Skip to content

Week 262: Simplify

 Portfolio Performance

week-262-yoyperformanceweek-262-Performance

 

Top 10 Holdings

week-262-holding-concentration

See the end of the post for my full portfolio breakdown and the last four weeks of trades

Thoughts and Review

I made a grand total of two transactions this month.  I think that might be a record low for me.

The dearth of transactions is that it is not by design.  It’s the result of a shift I made back in February when the market was crumbling.  I decided I would get away from anything that looked like a swing trade.

In the past I’ve taken positions in stocks not because I see strong fundamentals or a particularly good event horizon or an industry development.  Instead I’ll take it as a trade because the stock has sunk down to what looks like the lower level of a range and I think I can catch a bounce as it traces back.

Its a strategy that I think, overall, has been profitable.  Over the years I’ve done it with success with companies like New Residential, Northstar Realty, Brookdale Senior, various oil stocks, and with the tanker stocks.

But its a strategy that expends a lot of brain power and it drains a lot of emotional capital without the opportunity for a big upside.  It also tends to put me into positions that I don’t have a lot of conviction in, and when a market event like what happened in January and February occurs, I end up selling stock at the wrong time.

So I’m not doing it any more.

For example, even though the tankers have traded down to what is really very cheap levels, I’m not playing a bounce.  I didn’t buy into any of the REITs that have recovered since earlier this year.

For what its worth, its probably saved a few grey hairs as I watch Teekay Tankers and DHT Holdings flounder with no appreciable momentum even as the market as a whole rises.  While some REITs have done well, others continue to flounder at lower levels.

It makes for a more boring and arguably slightly less profitable portfolio, but also for one that is easier to stand by through the market gyrations.  As Brexit hit and the market tanked for a couple days it didn’t even occur to me to sell any of my positions even as I lost a few percent.  The stocks I own I do so because I like them and I want to see them through to the events that I believe will result in their upside.

Without many trades this month I will talk about a stock I bought the previous month but haven’t discussed yet (BSquare), one event worth mentioning (Empire Industries spin-off) my investigation into cybersecurity stocks, and an update on what has been happening in the world of NFV/SDN.

BSquare

I’ve owned Bsquare once before but under a different auspice.  The first time around it was because of a good earnings report that made it look cheap.  But I didn’t have a lot of conviction in the business so I sold it soon after for a small gain.

This time I’m buying BSquare for the potential that they may be on the cusp of some growth.  This is another one of those stories like Radisys, like DSP Group, where you have a so-so legacy business and company that has traditionally floundered but there is a new product coming along that might be able to change that.

In BSquare’s case that product is DataV.  DataV is a software application that collects device data, performs monitoring and analytics on the data, and applies rules for predicting future conditions and failures and automating corrective processes within the device.

The product is an example of an Internet of Things application, where a companies assets are connected to the network, information obtained from the asset is used to quickly identify problems, and solutions and operational changes are pushed back to the asset through automated routines.

DataV operates both on the asset and in the cloud at the data center level.  The figure below illustrates the functionality at each.  The green boxes represents a feature set provided by DataV.  At the asset level monitoring and automation of simple rules are performed for time critical conditions.  At the data center level further monitoring and more complicated and less time sensitive automation rules are performed, as more complicated analytics like predictive rules and optimization routines are performed.

datav

Unlike some of the IoT solutions I researched, I feel like DataV is going down more of a solution specific path.  Rather than providing a platform to be implemented across an company’s asset base like some of the bigger IoT names, DataV is being targeted to customers to deliver specific solutions where there is an existing issue that it can solve. It seems like the right strategy, especially since their target market for DataV is the smaller end of the Fortune 500, who are less likely to invest large amounts of capital up front for a platform solution.

BSquare announced their first DataV contract with a major industrial company back in June.  The company described the use cases to be addressed as follows:

Predictive failure. The use of data analytics and real-time device information to accurately predict problems that could impair asset uptime, as well as prescribing remediation steps.

Data-driven diagnostics. Further use of data analytics and historical repair information in order to speed diagnostic and repair time, getting vital assets back in operation more quickly while reducing service and warranty costs.

I also found the following quote from the press release useful for understanding the product:

“This project is emblematic of what is truly possible with IoT: real-time data analytics applied to very large data sets in order to predict future conditions, prescribe corrective steps, and accelerate repair times. Collectively, these DataV capabilities can dramatically improve uptime while reducing cost. We look forward to a long-term relationship with this customer, working closely with them as they leverage IoT to achieve business objectives throughout their organization.

The contract is for $4 million over 3 years.

My hope here is that this is the first win of many.  While the company has only one win, they did make the following comment in one of their job postings, which gives me some optimism that there will be further wins:

Bsquare is investing significantly in marketing demand generation tied to its industry leading DataV IoT platform.  Market response has overwhelmed our current sales capacity, and we are looking for proven inside sales dynamos to join our team. 

I would say my conviction that this works out is medium at this point, so like many of my positions I will start small and build as positive data develops.  Given the size of BSquare, a $66 million maket capitalization with $27 million of cash on the balance sheet, there is plenty of room for upward appreciation if the product takes off.

I have also looked closely at the legacy business and while I don’t want to spend too much time on it here, I will say that it gives me pause.  The company is almost wholly dependent on Microsoft as a reseller and the contract terms with Microsoft have recently tightened.  It doesn’t feel like a very comfortable position to be in. Please contact me if you want more of my thoughts on the legacy business or if you have any insights into it yourself.

Empire Industries and their Hydrovac spin-off

In February Empire Industries announced that they were spinning off their Hydrovac business into a separate company. The transaction makes Empire more of a pure play on their amusement park ride business and creates a new hydrovac focused entity.

Both sides of the spin-out look pretty interesting.

Dynamic Attractions, which is the existing Empire business, is still very cheap, trading at around 3x EV/EBITDA with a market capitalization of about $25 million.  There is a healthy backlog of $107 million though that is down from year end of $130 million.

There is some talk that the next step will be the divestiture of the steel fab business, which would be another step towards making Empire a pure media attraction product company.  The company still has the telescope business and the 30m telescope contract, though recent setbacks make it unclear whether a new site will have to be found for the project before it can proceed.

Equally interesting is the hydrovac spin-off called Tornado.  As part of the spin Empire partnered with a Chinese company, Excellence Raise Overseas Limited, who injected a little under $10 million into Tornado.  $6.9 million of that is equity, $2.5 million is debt (it was supposed to be $7.5 million but the injection was done in USD and Reminbi and the Canadian dollar has gone up since the original agreement).  The equity portion gives the Chinese firm 45.5% of the new hydrovac entity.  If you do the math on that the Chinese entity paid about 25c per share.  The stock is trading below 15 cents.

Tornado is going to use the cash to set up an operating subsidiary in China and offer Hydrovac services there.  In Canada they just sell the trucks.  The business in China will be more akin to Badger Daylighting; contracting out the usage of the trucks and personnel.

Here is what the Tornado management said about their new business endeavor in their first ever MD&A:

news-money-transfer

What I find interesting about Tornado is that at the current price the market capitalization is $9.5 million you are only paying a little more than what the Chinese partner invested in the company.  Yet you are getting both the existing hydrovac manufacturing business in Canada, and the new Chinese expansion.  While the truck manufacturing business has been poor of late, basically delivering flat EBITDA for the last year, before the collapse in oil prices this business generated $2.5-$3 million of EBITDA.

So there is plenty of upside from the existing business that is arguably not priced in.  In addition you have a stake in what happens in the China segment, which is admittedly uncertain.

In addition to what I received with the spin-off, I bought a little bit of the stock because it seems cheap.  I would like to buy more but its hard to get a real sense of how substantial the opportunity in China is.

I have no idea if this is a huge market that they will win big with, or whether this is going to be an uphill battle.  It seems somewhat positive that the Chinese company wants to take a big slice, presumably they are doing so because they see the market opp, and the Empire management has been pretty astute, but who knows for sure.

So we’ll see.  Management is making some interesting moves, they may have some more up their sleeve.

I’m not smart enough to invest in security companies

I spent quite a bit of time over the last month trying to familiarize myself with the cyber security universe.   I went through transcripts, listened to conference calls, read presentations and 10-Ks.  I looked at Palo Alto, FireEye, Proofpoint, Rapid7, MobileIron and Qualys in some detail and more briefly at Tanium, Imperva and Splunk.  I come out of the whole thing still feeling like I only have a foggy understanding of the space.

Of all the firms I think I understand the biggest, Palo Alto and FireEye, the best.  Palo Alto is a firewall company and FireEye is an intruder detection and mitigation company.  I think on the most simplistic level, Palo Alto is trying to stop an intruder whereas FireEye is trying to detect and stop one once one gets in.

Both companies and for that matter most cyber security companies, provide an appliance (which is essentially a server blade that goes into the stack) supplemented by one or more subscriptions (along with maintenance and support which may or may not be bundled into the subscription price, depending on the company).  The appliances sit on premise and perform the basic protection services.  Some of the subscriptions are attached to the appliance, and some are not.

For example Palo Alto, to the best of my understanding, offers an appliance and 8 subscriptions.  These are shown in the diagram below.  The red boxes are subscriptions not attached to the appliance while the blue one’s are stand alone

subs

Just to give some color on what these do, Wildfire updates the firewall appliance with new emerging threats, Aperture provides the ability to monitor SAAS applications, Traps, is installed at the endpoint that prevents untrusted apps from operating. GlobalProtect extends firewall capabilities to mobile and offsite devices, Autofocus allows you to access a database of threat tags that help you identify the source and nature of a threat you’ve discovered, and Threat Prevention and URL Filtering provide some of the basic data required for performing the firewall functions.

So that’s Palo Alto.  If you go through the universe of companies you will find something similar in terms of an appliance with subscription services and/or stand-alone subscription services.

Where things begin to get fuzzy for me is once we get into the smaller players.  So Proofpoint software is primarily geared towards email protection.  Rapid7 and Qualys provide data hunting and analytics that try to aggregate and streamline the vast amount of data coming down to what is relevant.  Mobileiron’s platform manages security for mobile devices.  Imperva provides security to data centers and to a lessor degree to cloud applications and websites.

What I can’t figure out is how it all plays out between these niche companies and the larger one’s like Palo Alto and FireEye.  Is there room in IT budgets for all of these products?  Do the niche players get bought out by a consolidator?  Or does revenue growth start to slow for some of them?

 Another question that isn’t clear to me is how the move to the cloud impacts these businesses.  Some of these companies still generate a significant amount of revenue by selling the appliances.  As those appliances become virtualized and sales are software only, I wonder how margins and revenues will be affected?

In this regard, one of the most interesting things I listened to was this discussion at the Bank of America Global Technology Conference with former FireEye CEO, now Chairman David Dewalt.  Dewalt makes a number of very strong comments; that security is going to move to the cloud, that this will be disruptive, that this will change the landscape of what products and services are required, and that it will move dollars from a product or appliance bucket to a subscription bucket.

The final piece is whether spending has been artificially heightened by a few outsized threats.  There were some significant breaches in 2014 and even some of the company executives I listened to described the following period as being one where companies were throwing money at the problem without discretion.  That appears to be changing now.  We just saw Imperva issue pretty dismal guidance.  Qualys recently characterized the environment as “much more rational” and that we were seeing more caution on the part of customers, that they were looking to consolidate vendors, etc.

Finally, I don’t really understand the growth expectations behind all the names I looked at.  For example, the Stifel universe has 22 cybersecurity companies and the average revenue growth of those companies is 19% for 2016 and 2017.   Yet the cybersecurity market as a whole is expected to grow at 6.9%.   So who are all these low growth or market share losing companies?

It all sounds like one big bucket of uncertainty.  Which is hard to stomach when you are paying the multiples you are for these companies.  So the research has been interesting, but I’m not sure I will be adding any of these names soon.

Whats Happening in the NFV/SDN World

There are a whole lot of datapoints hitting the presses in the world of NFV/SDN.   Here’s a brief run down of what I have come across.

In the last week AT&T announced that they will offer the code to their SDN platform into open source, that they will be introducing virtual security functions for their virtualized network, and that they will be launching network functions on demand starting with 4 virtualized functions.  Of this news, the second may have relevance to Radcom, where there have been hints that their contract with AT&T could be expanded to some sort of security application.  The third piece (more details here) refers to a 3rd party server vendor for the white box back end, which certainly could be something Radisys provides.

Along the lines of the third news item, Radisys and AT&T held a joint presentation demonstrating their Mobile-CORD initiative and how you can monetize SDN and NFV.  Some more circumstantial evidence of the relationship developing between Radisys and AT&T.

This article (here) compares the move to NFV as being the equivalent to the datacenter move to cloud over past decade.  The key difference is that enterprises moved apps like Oracle, Exchange and SAP, CSPs are moving network functions that deliver wireless and wireline calls, text messages, and streaming media, along with services such as VPNs and firewalls.  This article specifically highlights service assurance as one of the two most important attributes of software defined infrastructure:

The second important characteristic of a software-defined infrastructure is service assurance. Customers expect seamless voice, video, and media quality and data protection. A truly carrier-grade infrastructure will deliver on these expectations by quickly analyzing the root causes of component failures, remediating those failures before they impact subscriber services, and ultimately, predicting and avoiding outages and performance issues before they occur. All of this can only be accomplished through automated software.

Another article I found interesting was this one, which exposes 10 myths about NFV.    Two important points made are that encumbents will have to rebuild from the ground up to make their app virtualized:

The best way to build a carrier-grade virtual network function (VNF) is to take a ground-up approach, starting with a purposefully designed modular architecture that addresses performance, scalability and other important requirements, Luxoft recommends.

And that Verizon is looking to share risk with vendors, also move might be to subscription type of relationship with vendors:

Verizon, for example, proposes a new business model in which its vendors share the risk in the introduction of new services.  If a service succeeds everyone will make money.  If it fails everyone shares the risk…Furthermore, virtualization lends itself to usage billing models, not only for consumer services but for business to business services.

I also found this article that talks about the need for both SDN and NFV being brought on by the amount of data that will be travelling the network as the Internet of Things grows:

As the Internet of Things (IoT) becomes more of a reality, and as these companies look to deploy 5G and reap all its promised benefits, most realize that they need to revamp their networks in order to deliver value and to compete (with you-know-who). These trends will result in significantly more data of widely different types traveling across their networks, and to retain service agility on a more-or-less static infrastructure, these operators need NFV and SDN, along with “cloudification” and advances in distributed computing.

This article gives the rather impressive 116% CAGR for NFV and SDN from now until 2021:

Spend on NFV and SDN ramped up in 2015, with analyst firm TBR forecasting the market reach nearly $158 billion by 2021, representing a 116% CAGR.

And finally Mark Gomes gave some interesting scuttle about Radcom in a conversation with an industry contact that he posted over the weekend.

Reluctantly exiting Photon Control

There is nothing more fun than getting this kind of press release about one of your companies while being on vacation with limited internet access.

news-money-transfer

I have absolutely no insights into how this plays out.  Maybe the loan gets repaid and the company puts itself up for sale at a premium.  Maybe the company rights itself and gets on with the business of delivering sensors.  No idea.

What I do know is that when I don’t know what is going to happen, I am more often than not better off selling first and asking questions later.  So I sold my shares.

I note two things since that time.  First, the shares have held up reasonably well, so there is clearly someone willing to buy into the panic.   Second, there hasn’t been any news that the money has been paid back.

I continue to watch the story because the company valuation is compelling.  The market capitalization is $73 million and the company holds $27 million in cash.  After subtracting cash, the stock trades at only about 3x free cash flow.

This is too cheap if the business is viable and there isn’t any overhang from executive malfeasance.

The sensor business hasn’t grown like I had hoped, but that still may come and even in its current state it remains nicely profitable.  I’d love to get back into the stock, but I need to remove the uncertainty before I do.

Portfolio Composition

Click here for the last four weeks of trades.  Note that the two transaction labeled Adj are me manually readding the Empire Industries and Tornado shares.  When Empire did the stock consolidation and spin-off my shares were lost in the practice account.

Also note that I bought RMG Networks stock, which I talked about already owning last month.  This was another unfortunate example of me forgetting to take a position in the practice account, and as a result having to buy the stock later at a higher price.  Oh well, if I am right about RMG Networks the upside will make 20 cents more I paid irrelevant.

week-262

Week 258: In Search of the Next Big Thing

Portfolio Performance

week-258-yoyperformance

week-258-Performance

Top 10 Holdings

 week-258-holding-concentration

See the end of the post for my full portfolio breakdown and the last four weeks of trades

Thoughts and Review

I’m wrapping up the fifth year of the blog and portfolio I track here.  Unfortunately it was my worst year since inception.  With about a week to go I’ve eked out a miserly 3% gain.

In my last few posts I touched on what I think I’ve been doing wrong.  My observation is that I am spending too much time looking for value and not enough time looking for growth and finding major trends underway.

To put that in context, let’s look back at the last number of years for a minute.

I did well in 2009 and 2010 as I bought stocks that benefited from the infrastructure build-out in China, in particular a number commodity producers, mostly copper/nickel (FNX, Hudbay, Quadra) and met coal (Western Canadian Coal and Grande Cache Coal).

In 2011 I extended that thesis into pulp stocks, with wins from Mercer International and Tembec.  In 2011 I also made a few bets on gold stocks that paid off.

In 2012 I stuck with gold and began to see opportunities in small community banks that were recovering but where the market had yet to acknowledge this.  I also saw a slowly recovering housing market, and made successful bets on mortgage servicing stocks like Nationstar, which was a recent IPO, originators like Impac Mortgage, and hated mortgage insurers like MGIC and Radian.

In 2013 I continued the theme of a recovering housing market, with my mortgage insurer bets continuing to pay off, added more underappreciated community banks, and bet on a number of oil and gas opportunities that were taking advantage of the new fracking revolution.  I also correctly discerned that the market would take a more favorable attitude to debt, and so I made some of my biggest gains with stocks with debt, particularly YRC Worldwide, which rose from $6 to $36.

In 2014 my biggest gains were thanks to the ethanol stocks, in particular to Pacific Ethanol, which rose from $4 to $24.  I also did quite well playing the cyclical turn in airline stocks, particularly Air Canada and Aercap.

And how about 2015?  What led to my less than remarkable results?

For one I think that I spent too much time following tanker stocks.  While these stocks were cheap, they couldn’t and can’t shake their cyclical stigma.  Looking at the ships being delivered later this year and into 2017, maybe that is for good reason.

I focused too much on companies that were only marginally undervalued or where there was no real catalyst at hand to improve valuation.  In particular, I wasted far too much time on REITs, both simple single asset REITs like Independence Realty and Sotherly Hotels, and more complicated multi-asset REITs like Ellington Financial, Northstar Realty and even New Residential.  I remember Brent Barber commenting to me at one point to be careful with REITs in the environment we were  entering into, and I should have heeded that call.

I also spent too much time trying to justify the airlines.  As a whole the group is captive to their own history of pitiful returns.  One day multiple expansion may come, but holding too many of these stocks in anticipation of that day is not a good use of capital.

And finally, and more generally, I didn’t have a big theme or trend that worked for me.  There was no China infrastructure, pulp stocks, mortgage servicing, community bank or ethanol idea that I could ride.

For the upcoming portfolio year (beginning July 1st) I am going to focus on finding trends and growth.  The one I have latched onto so far is the move of telecom service providers to software defined networks and network function virtualization, and more generally, the continued move by businesses to locate resources to the cloud.

So far I have made the bet with Radcom, Radisys Vicor, Oclaro and Apigee.  Each of these is bearing or at least starting to bear fruit.  Unfortunately I also came extremely close to taking a position in Gigamon, a company I really like, but instead waited for it to slips into the mid $20’s. It never did and now its $37+.

While I made a couple of endeavors into bio-tech stocks last year and for the most part got taken to the cleaners on those, I’m not giving up on this sector yet.  I have been prepared to lose a few dollars under the agency of education and I am slowing learning more. I have a few more words about TG Therapeutics below.

Overall I really like the stocks that I own right now.  While the risk of what I own remains high as always, I also haven’t felt like I have had so many potential multi-baggers in some time.

I’ve been talking about some of the above mentioned names in the past few posts.  Below I am going to highlight a few others: a new position in RMG Networks, a position revisited in TG Therapeutics and some more information about Radisys.   Lastly I’ll review Intermap, which is more of a crap-shoot than the other names I own, but if the cards align it most certainly is a multibagger.

As for stocks I haven’t talked about in a while but will have to review in a later post, Swift Energy is treading water in the grey market and the warrants I received post bankruptcy don’t even trade, but I remain optimistic that when the stock gets to a big board it will go significantly higher.   While I remain wary of the Iconix debt load a few astute moves by management and the stock will trade at a more reasonable free cash flow level.  And Accretive Health, a very small position that trades on the pink sheets, is struggling through its transition but will soon begin to on-board patients via its long term agreement to manage services for Ascension, the largest non-profit health system in the United States.

It was a tough year but I feel good about the future.  Hopefully its a year that I have learned a little from, and that will set me up for a better one to come.

RMG Networks

RMG Networks provides what is called “digital signage” solutions.  They provide the hardware, content, content management system, and maintenance of the product.  The easiest way to understand “digital signage” is to see a couple of examples:

whatisdigitalsignageThis is a small company with 37 million shares outstanding and about a $37 million market capitalization at the current share price.  Yet even though the company is tiny, they do business with 70% of the Fortune 500 companies.

I came across the idea from a hedge fund letter I read by Dane Capital.  At first I wasn’t very excited about the idea; it seemed like a turnaround story with a struggling business, something I have been trying to stay away from.  It was really this quote from Robert Michelson, CEO, that led me to persist in my investigation:

I joined the company and was incentivized by two things. One, was on the company’s position in a really interesting growth industry, and two, my ability to make a lot of money and not salary bonus, but through equity. And you know, for me — I guess everyone wants to make a lot of money but I want to be able to make millions and millions of dollars. And you know I certainly go back and do the math and say, “you know, to get where I want to get to and it’s not just me — obviously, I’m doing this for the stockholders — this company needs to be significantly larger.” And I didn’t come to a company that was grow at like you 5% or 10% per year. You know, if you take a look at public companies, they get higher multiples when their growth is 20% plus.

The other thing that made it interesting to me is its size.  I already mentioned that RMG Networks has a miniscule market capitalization.  The company generated about $40 million of revenue in the trailing twelve months.  That means that relatively small amounts of new business are going to have an out sized impact on growth.  I will outline the growth strategy below.

The turnaround story at RMG began in 2014 when Michelson was brought in.  He proceeded to cut what was a fledgling international expansion, reduce the sales staff and bring back R&D spending to a more sustainable level.  We’re just on the cusp of seeing the fruits of that turnaround.

