about $50 million of sales (I’m ignoring the cash which I assume they’ll burn through to get there).  Sales at that level are probably 3-4 years out so maybe I am too optmistic.   But even so it doesn’t seem like a high bar to pass given the pipeline of opportunities they have.

But this is a case where I can truly say – but what do I know?  I’ll keep my position small and wait out more information.  We’ll see how the data comes out with Mirataz and I’ll maybe look at adding if it appears Lake Street is wrong and the chronic market for Mirataz is there.

 

Some thoughts on the CNX Midstream guide down

So this isn’t a stock that I own right now.  I have owned it though.  I’ve been following it and some other midstream plays fairly closely since early December.

Up until recently these midstream stocks weren’t performing all that well.  They were getting beaten up with oil even though some of these companies have absolutely nothing to do with crude.

CNX Midstream for example.  100% natural gas and liquids.  They are the child of the old Consol – basically a situation where the E&P assets went into one company (now called CNX Resources) and the midstream assets, so pipelines, compressors, and facilities, went into another.

CNX Resources is a fairly large Marcellus/Utica producer, wet/dry natural gas, 1.4 bcf/d.

CNX Midstream operates all the pipelines for them.  They basically handle gas for CNX Resources and one other customer (HG Energy, which is private) so they are very concentrated.

Most importantly, CNX Resources owns 33% of CNX Midstream.  They are also the general partner, which means they manage and operate CNX Midstream.

On their fourth quarter call CNX Midstream surprised the market.  EBITDA guidance was $200 million to $220 million.  Distributable cash flow guidance was from $150 million to $170 million.

Up until that point analysts had been expecting an EBITDA guide of around $245 million and the floor on DCF was thought to be $170 million.  So this was a significant guide down.  Below is from their analyst day forecast back in March of last year:

So what happened?

Well part of it was that their E&P partner CNX Resources reduced their activity in 2019.  They phrased it as “minimum activity levels” and stressed that they would be “flexible” and add capital depending on prices and returns, but bottom line is that they are budgeting less than was anticipated.

So there’s that.  What can you do – your customer is worried about prices or returns or whatever else and they decide to reduce activity.   That means reduced through-put for CNX Midstream, or at least less growth than the analyst community was expecting.

But that’s only part of the story.  One analyst, I believe his name was Matt Niblack (?) pointed out that there was still something that didn’t quite compute:

…the minimum [DCF] has been adjusted down from $170 million to kind of $150 million to $170 million due to timing and other factors. But there’s still upside to that, and we just have to see how that goes. I guess my only other question here then is, in the minimum guidance range, if that seems — and also, I think implied in CNX’s production growth range, you’re looking at kind of roughly flat economics relative to Q4, right? And I’m just taking your EBITDA in Q4 and multiplying it by 4. I realize there will be some seasonality associated with that, so that will vary quarter to quarter. But for the full year, that’s what you’re looking at. And yet, there’s significant growth CapEx…

So the question is, why are you spending the same amount of growth capital if you aren’t growing as much?

I read the transcripts a couple times and while the company is a bit vague about it I think the hint they give is when they start talking about de-bottlenecking:

“So a significant portion of the capital that we’re spending in 2019 is associated with de-bottlenecking projects”

So CNX Midstream spends money de-bottlenecking.  That’s either compression, looping, twinning… it’s something that is going to lower pressure in an existing line.  Lower pressure of course means more gas.

But it’s more gas on the back of Midstream’s capital.

This brings up the point about the competing interests of the E&P and midstream.  Particularly when the midstream is controlled by the E&P.  Whose best interests is the de-bottlenecking in?

I would argue that the E&P, so CNX Resources, benefits more from de-bottlenecking.   If it was all one company the capital decision would be based on whether we get more bang (ie production/NAV/cash flow per dollar spent) from drilling a new well or from adding compression/looping an existing line and getting uplift from existing wells.

In this case it’s not all one company.  CNX Midstream pays for the de-bottlenecking.  So its a bit of a free-bee for CNX Resources.

Yes, CNX Midstream gets the volumes as well.  But they just get a toll, and they could have gotten those volumes anyway if the E&P had used its own capital and drilled some more wells.  Now I realize that drilling more wells in an area that could use some de-bottlenecking is likely going to back out other production.  Sure. So drill them somewhere else, where there is capacity.  Volumes are volumes for the midstream.  My point here is that the uplift is paid for by the midstream but they aren’t getting the full benefit.

Of course CNX Midstream says that its a good rate of return. From the call: “I mean, we could follow up with those specifics. I mean, those are good rate of return projects. Otherwise, we wouldn’t do those on a standalone basis. It’s sort of like core, like baseload, sort of like easy low-hanging fruit stuff to do.”  And it does give CNX Resources the ability to ramp production more at some point, now that pressures are lower.  So there’s that.