While the graphic I posted above shows five distinct end verticals the company has only made significant penetration into the contact center market.

This, in part, is where the opportunity lies.  Michelson is trying to address new markets.  His focus is the supply chain vertical and internal communications.

RMG’s supply chain solution provides real time data to distribution centers and warehouses.   Think about big screens in warehouses providing information about shipments, and performance metrics of teams.  The company currently sees a $10 million pipeline and has been seeing progress with leads with 40 prospects.   In the last few months they moved ahead with pilot programs with five of those leads.  RMG is targeting $5 billion companies with 80+ distribution centers and they expect to generate $1 million of revenue from each pilot if closed.

As for internal communications, RMG has a solution that delivers the existing content and management system but directly to employee desktop computers, mobile devices or to small screens around the office.

Internal communications is a $2 billion market.  The company has had advanced discussions with large customers to roll out their solution across their enterprise.

Maintenance revenue has been a headwind over the past two years, falling from over $4 million per quarter in 2014 to $3.4 million in the last quarter, but should stabilize going forward.  There have been two factors reducing maintenance revenue.  First has been the election to end-of-life older equipment that has componentry no longer supported by manufacturers.   Second, the new products being introduced can have a list price 40-50% less than their predecessors that were purchased 8 years ago and because the company charges maintenance as a percentage of sales, this has led to a reduction in maintenance revenue.  Both factors should begin to abate going forward.

Since Michelson started with the company a focus on sales productivity has led to an improvement in lead generation and new pilots.  Sales productivity was up 50% year over year in the first quarter as measured by sales orders per sales representative.  Michelson describes management as having “a relentless pursuit on costs” which is validated by the decline in general and administrative costs from the $5 million level in early 2014 when Michelsen took over to around the $3 million level and a decline in overall operating costs from $11 million per quarter to $5.6 million per quarter.

With the focus on the new verticals and improve productivity of the sale force new opportunities in pipeline are up over 40%.  And here is where we start to see an inkling that the strategic shift is bearing fruit.  In the sales pipeline, Michelsen said that the number of deals $100,000 or greater has increased by 50% in the last year while the number of $1 million deals have tripled.

My hope is that these early signs of sales improvements lead to an uptick in revenues in short order.

The stock is reasonably priced given the potential upside and it will only take a few good sized contracts to move the needle substantially.  I can see this one becoming a bigger position over time if they continue to execute along the current path.

Wading Cautiously back into a Biotech – TG Therapeutics

Here are a couple of thoughts on Biotechs that have begun to crystallize for me. I just finished reading a book called “Cracking the Code” and have started reading another called “The Billion Dollar Molecule”.  Please let me know if you have any recommendations for other good books or articles to help me with the sector.

While I am still a newbie in the bio-tech world, I am starting to understand a few things about the business.   I would distill the most important of my thoughts into the following three points:

  1. Approval/non-approval of any drug and the subsequent market for it is under SIGNIFICANT room for interpretation. Apart from a few obvious blockbusters that get snapped up by the large pharmas well in advance, there is a lot of uncertainty about what will work and what won’t and if it does work what kind of sales it will generate
  2. There is a big difference between the value of a company in Phase II or II trial that will eventually have to ramp up its own sales and marketing of the drug versus what that drug would be worth rolled into a larger entity that already has the salesforce, marketing engine and infrastructure in place.
  3. Biotechs in Phase 1-3 are event driven, open to interpretation, and their share price is as dependent on the capital markets as it is on the state of their particular research.  In this respect they have a lot of similarities to gold exploration companies.

With those points said, and being fully aware of what remains to be limited knowledge in this sector, as I wrote about last month I did purchase, or re-purchase, a biotech position this month.  I have been buying shares in TG Therapeutics.

The story at TG Therapeutics is the same one I wrote about a few months ago.  But that thesis has moved forward in some ways.

TG Therapeutics has two drugs that are in late stage trials for B-cell cancers.  The first, TG-1101, is what is called a CD20 monoclonal antibody.  To dissect what that means, an antibody is a protein designed to attack a pathogen, monoclonal means it is an antibody that latches on to one particular cell type, and in the case of TG-1101, the cell that is latched onto is a B cell, the latching achieved by way of a protein called CD20, which is expressed on the surface of B-cells. Once TG-1101 grabs onto the CD20 receptor it works eventually to destroy the cell.

The second drug that is in the pipeline is called TG1202, which is a PI3K-delta inhibitor.  An inhibitor blocks a particular pathway (a pathway is a series of action by which a cell changes or creates something), in this case the pathway is called the 3-kinase pathway.  The 3-kinase pathway is one of the most activated pathways in human cancers.  So the theory is that if it can be blocked, cancer development will be stunted.

TG-1101 is in Phase 3 trial in combination with an already approved drug called Ibrutinib, which goes by the trade name Imbruvica, and is owned by Abbvie.  Ibrutinib inhibits another receptor on the B-cell called Bruton’s tyrosine kinase.  Abbvie bought Imbruvica for $21 billion in 2014.   Ibruvica has been approved and has shown strong sales; it generated $1.3 billion in sales in 2015 and estimates are that sales could peak at as much as $12 billion.   TG-1101 is expected to improve both the efficacy and safety profile of Ibrutinib when used in combination and so far the results are bearing that out.

A second Phase 3 trial has TG-1101 and TGR-1202 working together.  TGR-1202 is also in a stand-alone trial.  In the stand-alone trial efficacy rates of TGR-1202 are tracking at slightly better than Ibrutinib monotherapy.  In combination, efficacy is even better.

One of the concerns that I believe has hit the stock is because of results that have recently been released for two other PI3Kdelta drugs in development.  Duvelisib (owned by Infinity Pharmaceuticals) and Zydelig (owned by Gilead), have run into issues with efficacy. The market could be looking at this that the read through to TGTX drug is that it is a PI3K inhibitor so in same class as these drugs and so maybe concerns spill over

Everything I have read suggests that Duvelisib and Zydelig had very similar structures whereas TGR-1202 does not.  More importantly, so far TGR-1202 is showing a good toxicity profile (meaning manageable side effects).  So I think we could see the current read through go in opposite direction as the data is digested.

This Barrons article quotes Wedbush as saying that the Zydelig problems have a negative read through for Duvelisib:

Zydelig safety issues raise red flags for duvelisib program. Given their structural similarities and similar mechanism of action, we believe the new Zydelig-related safety concerns provide a negative read-through for Infinity Pharmaceuticals’ ( INFI ) duvelisib program. Zydelig and duvelisib are both inhibitors of PI3K, a family of enzymes that regulate a variety of cell signaling processes, with Zydelig inhibiting just the delta isoform while duvelisib inhibits both the delta and gamma isoforms. A comparison across clinical studies suggests that duvelisib has a poorer safety profile compared to idelalisib, which we attribute to the potentially immune-weakening effect of PI3K-gamma inhibition.

Zydelig, before the recent issues, was approved and brought in $130 million in sales last year.  I saw estimates that Zydelig could reach peak sales of $1.2 billion by 2020.  If TGR-1202 can continue to show a better safety profile, presumably it should be able to take

The differentiation of TGR-1202 the other PI3Kdelta drugs was addressed by TG Therapeutics in a recent press release:

The integrated analysis, which includes 165 patients treated with TGR-1202 alone or in combination with TG-1101, demonstrates that the toxicities observed with other PI3K delta inhibitors such as liver toxicity, colitis, pneumonitis and infection are rare with TGR-1202 with discontinuations due to TGR-1202 related AEs occurring in less than 8% of patients.  We see this as particularly compelling given the recent setbacks for idelalisib with the closure of a series of randomized studies due to safety concerns.  The data presented today provides strong evidence to support the hypothesis that the adverse events seen with idelalisib are not necessarily a class effect.”

TG Therapeutics has about 55 million shares outstanding.  At the current price the market capitalization is about $380 million.  They have $85 million of cash on the balance sheet which should be good for a couple years of cash burn.

Success in the TG-1101 trial will give them a complimentary drug to the widely used Ibrutinib that can be prescribed alongside it.  Success in the combination trial will give the company a “platform” of two drugs from which others can be layered in order to attack the cancer from multiple angles and deliver the knock-out punch.  There are a couple of drugs addressing other mechanisms of attack of B-cells in earlier stages in the pipeline.  And there are investigations ongoing into whether TG-1101 can be used in the treatment of Multiple Sclerosis.

Radisys – Comments on the B Riley Conference

For some reason I get a lot of emails about Radcom and absolutely none about Radisys. I don’t know why? I would be hard pressed to call Radcom the better investment of the two. Maybe there is more upside to Radcom, particularly if they can evolve their product into something that could be used in a larger market (ie. Data center or security) but in terms of product and sales performance, not to mention stock performance, Radisys is the clear winner so far.

Radisys presented a very bullish call at the B Riley conference.  It isn’t coincidence that the stock moved up from $4.20 to $5 in the subsequent days.

To recap the story, Radisys is growing off of three products. FlowEngine, MediaEngine and DCEngine.

FlowEngine is a software defined network (SDN) friendly load balancer; basically a packet forwarding box. It already has a Tier 1 customer (Verizon) that uses it to triage packets in their network. FlowEngine had no revenues in 2014, had $5 million in 2015 and is expected to double revenue in 2016.

At the B Riley conference Radisys CEO Brian Bronson said it’s a $100 million business in the long term.  Towards the end of the Q&A Bronson pointed out a specific deal in India where they were competing against incumbent equipment manufacturers that were delivering similar functionality in a more traditional appliance for $750,000, while FlowEngine could provide the same for $250,000.

MediaEngine manages and manipulates media, is used in the conference space (I believe Mitel is a customer) as well as in VoLTE and transcoding. It’s the biggest revenue driver of the software and systems segment, had about $50 million in revenue last year, and while further growth is expected, it will not be the driver of growth going forward.

DCEngine is a rack solution for telecom datacenters.  As they upgrade service providers are migrating equipment to a data center environment, replacing the central office that they operate in today. The DCEngine rack is half as expensive as the competition. Bronson outlined that their advantage with DCEngine is that they are not the incumbent equipment provider, which stands to lose revenue and margins by replacing their fully populated custom solution with a rack populated with 3rd party equipment.

Because most of the rack is populated by third-party equipment, DCEngine is a low margin business, pulling in 15-20% gross margins though it does deliver 10% operating income. More importantly it will begin to pull through FlowEngine sales beginning in the second half of this year, as there will be as many as two FlowEngine appliances installed per rack, depending on the application.  Bronson suggested that at some point it could pull through MediaEngine sales as well but that is the first I have heard of that so I don’t know what sort of volumes we are talking here. Finally, selling the rack makes Radisys the natural player for profesional services (ie. installation, integration and maintenance) which on a gross margin basis are only about 20-30% but most of that drops to bottom line.

I gave my model for Radisys in the last update. What I have learned in the last month only strengthens my belief that I am likely going to be conservative on my revenue growth forecast.

Intermap Gambling

I had a friend go to the Intermap AGM, and some questions he subsequently asked about the company got me to review my research on the name.

I’ll review the details again but first the conclusion.  Same as what I concluded originally, this is a coin flip with a large potential upside if things pan out, and an absolute zero if they don’t.   I still feel the odds are favorable given the reward but only for a small “option” position type that I have reconciled to losing in its entirety.

Let’s review.  The story is that of an Spatial Data Integration contract, or SDI.  An SDI encompasses data acquisition, which in Intermap’s case entails crisscrossing a jet  over the country collecting IFSAR data, and data integration, which includes bringing the mapping data into Intermap’s Orion platform, integrating it with existing data (both geospatial, think LIDAR, and other layer information that can be tied to a GIS location), and building queries to automate searches and perform analytics on the data.

The SDI that Intermap has won is with the Congo.  Intermap is not dealing directly with the Congo. They are dealing with a prime contractor, of which the rumor is a company called AirMap.  The purpose of a prime contractor is to provide the local contact and regional expertise, and to arrange project financing.

The project financing is what everyone is holding their breath on.  You do project financing on a big contract like this SDI to help address the mismatch between project costs and funding timeline by the government.  It basically is put in place to insure that Intermap gets paid on time and has the cash flow to keep executing on the deal.

The project financing was supposed to be completed within 90 days of some date in February.  This would have put the deadline at the end of June at the latest.  On the first quarter conference call management implied that there could be an extension, but that the expectation was, by way of the prime contractor, that the financing would close by the end of the quarter.   Management said that financing discussions had moved away from financial details and were now focused on operational details, which presumably is to say things are progressing.

Intermap has 120 million shares fully diluted, so about a $20 million market capitalization.  They have $21 million of debt, mostly payable to a company called Vertex One.  The relationship with Vertex One is another wrinkle.  Here is Vertex One’s position in Intemap:

  • They owned 19.8mm shares in June 2015 (from here) and have subsequently reduced by 4.1mm (from this Sedar Filing)
  • 7 million warrants at 7.5c (from Gomes and from Vertex One filing)
  • They have a 17.5% overriding royalty on revenue
  • Hold $21 million of debt as already mentioned

The question is, given the distributed position, what is in Vertex One’s best interests?  I remain of the position that as long as the SDI is in play, Vertex One interests are best held by keeping their hand.  The equity upside is at least $1, the royalty will skim off the top, and they will collect on the debt through cash flow repayments.

But if the SDI is lost the relationship with Vertex likely means game over for Intermap in their current form.  Interest payments will overwhelm cash flow generated from data sales and InsitePro.

Its worth noting that InsitePro is a product sold to the insurance industry to help them identify insurance risks such as flood plains.  While InsitePro is an interesting little product, and management has noted that the addressable market is upwards of $500 million with a similar competitor product from CoreLogic currently running at $50 million annual sales, the company is really all in on the SDI and it is the success or failure of it that will determine Intermap’s fate.

So Intermap is a binary bet worth holding a small slice of if you don’t mind taking a significant risk.  I’m ok with it, I still think it makes more sense at this point that the deal closes then doesn’t.  But I won’t be shocked if I am wrong.

Extendicare’s Slide

In retrospect Extendicare was probably fully valued when it crossed above $9 into that $9.50 range. But I like the long-term trends in the business which always makes me reluctant to sell a stock like this. With the stock back down to below the $8 level it looks like I am in for another cycle. While I didn’t add any in the tracking portfolio, I did add to the stock in my RRSP.

I can’t be sure what has precipitated the sell off. It could be that the activist is reducing or exiting. The first quarter results were a little light, they are struggling with the Home Health business that they are integrating and margins are coming up a bit short.

I believe they are correct to expand into the home health space. Government is going to try to keep people in their homes as long as possible because its cheaper.  While the publicly funded side of the business is always going to be constrained by funding, it does give the company a base from which to build a private business, which they are starting to do.

I think of my wife’s parents, who take care of her mom’s parent in their home in Ontario. They get a nurse every day for an hour that is publicly funded but even with that help its becoming too much.  One option is to start paying a nurse to stay longer, or come a second time later in the day, out of pocket.  Its those kind of needs that Extendicare can serve.

What I learned about listening to Oil Bears

Its pretty interesting to look back at what has been said about the oil market on twitter over the past 6 months. From January to March there was a decidedly negative bent on oil market tweets. Many of these tweets were made by users with a large follower base, which presumed a degree of authority to their comments. I actually made a list of these tweets at the time, because I really wondered whether the market was as dramatically out of balance as was being suggested.

I’m not going to call out names, but it just reiterates that twitter has to be taken with a grain of salt.

I mostly sold out of my position in Clayton Williams Energy and Surge Energy.  I hold a few shares in one account but am out of these stocks in the practice portfolio.  I’ve replaced the position with another name that feels a bit safer with oil at these levels, an old favorite of mine called RMP Energy.  I continue to hold Granite Oil.

What I sold

I sold out of Health Insurance Innovations after the announcement of the proposed ruling by the Health and Human Services department to limit short term medical plans to three months and not allow renewals.   This is their whole business model, and if it goes I don’t know what happens to the company.  I also noticed that I have been seeing complaints about the company’s call centers aggressive sales tactics pop up, which is worrisome.

I also sold out of Oban Mining, which has been another gold stock winner for me, more than doubling since the beginning of the year.  I just don’t want to overstay my welcome here.

Also note that I did take a position in BSquare, which I will write up in the next post.

Portfolio Composition

Click here for the last four weeks of trades.

week-258

Week 254: Just a Bunch of Company Updates

Portfolio Performance

week-254-yoyperformance

week-254-Performance

Top 10 Holdings

week-254-holding-concentration

See the end of the post for my full portfolio breakdown and the last four weeks of trades

Thoughts and Review

First some house keeping.  RBC’s has added new tools to make it easier to show performance for practice accounts.  I’ve maintained my portfolio manually through an excel spreadsheet for the last couple of years because RBC screws up the purchase values on their portfolio holding page and the gain/loss on individual stocks are, at times, ridiculous (my average cost is sometimes negative).

Recreating the results, even after building a visual basic routine to update the month of trades, was quite cumbersome, so I welcome these new tools.   At the beginning of the post I showed a list of my top ten holdings and below are all my positions, both are from the new tools.

The only information that is lost in this new format are the position by position gains and losses. While this is unfortunate, its so much less work compared to the process I had to go through before that this is how its going to be.

With that said…

I didn’t purchase any new stock in the last month so this is going to be a bit of a boring update.  I’ve be dedicated the space below to a discussion of a few of my larger and/or more interesting positions.

With April/May being an earnings period, there is a lot of information to consume.  I had mostly good news from the companies in my portfolio. I’ve tried to stick to names with solid operating momentum, staying away from those that might be turning it around but where good news has yet to trickle out.  And that has served me well.

As I have remarked before, my portfolio has been sitting in a holding pattern for the better part of a year.  While I am still waiting on a break out from the range, I feel better about the stocks I own than I have for a while.  Not all of them will pan out of course, but a few will, and hopefully 1 or 2 will be the multi-baggers that I depend on for out-performance.

Radcom

There is a lot to write about Radcom.

Radcom’s first quarter results were fine.  The company had revenue of $6.5 million and generated non-GAAP income of 15 cents per share. Perhaps the only negative about the quarter came out in a subsequent filing, that over $5 million came from their Tier 1 client, AT&T.

For the first time the company provided revenue guidance for the full year, a range of $28-$29.5 million.  They said that they were very confident in their ability to achieve this guidance as 80% of it was already secured with contracts.  In a later filing they said that 50% of their revenue in 2016 would come from North America.

Putting that together, Radcom is saying that they will generate about $14-$15 million from AT&T, and another $14 million from their existing non-NFV deployment.

Overall this is all as expected to slightly positive.   But the quarterly results and guidance don’t begin to tell the whole story here.  In fact what is most telling about guidance is what is left out; it does not include any contribution from additional Tier 1 service providers.

The company is actively pursuing additional Tier 1 customers for their virtual probe solution (MaveriQ).  They said they are in discussions with carriers from North America, Western Europe and APAC.  I’ve heard that the number of Tier 1’s is in the range of a handful.

It was reiterated on the conference call that MaveriQ is well ahead of its peers. Competitors either haven’t rolled out an NFV product, or if they have they don’t have real world implementation on it, and it is still tied to hardware.

We have competitors in the market but to our best understanding and everything that I am hearing from the CSPs and say they enrolled out an NFV product, some are saying that they have – they don’t have real world implementation on it. Some seem to be still in the hardware area and you cannot monitor an NFV network with the equipment, that’s why we believe they were the first mover and we were widening the gap with our competition.

This is inline of what I have gathered from one of the leaders in physical probes, Netscout, who recently said that their first virtual device would not be released until May.  I listened to Netscout’s webinar dedicated to NFV where they talked about their virtual probe technology and I was not impressed.  It felt like the event was put together to prove that they were in the game.

I note that Mark Gomes wrote the following on Friday, which corroborates with scuttle I had picked up from a different source:

In fact, word is spreading that RDCM’s product (MaveriQ) scored a perfect 100/100 in its lab trials, while the nearest competitor could only manage a 70/100. In other words, RDCM’s technology lead is wide, making them the de facto leader for NFV Service Assurance.

Amdocs provided some color around the cost advantage of virtual probes in this interview.  Justin Paul, head of OSS marketing at Amdocs, said the following:

The fixed video network model uses virtual probes instead of physical probes. This is because traditional, physical probes can’t probe a virtual network and the cost of a virtual probe is significantly lower than a physical one. We’re working with Radcom to implement a vProbe solution with a North American CSP and we’re seeing from the work we’ve done there that physical probe is 20-25% less costly than a physical probe. In addition, you can throw up a ring of probes around a specific area to address a specific peak in demand and redeploy those licences elsewhere when the peak has passed. They’re cheaper to buy and they offer greater flexibility and agility to operators because of that redeployment capability.

Since the results of the first quarter Radcom announced a share offering.  What has followed is an ensuing sell-off in the shares ha culminated Friday when the pricing of the shares came in at a disappointing $11.

Maybe I am too sanguine but I am not worried about the sell-off and while the dilution is unfortunate it is not overly material compared to the eventual upside.

Whether Radcom did a poor job selling their story, were poor negotiators, or just deemed the institutional backing and analyst coverage as being worth the cost of dilution at a somewhat low-ball price is unclear to me.

In the same article I quote above Gomes commented about over-subscription.  I have heard similar comments from another source.  The price action on Friday where the stock traded enormous volume and did not dip below the offer price suggests significant demand even as some shareholders throw in their cards in frustration after what could be perceived as a poor deal.

So the evidence is that the offer price is not a function of lack of interest and not a reflection on investor enthusiasm for their business prospects or for the strength of their MaveriQ solution.  And that was the real negative here; does $11 reflect poorly on Radcom’s business?  If it does not, and is a function of their willingness to concede in order to improve their balance sheet and get institutional support then really its not very negative at all.

I added to my position in the days leading up to the pricing.  That’s unfortunate.  I could have gotten those shares lower on Friday. But I do not see any reason to back track on those purchases.

I sat on a 1-2% position with Radcom for a couple years, all along thinking that this was an interesting little company with a promising technology that was worth keeping close tabs on in case they were able to step into the big time.  That is exactly what they’ve done with AT&T and are on the cusp of doing with other Tier 1’s.  I would be want not to do exactly what I anticipated doing in the event of such a progression.   And in the long-run I don’t think I will care too much that I bought the stock a day or two too soon.

Radisys

The first quarter results marked another step along the trajectory towards transforming Radisys’s business. The company continues to add to its suite products and services designed to facilitate the migration of service providers towards virtualizing their networks.

The company hit the high end of their guidance and then raised their guidance for the rest of the year.  They raised revenue to the range of $195-$215 million from $180-$200 million previously.  They left earnings per share guidance with the range of 22-28 cents on the expectation that additional costs would be incurred to support the expected revenue ramp.

he guidance raise was in large part due to the new DCEngine product.

DCEngine is a rack frame pre-installed with open-architecture software and white box hardware.  Its designed to be an alternative to the “locked in architecture” sold by the incumbent providers, and is consistent with the move to virtualize network functions (as opposed to tying them to hardware) so that upgrades, additional capacity and new functionality can be installed via software installs rather than hardware swaps.

DCEngine had its first order from Verizon, a $19 million order, at the end of the fourth quarter and this order was fulfilled in Q1.  On the first quarter call the company said the order from this service provider was expanded to $50 million, with the rest of the order expected to occur in the second quarter.

While this a large order for a company Radisys size, what is most interesting is that Brian Bronson, the CEO, referred to it as a “rounding error” in comparison to what Verizon needs to build out.

DCEngine is a low margin product, somewhere south of 20% gross margins.  But volumes could be significant, and management said that once the product gains traction that DCEngine orders “should be in the hundreds of millions.”

In addition, there is ancillary revenue to be gained from DCEngine sales.  Right now Radisys populates each rack with two white box switches.  In the second half of 2016 the company’s FlowEngine product will be upgraded and allow Radisys to replace those switches with it.  FlowEngine is a 60%+ gross margin product.

Second, the move from central office to data center is complicated and often requires support services from Radisys.  Providing the rack positions Radisys as the natural support resource, which on the call the company said can add another 10 points of operating income.

The company painted a positive picture of growth going forward.

They said that in addition to the Verizon order they were in discussions with a dozen service providers for DCEngine and expect to have 4 to 6 in trials by the end of the year.

With MediaEngine Radisys continues to ship product to their Asian servicer provider customer and said they are  “increasingly confident in our ability to secure further orders.”

They also see strong orders for FlowEngine in the first half from their Tier 1 carrier and while that might taper off somewhat in the second half they are still expecting revenues for FlowEngine to double year over year and there is the opportunity that more orders will materialize in the second half.

There are a lot of evolving parts with Radisys which make it difficult to pinpoint a forecast.  If I assume that revenue can grow 10% in 2017 on top of midpoint of guidance growth in 2016, that gross margins stay constant and SG&A and R&D costs increase modestly, I easily get to an EPS above 40c in 2017.  This seems like pretty conservative projections and yet it should easily support a stock price that is 50% higher.

guidanceWhat is interesting is how sensitive the numbers are to incremental revenue growth.  15% revenue growth produces and EPS above 50c while 20% revenue growth in about 60c.

What this makes clear is that there is real upside if the product suite begins to gain traction and realizes some of the expectations management alluded to one the conference call.  The speed of the move up above $4 makes it difficult to pinpoint exactly where one should add to their position, but I feel like somewhere in the low $4’s, high $3’s will look like a good price in the long run.

Medicure

I was pleased with the first quarter results announced by Medicure.  Sales were down to $6 million from $9.5 million in the fourth quarter.  Earnings per share were 5c again down from the fourth quarter.  None of this was unexpected after the run-up in earnings in Q4 due to Integrillin shortages.

Earnings as reported by the company are also being depressed by higher intangible amortization due to Medicure reversing some of the write-down of intangibles related to Aggrastat in the fourth quarter of last year.  These intangibles show up in the cost of goods sold (which is why margins were down to 86% in the quarter) and most drug companies exclude them from their adjusted earnings.  Without the intangible earnings would have been 8c per share.

As the slide below, from their first quarter presentation, demonstrates, first quarter sales of Aggrastat were down sequentially as wholesalers that had stocked in the fourth quarter due to shortages of Integrillin purchased less but still up from the third quarter.

q1salesThe company also provided data for hospital bag demand, which was down again from the fourth quarter but to a lessor extent than sales, and up significantly from Q3.

q1bagdemandInterestingly, the company gave a couple data points to help investors normalize their sales data.  They said that first quarter sales understated demand by “a couple million dollars” because of the destocking.  They also said that they are currently shipping 1,700 bags per week, which works out to 20,000 per quarter and means that bag demand has continued to ramp subsequent to the first quarter.

The day before earnings Medicure announced that they are in the process of filing for bolus vial format approval – this will make it easier for hospitals to use Aggrastat. Some hospitals struggle with delivering high dose bolus via intravenous pump instead of syringe. The company provided the following clarification on the conference call:

Although the current bag format can be used to deliver the HDB as well as the maintenance infusion, some physicians and hospital catheterization labs prefer to administer the initial bolus dose with a smaller volume of drug product.  Moreover, the availability of a ready-to-use bolus vial will provide greater operational similarities and efficiencies for hospitals transitioning to AGGRASTAT.

Finally, although there is nothing concrete yet, the company reiterated its interest in purchasing Apicore, the generic supplier that they own 5% of, have a purchase option on the remaining interest, and are in partnership with for the production of a as of yet unnamed generic later this year.

There were a couple of questions in my last post about Medicure.  In particular what generic Integrillin meant to Aggrastat and second, whether Aggrastat itself would have a generic equivalent soon.

The second question came up because when you look at the patents that Aggrastat has, some of them run out as soon as 2016.  While its still not totally clear to me everything I have read suggests that when a drug is approved for a new indication it extends the exclusivity of the drug.   Medicure was granted patent until 2023 on the high dose bolus.

I still haven’t found the smoking gun that addresses this type of situation specifically but I did find a number of resources that indicate that generics will not be allowed until the high-bolus patent expires. This link to the FDA describes the periods of exclusivity for various NDAs. This slide show describes how a new drug is patented and how the exclusivity period is determined.  This q&a describes how a patent is extended with a label change for a new indication and how that will keep a generic off the market. In the book “Cracking the Code” authors Jim Mellon and Al Chalabi write:

Quite often, drug companies therefore try and extend patent life by tweaking the molecular structure of their drugs, changing the dosages or combining their drugs with other therapies to try and create a novel but similar product that allows the patent life to be extended.

Also worth noting is that Medicure does not refer to generic tirofiban (the drugs name) competition as a risk factor in their AIF.

As for the generic competition from Integrillin, it is real and occurring but Medicure allyed concerns by updating their price competition slide to include the cost of the generic.

pricecomp

Aggrastat remains the cheapest of the bunch.

I have added to my position around the $5 range and even caught a couple purchases in the $4’s.  Unless I am wrong about the direct generic competition being years away I think the stock is too cheap and should trade up to a high single digit number on the current level of Aggrastat sales alone.  If there is a positive event with Apicore, the new generic introduction, or additional sales from new indications for Aggrastat, then all the better.

Air Canada

I continue to believe that Air Canada is misunderstood.  Maybe some day I will be proven right.

The stock trades at a significant discount to all of its peers.  The justification behind the discount amounts to:

  1. Air Canada has a lower operating margin
  2. Air Canada has a comparatively higher debt load
  3. Air Canada’s strategy of capacity additions is bound to end in tears

I get that (1) and (2) validate a somewhat lower multiple than a debt free, high margin peer.  But the current discount is too much.  As for the third justification, I think it fails to recognize what Air Canada is trying to accomplish.

Air Canada is adding capacity, but it is not to serve a slow Canadian economy. Capacity is being added to international flights in what they see as under-utilized Canadian/international hubs in Toronto, Montreal and Vancouver.  The strategy is to pin-point international demand where the location of the hub and cost structure puts them at an advantage against the competition.

Air Canada is also taking advantage of what is actually a lower cost structure on some routes (due to Canadian dollar based expenses and new airplanes with better efficiency) to claw back trans-border traffic that they lost to US carriers during the dark period of their bankruptcy and near-bankruptcy.

Finally Air Canada has added new planes and routes that increase their flexibility to redistribute the fleet during slowdowns like the one that we have seen in Alberta.  It didn’t seem to get a lot of focus in the first quarter follow-up but the Alberta slowdown barely blemished their results.

I think its instructive that with few exceptions when Air Canada comes up on BNN’s Market Call, the pat responses is:

  1. The Airline industry is always terrible
  2. Air Canada has gone through bankruptcy before
  3. It can’t be different this time

What is unfortunate is that there is no quick fix to this perception.  The past couple of years of mostly excellent results are proof that it is going to take time, maybe a full cycle, before portfolio managers become comfortable with the idea that Air Canada has positioned themselves to withstand economic weakness and grow the business in good times. Perhaps when oil prices recover and we see the Canadian economy turn up investors will start to conclude that hey, that was the downturn, and look, Air Canada is still standing.  I’m willing to wait that out as long as the company continues to perform.

Health Insurance Innovations

Health Insurance Innovations turned in a very good first quarter but they haven’t gotten a lot of credit for it.  Revenue was up 88% to $42.5 million. EBITDA grew from a negligible amount in the first quarter of 2015 to $4.2 million in 2016.   Policies in force grew from 195,100 to 258,000 sequentially while submitted applications grew from 153,300 to 192,200.  They saw growth from all their sales channels but in particular Agilehealthinsurance.com, their online sales channel, doubled from 11,000 policies submitted in the fourth quarter to 23,000 policies submitted in the first quarter.  Both revenue and EPS guidance were increased for the year.

I’m not sure why the stock hasn’t responded better.  There is a large short interest, which I don’t really understand, so maybe those players have been doubling down on their bet.  The mid point of EPS guidance is 40c, so the stock trades at 15x this years earnings which does not seem expensive given the growth they are beginning to experience.  I suspect that comments on the conference call are partially responsible for the muted response.  They said their baseline assumption is that growth will level out at Agile until the next open enrollment:

we’re taking a view that says a lot of people bought it during open enrollment that’s why we’re still strong and things are going to level off until the fourth quarter when open enrollment comes in.

Hopefully, we’re wrong and we have dramatic sales in between these open enrollment periods, but frankly given the dynamism of this market, we’re not sure and so we’ve done our best to forecast sales at Agile and the rest of the company over the next six months and that take place in our guidance.

I think this might be conservative.  The story seems to be getting better.  At the current price the growth trajectory that has began to emerge over the last couple of quarters is not priced in. While something has held the stock down since the release of the first quarter results, I doubt that can continue with the release of another strong quarter.

Shorter thoughts on a few other names

Granite Oil

Granite Oil had their credit line reduced from $80 million to $60 million.  While I expected some reduction, this was a bit larger than I had anticipated given that the company has such modest debt levels compared to its peers.  Fortunately the company only has $40 million drawn so the reduction is not really an impediment.

Intermap

Intermap still hasn’t received initial payment to allow it to start its SDI contract in the Congo.  I never expected this to be easy and I acknowledge that the stock is a flyer so I have it sized accordingly.   The bottom line is that the risk reward remains attractive if you treat the position like an option that could expire worthless (or close to it anyways) but also could be a ten bagger.  I note that Mark Gomes, who I quoted above, is involved in Intermap as well and has written a number of good posts on the name.

Rentech

Rentech had a not unexpectedly terrible quarter.  In the fourth quarter the company was pretty clear that the ramp at Atikokan and Wawa wasn’t going smoothly, needed more equipment, that they were still tweaking operation plan, and that they were not even sure Wawa would reach original capacity.  In the first quarter they appeared to get Atikokan on-track which leaves Wawa.  Here is what they said about Wawa on the conference call:

Our production shortcomings appear to be the product of limited experience operating the plant at higher levels of throughput and sustained operations as a result of our past conveyor problems. We are now experiencing the operational and production issues that we should have witnessed last year, but for the conveyor problems.

Even with these recent challenges, we’re still learning how to respond to or prevent these causes of production disruption that are typical of ramp-up of new pellet mills, such as sparks, jams, plugging, dust, moisture content, silica content, truck dump outages, hammer mill clogging, et cetera.

On top of that they experienced weather related weakness at NEWP.  The warm winter in the North East reduced demand for wood pellets.

I have only taken a small position in the stock and I don’t plan to add more until we see positive momentum from the Canadian operations.  But I look at these plants like a mine, which I have quite a bit of experience investing in, and the two things I have learned about starting a new mine is that A. it never goes smoothly and B. the initial start-up problems are typically figured out after some time.  So I think Rentech will get their hands around this, and I want to be ready when they do.

Mitel

I sold out of Mitel, at least for now.  The acquisition/merger with Polycom takes the company further down the path of being a hardware provider for enterprise telecom solutions, which is not really why I found the stock interesting.  The justification around the deal is mostly about cost reductions and synergies, not growth, which again is not inline with my original thesis.  And the combined entity still has to compete against Cisco which is significantly larger and has been taking market share from Polycom.  Until I get a better understanding of where Mitel is going from here, I thought it best to exit my position.

TG Therapeutics

I bought back into TG Therapeutics at $7 last week.  There hasn’t been any negative data to justify the fall in the stock of late.  My original investment thesis still stands, just at a price now that is about 2/3 of what it was at the time.  Really, if anything we are getting closer to the conclusion of their Phase II and Phase II studies.

By the way, if anyone can recommend any good books for understanding biotechnology please send me an email liverless@hotmail.ca.  Thanks!

Portfolio Composition

Click here for the last four weeks of trades.  Note that the 224 share AdjIncr transaction is because when Swift pink sheet equity converted to new equity I lost my shares in the practice account and so I had to restore those manually.

week-254

Week 250: Getting back to even

Portfolio Performanceweek-250-yoyperformance

 

week-250-Performance

See the end of the post for the current make up of my portfolio and the last four weeks of trades

Thoughts and Review

I’ve been trying to stick to core ideas over the last four weeks, not taking fliers and taking a very close look before I purchase anything.  If you remember, last month I reflected back on the last year, where I really didn’t do all that well, and concluded that my so-so performance could be attributed to too many mistakes with peripheral ideas that I either held too long or should not have gotten into in the first place.

At the same time I’ve been willing to tweak my exposure to stocks up a notch because my two main worries have abated.  As I wrote in my February post what worried me was:

  1. The collapse of oil bringing about energy company bankruptcies that a. lead to investor losses that start to domino into broad based selling, and b. lead to bank losses and bond losses that cause overall credit contraction
  2. The collapse of China’s banking system leads to currency devaluation and god knows what else.  Kyle Bass wrote a terrifying piece (which I would recommend reading here) about how levered China’s banking system is, how their shadow banking system is hiding the losses, and about how government reserves are not large enough to pacify the situation without a significant currency devaluation.

Both of these events seem off the table, with the first maybe completely eliminated and the second at least postponed.

Still the market is back to that 2,100 level and it is difficult for me to get excited about another move higher.  Where I can I have added some index shorts and also some individual tech name shorts to balance in case of a pullback.

Still finding new ideas

Even as I try to be cautious, I still have found a lot of new stocks this month.  I added positions in Swift Energy, Clayton Williams Energy, Granite Oil, Medicure, Rentech and Oclaro.  It was a busy month and there are lots of stocks written up below.  I feel pretty good about all the ideas, with the usual caveat that if oil starts to go south my oil stock positions will be reduced quickly (not Swift though, which is a special situation as I will describe).

Canadian Dollar Doldrums

I’ve had some decent gains in the last month and am back within a a few percent of my highs.  But quite honestly my portfolio would be back to its high already if this damn Canadian dollar wasn’t killing me.

About half of my portfolio is in US stocks but as a Canadian I report my gains and losses in Canadian dollars.  Lately, every day the market is up the Canadian dollar is up (usually a lot) and because of that a chunk of my gains disappear.  To give it perspective: since the beginning of the year the Canadian dollar has gone from about 1.38 US to 1.27.  Every $100,000 I had in US dollars was worth $138,000 at the beginning of the year; today its worth $127,000.  Its been a headwind.

I’ve been saved by picking some US stocks that have done very well.  Radisys continues to be huge.  Apigee is a big winner off its lows.  Clayton Williams has doubled in a few weeks.  Both Iconix Brands and Patriot National have had big runs off their lows.  Things would really be rolling if I didn’t have to deduct 10% from the aggregate sums.

Oh well.  The Canadian dollar going up means that oil is going up, and living here in Calgary I can tell you that is a good thing.  Things are unquestionably slow in the city.  If you are in the oil and gas sector, its depressing.

Cowtown Slowdown

As an aside with respect to my home town; I honestly don’t see the Armageddon situation that some have described. I bike past downtown condos every day and while the sun is up so I can’t count the lights, I can count bbq’s and bicycles on the balcony in these supposedly empty apartments.  I live in one of the downtown “high-end” neighborhoods where its been said that “every second house is for sale” and yet I see only a smattering of for sale signs and a number of them sold.  The restaurants I walk by still seem busy.  To be sure, things are slow and if you work downtown in the patch they are miserable, but overall it seems not very different than a year ago.  Is this what depression looks like?  Or do I just not have the clear perspective of an outsider, what I see being distorted by a home town bias?

Oil move

I’ve given up trying to predict whether this is the real move in oil  and if not when that move will come.  So just like all the other head fakes, I’ve added positions on the move up with the expectation I can be nimble enough to squeeze out some profits even if this turns out to be another short term blip.

I will repeat what I wrote in September about oil, which could be paraphrased to say “I don’t think anybody really knows”:

But with all that said, I remain neutral in my actions.  I’m not going to pound my fist and say the market is wrong.  I’m just going to quietly write that I don’t think things are as certain as all the oil pundits write and continue to be ready to pounce when the skies clear enough to show that an alternate thesis is playing out.

With that let’s talk about some stocks because I have a lot to say, starting with two of the three oil stocks I bought (I’ll talk about Clayton Williams at a later date).

Swift Energy

I think this would could be a legitimate 20 bagger if it all pans out.  If only I had the confidence to make a Cornwall Capital style bet on it.  I tweeted about this last week because I wasn’t sure if I’d be able to mention it in a post before the effective date.  Unfortunately that looks to be the case as the stock was halted all day Friday.

Swift is in bankruptcy.  At the end of last year they prepackaged a plan with bondholders.  That plan has been approved by a judge and the company should be coming out of BK shortly.  In the plan existing equity actually does quite well, retaining 4% of the new company shares plus 30% of equity via warrants.  The warrants are well out of the money compared to the current pink sheet price.  But they are also very long term, with half of them expiring in 2019 and the other half in 2020.

The bankruptcy plan converts ~$900 million of bonds into equity.  The company that emerges from bankruptcy will have $325 million of bank debt and, net of cash, somewhere around $250 million of net debt.  So the balance sheet is very de-levered compared to the company pre-bankruptcy and also compared to its peers.

The pink sheet implies a market capitalization of around $240 million and an enterprise value of  just under $500 million.  That means that the market is giving Swift an EV/flowing boe valuation of $16,000.  Checking that against the RBC universe, peers trade at between $30K and $100K.  On an EV/cf basis, which I again compare off of the RBC price deck for 2016 ($40 oil and $2.50 gas), Swift gets a 5.5x multiple versus 10-20x average for the RBC coverage universe.

As I said the warrants are way out of the money but by my calculations they provide an extremely healthy upside scenario.  You get 7.5 warrants per share.  Half of those warrants are in the money at ~72 cents, with the other half at ~78 cents.  If you get a stock price of 90 cents by 2019 you are looking at nearly a $2 return on your ~20 cents purchase.  $1 gets you close to $3 return.  See the model below:

pinksheet-returns

Of course a lot has to go right for all this to happen but its a long runway and even at 90 cents you are looking at an EV/flowing boe of around $43K and EV/cf of 15x assuming flat production, $40 oil and $2.50 gas.

The dream scenario is that natural gas prices go up some time between now and 2019.  If we hit $4 gas again Swift is going to make a lot of money, and a $2 billion enterprise value is not impossible (would still only be $62,000 per flowing boe on current production).  That would give you a 26x return on a 20 cent stock purchase.

On the downside, obviously management is not ideal.  Went into downturn with no hedges and way too much debt.  Operationally it actually seems like they’ve done pretty well though.  And the acreage they own, particularly Fasken, looks like some of the best of the Eagleford.

Granite Oil

This is an oil stock I’ve held in the past and that I bought again after it appeared that oil was going to make a legitimate run. I have added to it in the last week as oil has stayed very firm in the face of some bad news (Doha, Kuwait).

But I’m a bit worried.  Granite just doesn’t seem to be performing like it should. Below is a performance comparison I stole from this Investorvillage post:

peercompapr2016

The problem with investing in any of these Canadian juniors and intermediates is that production data comes out semi-publically through a subscription you pay for via IHS.  I of course, do not have access to this data.  So there is a chance that some are seeing declines in January and February and getting a head start selling on what will be a weak first quarter.

Granite also hasn’t put out a new presentation since February, which you can construe a few different ways, both positively and negatively.

Granite may also be in the penalty box because the same management team sold out their shareholders when they took an offer for Boulder Energy (of which Granite had split last year) at around $2.50 per share, or about one quarter of what Boulder traded at last year.  I imagine there are pre-split shareholders of both names that decided to jettison Granite in disgust after the Boulder news.

Granite currently trades at a $200 million market capitalization and has $40 million debt.  In the third quarter they produced 3,476 boe/d.  Their valuation is roughly inline with peers, though Granite’s low debt position should allow for some premium in my opinion.

They have proven themselves to be solid operators; in 2015 they “decreased capital costs by 29 percent through the year to $2.0 million per well” and operating costs from $7.50 per boe to $6.00 per boe (source).

What I have always found exciting about Granite is that they have a low-decline and relatively low risk development opportunity applying a gas injection enhanced oil recovery technique on known reserves.  But they also have a very large surrounding land position, which allows for a significant expansion of the program if oil prices recover and make them attractive to a larger acquirer.  Below is a map from their presentation to give you an idea of their current drilling focus and more importantly the expansive land package that surrounds it:

landposition

So I like Granite as a reasonably safe way to play a price recovery.  I am optimistic that the poor share price activity is an opportunity and not an omen.  The company remains reasonably priced with low debt and is one of the very few oil companies in Canada that can squeak out profitability with oil prices above $40.

Medicure

I got the idea for Medicure from a radio program we have in Canada called Moneytalks.  It used to be that Moneytalks was full of gold and silver interviews and end of the world enthusiasts so for a long time I did not make time to listen.   But lately Michael Campbell has been interviewing more real managers who have been giving out the odd gem of an idea with Medicure being one that I was enticed to buy.

Medicure was recommended by a PM at Maxam Capital.  I found this excerpt on the company in one of Maxam’s recent letters to clients:

maxamposition

Located in Winnipeg Medicure is a small pharmaceutical company with a drug called Aggrastat that prevents thrombosis and is used intervenously in hospitals.  Sales of Aggrastat have been growing rapidly since FDA approval first of recommended dosage in 2013 and then an expanded dosage regime in April of 2015.

aggrastatsales

On top of their ownership of Aggrastat, Medicure also has an option to purchase a growing generic manufacturer in India called Apicore.  This is where things get a bit fuzzy.   As part of a financing they orchestrated for Apicore in the summer of 2014 Medicure received a 6% interest in Apicore stock and an option to acquire the remaining shares at any time before July 2017.  But in a strange twist, the purchase price of the remaining shares of Apicore is undisclosed.  I looked all over trying to find an indication of what the option price is, but to no avail.  So trying to value the option is a bit of a guessing game.