One thing de-bottlenecking definitely does is it helps an asset look better, at least for a while.  Not saying that’s the case here, I really don’t know.  But type curves never talk about pressure.  It’s rate vs. time.  Nevertheless, you lower the pressure and rates go up.  There is a reason engineers do a bunch of crazy math on their wells and introduce concepts like material balance time and pseudo-time.  Its because its pretty easy to get the wrong impression from a rate vs. time graph.

It all just makes you wonder if CNX Midstream might be taking one for the team here?  CNX Midstream spends some money on de-bottlenecking.  It’s not really a big deal in the grand scheme of things, the stock takes a bit of a hit but it bounces because it doesn’t affect the dividend or anything.  CNX Resources gets some free uplift from it.  That helps their guidance.  Everything looks a bit better. No one gets hurt.

Who knows!  Maybe it’s all just efficient capital allocation.  Nevertheless I think the thought exercise is worthy of contemplation: that there is at least the potential of misalignment with these E&P-midstream separations in the United States.

New Position in Digital Turbine

So far I’ve been pretty cautious about buying any stock that is economically sensitive.  I bought some gold stocks, a couple healthcare/biotech names, but nothing that really is at risk of an economic downturn.

Digital Turbine is a departure from that.  They are directly dependent on smart phone sales, particularly in the United States.

So with all the headwinds around smartphones and my own skepticism about the economy, why Digital Turbine?

I think it has potential, even in the return of a bad market, and there is more here than just following the smart phone sales trend.  The stock performed extremely well while the market fell apart in December.

Digital Turbine provides a mobile device app management solution called Ignite.  This isn’t an app-store app.  Digital Turbine partners with carriers (they have 30 carrier customers including AT&T and Verizon) and OEMs (recently signed up Samsung, have another 7 smaller OEMs signed and have hinted at others to come) who install the apps on the phones before sale.

When a customer buys a phone from the carrier Ignite installs sponsored and partnered apps.  These apps have been curated by the carrier and Digital Turbine based on the users preferences and from a list of app developers who have paid for the right to be included on the install list at the time of activation.  A list of other sponsored apps that might interest the customer is also displayed during the set-up process.

In the past virtually all of Digital Turbines revenue came from these installations and recommendations at the time of activation. App developers paid Digital Turbine for those placements and installations.

Recently the company has leveraged their platform by adding a number of products that add value through the device life-cycle: Single Tap, Smart Folders, and Post-Install Notifications.

The Smart Folder app organizes apps into folders.   Embedded in each folder are recommendations of other apps to download, which based on past preferences the user might find interesting.  For example a gaming folder might be created for the users gaming apps.  When accessing this folder they would see “similar” apps, which are sponsored content of other games that can be downloaded.

Another product is Single-Tap.  This allows the user to download an app directly from a notification, advertisement or Smart Folder list without accessing the app store.  Because the app is not installed via an app store, Google or Facebook don’t take their 25-30% cut.  The app developer benefits with more revenue per download.

These downloads and placements also benefit the carrier.   An important aspect of Digital Turbine’s business model is that the carrier is not Digital Turbine’s customer.  In fact, when Digital Turbine receives revenue from app developers they pass on a chunk of it to the carrier.  Rather than being dumb pipes, the carrier participates in revenue from each placement, install or notification that is generated (note: there is an exception to this if the carrier owns media or apps they want placed on the platform in which case they remit revenue to Digital Turbine for the placement).

It seems like an easy win for carriers.  They put in none of the R&D, none of the marketing, but they get maybe 50% of the margins (its not broken out so that’s my ballpark guess) for simply putting the Digital Turbine platform on their phones.  My understanding is that the carriers are also final decision makers on what and how much content is delivered via Ignite, so they remain in control.

You can see the model is working.  Digital Turbine is installed on 230 million phones right now.  These are all Android phone (the Apple ecosystem doesn’t allow for this type of product).  That is up from 155 million phone in March of 2018.  They peg their annualized install rate at 100 million.

They don’t have a recent snapshot of their quarterly device growth but the snip below is from their Inventor Day presentation in June. You can tack on three more quarters (their year end was March) to get them to the 230 devices that are out there now:

Its a strong base (>10% of android phones) to layer on additional products.  Carriers seem happy to comply since they are getting a nice cut.  To wit, Single Tap was introduced about a year ago and its already on 120 million phones as per the conference call last week.  While the post-install products have all been introduced in the last year, they already account for 15% of revenue.

Revenue is generated as app developers pay for adding their app to the pre-install process, adding it to Smart Folder recommendations, and for notifications or advertisements that are displayed.  The agreements vary between app developers and between carriers but they either take the form of a cost-per-install (CPI) fee, a cost-per-placement (CPP) fee, or a recurring revenue fraction after the app is placed.