Medicure gives a small hint in their presentation that it is probably worth more today than it was in the summer of 2014.  They provide the following information with respect to Apicore’s sales each of the last 4 years:

apicoresales

Clearly there has been significant revenue growth at Apicore since Medicure was granted the option to purchase the company.

The balance sheet accounting of the Apicore interest doesn’t help much because the only changes Medicure has made to the value of their position is due to currency fluctuations.

Medicure trades at a market capitalization of a little under $90 million.  They generated operating cash flow of $7 million in 2015 and do not have significant capital expenditures.  Aggrastat is growing and so one should expect increasing cash flow going forward.  And then you have Apicore on top of that, which must be worth something, though its not clear what.  So adding it all up, it seems that the current price of the stock does not reflect the cash flow generation capacity of Aggrastate let alone the value of the purchase option for Apicore.

Rentech

I got the idea for Rentech from @alex_estebaranz on Twitter.  Up until this year Rentech has operated two businesses: the first being wood processing (wood chips and pellets) with operations in Canada and the United States, and the second being fertilizer, with two plants producing nitrogen based fertilizer.

In 2015 the company decided to get out of the fertilizer business in order to reduce debt.  In August Rentech sold their East Dubuque fertilizer plant to CVR.  They followed this up with the sale of their Pasadena facility in March of this year.

The sale of East Dubuque to CVR was the more significant of the two deals.  Rentech received 1.04 units of CVR Partner stock in addition to $2.57 cash.   The proceeds have allowed Rentech to pay off about $150 million of debt.  Even after the payoff of Rentech retains 7.2 million units of CVR (valued at about $60 million).  They have $95 million of cash.

Rentech has 23 million shares outstanding so at $3.30, it holds an $82 million market capitalization.  The remaining debt they have is about $136mm. Subtracting what’s left of the CVR units and cash on hand and the enterprise value is low, only about $60 million.

What do you get for $60 million? A wood chip business called Fulghum Fibers, a US wood pellet business and a Canadian wood pellet business.  Below was 2015 EBITDA by segment in addition to an EBITDA forecast, which I will talk about shortly.

ebitdaforecast

As you can see the Canadian business is a bit of a mess.  They are ramping up new two new facilities and having trouble doing so.  It’s costing more money than anticipated, they’ve had to replace equipment and there is some question whether one of the facility can be ramped up to the original capacity expectation.

Nevertheless, even with reduced expectations Rentech expects that these facilities can generate between $13 to $16 million of EBITDA.  They sell their pellets to Quebec and Ontario Power for power generation, so they have steady customers for their product.

Rentech has also said they are in the process of taking out $10 million to $12 million out of SG&A.

Basically with the sale of the fertilizer businesses it’s a story about turning around the Canadian business and cutting some costs.  If the cost cuts materialize and they can generate the expected EBITDA in Canada, EBITDA can probably touch a number north of $30 million.  That would make a $60 million valuation far too low and something at least double that would be more reasonable.

Oclaro

I got the idea for Oclaro from a friend who is always coming up with off the radar ideas.  Oclaro makes optical transceivers.  The optical transceiver business is not a great business; competition is high and there is always a higher speed device on the horizon to upset any market share gains that you might have scraped together.

You can witness this by taking a look at Oclaro’s gross margins, which tend to hover around the 25% range historically.  But Oclaro is on the right side of the cycle right now.  The move in the high end of the optical market is towards 100G transceivers, and Oclaro has a leg up in this segment.

In particular there is a large build of long-haul optical in China that Oclaro has been winning business from.  They have a contract with China Mobile for 21,000 plus line side 100G long-haul ports.  The China Mobile contract is going to be delivered in Q1/Q2.  There are also contracts with China Unicom and with China Telecom for 8,000-10,000 ports each so similar size to China Mobile, and these are scheduled for early second half of the year.  On top of this there is regional demand from metro China customers that is ramping.

The product wins are leading to a ramp of their 100G production lines:

We will ramp both manufacturing lines for the ACO over this calendar year and we expect to go from shipping hundreds per quarter to thousands per quarter by the end of this year. We continue to believe that the majority of the early demand will be focused on data center interconnect

On their last conference call (second quarter) management made the following interesting comment that demand is exceeding their capacity to build the transceivers:

Our growth in Q3 will not be gated by demand. We’re running very tight on capacity for most of our 100G products, as well as our tunable 10G offerings. As a result, we’re adding significant capacity in all these areas. Our ability to grow will be governed by how quickly our capacity comes online, as well as the capability of some of our piece-part vendors to respond to our increased demand.

In the spreadsheet below I’ve tried to model out what I see happening to Oclaro over the next couple of years and their strong 100G position takes hold.  Their fiscal 2016 is half over, with revenues of about $180 million, so I am forecasting some growth over the next couple of quarters there.

forecast

In 2017 I am making what is probably a pretty optimistic forecast, with 20% growth in revenue and gross margins increasing to 35%.  I’m doing this to get an idea of what Oclaro might be able to generate if things go well.   I suspect that the 40 cents of EPS that I estimate would lead to a share price in the $8 range, maybe higher if growth is expected to continue to be strong.

Health Insurance Innovations

I sold some of my Health Insurance Innovations position.  Not a lot, but enough to reduce my risk if something goes wrong.  I got this across my google alerts and while I don’t know what to make of it, it doesn’t sound positive.

Arkansas News Bureau

LITTLE ROCK — State Insurance Commissioner Allen Kerr said Monday he has issued a cease-and-desist order against a Florida-based company over allegations it has used deceptive practices to try to sell short-term health insurance plans in Arkansas.

Kerr also released a list of tips for avoiding falling prey to dishonest telemarketers trying to sell health insurance plans.

The cease-and-desist order directs Health Plan Intermediaries Holdings, doing business as Health Insurance Innovations, to stop immediately the sale, solicitation or advertising of any insurance plans using unlicensed agents and to stop intentionally misrepresenting the terms of contracts or applications.

Kerr said in a news release that in a phone call with Insurance Department investigators, a Health Insurance Innovations employee offered insurance plans and gave price quotes despite admitting he was not a licensed insurance agent. Also, several company representatives falsely told investigators that two short-term plans, HealtheFlex and Principal Advantage Plan, were in compliance with the federal Affordable Care Act, according to Kerr.

I don’t really know what to make of this news.  It’s probably nothing.  Still, I felt a little better with a little less exposure to the name.

Radcom

A couple of data points occurred with Radcom in the past month.

First of all Netscout did a call on the NFV market and their service assurance offering.  The call was broken into two segments, with the first segment being the more interesting of the two.

In the first segment is an industry expert from Analysys Mason gave a pretty good overview of the NFV opportunity, its risks and why service providers are inevitably going to move towards an NFV solution. His projections for assurance seem a little light based on what I see so far from Radcom, but I guess we will see how that plays out shortly.  The call is worth listening to in full.

Second, I listened to the Amdocs fourth quarter conference call.  Amdocs gave lots of commentary around what they are doing with NFV and even provided some reference to how RDCM fits in.  Here are the comments I note (I highlighted a couple comments in particular):

When speaking about who will be the winners in this new market:

we think that actually the early adopters would come and the disruptor will come from the small companies. There is a lot of startups in this field, and we believe that some of it will go to the tradition, Cisco or Ericsson and the like but a lot of it will go to smaller companies.

Speaking of carrier advantages of NFV and their role as consolidator:

You can imagine that if you have a network that is all software devices, if you want to accelerate capacity or to change features instead of sending a technician that go to the box and do something, you just tweak it on a control plane in the data center. It’s like managing a huge data center. So the bottom line is that the trend is absolutely there. The nets are trying to fight it as much as they can, we are the disruptor, there are very few others, definitely not in our scale. We believe we could be the integrator of small companies.

And in terms of which carriers are getting a head start on their deployment:

In terms of the geographic spread that you asked, AT&T is probably by far the most advanced company with its theory and its power line under the Domain 2.0. You see some activities in Singapore Telecom, in Bell Canada, in Vodafone Group.

So in the next 12 months to 18 months, you will see the big guys making decisions, that is to say Bell Canada in Canada, AT&T and Verizon in the USA, Singapore Telecom in Asia, Telefônica probably, Vodafone, these are the guys that will make decision.

Finally, what Amdocs will and will not do:

We will not try to build a better virtualized probe than the people that I expect on this or virtualized– if you see packet core (50:39) or something like this, we would not. So we are mainly after the high-end NFV component and maybe some services and integration on the SDN.

Radcom hasn’t performed terribly well as the market has recovered.  The stock has been essentially flat.  But this isn’t unexpected.  It’s still a $100 million dollar company that reported revenue of a little over $2 million last quarter.  I don’t expect a significant move in the stock until it either reports some big numbers, announces another contract, or gets bought out.  The problem is that the last two items are game-changing events, and you can’t predict if one of them is going to happen tomorrow or next year.  So I wait patiently.

Portfolio Composition

Click here for the last four weeks of trades.

week-250

Week 246: Hidden in Plain Sight

Portfolio Performance

week-246-yoyperformance

week-246-Performance

See the end of the post for the current make up of my portfolio and the last four weeks of trades

Thoughts and Review

The market was up and so not surprisingly I had much better performance in the last month.  Even so, I performed better than I might have expected given just how much uninvested cash I have sitting around.

It just goes to show how much of a drag the losers have been.  I’ve had my share of winners in the last year, but my performance has been flat because I also had a bunch of crappy losers.

It would be one thing if I couldn’t distinguish between the winners and losers ahead of time.  But when I look back at what has cost me over the last year, it has been pretty predictable; stocks where I am stretching for a trade, stocks where the value wasn’t clear, or stocks where my primary motivation was their attractive yield.

I’m going to make a concerted effort to prefer cash to those positions going forward.

In the last month I haven’t been actively looking at stocks.  I’ve been surprised by how quickly the market has bounced back and I remain skeptical that it can continue.  So with the exception of a couple of opportunities that I will describe below, I am will remain holding a high cash position until I see a reason to believe the market will sustain a move higher.

Takeovers!

I went a long time without a takeover and then in the matter of 6 weeks I got 3 of them.  First, both of my gold stock picks, Lake Shore Gold and Claude Resources, were taken over.  I bought Lake Shore at $1.12 and, after the takeover offer from Tahoe Resources to exchange each share of Lake Shore for 0.1467 shares of Tahoe, the stock now trades at a little under $2.  I bought Claude at 76c. Silver Standard Resources made an offer of 0.185 shares for every share of Claude.  At the time of the offer this amounted to $1.65.  I’ve sold some of each position and so have reduced stakes in both.  They have been solid performers and I am not unhappy.

A few days after the Claude Resources news my long held fiber-to-the-home play, Axia NetMedia, got scooped up by a private equity firm, Partners Group.   While I was happy to see a quick takeover of both of my gold stock positions, I was more divided by the news from Axia.

The problem is that the opportunity at Axia is much greater than the $4.25 takeover offer.  The company has a massive build out on its horizon in both France and Alberta.  Its becoming clear that fiber-to-the-home is not just a “higher speed-nice-to-have” but a necessary conduit to access all forms of media.  Axia’s cash flow stream once this build-out is complete will far exceed the price paid by Partners Group.

The problem is getting from here to there.  As Axia outlined on their last conference call, the capital necessary to realize the growth is a stumbling block for a $200 million Canadian company.  Axia warned on their last call that they were evaluating alternatives; that they would try to raise capital and if not consider offers by a larger entity with greater access to capital.  Partners Equity is a $50 billion investment management firm.  The only reason that a firm that large bothers with a takeover this small (Axia was a $200 million market capitalization before the offer and under $300 million at $4.25) is because they see significant upside.

Radisys, Radcom, Willden, and what the Market Misses

I’ve made a number of mistakes over the last couple of months but one thing I have done right is add to my positions in Radcom and Radisys in the face of market weakness.

Radisys has had a big move in the last month, moving as high as $4 from $2.50 in January.  I have added to my position on the way up.

The Radisys move over the last couple of weeks has been instructive.  Consider that during the fourth quarter conference call the company announced a large contract from a Tier I customer (from this transcript):

And finally, and maybe most important in this release is, we secured orders totaling approximately $19 million, the majority of which is contained in deferred revenue at year-end for our new data center product targeted at telecom and cable operators which we expect to launch more broadly in the coming months.

The stock moved a little but nothing that couldn’t be explained by what were decent quarterly results.

About three weeks later Radisys officially announced the product, DCEngine, with this press release, along with the name, details and comments from the Tier 1 customer, Verizon.

“As Verizon introduces open, flexible technology that paves the way for central office transformation, we look to companies like Radisys to assist us in that journey,” said Damascene Joachimpillai, architect, cloud hardware, network and security, Verizon Labs. “Network modernization will rely on solutions such as DCEngine that meet service provider needs with open source hardware and software technologies.”

The stock has moved straight up since this press release.

I think this demonstrates how poorly small cap companies like Radisys are followed and how slow the market can be to react to positive developments.  While I find it easy to second guess myself when what I construe as good news in announced and the stock doesn’t move, it is worth reminding myself that this isn’t always an indicator of importance.

With that in mind consider the following situations, Radcom and Willdan Group, two stocks I have had in my portfolio for some time, and Vicor and DSP Group, two new positions that I have added.  I believe all four of these situations represent similar “hidden in plain sight” opportunities.

Radcom

First, Radcom.  Radcom announced in early January that they had signed a contract with a Tier I customer for their next generation service assurance solution MaverIQ.  There wasn’t a lot of details provided, only that the initial phase of the contract would be completed mostly in 2016, and was worth about $18 million.

On their fourth quarter conference call in mid February the company gave more color.  They said the contract for NFV deployment was much bigger than the $18 million announced.  I’m pretty sure its with AT&T.

While they declined from giving guidance (historically the company has given virtually no guidance in the past so this was no surprise) they were willing to say that they expected their cash level to increase to $20 million from current $9 million by end of the first half of 2016, and that the increase in cash would be due to new revenue and not deferred payments.

They also gave an indication of just how big the deal with AT&T might be (my bold):

We just said that we received an $18 million initial deal out of a bigger deal. There is – it’s a large transformation, so it’s not – I think when you’re envisioning it, so I’m going to try to help you model it, right. So when you’re envisioning it, envision something between 2.5 to three year evolution for the very significant portion of the transformation, okay. It doesn’t mean that everything stops after three years, but envision that over the course of those three years, that number $18 million that we’ve disclosed is just an initial number out of something bigger, that’s bigger than that. And I can’t disclose the accurate numbers here. There is things that it depends on. There is – it’s more complicated just throwing other number out there, but it’s much bigger than $18 million, okay.

In addition they made it clear that they are ahead of the competition, witnessed by their comments about Netscout on the call.   They are in the process of trials  with other Tier 1 customers and believe that the next-gen service assurance market will be a “winner takes most” market where they can take the most.

Radcom is a $130 million market cap company.    They just said they can generate $10 million of free cash in the first half of 2016, that the contract they have announced is actually much larger than the announced number, and that they have a product that is significantly better than the competition.

If Radcom can win a couple more contracts in the next year the stock should trade significantly higher than it is now.  it probably gets bought out at some point.   In the mean time I think its quite a good growth story.  The market is really not paying a lot of attention to the “color” provided on the conference calls, and instead is focused on the rather puny revenue that the company generated in 2015 ($18.6 million) and the rather lofty valuation for the stock if you use that backward looking measure.

Willdan Group

Update: I got a response from Willdan IR and they say the revenue is not new revenue and is included in guidance.  I am still of the mind that this is an expansion of scope though and I am happily holding the position I added that I describe below.

Second example.  On their fourth quarter conference call, which I thought was quite positive in terms of the outlook provided for 2016, Willdan stated the following about their ongoing contract with Con-Ed:

We have the extension for 2016 at a value of approximately $33 million. We’re prepared to go beyond this baseline and expect to. The good news is that we continue to perform well for Con Ed and as a result we are in discussions to expand our scope of activity in the second half of 2016 to include more programs targeting customer segments, for example, more of Brooklyn, Queens and larger projects, 100 kW to 300 kW in our SPDI program, the type of programs that will include in the larger retail stores and warehouses and more real estate.

Note that the transcript is incorrectly referring to the SPDI program, which should read SBDI (small business direct install program).

Flash forward to Thursday. In a press release Willdan said the following:

Willdan Group, Inc. (“Willdan”)(WLDN) announced that it has been awarded a one-year, $32.8 million modification from Con Edison to an existing Small Business Direct Install (SBDI) contract.  Under the modification, which extends through the end of 2016, Willdan will be delivering approximately 86 million kilowatt-hours in electric energy savings to Con Edison’s small business customers throughout the entire Con Edison service territory. This includes the Bronx, Brooklyn, Queens, Manhattan, Staten Island and Westchester County, New York. Willdan described this forthcoming modification in its recent fourth quarter earnings conference call.

Based on the language used it seems pretty clear to me that the $32.8 million is in addition to the $33 million baseline contract.  They talked in the fourth quarter conference call about scope expansion with respect to the SPDI and this is scope expansion to the SPDI.

If I’m right, then the market hasn’t caught onto this yet.  Full year guidance is $170-$185 million and so $33 million is significant.

It’s possible I am wrong.  Maybe Willdan is just re-releasing old news.  I would be surprised though.  I have followed the company for some time and their management does not strike me as the sort to throw out a press release with a big number that is a rehash of an already disclosed contract.  It just doesn’t strike me as something they would do.

I think its equally possible that this was the Thursday before a long weekend, that there are maybe one or two analysts following the company, and so no one that was around to check the news cared enough to notice it.  Yet.

For what its worth I added to my Willdan position significantly.  What the heck; I’m buying the stock at the same price I was buying it at a few weeks ago before this announcement anyways.    What’s the downside?

DSP Group

I have been watching DSP Group for a couple of years and have owned it once in the past.  The previous time I owned it the story was primarily one of valuation.  The stock was trading at $7 and the cash and investments on the balance sheet accounted for nearly $6 of that.   But there wasn’t a clear story behind the business itself and so I sold the stock after it went a few dollars higher.

In the two years since the story around the company’s business has been evolving for the better.  The legacy business that they have, and for which I had a lack of excitement in my first endeavor, is the design and manufacturing of chipsets used in the cordless telephones.  It’s profitable and brings in decent free cash, but it’s an industry in decline to the tune of 10-12% annually in recent years.

This business has fallen off the cliff even more in the last couple of quarters.  Slower demand and an inventory build has led to 20% plus year over year declines.   These declines are expected to moderate back to trend in the second half of the year.  However the bad numbers drag down the overall revenue numbers for the company and are hiding some pretty decent growth businesses.

DSP Group has been investing in a number of new technologies that are starting to bear fruit.  Lets step through them briefly:

  1. HDClear – they have developed a new technology that will improve voice quality on next generation phones. On the fourth quarter call the company announced that they had a couple of wins and one of the wins was with a Tier I device supplier.  Turns out that is Samsung, where it has been designed into the S7.  They expect $2 million to $3 million in the first quarter and guided to lower double digit or high single digit revenue for the year.  When I look at some of the numbers I wonder whether it could be higher: according to this article from Reuters (here), DSPG should get 70c-$1 for each HDClear chip sold.  The Samsung S6 sold over 50 million units last year.
  2. VoIP – their VoIP business unit had $22 million in revenue in 2015. They have guided for 50% growth in 2016.
  3. IoT – Eight OEM’s and three service providers have launched products based on DSPG’s ULE technology. They have a ULE chipset that can be used in home automation, security, remote healthcare or energy management products.  They generated $3.8 million of revenue in 2015 and they think that can get to $5 million in 2016.
  4. Home Gateway – Home Gateway generated $14 million in 2015. It is expected to take a step back in the first quarter of 2016 with around $2.5 million of revenue, but this is going to climb as the year progresses and some new product launches, in particular a North American telecom provider.
  5. SparkPA – DSP Group announced a new product, a power amplifier to be used in the high end access point market. They don’t expect any revenues from this business in 2016 but it will ramp in 2017 and they consider the market they are tapping to be over $100 million

The company gave quite a bit of color about the revenue expectations for each of these businesses in 2016 on their fourth quarter conference call.  If you add up the expected 2016 revenue from the new businesses alone you get around $57 million.  These businesses grew at 35% in 2015 and the company said that in aggregate they expect higher growth in 2016.

When I think about a company with an $80 million enterprise value and $57 million of high growth revenue products, it doesn’t make a lot of sense to me.  I understand that overall the company’s revenue is not growing because of the out sized contribution of cordless declines.   But this business is profitable and therefore not a drag on the company, in fact it even helps fund the growth.

I think the stock should trade at least at 2x the revenue of its burgeoning new product lines.  This would be a 50% upside in the stock.  If the growth continues I would expect it to be even higher.

Vicor

I got the idea for Vicor from a friend who emails me regularly and goes by the moniker Soldout.  He gave me a second idea some time ago, called Accretive Health, that I didn’t initially buy and has done really poorly for the last half a year but that I added recently and will talk about another time.

As for Vicor, the company has a market capitalization that is a little under $400 million, $60 million of cash on its balance sheet and no debt.  The company sells power converters.   They offer an array of AC-DC and DC-DC converters that are used in telecom base stations, computers, medical equipment, defense application, and other industries.

Vicor has a history of high-end products and so-so results.  Their technological edge goes back to the 80’s, as they were the original inventor of the DC-DC brick converter, a device that allows the power converter to sit on the circuit board, which in turn allowed a single DC voltage to be distributed throughout the system and converted as required to lower voltages.  However they haven’t made a significant profit since 2010, and even then it was only 80c per share.

The story going forward is simple.  The company says that with recent design wins and product launches, in particular wins for new data centers that will utilize the VR13 standard (more on that in a second), as well as high performance computing, automotive and defense, they can grow revenue 3-5x in the next couple of years.  That estimate comes directly from management (from the third quarter call).

I think it’s fair to say that the array of products that have been introduced and the products which are about to be introduced, for which the development cycle has ended and we’re very close to new product introductions, that in the aggregate these products are more than capable of supporting the 3-by-5 revenue growth goal that we had set for ourselves, and with respect to which we suffered delays.

The increases in revenue in 2016 will coincide with the move to the VR13 class of processors made by Intel (known as the Skylake family of processors) and that are used in a number of high end computing applications.  These processors require power conversion levels that are easily addressed by Vicor’s high efficiency products.  Vicor has already had a number of design wins to be included in VR13 system designs.  The move to a VR13 based architecture has been slower than expected though, and the company has pushed back the revenue ramp from originally beginning in early 2016 to now occurring in the second half of the year.  The company describes the VR13 opporunity below:

VR13 is a class one processor, it’s a class of processors, and it’s processors that in many respects represent the significance that [inaudible] performance relative to the earlier class, which is VR12.5. Now this can be potentially look confusing because, as you follow Intel’s introductions with respect to the many different flavors of these devices, some of them play in a space where now we do not play, and other ones are targeted in particular to higher-end datacenter, more intensive — computing intensive applications. And those are the ones that are relevant to our revenue opportunity.

Vicor has significantly more design wins for the VR13 product line than they did for VR12.5 (again from the third quarter conference call):

To the extent our footprint with factorized power solutions across applications and customers will increase going from VR12.5 to VR13, this product transition is a mixed bag as it may cause near term softening in demand but should result in substantially greater total revenue as VR13 applications begin to ramp.  On a related note, we have started to see significant design wins for our new chip modules as point of load, board mount devices and in chassis mount VIA packages, which validates our expectations of market reception of these products.

Vicor’s technology differentiates them from competitors.  For example they have introduced a factorized power 48V architecture that includes components that can step down voltage directly from 48V to 5,3 and 1V without an intermediate 12V stage.  I believe they were the first company to come up with this solution and I have only seen one other advertising the capability.  Stepping down directly from 48V has higher efficiency and takes up less board space than existing architectures.  On the third quarter conference call the company said the following:

In my recent visits to customers in the U.S. and Europe, I confirmed spreading a rising level of interest in our factorized power 48-volt architecture and are now frontend solutions for automotive, datacenters, high-performance computing, and defense [ph] electronics applications among others.

The 48V products are particularly interesting to data center and server applications where power losses due to the intermediate step-down to 12V are undesirable.  Google, for one has championed a 48V server solution with a new 48V rack standard.  Vicor released a press release describing Google’s initiative:

Patrizio Vinciarelli, President and CEO of Vicor, commented: “By developing its 48V server infrastructure, Google pioneered green data centers. And by promoting an open 48V rack standard, Google is now enabling a reduction in the global cloud electricity footprint.”

The company has been building out their capacity and their existing cost structure can support the anticipated rise in revenue.

So we have significant design wins. We have been working furiously to establish automated manufacturing capacity. There’s been good progress to that end. You know, there’s equipment coming in, factory flaws, have been prepped for it, and we’re going to have a turn now in the very near future in anticipation of volume ramp in Q1 of next year.

If you step through how the numbers would play out and assume that revenues double at some point, a modest increase in SG&A and no improvement in gross margins as revenues ramp, you can see the leverage to earnings that quickly develops. Note that the company has significant net operating losses that will shelter them from tax:

forecast

Keep in mind that I’m not trying to exactly predict how earnings will ramp.  This is not intended to have the accuracy of a forecast.  Its intended to demonstrate the magnitude of the earnings leverage if the company can make good on their expectations.

I have a position in Vicor and expect the stock to move significantly higher if they can realize their revenue expectations.

Tanker Stocks

After watching the tanker stocks dramatically under-perform for the last two months I decided to take a closer look.  I concluded that you can attribute the negativity entirely to the order book for Suezmax and VLCC’s over the next couple of years.  The slide below is taken from the Euronav September 2015 presentation.

orderbook

Note that since that time the gross additions for Suezmax have fallen by 3 in 2016 and risen by 15 in 2017, while gross additions have risen by 5 in 2016 and 5 in 2017 for VLCCs.

The rule of thumb on VLCC demand is that every 500,000bbl/d of demand requires about 15 ships.  The new ships being added covers somewhere between 1Mbbl/d to 1.5Mbbl/d of additional demand.  This seems to be inline with 2016 demand expectations, which I believe are around 1.2Mbbl/d according to the EIA.

Some of the new build activity was likely a rush to procure ships before the introduction costly NOx Tier III compliance requirements which adds an additional $2 million to $3 million to the price of newbuildings (source here)

Adding it all up, this seems like a balanced market to me.  But the stock prices of the tanker equities are trading like a dry bulk type oversupply was about to occur.   I think the extremely low prices we are seeing in these stocks will be corrected at some point during the year, if for no reason other than the typical rate spikes that we see periodically.

I have taken a basket approach and bought positions in Teekay Tankers, DHT Holdings and Ardmore Shipping. Of all these names I think I like Ardmore Shipping the best because the order book for product tankers, where Ardmore has all of its fleet, is the least concerning but also think that in the $3 range Teekay Tankers seems particularly overdone.

These should be viewed as trades.  A move to $5 in Teekay, somewhere in the $11s for Euronav, $6.50 for DHT or $10 for Ardmore and I will cut them loose.  All of these price targets are well below where the stocks traded at the beginning of the year.  I just don’t think conditions have changed that dramatically to warrant the change in stock price.

Portfolio Composition

Click here for the last five weeks of trades.

week-246

 

Week 241: Surviving

Portfolio Performance

week-242-yoyperformanceweek-242-Performance

 

See the end of the post for the current make up of my portfolio and the last four weeks of trades

I had more than one acquaintance send me news that Orange Capital was shutting down.  I found this sad.  Those of you that have been following the blog know that Orange Capital and myself came into large positions in Bellatrix at about the same time.  The fall of 2014.  Both of us saw a company with excellent assets, the potential for significant growth, and a valuation that was compelling.

Unfortunately for us, while company specific factors lined up, the macro backdrop was quite the opposite.  As a consequence in the last year and a half Bellatrix has dropped from my original average cost of $6 down to, at one point, below $1 and current $1.42.

How Orange Capital and I responded was quite different.  Strong in their conviction that Bellatrix had solid assets and weather the storm, Orange Capital held their position and continued to buy more.  Myself, never all that sure whether I am missing some vital information, always wary of “giving it all back”, threw in the towel at around $4.50 in late November, capitulating into an interim low.

That I happened to be right in this case isn’t the point.  I didn’t forsee $20 oil or a $1 handle in front of the AECO spot contract.  I am positive that Orange had a better researched position than my own.  That I was right was, to a large extent, just luck.

What is demonstrated though is a difference in philosophy between what I am trying to do versus many money managers. I’m not a big believer in my own infallibility.  As my positions go down, I try to reduce them.  I’m not perfect in this respect, but its something I try to follow.

This is a methodology that I am finding has its shortcomings in this bear market.  You end up selling a lot of stock only to see bounce back shortly after.  I’ve been whipsawed on a few positions.

The other point I want to discuss, which is semi-related to Orange Capital, is the topic of blowing up.

The point of existence of a hedge fund is to risk money in order to make more of it.  You can argue the particulars of that statement, that risk reduction can occur through various hedges, diversification, concentration, whatever your flavor is, but the bottom line is that the money should be at risk somewhere or why is the fund even there?

But that’s not my job.  While part of what I am trying to do is of course maximize my profit line, my first mandate at this point in my life is also very clearly and in capital letters, TO NOT BLOW MYSELF UP.

I see some of the funds shutting down and stories about others that are down 15 or 20% this year already.  If a hedge fund is down big going into this weekend (I suspect that this is not completely uncommon and that there are many I have read about that are down far more) their primary motivation has to be to get it back.  They need to make money to survive.

I am down 9% since the beginning of the year as well.  But while it would be nice to get it all back, my primary motivation right now is not that.  My motivation is simply to make sure that my family and I are in a position to live comfortably regardless of what happens.  Whether that is 9% higher or not is really not the fundamental point.  Most important, and what I guard against with absolute vigilance, is insuring that my capital doesn’t permanently disappear.

With that said, my biggest transaction over the past month is irrelevant to this blog.  I paid down my mortgage in full. I also went to a mostly cash position in my RRSP (the Canadian equivalent of an IRA).  My investment account, which I track here, has more risk to it at the moment than I would perhaps like, but that is because, as I tweeted on last Wednesday, I thought there was a decent chance of a rally, which we seem to be getting.

So what do I see that is making me take such a bearish, worried stance? A couple things, and I will get into those in a minute, but the overriding factor is the same one that led me to sell Bellatrix in November 2014.  It simply isn’t working.  And when it doesn’t work I have to stop doing it before I suffer a permanent and significant capital loss.

As for those other things, the two legitimate concerns I see are the same one’s everyone else is talking about (which is partly why I think we might be due for a rally).

  1. The collapse of oil bringing about energy company bankruptcies that a. lead to investor losses that start to domino into broad based selling, and b. lead to bank losses and bond losses that cause overall credit contraction
  2. The collapse of China’s banking system leads to currency devaluation and god knows what else.  Kyle Bass wrote a terrifying piece (which I would recommend reading here) about how levered China’s banking system is, how their shadow banking system is hiding the losses, and about how government reserves are not large enough to pacify the situation without a significant currency devaluation.

Just how and to what extent these things come to pass is about as certain to me as $20 oil was in November 2014.  I have no clue.  But they are there, they are clearly worrisome, and what I have been doing is not working.  So I have to act accordingly.

What I did this Month

Not a whole heck of a lot.  In my online portfolio I added back two stocks and sold a few other. I bought small positions back in Relypsa and TG Therapeutics a few weeks ago.  I also made a couple of more buys on Wednesday of last week, adding (very small) positions in Cempra, Apigee, Five9, Ardmore Shipping and DHT Holdings (I subsequently sold DHT on Friday in favor of Teekay Tankers).

This week I added a small Air Canada position back and made two adds to existing positions: Radcom and Intermap.  Radcom gave a very positive quarterly update, said that the recent contract for NFV deployment is much bigger than the $18 million originally announced and that we should expect more contracts in the second half of 2016 or beginning of 2017.  I’m pretty sure this contract is with AT&T.  And while Radcom doesn’t give guidance they did say they expect $20 million of cash by the end of the first half of 2016.  This would be up from current $9 million.  They clarified that the cash is due to new revenue not deferred payments which exemplifies how profitable the new NFV contract is.  I think its quite a good growth story in a landscape bereft of them.

Intermap closed their $125 million SDI mapping contract and I don’t think the market is giving them full credit it for it.  I would expect that as the money rolls more believers will jump into the stock.  Intermap remains highly speculative but if they can follow up this contract with another large contract the upside for the stock would be significant, making it just the sort of market-insensitive story that I like to have in this environment.

Portfolio Composition

Click here for the last four weeks of trades.

week-241

Week 236 Mistakes were Made (by me)

Portfolio Performance

week-236-yoyperformance

week-236-Performance

See the end of the post for the current make up of my portfolio and the last four weeks of trades

I am late getting this update out. Last week I found it hard to write about my investments as my portfolio is getting ravaged every day.

I was doing pretty well up until the end of the year.  I wasn’t at a high, but I wasn’t too far away and the market was only doing ok so that didn’t seem too bad.  I’d taken some one-stock hits in December, on news from Patriot National, Acacia Research and Iconix, but I had managed to make back those losses by working hard to find other names that worked.

Then the new year hit and it all fell apart.

I wrote about 80% of a write-up last weekend.  I intended to write the rest Monday, but my portfolio got smacked.  Same thing Tuesday.  By Wednesday I was selling some positions and adding to others, so my original write-up seemed out of date.  On Thursday I had a miserable day as the positions I had added to (Northstar Realty, Brookfield Residential, TG Therapeutics, Relypsa) took further hits.  On Friday, after some further losses, I threw in the towel, sold a lot of stock, and went back to a big cash position and (where I can) shorts to hedge the rest.

It is a little depressing. I am literally back to the exact same level I was at during the mid-August bottom which is the same level I was at during the early October bottom (note that I’m pretty sure that intra-day of the crash that occurred in August I was quite a bit lower, though stocks recovered a lot of those losses by the end of the day so we’ll never know how bad it got).  No progress.

You work hard, find some good stocks, manage through some bad one’s, scalp a few trades where you can and make some progress and then in a week you are right back where you started.

Not fun.

I made the following tweets on Friday evening that sum up my sentiment:

 

 

 

 

 

 

 

 

So I don’t know, maybe this is going to turn out to be a whole lot of nothing again, but you never know.  What kind of worries me about last week is how many stocks I own and follow made 52-week lows on basically no news.   Stocks that fell like a knife through support on absolutely no reason.  The overall move in stocks was supposedly caused by China but that disagrees with what I saw because what I watched were positions in Northstar, Brookfield, Delta Apparel, Vicor, TG Therapeutics, Relypsa, get obliterated and none of them have anything to do with China (to make no mention of others like Patriot and Iconix, where yes they have their own issues but still the collapsed on no news was somewhat stunning).  In fact much of my losses were the result of buying stocks that I felt were isolated from China but which fell extremely hard anyways.

The last time this sort of move happened was when Bellatrix, RMP Energy and Swift Energy went into free fall in October 2014.  It all seemed terribly overdone at the time but was fully justified in retrospect given what happened to the oil markets.   Looking back on that time, the only thing I wish is that I would have sold out sooner.

I sold sooner this time. Never soon enough, but sooner.

One of my favorite books over the last few years has been Mistakes were Made (but not by me) by Carol Tavris and Elliot Aronson.  In the book the authors investigate how the brain is wired for self-justification. When we make mistakes we experience cognitive dissonance that is uncomfortable, maybe even unbearable.  If we allow ourselves to rely on our natural fallback mechanisms our response is to disengage ourselves from responsibility, make up a story in our head to justify what we did or change the narrative entirely to a more pleasing one.  The intent of which is to restore our belief that we are right.  The consequence is that we do not learn, we do not change, and we are more likely to make the same mistake again.

I am not going to allow myself to justify why I am right and the market is wrong.  Not when I get bombarded with evidence like I got last week.  I don’t know the reason.  Maybe (like with oil in October 2014) there is something out there that I just haven’t figured out yet.  Maybe I’m just picking the wrong stocks in the wrong market.  Maybe everything bounces back next week and I am left scrambling (and I will scramble back into some of these positions if it looks like the coast is clear).  Nevertheless if I was doing things right, this week should not have happened.  I should not be losing 5% in a week.  Something is wrong and the only prudent thing I can do is take a step back until I figure out what that is.

What is written below is what I wrote before the carnage of last week.  Not all of it is relevant.  I sold out Iconix.  I sold out of Relypsa.  I cut Patriot back substantially.  I still hold my golds, and added to a few in the last week.  Note that I also started one new position that I kept, Vicor, but I am in no mood to write it up right now.

Gold stocks: Lake Shore Gold

These gold stocks get no respect.  If I told you that I had a company with a $500 million market cap, zero net debt, generating 50% gross margins and with free cash flow of $42 million in the first nine months what would you say?  Sounds pretty good doesn’t it?  Except its Lake Shore Gold.

I am returning to the gold sector because I see it as a potentially misunderstood investment.  The gold stocks all move inline with the price of gold.  Its painful to watch.  The price of gold goes up $5 and they all get a bid.  It drops $5 and that bid disappears.

Yet for non-US based gold producers it is not the price of gold in US dollars that determines their margins.  Its the price of gold in local currency, or to look at it the other way the cost of production in US dollars.  For Canadian, Mexican and many South American producers, the cost of producing gold has fallen dramatically.  Add to that the reduction in energy costs and many producers are experiencing margins that are actually better than they were when gold was a few hundred dollars higher.

Lake Shore Gold has 439 million shares outstanding.  It has long-term debt of $91 million, cash on hand of $80 million and another $20 million in gold inventory.  In the first nine months of the year the company generated $77 million in cash flow before working capital changes, spent $37 million in capital expenditures and another $7.5 million in finance equipment leases.  Free cash flow was $42 million.

Lake Shore operates two gold mines in Ontario.  The Timmins West Mine is 18km west of Timmins.  Lake Shore produces from two deposits: Timmins and Thunder Creek.  The trend is ripe for new discoveries and there have been a couple with the 144 Gap Zone and 144 West Gap Zone.  Below is a schematic of the four deposits.

timminswest

Production from Timmins West has increased over the last three years:

timminswestproduction

The 144 Gap resource is expected in the first quarter.   By the looks of their underground schematic the 144 Gap can be accessed via existing Thunder Creek infrastructure – Lake Shore said in Q3 MD&A that exploration drift from Thunder Creek to 144 Gap was completed in the third quarter, which should simplify the road to production.

I ran a quick and dirty resource estimate on 144 Gap and think it could post an impressive number.  In their MD&A Lake Shore says that the 144 Gap is 300m x (50-125)m x (75-125)m.  I grabbed a specific gravity estimate of 2.92 from the technical report created for Thunder Creek and West Timmins.   The volume of deposit is between 1.125mmm3 and 4.6875mmm3.  I eyeballed the grade of the deposit from slides 13-15 from this presentation.  The results are as follows:

– 2.92 x 1,125,000 = 3,285,000t

– 2.92 x 4,687,500 = 13,687,500t

– 3,285,000 x 4.5 / 31.1 = 475,000oz

– 13,687,500 x 4.5 / 31.1 = 1.98moz

Lake Shore’s second mine is Bell Creek, which is 20km east of Timmins.  The mine also has the milling facility in addition to the Bell Creek Mine where ore from both Timmins West and Bell Creek are processed.  Bell Creek produced 43,400oz in 2014.

bellcreekproduction

Lake Shore recently bought Temex Gold (September 18th) and their interest in the Whitney project for $23 million.  They acquired 708,000 M&I oz and 171,000 inferred oz at Whitney.   The M&I resource is quite high grade at 6.85 g/t.  Whitney is strategically located; its right next door to the Bell Creek Complex.  Whitney was 60% owned by Temex and 40% owned by Goldcorp.

Below are the company’s reserve and resource.  Because so much of the company’s operation is underground, the resource is less robust than many of their open pit competitors.  I wouldn’t read too much into this.  Underground operations are by their nature going to have smaller resources because its simply not economic to drill extensively at depth until mining has commenced nearby.  As we see with the recent 144 Gap zone discoveries there is plenty of potential for additional ounces to be added.

reserveandresource

The only unfortunate thing is that Lake Shore remains a bet on the price of gold.  And I’m not really sure how constructive I want to be on the gold price just yet.  I’m feeling better about gold; I look back to the years between 2004-2007 where the Federal Reserve was raising rates and gold was rising.  I’m hopeful that the beginning of the rate hie cycle will mark the bottom in the gold price.  But I’m not convinced. If I was I would be plowing money into a profitable and well managed miner like Lake Shore and building a big position.  As it is, I’m keeping my position modest, and we’ll wait and see what the next move is.

I also added positions in Claude Resources and Argonaut Gold.  I already have a position in Oban Mining and Carlisle Goldfields.

Taking Hits and Bouncing Back Part I – Patriot National

I had an abnormal number of negative events hit my portfolio in the last month.  Had it not been for these events, my portfolio would have broken out to new highs.  As it was I instead spent the month paddling upstream against the current.

But this is the nature of my investing strategy, which to some degree is bottom feeding in stocks of questionable merit but with the potential for outsized returns if events fall into place.  Unfortunately in each of these cases events fell outside of expectations.

When I invested in Patriot National it was with the understanding that the company had some questionable behavior in its past.  A perusal of the related party acquisitions over the last 18 months leads to some questions and while I am not going to get into the details here, I would direct those interested to read through the proxy for Global HR Research for an example.

Nevertheless I felt comfortable enough investing in the stock because the business was (and is) growing and the CEO Steven Mariano, owned over 60% of the outstanding shares.  This seemed like a good put to me, that nothing too shareholder negative would be done as his own net worth would suffer.

Unfortunately that turned out to be naive.

My mistake here was that I read the news release, thought that the attached warrant was unfortunate, but did not dig any further.   That is until about two hours into trading that morning with the stock down $4 when I realized something must be wrong.  In the proxy document for the offering was a description of the nature of one of the two warrants being offered along with shares, in particular the exercise price associated with the warrant:

Variable Exercise Price” means, as of any Exercise Date, 85% of the Market Price on such Exercise Date (subject to adjustment for stock splits, stock dividends, stock combinations, recapitalizations or similar events occurring on such Exercise Date).

When I read this I honestly couldn’t believe it.  I thought I must be missing something.  Who offers shares that it is questionable the company even needs and tacks on a warrant that lets you buy more shares at essentially any price.  What stops the warrant holders from shorting the shit out of the stock, driving down the price and then redeeming their warrants at the depressed level?  And even if that is explicitly prohibited by the proxy (which it was) what stops investors like me from worrying that they will figure out a way to do it anyways, and selling their position before it happens?

It was essentially a “no bottom” situation where the more the stock fell the more worried you’d get that there were nefarious forces at work and that it would fall further.  So I sold.  About 30% lower than the stock closed at the previous evening.  But over 30% higher than its eventual bottom.

Amazingly, a week later, on Christmas Eve no less, Patriot announced that they had come to an agreement with the subscribers and cancelled the company offering.  Mariano, who was offering some of his own shares as part of the deal, would still sell his.

This brings us to the current state, which is interesting.  As far as the company, its basically status quo.  Guidance has been reaffirmed, no dilution has occurred, its the same company it was a month ago.  Ironically my original thesis, which was that Mariano owned too much stock to do anything too stupid, played itself out as one would expect.  I doubt that the decision go back on the offering was out of concern for the shareholder base so much as the shock that some $80 million of his net worth had evaporated in a few days.

The problem is that credibility has been lost and as a result the stock is trading at about half the level it was at prior to the debacle.  While I totally understand the perspective that you just have to walk away from any management team that would attempt something like this, I am compelled by just how cheap the stock is.   So I added my position back.  We will see if time and maybe a few good moves can heal some wounds.

Taking Hits Part II and II – Acacia Research and Iconix

Acacia Research was the second negative event to befall me.  This one was relatively simpler than Patriot.  The company lost a patent infringement suit that I didn’t think they were going to lose.  It was for their Adaptix portfolio, which is one of their marquee portfolios, and so it calls into question the valuation of that portfolio.  With the stock down at $4 its trading extremely close to cash and you can certainly make the argument that the current price exaggerates the impact of the legal loss.

I sold because I saw the stock falling, knew that the lawsuit was pending and that therefore it had likely went against Acacia, and suspected that there would be more selling than buying over the following weeks so it was better to get out sooner than later.  I plan to revisit after my 30 day tax loss selling period has expired.

When I entered into a position with Iconix it was with the knowledge that there may be more shoes to drop.  So when the SEC announced a formal investigation into the accounting treatment of the company’s joint ventures, I was disappointed but not surprised.  As in the case of Patriot and Acacia I thought it better to sell first and ask questions later, which turned out to be the prudent move as the stock fell further (20+%) than I would have expected.

Iconix feels binary to me at under $6.  Even after the move last Thursday which jumped it to $7 the stock still seems to reflect quite a bit of pessimism about the investigation.