The recurring revenue is new, within the last year.  They’ve already signed up Amazon, Netflix, the Weather Channel, Yahoo among others.  If a user installs a Netflix, an Amazon or whatever app via the Ignite platform (be it a pre-install from a Smart Folder recommendation or an ad) then Digital Turbine gets a piece of monthly revenue from that app.

A year ago recurring revenue was nada.  Now it amounts to 5% of revenue.  It was 3% the previous quarter.  Annualized that amounts to maybe $5 million but clearly growing quickly.

The latest big win for the company was Samsung.  They made a deal with Samsung in the fall that added Ignite to Samsung’s factory install.  Once it’s fully rolled out this could mean that Ignite is on every Samsung phone.

The OEM partners are important for international carriers where bring-your-own-device (BYOD) is much more common than in the United States.  Until now an international carrier couldn’t do much to customize the experience of a BYOD customer.  With Ignite pre-installed on the phone, they can turn it on and run through their own customized set-up.

While Samsung accounts for some 500 million devices on their own, Digital Turbine has hinted at more OEM relationships in the works (maybe LG, Sony or Huawei, which were all mentioned in passing on the last call?).

Right now revenue primarily comes from the United States carriers (AT&T, Verizon, T-mobile make up 85% of total revenue).  International is growing.  It was up 100% year over year last quarter with revenue from their large Latin American partner (which must be American Movil) tripling.

This is a business where both revenue and margins are a bit deceiving.  Revenue is more recurring then you think.  The company has an annualized install rate of 100 million devices, so the turnover from that base recurs every few years on a replacement cycle.  The ads, notifications and placements are on an on-going basis.

Margins look weak at a glance, coming in at 35% last quarter.  But those margins take into account the carrier revenue share.  While I don’t know what the revenue share is, it wouldn’t surprise me if its around 50%.  That would make true margins for the business closer to 80%.

Revenue would be less of course.  But if you looked at Digital Turbine and saw an 80% gross margin business with what is essentially recurring revenue, relationships with 30 major carriers, most of the major app developers, and that is on over 200 million smart phones growing at 30% per year, what would you pay?

The company might be a play on 5G as well.  They’ve targeted their platform at phones, but there is nothing stopping them from expanding to other connected devices.  TV’s for instance.  In fact the business model here has some similarities to Roku.

I found the stock on a screen after it popped on its earnings beat earlier this week.  It’s moved some since then and has a market capitalization of $200 million.  Revenues last quarter were $30 million.  With analysts expecting 20% growth next year that’s a P/S multiple of under 1.5x.  They generated $4 million of EBITDA and $2 million of free cash last quarter.  It doesn’t seem that expensive for what you get.

Some of the risks would be:

A. Could Google do the same thing? Maybe, but they haven’t.  They would be cannibalizing their own app store and sharing revenue with carriers when they don’t now, so I don’t know if it would make sense for them.  It’s a pretty small business in the overall scheme of things.  Nevertheless its a risk.

B. Could Google block the platform on Android?  It’s hard to believe that this wouldn’t violate competition laws but maybe it’s a risk?

C. Would carriers develop their own product?  Again, maybe, and in fact based on the filings I’ve read I believe this has been the primary competition for Ignite (though there may be others I haven’t found any other than those mentioned in the 10-K: IronSource, Wild Tangent, and Sweet Labs).  But carriers are getting a pretty good deal here.  They basically do nothing, share in ad revenues, install revenues, app developer relationships that Digital Turbine cultivated.  No R&D, marketing spend on their part.

D. Smart phone replacement cycle slows.  This is why international expansion is important and the OEM deals are key.  Digital Turbine can’t rely on growth in the North American phone market.

E. International expansion doesn’t work. Right now 85% of revenue is the the United States.  They have been working on a ramp with American Movil for over a year now and its still fits and starts.

F. Carriers squeeze margins more.  They just signed deals with Verizon and AT&T so this shouldn’t be an issue in the short-term. It will probably be important to show they can drive revenue growth for the carriers, which of course is good for Digital Turbine as well.

G. The fourth quarter (year end March) guidance did not indicate acceleration – 27% year over year growth at the mid-point and a sequential, seasonal decline greater than last year.  With all the levers: ramping Single Tap, Smart Folders growth, Samsung relationship, I might have thought this would be higher. I’m not sure if I should read into it much though.

H. I feel like their R&D spend is low, which makes me wonder about how robust their business is against competition

I. Oath, which is Verizon’s media group (ie. advertising), represents almost 25% of sales so it is a very large piece of the revenue and represents concentration risk. Overall AT&T and Verizon represent around 80% of revenue.

As always, I’m starting my position small, will add if it appears to be working and will sell quickly if I look like I am wrong.