The company isn’t perfect, to be sure.  To reiterate some of what I wrote last post, debt lies at $1.5 billion which is simply too high.  A few of their menswear brands are experiencing headwinds which may or may not be permanent.  The new management conceded that not enough dollars have been spent on advertising and that a “refresh” of a number of their brands is necessary.

Nevertheless, the company owns strong brands prominent in a variety of retail (Walmart, Target, Kohls, Sears/Target) as well as entertainment brands like Peanuts and Strawberry Shortcake that have long term appeal.  They should be able to continue to deliver consistent licensing revenue.  At $6 the stock reflects 4x free cash flow even using somewhat depressed 2016 numbers.  That’s a cheap number for any business that doesn’t have questions about being a going concern.

On further reflection though I decided that the market was probably punishing the stock on uncertainty and passed transgressions than it was on any new revelation.  I think what happened is that the company is suspect because of the already announced accounting issues, and the press release announced was admittedly vague and light on details, so it was an excellent opportunity to imagine the worst.

Relypsa

I got the idea for Relypsa from @exMBB on twitter.  Relypsa has 41.7 million shares outstanding so at the current price it has about a $1.1 billion market capitalization.  the company has $285 million of cash.

Relypsa specializes in polymeric drugs.  In particular they are targeting a condition called hyperkalemia with a drug called Veltassa.  Here is what hyperkalemia is:

Hyperkalaemia (higher-than-normal potassium levels) follows the kidney’s inability to excrete potassium, mechanism impairment of potassium transport into cells or a combination of both, according to ZS’ website. It can cause cardiac arrhythmia and sudden cardiac death.

 

Veltassa is a polymer that will exchange calcium for potassium.  The existing treatments work on exchanging sodium for potassium, which is not well tolerated in patients.

Our bodies relatively narrow range for which we can tolerate potassium in our kidney.  Most of us take in more potassium than we can handle but we just excrete the extra.  However if you have chronic kidney disease you can’t and you end up with dangerously high potassium levels.

If you have a potassium level of 5.5-6 or greater, there is need to treat the patients, but treatment is intermittent because of the poor tolerance of the available options.  With Veltassa you can take patients that are hyperkalemia, pull down their potassium to the normal range and keep it there.

The patient population is 2.5-3 million patients, with these patients all being parts of the CKD3 and CKD4 (CKD is Chronic Kidney Disease) populations that have high potassium levels.  On one of the conference calls Relypsa said that Veltassa would be sold for $600 per month.

Veltassa has been approved for treatment of hyperkalemia, broad application. The approval occured on October 21st.   The problem with the approval was that it included a limitation of use that it is not be used in emergency situations.  The stock dumped initially but recovered much of the losses through November and December.

The warning label was required because there was some indication of interaction of Veltassa with other drugs – in particular in vitro studies showed interaction with 9/18 drugs tested against.

Listening to some of the recent conference presentations, Relypsa argues that the in vitro test is conservative.  In vitro studies are very good at showing where there is no interaction but give false positives for interactions that need to be verified.

Relypsa is going to perform human drug interaction studies to find out if the in vitro studies are correct.  The human studies they are done with healthy volunteers, there may need to be additional studies with some other patient groups such as type 2 diabetes patients who have stomachs that empty much slower and where a 3hr separation wouldn’t be enough.  But the first results are expected in early 2016.

The concern is that the warning label, if it stays, will put Veltassa at a disadvantage against competition, in particular ZS-9, which was developed by a company named ZS Pharma.  ZS-9 is further behind than Veltassa, an FDA approval decision isn’t expected until the spring and it carries some concerns of its own.

Glassock maintained ZS005’s high hypertension threshold will impact approval or prompt a black-box warning. Lipicky agreed a black box could be issued. Veltassa’s boxed warning states it binds other orally administered medications, potentially decreasing their absorption and reducing effectiveness.

ZS Pharma was recently taken over by AstraZeneca.  They paid $2.7 billion for the company.  ZS Pharma is essentially a one drug company.  The implication is that apart from the warning label concerns about Veltassa, Relypsa should reasonably expect a takeover value in the same range.

Some of the takeover talk has ramped up through December, first with rumors about Merck and then with rumors of a bidding process in the works.  Here is what is said about the takeover possibility on IBD:

Shortly before noon, Street Insider quoted an anonymous source saying that Merck (NYSE:MRK) was about to make an offer for Relypsa for an unknown price. About an hour and a half later, the Financial Times reported that its own anonymous source said that Relypsa was merely starting the process without a particular buyer, though GlaxoSmithKline (NYSE:GSK) and Sanofi (NYSE:SNY) are both potential bidders.

Speculation that Relypsa could be bought has been buzzing since AstraZeneca (NYSE:AZN) agreed to buy ZS Pharma (NASDAQ:ZSPH) last month for 2.7 billion. Relypsa and ZS Pharma both make drugs treating high levels of potassium in the blood; ZS Pharma’s hasn’t been approved, while Relypsa’s drug Veltassa was approved in October but with a stiff warning label about dangerous interactions with other drugs.

Its an interesting situation, one that is speculative to be sure.  There is a short interest that doesn’t buy the story, and plenty of action in both puts and calls.  There is also the question as to why AstraZeneca bought ZS Pharma and not Relypsa in the first place.  Still, I think its worth a speculation.

Portfolio Composition

Click here for the last four weeks of trades.

week-236

Week 231: Tax Loss Buying

Portfolio Performance

week-231-yoyperformance

week-231-Performance

 

 

See the end of the post for the current make up of my portfolio and the last four weeks of trades

Monthly Review and Thoughts

I didn’t make a lot of trades this month.  I added a couple of beaten down stocks (Dixie Group and Iconix Brands), added to a couple of existing beaten down positions (Acacia Research and Health Insurance Innovations), added to a less than beaten down position (Axia NetMedia) and sold out of a few poorly performing positions in PDI Inc, Nevsun, Independence Realty and Hammond Manufacturing.  I also reduced two of the three out-sized positions that I talked about in my last update, New Residential and DHT Holdings on pops.  At this point the only really uncomfortably large position I have is in Air Canada, a stock that seems to do nothing but go down.

It is my experience that the last three months of the year can be very quirky.  The confluence of redemptions and tax loss selling leads to seemingly endless downward moves.  While its easy to describe this as an obvious opportunity when you limit yourself to generalizations or retrospectives, the reality is that it is not so easy to buy that which has collapsed when it goes down every day.

I have plenty of examples of stocks I am following that are examples of this. Most are either yield stocks or energy names of one type or another.

First the REITs.  I could pick from a litany of REITs here but I’ll focus on Northstar Realty because I know it fairly well.  The stock can’t seem to get out of its own way, having endless down days followed by briefing sharp rallies that are followed by further relentless selling pressure that can’t be overcome by even a 2% up day by the market like we had on Friday.  Northstar has a yield 15%.  The dividend is backed up by real estate assets, mostly healthcare and hotels.  On September 29th the company announced a $500 million buy back.  Given the current market capitalization of a little over $3 billion, this is not insignificant.  On the negative side, the stock is externally managed, something that seems to be the kiss of death right now, and its hotel properties have underperformed lately.  Risks for sure, but at what point are those risks priced in?

Another example is Navios Maritime Partners, a dry bulk/container shipper.  Navios cut their dividend in November from $1.77 to 85 cents.  They operate in an extremely tough market, but at the time of the dividend cut they made a strong case that the current level was fully supported by existing contracts with almost a 9 year period.  This outlook was confirmed in a solid analysis posted in Seeking Alpha.  The stock has went down relentlessly both pre and post dividend cut.  It’s at $270 as of Friday’s close so its about a 30% yield.

A third example that I just started looking at over the weekend is Suncoke Energy Partners.  Suncoke owns three facilities that turn coal into coke for steel making.   The company has a market capitalization of $300 million versus a tangible book value of around $500 million.  Earnings for the first nine months were $1.16 per share and full year estimates are $1.50 per share.  The stock trades at $6.59 at Friday’s close.  The steel industry is hurting and Suncoke’s partners are expected to shutdown mills that Suncoke supplies.  On the other hand Suncoke has take or pay contracts and their customers are large producers: US Steel, ArcelorMittal USA, and AK Steel.  So are they really doomed, as the stock price performance (down from $15 since August) suggests?  Or will the partners pay and this a great buying opportunity for assets that are temporarily impaired?

Here is one from the energy sector.  Surge Energy.  I’ve owned it before, in the late spring/early summer.  They are currently producing around 14,000 boe/d with 80% of their production being liquids.  In the first half of 2015 they generated $85 million of funds from operations with the oil price (including hedges) averaging a little less than $60.  In the third quarter they generated $17 million of funds from operations on an oil price of $41, so about the current price.  Capital expenditures in the third quarter were $17 million.  The company has about $140 million of debt, so less levered than most.  Is oil destined to float around the $40 mark forever, in the process sending basically the entire North American industry into bankruptcy, or will it eventually find a higher equilibrium?  If it does what will one of the survivors, as Surge would surely be, trade at?  At 5x cash flow on $60 oil Surge would be worth more than 50% more than it is today.

And one last one from energy infrastructure.  Willbros Group.  Management has been much maligned and struggled to turn a profit in the past.  This year, perhaps because of the pushing of activist investors, they’ve sold off a number of their divisions, raising cash and paying down debt.  With the recent sale of the Professional Services segment to TRC Solutions for $130 million they have reduced debt to under $100 million and they have cash on hand of $50 million.  With 63 million shares outstanding Willbros has a market capitalization of about $170 million.  They generated $2 billion of revenue in 2014 and this year, even after the sales of multiple divisions and the devastating downturn in the energy industry their revenue run rate is close to $1 billion.  The company will likely not be profitable until oil prices turn, but when they do there is a lot of leverage to margin improvement and incremental contracts.

So there are some names.  None are sure things, all can have cases made for and against.  My point is simply that at this time of year there tends to be real bargains, but pulling the trigger is a lot harder because there are also always real questions, and the answers are rarely clear.

The stocks I’m going to talk about below, with the exception of Axia NetMedia, all positions that fit into this mold.  These are stocks that have been beaten up, that have warts, but that I feel are overdone.  I just hope that I am right in more cases than I am wrong.

Dixie Group

Dixie Group is a company I have owned in the past, followed for a long time but held out from buying until it got to a price that I thought presented very little downside.

Dixie Group is a supplier of commercial and residential carpet.  They have 16 million shares outstanding at $5.50 for $88 million market capitalization.  They have $131 million of debt that consists primarily ($84 million) of a revolving credit facility that comes due in 2019.

Dixie Group has undergone a lot of changes in the last couple of years.  They made a number of acquisitions of high end commercial and residential businesses in 2013 and 2014, and have spent the last year digesting the capacity.

The results so far have been lukewarm.  Sales have shown some slight growth while the rest of the industry has seen slight declines.  But the increased scale has not translated into improved profitability.

Some of this is skewed by continued restructuring and sampling costs, and some of it is because there have been employee and quality issues that have arisen along with the capacity additions.

Revenues in the third quarter was $109 million which is flat year over year and up somewhat from the first half.  Ignoring working capital changes cash flow was in the third quarter was $8.4 million.

Even though the headline showed a big miss on both revenue and earnings, I didn’t think it was a terrible quarter in a lot of ways.

Gross margins were up to 26% which is a little above the 25% I had been hoping for two years ago when I was looking at the stock.  G&A is rising more than it should and this appears to be due to restructuring costs, increased medical expenses, consolidation of offices.  They introduced a number of new brands over the last few quarters and those new brands are requiring higher sampling costs.  So there are lots of one time things.

But I think that it is the quality problems that are holding back the stock the most.  They said the impact to quality in the third quarter was 1% to their gross margins.  While they suggested this would decline in the fourth quarter, they weren’t very specific about how quickly that decline would occur and implied it could persist into the first quarter of 2016.

I don’t think the market likes the uncertainty.  Heading into earnings the stock wasn’t that cheap if it was producing no earnings and EBITDA on a $20 million run rate.  But after the collapse from $9 to $5 much less is priced in.  The stock trades at a little under book value.

In their third quarter earnings presentation Dixie presented the following pro-forma to restructuring 2014 earnings.

proformarestructuringSo if the dust settles you are looking at a $27 million EBITDA company with a $219 million enterprise value.  So about 8x EV/EBITDA.  Its not incredibly cheap but with some growth the equity portion of that enterprise value could quickly grow back to the $9 level.

Now of course this is the carrot not a forecast.  I don’t know if Dixie will regain operating momentum, get past their integration issues, and begin to grow the business.  They have the capacity now to produce $550-$600 million of carpet.  They just need to find the customers.  What I do know is that at the current price their is not much expectation priced into the stock.  I think its worth a position, one of those stocks where if anything good happens its bound to go significantly higher.

Acacia Research Third Quarter

Acacia had a really bad third quarter.   Revenue was $13 million down from $37 million in the third quarter last year and a $44 million average revenue over the prior two quarters.

So the stock got clobbered.  For four weeks it went down almost every day, from the $9 level to almost $5.  Was it deserved?  Well, the thing about Acacia is that revenue is always going to be lumpy and one quarter does not suggest any particular trend.  The company generates revenues primarily through the settlement of patent litigation.  The nature of the business is that the counter-party in the litigation is unlikely to settle until the very last moment, usually right before the trial starts.  So Acacia’s revenue recognition is always at the mercy of court dates and negotiations.

The poor third quarter was due to delays on litigation on a number of their patent portfolios.  This quote, from the third quarter conference call kind of summarizes their thoughts on the quarter:

The third quarter developments created paradoxical outcomes. On one hand, our marquee portfolios were strengthened through Markman inter-parties review and new patent issuance wins, and now have even greater future value. But on the other hand, we experienced a delay in collecting on that value.

In particular, their Adaptix portfolio is going to trial against Alcatel-Lucent and Ericsson but that was postponed by a quarter.  This is because of the introduction of evidence that actually strengthened Acacia’s case but required delays for all parties to review.  They also announced that they had won two infringement cases on their Voiceage portfolio (HTC and LG), but that it would take time for a formal opinion from the German court that would lead to a settlement.  Subsequently, Acacia announced a settlement with HTC on November 17th.

Acacia’s business model is to partner with patent holders, applying their legal expertise in patent litigation to help the patent holder maximize the value of their asset.  On that note Acacia said that in the current environment they expected to be able to partner with other patent holders without putting up their own capital going forward.  The environment was a “buyers market”.

At a little over $5, where I was buying, the company was getting close to its cash level of $3 per share.  Even here at $6 it still doesn’t attribute a lot of value to the patent portfolio.  There are a couple of good SeekingAlpha articles that discuss the stock here and here.

Health Insurance Innovations Third Quarter

Health Insurance Innovations (HII) had a so-so third quarter. The revenue number was a little lower than I expected at $25.8 million versus the $28 million I had been hoping for.

But there are a number of changes going on at HII that make the story interesting enough for me to add to my position.   First is the development of an online insurance portal, AgileHealthInsurance.com.  They have had Agile up and running for a few months now, and reported that it had accounted for 1,300 policies in July and 5,800 policies in Q3 (suggesting it averaged 2,250 policies in August and September).  Second, through the addition of a number of former sales personnel from Assurant, HII has expanded their broker channel significantly.

Overall the business is progressing.  Total policies in force increased in the third quarter to a record 137,000, up 31.7% year-over-year and 21.2% sequentially.

The revenue recognition associated with policies procured online is part of the reason for lower revenue.   Unlike broker or call center procured policies, those come from Agile have revenue recognized over the full term of the policy while the customer acquisition cost is taken up front which in the short run will depress margins.

Going forward HII expects to gain from a shorter ACA enrollment period and the reality that premiums on ACA plans are “rising rapidly”.

On the third quarter conference call management seemed quite upbeat about how well they are doing through open-enrollment:

Our short-term medical, our hospital indemnity plans, they really fit the need and we’re seeing, unlike last open enrollment period, a dramatic increase in our sales. We can’t wait to share with you the fourth quarter results when we get to that point. This is for the first time, we’re really playing offense during open enrollment versus last year, we were playing a bit of defense.

The fourth quarter will be interrupted by the ACA period, which began in November.  Still, I think that if the company can put up a decent showing during this period the market will take notice.  Perhaps we are already seeing the start of that with the recent $1 move up.

Iconix Brands

It’s been a while since I have been drawn into a company with a recent accounting scandal.  And while I am wary that these sort of situations often go down far further than I expect, I also know that in many cases the eventual profit can be quite significant if you can get through the rough waters.

Iconix is a company that essentially rents out the usage of their brands.  They buy the rights of well known clothing and entertainment brands and then for a price licenses the usage of the brand by department stores and manufacturers.  Their portfolio of brands encompasses a wide variety of low to high end men’s and women’s fashions as well as well known entertainment brands like Peanuts and StrawBerry Shortcake.

brands

Its a pretty good business that has consistently generate 30% margins and significant free cash flow.

The company ran into problems earlier this year. In March the CFO resigned.  Two weeks later the COO resigned.  And then the biggie in August, the CEO resigned.  At the same time they announced their second quarter results and said that they would be reviewing the accuracy of past financial statements.

This was followed up on November 5th by a mea culpa by the new leadership team that past financials were not accurate and would have to be restated.  Shares which had already fallen from the $30’s to the mid-teens, got halved again to around $7.

What’s interesting though is that the accounting irregularities revolve entirely around the income statement.  Here is what the interim CEO, Peter Cuneo said on the third quarter conference call.

This review has identified errors regarding the classification of certain expenses as well as inadequate support and estimation of certain revenues, and of retail support for certain licenses. As such, we will restate our historical financial statements for the fourth quarter of 2013 through the second quarter of 2015.

A table detailing these adjustments was included in last Thursday’s press release. What should be emphasized is that the amounts of the restatements have no impact to 2013 net income. They do result in a small reduction of approximately $3.9 million or 2.5% to 2014 net income, and they are slightly positive for 2015 net income.

Further, these changes do not impact cash, do not impact historical free cash flow and do not impact debt covenants or securitized net cash flow as defined in our securitized financing facility. In fact, gross collections for our securitized brands are up 3% for the first ten months of the year, which reflects the strength and stability of the assets in the securitization.

Now that its down almost 80% Inconix, with 48.5 million shares outstanding has a market cap of about $325 million.  Iconix also has a lot of debt,  $1.47 billion.  Included in that debt is a $300 million 2.5% convertible that comes due in June of 2016.  Normally this convertible would not be an issue.  Given the company’s problems they may have to fund its repayment out of cash.  When I look at the cash on hand and cash flow they can generate from operations, they should be able to do that without too much problem.

The bullish story here is simply that once the accounting issues are behind them, what will be left is a company that generates significant free cash and trades at an extraordinarily low free cash multiple.  Iconix issued the following guidance for 2016:

We expect organic growth to be flat to up low single-digits driven by double-digit growth in our international business and U.S. revenue down slightly. We’re including no other revenue in our 2016 forecast.

Reflecting these expectations, our 2016 guidance is as follows: We expect revenue to be in the range of $370 million to $390 million. We expect non-GAAP diluted earnings per share to be in the range of $1.35 to $1.50 and we expect free cash flow to be in the range of $170 million to $185 million.

Free cash of $170 million is $3.50 per share.

There are hurdles to reaching that guidance to be sure.  On the third quarter call they said their mens apparal segment was performing poorly because of poor performance by Rocawear and Ecko, both mature brands that may be reaching end of life.

Also one of their biggest brands is Peanuts which is experiencing some headwinds.  Peanuts accounts for somewhere in the neighbourhood of $100 million of licensing revenue, so 25%.  While the recently released Peanuts movie has done fairly well in the box office and in ratings, it is suffering on the merchandising side because it has to compete with Star Wars for shelf space over the Christmas season.

Nevertheless, even with the debt, even with the accounting issues, it seems too cheap to me.  Unless there is something further that comes out on the accounting front I think the stock has to move higher at some point next year. It could go down more over the next few weeks with tax loss selling, but I can’t see it staying here for good.  The fundamentals, un-obscured by fraudulent accounting, just aren’t bad enough to justify it.

Axia NetMedia

I’ve owned Axia for years now and recently added to my position.  The company has 63.4 million shares outstanding, and at its current price of $3 they sport a $190 million market capitalization.

Axia owns and operates fiber networks in Alberta, France and Massachusetts.  Each of these networks supplies high speed connections to smaller cities and towns throughout the area.

Axia has already built fiber trunk lines that provide high speed connections to the major centers in each of their networks.  Now they are in the process of signing up homes and offices and building out fiber to individual customers (called FTTH and FTTO respectively).  The addressable market is over 1 million homes only counting the 20 largest of the 400 communities that the fiber reaches.

In Alberta they have completed at pilot FTTH in one community (Vulcan) and are in the process of ramping up in Drayton Valley and Lloydminster.  The package they offer (which I believe is via third party providers) is $59 per month for 25Mbps rates.  In Massachusetts they offer 100Mbps rates for $49 per month.

This doesn’t seem to me to be a bad package for small town households that previously were limited to slower cable or satellite connections that was intermittent or experienced outages.  Having lived in a small town and having had first and second hand experience of the existing internet options I can say that the following commitment would be a major step up:

We are confident that Axia provides the most reliable Internet possible. In fact, for business we commit to 99.9% availability and a maximum 4-hour mean time to repair in the rare event of a fibre cut.

You can view the Canadian and US plans here and here.

In France the opportunity for growth is even better than in North America.  Covage, of which Axia has a 50% ownership, has 10,600 km of fiber including 3,400 km of fibre backbone.

covagenetworkIn the third quarter Covage’s customer connections were up year over year 36% for FTTO and 61% for FTTH.  On the third quarter conference call Art Price (the CEO of Axia) said that “Covage has sustained growth on its existing networks and has tangible FTTO and FTTP opportunities that could more than triple Covage’s size.”

Subsequent to quarter end Covage won a large FTTO contract that encompasses an additional 22,000 businesses.  Covage currently has a little over 7,000 FTTO connections.  Bringing on 10-20% of these additional sites would mean a large uptick.

Earlier this year Axia won a contract to provide Fiber to Seine et Marne that will pass through 319,000 homes.  Right Covage has around 7,000 FTTH connections.  So think about that for a second.

Right now they are growing steadily (see chart below) but the profitability of this growth is masked by the continued build outs of networks and connections.

connections

 

 

On the third quarter conference call they had a long discussion talking about the need for capital in the business they are in and what this means the eventual end game has to be.   I think its worthwhile reproducing the response in full:

Well, we’re looking at different options, and the way the company is harnessing the capital markets. I would say in the broad, we’ve been a company that is incrementally growing from a small size to a €200 million market cap size. But now we’re a company that has opportunities in front of us that are multiples of our current market capitalization.

And if we were just going to make the comment that where is this fiber infrastructure ultimately destined in the capital markets, well, clearly this fiber infrastructure is going to end up in billion dollar equity market cap, with capital structure that can issue its own bonds for debt. I mean that’s where this kind of investment ultimately ends up and we all recognize that.

So the question is what’s the path to get to that point? Is that path an incremental path similar to the one we have been on, but moving to a different shareholder class in a different size or is it some other path? And the Board is actively looking at that set of issues and looking at it in the context of the current market and looking at in the context of our investment opportunities having this sort of North American and France character, which some of the capital markets looks together at and other parts of the capital market look at that as segmented.

So we’re in that process, because besides the opportunity in front of us, in order to make those available or actually take those opportunities on, of course there is quite a bit more capital involved and our path is either we line up the company for that capital to rate shareholders’ evolution or we aren’t able to take advantage of the number of opportunities in front of us.

That’s a pretty interesting comment.  It basically says that they see the bottleneck and they are going to figure out what is the best way to address it.  It means they either are going to get the market to buy into the Axia story (and produce much larger share price) or try to find an acquirer with the financial clout to build out the infrastructure that they require to grow.

Either way it seems like a likely win for shareholders.  I think Axia is in the right place at the right time.  I’ve been adding.

Portfolio Composition

Click here for the last four weeks of trades.

week-231

Week 227: No pain no gain

Portfolio Performanceweek-227-yoyperformance

week-227-Performance

 

See the end of the post for the current make up of my portfolio and the last four weeks of trades

Monthly Review and Thoughts

Over the last few months I have been focused on minimizing the fluctuations in my portfolio.   This has kind of worked.  I haven’t had the up’s and down’s that I might have had otherwise, given the volatility.  But I also haven’t had the returns.

The reality is that I very rarely do well without experiencing a lot of pain beforehand.  Let’s look at a few examples to prove that point (I’m going off of memory here so allow me a little leeway in the exact figures):

  1. Tembec and Mercer both fell ~30% from my original purchase price before rallying to be triples.
  2. PHH went from $15 to almost $10 before eventually running into the mid-$20s
  3. I originally bought MGIC at $2.50, watched it fall to almost 50c, before finally selling the stock over $8.
  4. YRC Worldwide fell from $8 to $6 before making its run to $30.
  5. I watched Extendicare go from $7.50 to $6, adding extensively on the way down.  Now its at $9
  6. Every time I buy New Residential it seems to fall incessantly for days or weeks after my first purchase before I finally wind up making a good return on the stock.

Unfortunately, the fall is part of the reason for the gain.  These situations turn out to be big winners is because

A. I get to know the story really well (as the name falls, I worry and fret about whether I have screwed up (because I screw up a lot) and in the process I learn a lot more about the position

B. I add to my position.

I know I say I have a rule that I don’t add to losing positions and I cut positions after a 20% loss.  And that is mostly true.  But its not totally true.  What I actually do is dramatically escalate my level of worry at that threshold, which in most cases leads to nausea and good riddance.  But sometimes I find the story compelling and I get stubborn, and in these cases I add.

The mental capital that I expend in these situations is enormous.  I grump and fight depression as the position falls.  I feel elated when it finally rises only to be sent back into gloom as it falls again. Its a gut-wrenching experience and one that I have come to dread.  But it is, unfortunately, an absolutely necessary part of the process.  I know of no other way to capture returns.

I haven’t been doing this lately.  I have been too scared to take risk.  The consequence is that I have sold a number of stocks way too soon.  I sold Hawaaiian Holdings at $26.  I sold Bsquare at $6.  I sold Apigee at $8 (I realize its back at $8 but that was before going to $10+).  I sold Impact Mortgage at $17.  And so on.  In no case have I been willing to scale up.

This month I decided to change my tack.

First, I took a brief but very large position in Concordia Healthcare in the midst of its free fall.  It may not have been prudent and it was probably born out of frustration as much as anything, but as Concordia dropped to $25 Canadian on October 21st I just kept adding.  At the low, I had a 15% position in Concordia and by 11am, as it hit $25 (I believe that was around $19 US) I had fully reconciled myself with the possible carnage I was risking.

I actually sold half of the position at what turned out to be essentially the low.  But seconds later I felt the fear of copping out at a bottom to be more overwhelming than riding the position all the down.  Or maybe I had a rational moment where I considered that the CEO had just been on BNN basically dispelling any connection to the troubles with Valeant and thinking to myself that maybe its just taking a few minutes for the market to catch on to what he just said.  So I bought the whole thing back and more.  I remember my hands were shaking and I was walking around in a daze.  I put a fork in the microwave at lunch.

Fortunately what appeared to me to be unwarranted actually turned out to be.  The stock moved up slowly then quickly, ending the day at $34 and two days later at $44.

I’d love to say I held the whole stash for the run but I didn’t.  Happy with the relief of turning big losses into reasonable gains, I sold stock at $30, at $34 and again at $38 the next day.  I let go of the rest a few days later at $42.

The event, which quite honestly was harrowing, was another reminder.  I have to be willing to be scared if I am going to make money.  This may have been an extreme example, and looking back on it I don’t think it was probably the sensible thing to do, but nevertheless taking a risk on a situation that doesn’t make sense to me is the essence of what I need to be able to do.

Since that time, having woken up again to the necessity of risk, I made a couple of other bets that are more “risky” than what I would have attempted a couple months ago.  I took two reasonably large positions over the last two weeks; one in Air Canada and one in New Residential.   I took a third on Friday with DHT Holdings.

I actually wrote this part of the write-up earlier last week, on Wednesday, but I had to delete it and write it again over the weekend.  When I wrote on Wednesday, my position in New Residential looked to be under never-ending selling pressure and my position in Air Canada felt like it would never move up.  So I wrote a couple paragraphs about how I was going to stick with these positions because I really thought I was right here and even as I was tearing my hair out and becoming angry at the world I still believed I would prevail in the end.

Fortunately things started to turn around.

What can I say.  I got kicked in the teeth for most of October.  I was literally down 9 straight days at one point.  Not down big mind you, but nevertheless I was down every freaking day.   Keep in mind that this happened as the market roared to new heights.  It felt like a never-ending assault.

Things started to turn last Thursday (the 26th) when Radcom put out a pretty so-so quarter but hinted at some excellent Tier 1 opportunities on the conference call last Thursday.  This was followed up by a solid quarter from Radisys.

Last week was up and down until Thursday when Air Canada reported a quarterly beat and the stock actually held its gains, Mitel reported a solid quarter and was up a buck, Granite Oil showed that someone can make money at $45 oil, raising its dividend and moving up a dollar and New Residential, while pulling in a modest 10c rise, pulled off an intraday reversal and a glimmer of hope.  Friday was even better with big gains from all of the above mentioned names.

I’m hoping its the start of something.  I’ve had enough pain.

New Residential

I’ve taken a fairly large position in New Residential.  At $12, which is where I was really adding, I think it is just too cheap, with a 15% dividend, positive exposure to higher rates, and below the book value of $12.40 which doesn’t even account for the $5-$10 of value that their call right portfolio could eventually yield (more on that below).

I’ve talked about their mortgage servicing portfolio on numerous occasions so I am going to leave that for now.  I’ll focus instead on the two other portfolio segments, servicer advances and call rights.

Servicer Advances

Here’s how it works.  New Residential buys a pool of outstanding servicer advances and with it the base fee component of the related mortgage servicing right (MSR).   The price of the purchase is a discounted cash flow value of the outstanding and future advances and the base fee.

Typically New Residential already owns the excess MSR in these pools.  The base fee they purchase would likely be around 20 basis points depending on the type of mortgage they are servicing.  Nationstar or Ocwen would remain the servicer and perform all the servicing duties in return for a servicing fee that New Residential pays them.  The fee structure of the servicing fee is described in the 10-Q and appears to be quite different for Nationstar than for Ocwen, but the essence of both is that there is a base fee paid and an incentive or profit sharing fee that is made once a return threshold has been reached.

New Residential makes money via the spread between A. the base fee they receive on the MSR and B. the combination of the fees that they have to pay the servicer (Nationstar or Ocwen) and the interest expense that they have to pay on the advances.  They explained it like this on the first quarter conference call:

The way that we get compensated, we receive a portion of the MSR off of the $251 billion UPB of non-agency loans. This compensates us for our advances. Our advances are currently funded with $7.9 billion of debt with an approximate advance rate of 90% and an interest rate of — cost of funds of 2.2%. On our debt, 50% have fixed-rate coupons, which will also help mitigate interest rate risks. And as I pointed out earlier, our life-to-date IRR on our advance portfolio has been 34%.

They also explain the whole process fairly well on slide 10 of their first quarter presentation:

serviceradvancesummary
Here is a table they provided on the same slide showing the advances and UPB of their 3 servicer advance portfolios:
serviceradvanceupb

The way to think about the investment is that its just another way to get at the monthly servicing income.  Instead of paying for the excess servicing right with only up-front capital, you pay for it with a combination of up-front capital and the on-going servicing fee and the interest on the advances.  But the essence is the same; its a perpetual income stream as long as the mortgage is not paid back or delinquent.  So it is pretty similar to the excess MSRs that New Residential is better known for.  I’m not sure whether the investment community sees it that way though, which may present an opportunity once the steady cash flows become appreciated.

Non-agency Call Rights

A call right is the ability to “call” securities once certain criteria have been met. My understanding, which admittedly isn’t perfect, is that the criteria to call for the non-agency securities in New Residential’s portfolio, triggers when the UPB of the underlying loans pays down to 10% of the original balance.

New Residential has been acquiring call rights as part of the private label servicing that they have acquired.  It seems like the call rights have been something of a free-bee thrown in with the mortgage servicing right in many cases.

This means that New Residential’s call right portfolio is not recorded as a significant asset on the balance sheet.  Management drove this point home on the first quarter conference call:

Douglas Harter – Crédit Suisse AG, Research DivisionSo just to be clear: there’s no value on the balance sheet today for those call rights?

Michael Nierenberg – Chief Executive Officer, President and DirectorThat’s….

Jonathan R. Brown – Interim Chief Financial Officer, Chief Accounting Officer and TreasurerThere’s essentially no value on the balance sheet. When we acquired them, we put a small number on, but it doesn’t move with the mark-to-market.

So book value calculations for New Residential ignore the value of the call rights.

Now for a little bit about how it works.

First, New Residential is going to look at the bonds underlying the call right and, where possible, purchase these bonds at a discount to par.   The call right gives New Residential the ability to call the bond at par plus expenses.  When the market is in their favor they do this, and then take the performing loans and repackage these into new securities which they sell at a premium to the par that they called the bonds.   The delinquent loans stay on the balance sheet and New Residential takes interest from these loans and liquidates them as opportunity permits.

To reiterate the process, here is how management described it on the second quarter conference call:
we buy bonds at a discount that accrete to par when we call them. We call the collateral at par plus expenses, we then securitize or sell the loans at a premium. The delinquent loans that we take back are retained on our balance sheet at fair market value and that those get liquidated or modified over time. Since we’ve begun this strategy, we’ve been averaging approximately two to three points of P&L per deal.

New Residential has about $200 billion of UPB in call rights (they said $240 billion UPB in the first quarter but have since then referred to it only as over $200 billion).  Impressively, this amounts to 35% of the outstanding legacy non-agency market.  Right now about $30 billion that meets the 10% UPB criteria to be called.  Therefore it can be called be if New Residential finds that it is accretive to do so, meaning specifically if the market conditions for the new securitizations are favorable.

That $200 billion will amortize over time, so the actual UPB at the time it is called will be somewhat less.  They think the eventual UPB will be in the $100-$125 billion, as they described on the first quarter call:

There is going to be amortization to get to a 10% clean-up call or 10% factor on the underlying deals. So in our best case or our best guess-timate at this point, that $235 billion at the time of call will be between $100 billion and $125 billion.

The economics of the deals were discussed on the first quarter call as such:

Our recent experience when we’ve called deals, the way to think about this, has been we’ve been making approximately 2 to 3 points per deal. Now some of this will be dependent upon rates, but as you think about it, on a $100 billion portfolio of call rights at the time of call, 2 points would be — would correlate to about $2 billion. Thinking about it, with 200 million — 198 million shares outstanding, it should bring in approximately $2 per share.

So I am quite certain Michael Nierenberg, the CEO, misspoke on the $2 per share comment.  This has caused me a bit of consternation because he actually said the $2 comment twice.  But I’ve read a few brokerage reports and the value they are more inline with what the other numbers imply.  Undiscounted the earnings potential here is more like $10 per share.   Piper Jaffrey gave a $5 per share value to the call right portfolio here.  UBS gives a value of $6 per share to the portfolio.

So that is a crazy big number for a company trading at $13.  Its why, even if we get a little run here to $14, I will be reluctant to part with my position.  I need to keep reading and making sure that I am not missing anything, but this feels to me like another one of these fat pitches that I see coming along every so often.  If there is one thing I’ve learned its that you have to take on some risk when these opportunities present themselves.

Nationstar Mortgage

I would not have bought Nationstar had I not had such a big position in New Residential.

I haven’t followed Nationstar closely for a while.  Last year I owned the stock for a short period but exited for a loss after giving up trying to determine how much of their net income would be absconded via a more watchful regulator, and a closing of loop holes like force-placed-insurance.

Fast forward a year.  The company’s earnings have taken a hit, in large part due to the aforementioned scrutiny.  I’ve found at least one lawsuit that they settled regarding force-placed insurance (here).  They paid another $16 million in borrower restitution for in-flight mods, which is where a borrower gets a modification from one servicer even as the loan is being transferred to another.  It looks like some of the executives at Nationstar were even sued on allegations that they did not properly disclose just how large the impact of the regulator crackdown to earnings would be.  The company paid out $13.9 million in the third quarter and $37.3 million in the 9 month period for legal fees and settlements.  Its worth noting that Nationstar still ranks as a below average servicer among customers.

So there are problems.  Nevertheless I bought the stock, primarily because, after listening to the third quarter conference call, I felt there were enough signs of a turnaround in place to warrant at least a bump in the stock price.  Witness the following:

The servicing business had a better quarter, servicing margins were up to 3.6 basis points, which was a 1.3 basis point improvement over Q2.

Nationstar thinks that by the fourth quarter they can get servicing margins up to 5 basis points. 1 basis point of that increase is expected come from improved amortization (which I essentially think means that rates are higher and so they can assume a longer amortization trend) with the rest coming from operational improvements.

For 2016 they are targeting 5-7 basis points of margins.  The average servicing unpaid principle balance (UPB) was $400 billion in the third quarter and they ended the quarter with $408 billion UPB.  A move back to 5 basis points would be $14 million more in pre-tax profits (or 13c).  7 basis points would be $36 million incrementally (33c).

Here is how servicing has trended over the past number of quarters. Note how much of an impact the increased amortization has had.  Amortization is going to look a lot better at higher rates.

servicing

While Nationstar may not be a leading edge servicer, they are starting to see improvement on prepayments (CPR), which dropped 4% in the third quarter.  Delinquency rates have improved from 10.6% to 7.2% over the past year

 servicingstats

Net of recapture CPR was down to 13.3% from 14.1% in the second quarter. The overall recapture rate was 28%

In October Nationstar signed a $50 billion sub-servicing agreement with “a major financial institution”. That is 15% growth to their existing UPB.  The company said in response to questions that this new UPB will add $30-$40 million of income once fully boarded in 2016.

Also interesting were the comments made around their online home selling platform, Xome.  Xome’s results were somewhat underwhelming, revenue was down from $122 million in the second quarter to $109 million as they sold less units than in the second quarter:

xome

But if you parse through the data the decline was generated entirely by REO units sold. So Xome actually saw year over year growth in third party transactions. Third party revenue was up 34% year over year an makes up 37% of revenue now.  And its third party transactions that will ultimately determine the value of Xome.

In response to a question regarding the strategic process to find a partner for Xome, Nationstar said that the valuations they were getting from prospective buyers were in the $1 billion range

Overall, earnings right now are in the $1.20 range adjusted for mark to market adjustments of the MSRs.  You get a possible upside when value is realized on Xome and you get potentially improved servicing margins as rates rise.  Its not a sure thing but there is upside potential.

Patient Home Monitoring

Patient Home Monitoring (PHM) has been beaten up over the past few months.  When I bought it in the mid-50 cent range I thought I was getting into the stock as it moved off the bottom.  This unfortunately proved to be premature, and it has since slumped back down to the lows.

PHM owns a variety of healthcare businesses that revolve around home based services for patients with chronic conditions.   They provide home sleep testing to patients that sleep apnea, home medical equipment such as oxygen nebulizers, and mobility devices, they have a complex rehab business, a pharmacy business – special programs to Medicare Part B programs, and a post acute respiratory care business.

They brought these businesses together via acquisitions, so they are a roll-up strategy, which has become a four-letter word over the past few months and which is partially responsible for the poor stock price performance.

The strategy is that you buy these smallish, single shop operations at an accretive price and then take advantage of their patient database to cross-sell the other products in your portfolio.  The former CEO, Michael Dalsin, described it as such in an interview last year:

a lot of these new devices and new technologies and new reimbursement codes are not immediately adopted by the large multi-billion dollar companies in our space. They are adopted by the entrepreneurs who are usually the sales reps of the device company, sometimes doctors themselves think they can make more money doing this care coordination than being a physician. So it’s small little companies all around the country – $10-20 million in sales, usually highly focused on one disease space. So they might only service pulmonology disease. And the reason they do that, ultimately, is because they know that market. They know the sales reps, they know the doctors, they can get prescriptions, they know pulmonology. And as they start developing their market, they become a little bit profitable – they make a couple of million dollars a year – but for us, the most important part of that acquisition is the patient database

Lets take a look at some of the acquisitions.  In September they closed their acquisition of Patient Aids for $23 million.  They expect Patient Aids to generate $17 million of revenue and $6 million of EBITDA annualized.  Patient Aids is a supplier of home health products and services in Ohio, Indiana and Kentucky.  Product lines include things like power mobility equipment, vehicle lifts, nebulizers, oxygen concentrators, and CPAP and BiPAP units.

Before Patient Aids PHM made its largest acquisition, Sleep Management.  Sleep Management provides ventilators to patients with Chronic Pulmonary obstruction.  The management of Sleep Management took on senior positions at PHM after the acquisition was complete.  Note that this transition has been partially responsible for the decline in the stock price, as investors were surprised by the CEO shuffle and the fact that the former CEO, Michael Dalsin, sold his stock upon his departure.   But according to an interview with Bruce Campbell I listened to on BNN, Sleep Management has grown by 100% over the past three years.   This was a $100 million acquisition that they expect will generate $18 million EBITDA annually.

Prior to Sleep Management there were a number of smaller acquisitions.

There was Legacy Oxegyn, which they paid a little over $4 million for and of which they are expected to generate $750,000 of EBITDA.  They have a business similar to Sleep Management, offering home-based medical equipment and services for patients with chronic pulmonary conditions in addition to wheel chairs, hospital beds, and other mobility aids.  They operate in Kentucky and Louisiana.

Before that was Blackbear Medical, which operates in Maine and provides home medical equipment like canes, crutches and walkers.  West Home Healthcare provides a similar set of products in Virginia.

All of these acquisitions are expected to cross-sell the array of PHM products over time.  I cobbled together the following table of pre and post-acquisition revenues.  They have a reasonably good track record of increasing sales from the businesses they acquire.

acquisitions

I don’t think there is any magic to these businesses.  They are basic product and services businesses that generate fairly low (10-15%) operating margins.  Those margins can potentially increase after they are brought into the fold and higher margin products, like COPD, are added to the product/services mix.  Meanwhile the stock seems pretty reasonable at around 4.5x EBITDA.  At this point its basically a show-me story where the operating performance over the next few quarters will determine how well the stock does.

Concordia Healthcare

Last month when I wrote up my reasons behind Concordia Healthcare I kind of rushed through it at the last minute and didn’t do a very good job.  The problem with these write-ups is they take time, and trying to write consistently every fourth week doesn’t always line up well with life schedules.  For example the weekend of my last write-up was Canadian Thanksgiving.

So I don’t own Concordia right now.  I think, however, that there is a good chance I will own Concordia in the future.  Given that Concordia is complicated and given the absolute roller-coaster ride the stock has been on it seems that a more thoughtful write-up is appropriate.

As I tried to make clear in my original write-up, Concordia is not a perfect stock.  It has the following problems:

  1. They have taken on a lot of debt with recent acquisitions.  Currently at a 6x Debt/EBITDA multiple
  2. They are labeled baby-Valeant by the financial press which means that every bit of bad news for Valeant is conferred to them
  3. They have relied at least partially on price increases in the past to boost revenues and lever returns from acquisitions

With those three negatives understood, Concordia also has a number of positives.

  1. They generate a tremendous amount of free cash from their portfolio of pharmaceuticals
  2. The product portfolio consists mostly of older drugs that have stable to slightly declining revenues but with predictable future revenue profiles
  3. At the current stock price the stock trades at a very attractive free cash flow multiple of around 5x
  4. They are less than 1/10th the size of Valeant, so the potential to continue to grow by acquisitions remains, even if one of the models of that growth, acquisition + price increases, is no longer viable

Concordia’s Acquisition History

Concordia hasn’t been around that long.  Their acquisitions started small and grew larger, with the biggest being the recent acquisition of AMCo.  Below is a table of all of Concordia’s acquisitions pre-AMCo.

acquisitionsLet’s go through each of these acquisitions in chronological order.

Kapvay, Orapred and Ulesfia

These three drugs were acquired May 2013 from Shionogi.  Concordia paid $28.7 million including a $2.3 million inventory adjustment.  There was also a pay-out clause that if revenue of Kapvay exceeds $1.5 million per year in the first 18 months Concordia would have to pay 30% of incremental revenue.  It looks like they had to pay at least some of that amount.

Kapvay is used to treat ADHD.  Ulesfia used as topical treatment for head lice.  Orapred is an anti-inflammatory used in the treatment of certain pulmonary diseases such as asthma.

Kapvay and Oraped face generic competition.  Both only became generics after Concordia acquired them.  Kapvay started to have generic competition in fourth quarter 2013 while Oraped first faced generic competition in fourth quarter 2014.  Ulesfia does not face generics yet.

Two of the three drugs experienced price increases by Concordia after they were acquired. From the 2014 AIF: “since acquiring Kapvay, Ulesfia and Orapred, the Corporation has increased such product prices by 52%, 43% and 10%, respectively, without any adverse prescription volume effect.”  All of these drugs appear to have prices inline with competition:

kapvay-orapred-ulesfiapricing

Here are sales of each drug:

 

kapvay-orapred-ulesfiaIts worth noting that Kapvay sales did plummet once the drug was exposed to generic competition in the fourth quarter of 2013.

kapvay

Photofrin

Photofrin was acquired in December 2013 for $58 million that consisted of $32.7 million of cash and 5 million shares at $5.63 per share.  Photofrin is used to treat Esophageal Cancer, Barrett’s Esophagus and non-small cell lung cancer (NSCLC).

Photofrin is kind of an interesting treatment.  The drug itself, which is called Photofrin, is administered intravenously.  This is followed up by a laser treatment focused on the tumor.  The laser reacts with the drug, oxidizing it and the tumor in the process.

I believe that pre the Covis transaction Photofrin was the only drug in Concordia’s “orphan drug division”.  Because of the unique combination of drug and device, they do not expect Photofrin to face generic competition.

Prior to being acquired Photofrin had $11 million of revenue in 2011 and $13 million of revenue in 2012.  The orphan drug division as a whole had $10.7 million of revenue in 2014, presumably all attributable to Photofrin.  In the first half of 2015 orphan drug division had $5.9 million of revenue.  Overall Photofrin appears to provide a steady revenue stream.  I don’t see any evidence of price increases on Photofrin.

Zonegran

Concordia acquired Zonegran for $91.4 million in cash including approximately $1.4 million for purchased inventory.  I believe that what was purchased was specifically the agreement to market the drug in the US and Puerto Rico.

Zonegran is an epilepsy treatment.  According to pre-acquisition financials Zonegran has $12.4 million of revenue in the first half of 2014 and $22 million of revenue in 2013:

zonegranrevsAccording to spring presentation in 2014 Zonegran revenue was 8% of Concordia’s $309 million of total revenue or about $25 million.

zonegranhistoryThe essentially flat revenue suggests hasn’t been much in the way of price increases for Zonegran.  It looks like Zonegran is inline with the costs of other Epileptic treatments.

Donnatal

Donnatal was purchased in May of 2014. This was the biggest acquisition Concordia had made at the time  Before the Covis acquisition Donnatal made up 41% of Concordia’s revenue, or about $150 million.

Donnatal treats irritable bowel syndrome and has been around for more than 50 years.  Therefore it predates the current FDA approval process, it is not a reference listed drug, and, according to the 2014 AIF: “at this time there is no defined pathway for approval of a generic competitor to Donnatal”.  Though to qualify this, there are a number of other irritable bowel drugs on the market that compete directly with Donnatal.

Donnatal is probably the most notable example of price increases.  The CEO of Concordia admitted as much last week during a BNN interview (segments one and two here and here).  What’s interesting is that while Concordia did raise the price of Donnatal significantly after acquiring the drug, similar cost increases appear to have been made even before the acquisition.  Also worth noting  is that Donnatal is well within the price range of its competition:

donnatalcomp

Here is Donnatal prescription volumes over past few years:

donnatalvolumesCovis

Covis was acquired for $1.2 billion on April 21 2015.  Things begin to get more complicated here, because Covis is a big acquisition with many drugs.   Covis added 18 branded or generic products.  Here is a list of what they got:

covisproductsOf these products Concordia focuses on the following four as being the most important:coviskeyproductsWhat’s key about most (but not all) of these products is that they are old, they have generic competition, and they have stable or falling demand profiles.

I haven’t been able/had time to dig up information on the individual drugs.   As a whole, Covis had revenue of $47 million to $52 million in the fourth quarter of 2014, so just before acquisition.   2014 revenue as a whole was was estimated by Concordia to be between $140 million to $145 million at the time of acquisition.

Post-acquisition, Covis had revenue of $38.7 million in the second quarter.   Given that the acquisition closed on April 21st, that revenue accounts for 68 of the 91 days in the quarter, so pro-forma over the full quarter revenue would have been $52 million, which inline with the fourth quarter results.

Amdipharm Mercury

Concordia sells the Amdipharm Mercury acquisition as a way to increase the diversity of their revenue and expand the overall platform, which sets them up to more easily compete in future acquisitions.  The acquisition is a departure from past acquisitions, which targeted either a drug or portfolio of drugs, as Amdipharm is a complete company purchase.

This wasn’t a cheap acquisition.  The total price at the time of the stock offering was $3.5 billion.  Concordia paid around 12x EV/EBITDA based on a little less than $300mm EBITDA for Amdipharm.  This included the assumption of $1.4 billion of Amdipharm debt.  They also issued 8 million shares at $65 USD.  The acquisition is closer to 10x EBITDA for those of us looking at the stock now with the shares having depreciated significantly.  But that is no consolation for the folks that bought at $65.

The company describes the acquisition as accretive to earnings, and I believe that’s true based on my own number crunching, but you have to realize that its accretive because they are taking on so much debt.  The debt is roughly $3 billion of the $3.5 billion acquisition price.  The accretion is because this is a very profitable drug portfolio, so even after subtracting interest costs there is significant earnings remaining on the bottom line.  The downside is that it made Concordia very levered up.

The benefits are diversification, as Amdipharm was primarly in the UK and Europe.  Concordia is now only 40% exposed to the US and 10% exposed to state funded plans, a global footprint, which Concordia suggests will make it easier for them to cross-sell their existing pharmaceuticals and expand with further acquisitions.  AMCo also appears to have a fairly stable product base, most of them have been off-patent for a long time, many of them are difficult to manufacture, and 88% of the portfolio have two or fewer competitors.  Of course cynically you could look at these points and say what a great portfolio to implement price increases on…

Amdipharm has 190 products, which makes it a lot more difficult for me to analyze.  Here are the top ten by revenue:

amcotop10products

Valuation

What continues to make Concordia tempting is that on a free cash basis they trade extremely cheaply.  The company’s guidance for cash earnings is $6.29 to $6.77 per share.  It looks to me like cash earnings has followed closely to free cash flow.

But I’m nervous about the debt and the short-selling.  Total debt is around $3.5 billion.  Given the company’s EBITDA estimate of $610-$640 million for 2016, Concordia trades at about 8x EV/EBITDA.  On a pure enterprise value basis that leaves them somewhat undervalued compared to other pharmaceutical companies (which seem to go for around a 10-11x EBITDA multiple).

Clearly there was short-selling involved that caused the precipitous drop to the teens a few weeks ago.  That they have their sights on Concordia is cause for concern for owning the stock.  As long as Valeant is in the headlines Concordia is at risk whether its warranted or not.

Other Adds: Alliance Healthcare, Nevsun Resources, Northstar Realty, Acacia Research

I bought Alliance Healthcare because I thought that at $8 it was getting just a little to cheap.  At $8 the market capitalization was only a little more than $80 million.  While the company’s debt remains enormous ($507 million) they continue to generate a lot of free cash ($40 million in the first nine months of the year, though this is before minority interests so the actual number attributable to the company is somewhat less than this).  The stock has been under pressure since their major shareholder, Oaktree Capital Management, sold their shares at $18.50 to Fujian Thai Hot Investment Company.  Thai Hot now has a majority interest in the company but as part of the deal has agreed to make no further purchases of shares, which essentially prohibit it from supporting their position.  The whole thing is weird, but at $8 I have to think most of the damage is done.

I bought Northstar Realty and Nevsun for similar reasons.  Northstar is a hated property REIT mostly operating in the healthcare and hotel sectors that has been beaten down to a 15% yield.  I don’t see anything particularly wrong with their property portfolio, and I suspect that the incessant selling has more to do with year-end and being a former hedge fund darling.

Nevsun is an $800 million market capitalization (Canadian dollars) copper miner with almost $600 million of cash on the books.  While the low copper price has hurt them, they are still generating free cash.  They operate one mine, called Bishna, in Euritania.  While I admittedly haven’t had time to go through the third quarter data, I bought the position off of the second quarter numbers where they showed $97 million of cash flow from operations and $53 million of capital expenditures, meaning decent free cash generation.  I also like that they are transitioning from being a primarily copper miner to a copper and zinc miner in 2017.  The supply/demand outlook for zinc looks pretty interesting and so they may benefit from higher zinc prices right around the timeI’ll try to talk about these positions in another post, as this one is already way, way too long.

Acacia Research partners, a patent litigation firm that partners with patent owners to realize the value of their patents, got creamed on a pretty terrible headline quarter.  I bought after the carnage had appeared to run its course.  So we’ll see if that’s the case.  At the current price the company has a $330 million market cap and $168 million of cash on the balance sheet.  The thing here is that a bad quarter doesn’t necessarily mean anything about future performance.  Acacia has a portfolio of patents that they are moving towards litigation.  The companies that they are litigating against generally hold-out against settlement until the very last minute.   The poor revenue number this quarter (it was $14 million, versus $37 million last year in the third quarter and an average of $37 million the last two quarters) simply reflects delays in a few of their cases, some of which were actually brought about by evidence that strengthened Acacia’s case.  From the third quarter conference call:

The third quarter developments created paradoxical outcomes. On one hand, our marquee portfolios were strengthened through Markman inter-parties review and new patent issuance wins, and now have even greater future value. But on the other hand, we experienced a delay in collecting on that value.

This is a stock that is going to whipsaw up and down on what will always be very lumpy results.  I think you have to buy it when the whipsaw down is extreme.  There is a very good writer on SeekingAlpha (he also has his own blog) who follows the stock closely and wrote a good piece on the company here.

What I sold

I reduced my position in the few gold stocks I bought after the latest Federal Reserve view on the economy came out.  I still hold a couple small positions here because for the miners outside of the US, even as the price of gold falls their costs are falling just as fast and in some cases faster.  The market doesn’t care about margins yet though, so there is no point fighting the headwind too hard.

I bought and sold Digirad within the month for a gain.  I bought Digirad on the morning of their takeover of DMS Health for $35 million.  The acquisition was accretive and after doing some quick math, on the morning of the acquisition the combined entity had a $77 million enterprise value and a 4.5x EBITDA multiple.  I thought this was likely too low so I bought, but the stock has risen since to a more respectable level and so I have since sold my shares.

I bought and sold Enernoc for a loss.  I played the swings from $7 to $9 on Enernoc successfully a couple of time an then got burnt when they released quarterly earnings.   Fortunately while it was pretty clear that the earnings were awful, the market gave a small window first thing in the morning to get out in the $6’s.  I took that opportunity.

I sold Gilead for a loss when I clearly shouldn’t have.  I did this before I made the decision to hold to my convictions a bit more firmly and I got spooked out on a dip below $100 that was clearly more of a buying opportunity in retrospect.

And of course I sold Valeant, for a loss, but thankfully well before things really got out of hand with the stock.  Better to walk away when things begin to smell bad.

Portfolio Composition

Click here for the last four weeks of trades.

week-227

Week 223: Playing the Volatility

Portfolio Performance

week-223-yoyperformance

week-223-Performance

See the end of the post for the current make up of my portfolio and the last four weeks of trades

Monthly Review and Thoughts

I was on vacation for three of the past four weeks, so my portfolio changes have beeen minimal.  It was nice time away but the timing was unfortunate; the market swooned but bounced back before I got back.  There were plenty of opportunities I missed out on.

As it were, the only two I was able to capitalize on were Mitel Networks and New Residential.  In both cases I had old stink bids that got hit (a little over $6 for Mitel and $12.50 for New Residential).  But even in these cases, the positions I ended up with were much smaller than I might have had I been actively watching the action.  I’ll talk about Mitel a little later on.

I haven’t been tweeting a lot either, but I can’t attribute that entirely to being away.  I find my mind hesitating on any conclusion.  Its very difficult to tweet when each comment requires a couple of caveats a maybe and at least two possible scenarios.  There are only 140 characters.

David Tepper was on CNBC a few weeks ago sharing his thoughts about the current state of the market (click here for one of the clips).  Most of the summaries I’ve read focused on his comments about the S&P possibly going to 1,800.

What I took from the interview was uncertainty.   The direction of money flows are criss-cross, whether the tide is still coming in or starting to go out is more uncertain then it has been in recent years. When quantitative easing was in full swing there was a clear easing of liquidity, now its much more muddled.  And Tepper isn’t really sure where it will all settle out.  It might be higher, but he seemed to suggest that he thought it was more likely to resolve itself lower.

If David Tepper isn’t sure of path of least resistance, I bet you can say the same for the market.  And that to me says we are in for volatility.  Which is what we are getting.

If we are going to be in market where directionality is wanting and volatility rules then the right approach is to not believe too much too fast.  Sell the rallies and by the dips.

If I’ve done one thing right in the last four weeks it is that I have manifested these convictions in my trades.  I sold out of a lot of positions as the market rose last week.  I will be ready to buy them back if the market falls back far enough.  Without QE, without China, and without sensible leadership from any of the market groups, I think we simply flounder around aimlessly, at worst with a downward bent.

A Position in Mitel

Mitel develops and installs unified telephone systems for businesses.  They also provide white label back-end services and software for carriers so they can offer their own telephone products to business.

With Mitel’s legacy business, called the “premise” segment, they install a telephone platform on location, including the phones, connections and back-end.  Upon sale of a telephone system Mitel generates revenue from upfront hardware and software sales, and a small amount of recurring revenue for maintenance and support.

The premise business has been shrinking as companies migrate toward a cloud solution.  The cloud system Mitel provides is similar to premise in terms of functionality: the business gets a telephone platform that operates and connects its devices, provides unified voice mail, conferencing, all of the functionality you’d expect.  But the system runs through the cloud, so the hardware component is mostly absent.

With the cloud product Mitel receives recurring revenue for each end-user that is hooked up.  For their retail customers (those who purchase cloud services directly from Mitel) they receive around $45/month revenue per user.  For their wholesale clients (carriers who resell the service as their own) they receive somewhat less, but at a much higher margin as they are only providing the software and support.

In April Mitel expanded into a third segment, mobile, with their purchase of Mavenir for $520 million. Mavenir offers a 4G LTE solution to telecom carriers.  4G LTE is the next evolution of telecom transmission.

4G LTE is slowly being adopted by carriers for its functionality and costs. With respect to functionality, 4G LTE allows for something called Rich Communication, which makes it easier to do things like video calling, group messaging or video streaming over mobile.  As well 4G can deliver voice over the LTE connection rather than the legacy voice network which is expected to improve call quality.

For carriers the cost advantage is that once installed 4G LTE uses less bandwidth, which limits the requirements of additional spectrum that they have to buy.

Mitel’s shift to cloud and mobile means that the overall business model is shifting towards one of  recurring revenue through subscription/licenses.  Below is a snapshot of recurring revenue growth for each of the segments.

recurringrevs

The overall premise business is shrinking by about 5% to 8% per year as companies migrate to a cloud or hybrid cloud/premise solution.  The cloud business has been growing at 20%. Mavenir grew at 30% in the second quarter.

Overall the company has been growing only nominally as the premise business, which makes up 75% of revenue, declines have overshadowed the smaller, growing cloud and mobile businesses.  But this will change as the other two segments become larger.

The early indications are that the Mavenir acquisition is going well.  Second quarter revenue for the mobile segment (which is essentially Mavenir), was $45 million.

mobilerevs

On both the second quarter conference call and at subsequent conferences Mitel has noted an acceleration in Mavenir’s wins since they have been acquired.   The concern of many carriers with respect to choosing the Mavenir solution was that it was a small company with limited resources and a small global footprint.  Mitel’s acquisition has alleviated those concerns.  At the time of the acquisition Mavenir had 17 footprint wins with carriers.  Since April Mitel/Mavenir have won 10 more footprints including 1 major cable company in the United States.

Mitel provides the following roadmap for earnings in 2017.

earningsroadmap

If I use the above roadmap and assume that Mitel can continue 20% growth in both the cloud and mobile business and that the premise business declines at 5%, I can see Mitel earning over a dollar in 2017.

I only wish I would have bought more of the stock when it was in the $6’s.  The timing was unfortunate.  As it is, I am contemplating adding to the position if it dips back into the $7’s.

There are a couple of decent Seeking Alpha articles on Mitel here and here.

Wading into the Biotech Controversy

I decided to jump in with the sharks and take a position in Concordia Healthcare.  I also took a very small position in Valeant Pharmaceuticals.

Concordia has a similar business model to its much larger competitor Valeant.   Its a roll-up strategy.  In the last year they have acquired three pharmaceutical companies: Donnatal, Covis and AMCo.  In the process they have increased their revenue from a little over $100 million in 2014 to over $1 billion in 2016.  Below is a table of the companies acquisition pre-AMCo.

acquisitions

The stock has been hammered as Valeant has been singled out for pushing through price increases on many of its newly acquired drugs.  The comparison is not unwarranted as Concordia has much the same strategy as Valeant, raising prices on newly acquired drugs where the market has been inelastic.

In both the cases I haven’t been able to get a solid handle on the extent of the price increases.  Articles point to 20% plus increases in some drugs.  Others go on to point out that these list price increases are not representative of what is actually paid, and that the actual price increases are more modest.

Valeant is also suffering from its own opacity.  There is an excellent four part blog series that I would recommend reading before investing in either Concordia or Valeant.  It is available here.  The author illustrates numerous examples where Valeant had questionable disclosures and raises some questions about the performance of their acquisition post-integration. Most important though, it provides an overview of how to think about the valuation of both companies that I found extremely helpful.

Concordia is not quite as opaque as Valeant, though some of this is a function of its size.  Until very recently the company only owned a few drugs and depended heavily on Donnatal for its revenue.  So its not too hard to separate the contributing parts.

Unlike Valeant, I don’t see evidence that Concordia’s acquisitions have underperformed after being acquired. Donnatal, being Concordia’s largest acquisition prior to 2015, is illustrative.  Donnatal was purchased in May of 2014.  In 2013 Donnatal had revenue of about $50 million.  In 2014 Donnatal had revenue of $64 million.  In 2015 Donnatal is expected to bring in between $87-$92 million of revenue.

Of course some if not most of that revenue increase was due to price increases.  How reasonable are future price increases on newly acquired drugs?  Without a doubt the potential has diminished.  But I think that as the front page headlines fade the reality will appear less dire than it does now.  Keep in mind that the price increases are not comparable to the 5000% jack-up by Turing Pharmaceuticals an other aggressively managed hedge-fund like pharma providers.  Meanwhile Concordia is down 50% in the last month; surely the more robust expectations have been priced out of the stock.

The bottom line is that both Valeant and Concordia have real negatives but they have also experienced really dramatic falls in valuation.  Concordia was a $100 stock (Canadian) a few months ago.  Valeant was over 30% higher.

I can’t take a big position in Valeant because I can’t really figure out how well its doing and I think the difficulty of performing their roll-up strategy  increases with size.  With Concordia performance is easier to evaluate and they are still small enough to be able to find interesting acquisitions and fly under the radar of the news. I think the question is more one of: are the negatives priced in?  And I think there is a reasonable chance that is the case.

A Few Small Bets on Gold Stocks

Gold stocks have been so beaten up that it just had to turn at some point soon.

I also thought I saw was kind of a win-win situation with respect to the September rate hike decision.  Either the Fed was going to hike rates, which would mean the event had finally passed and the stocks could stop pricing in its inevitability, or they wouldn’t, in which case the legitimate question would resurface as to whether we are really passed the QE-phase.

Additionally, there has been a shift quietly occurring in the gold sector.  Many producers are getting their costs under control.  This has been helped by improving currencies for non-US based producers, by lower energy costs and by lower construction costs.  While the market seems to have a curious focus on valuing gold companies on the price of gold, which has been stagnant to down, the margin they make have been improving.

Let’s take Argonaut for example, which is one of the companies I took a position in.  Argonaut has 155 million shares outstanding and trades at about $1.50, so the market capitalization is about $250 million.  Debt is nil and the cash position is around $50 million.  They have been improving their performance year over year.

yoycomp

Argonaut produced cash flow from operations before working capital changes of $28 million in the first half of 2015 (cash flow including working capital was $38 million, but because changes in inventory are such a big and fluctuating part of a gold mining operation I think they need to be ignored).

Sustaining capital expenditures and capitalized stripping at Argonaut’s operating mines (El Castillo and El Colorada) runs at about $5 million per quarter.  So free cash (so before expansion and development capital) is around $35 million for the year.

Argonaut, and other gold producers like them, are not expensively priced at $1,100 gold.  That means there is no expectation of higher gold prices priced into them.  I think there is a reasonable chance we see higher gold prices as there is a reasonable chance that the economy continues to muddle.  These stocks are multi-baggers if that happens.

Oil

I have had some strong opinions on oil over the past few months but I don’t have a strong opinion now.  When oil was in the low $40’s I once again bet on a number of oil stocks including Crescent Point, Baytex and Jones Energy.  I went through some consternation as Goldman Sachs came out with their $20 oil call and I listened to the twitter universe decry the inevitability of a collapse in the oil price.  But in the end it all worked out, and I sold Baytex for a quick 50% gain, Crescent Point for a 40% gain, and Jones for a 20% gain.

With oil back in the $50’s I feel much more non-committal.  For one, I think that at least some of this move is due to geo-political concerns, which isn’t a firm footing to base a stock purchase.  For two, earnings season is upon us and there is at least some risk that the lack of drilling leads to downward revisions in production forecasts for companies like Baytex and Crescent Point.  And for three, pigs really do get slaughtered, so when the market gives you a big gain in a couple of months I have found it more often than not prudent to take that gain and run.

I will be a bit sick to my stomach if Baytex runs quickly back up to $8, or Crescent Point to $25 but this doesn’t seem like the sort of market to be trying to squeeze out the last 10%.

What I sold (and one more I added)

As I already said I sold out of most of my oil stocks.  I also used the run-up in tanker rates (they breached the $100K per day rate last week) to sell out of DHT Holdings in the mid-$8s and Ardmore Shipping at $13.  I took some quick profits on my small position in Apigee, which ran back up from $7 to $10 on just as little news as what precipitated its move down from the same level.  And I sold out of Alliance Healthcare after the rather bizarre acquisition of shares by a Chinese investment firm (another case where poorly timed holidays contributed to a larger loss than I might have otherwise taken).

I also had a bunch of stocks that I neglected to add to my on-line portfolio, mostly previously held names like Enernoc, Espial Group and Hovnanian.  I took small positions in these stocks during the last dip but sold out them of quickly as they rose.  My plan is to continue to do this sort of cycling, taking advantage of dips and selling the rips.

With that in mind, I did re-add one last position on the last downdraft that hasn’t recovered like I had hoped and that I think will at some point soon.  Air Canada.  The third quarter is mostly passed and there isn’t a lot of evidence that overcapacity from Air Canada and WestJet is going to hinder their performance.   The stocks has barely budged from $11 while other airline stocks soar.  I think it catches up some of this performance in the near term. (Note that I forgot to add this one to the online portfolio but will correct that when the market opens on Tuesday).

Portfolio Composition

Click here for the last four weeks of trades.

week-223

Follow

Get every new post delivered to your Inbox.

Join 386 other followers