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Jan 31

Week 290: Renewal

Portfolio Performance

Top 10 Holdings

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

Thoughts and Review

I came into the new year wanting to reduce my exposure. I had racked up gains last year that I had held onto for tax gain reasons. It’s also been a good run, and there are at least a few signs that the market is topping out.

I also find too much exposure leads to poor decisions. The lack of cash causes me to ignore ideas I might otherwise pursue and I start to feel stuck with the positions I have. I end up “hoping”.

When it comes to investing “hope” is a dreaded word for me. Hoping that a takeover happens. Hoping that a news release comes out. Hoping that this quarter is different.

Moreover, hope is inextricably tied to patience and patience, while not so toxic as hope, has a love/hate relationship with me. Patience is necessary. You have to wait to have your ideas play out. And I do this. I sat on Willdan for 3 years before it decided to more than triple in 6 months. You can’t cash out on the first gain or jump ship on the first sign of loss.

But too much patience, at least for my style of investing, is counterproductive. It wastes capital of all kinds. When I am too patient with my positions it also means I am not looking for new and better ideas.

So every so often, maybe once or twice a year. I take a hard look at every position and ask myself if I really want to own it? Do I really believe in this idea? And I force myself to sell at least some of them.

I have to go through a renewal. I sell off a bunch of positions, reduce a bunch of others, and, at least in terms of my own mindset, I start over.

I did my last big reset last January and that one was sparked by the market moves. It was not pleasant. This reset was more minor. I shook things up enough that I could refresh my perspective. It seems to be working so far.

Changes to the Portfolio

I sold a number of energy positions: Jones Energy, Resolute Energy, Gastar, Granite Oil and Key Energy Services. I didn’t time these sales particularly well, as many of these names have rallied further after I sold.

You might ask why I sold Key Energy Services so soon after buying them? Partly it was logistics; in the account I track with the practice portfolio I wanted to raise cash and so I had to look for names to sell.

Second, it had appreciated 20% from my original price and, in light of my first reason, seemed like an easy gain. Energy services is a tough business and so this isn’t a stock I wanted to hold for a long run. Nothing has changed with the company though, and in my actual account I still hold my warrants, which give me exposure to upside in the stock.

I also sold Contura Energy. I did more research on the met and thermal coal market and I concluded it was more likely that coal prices would decline than increase. In particular, much of the increase seemed to be because of closures in China that could just as easily be reopened and there was evidence that was already happening. I’ve been in and out of the coal market since 2006, I know how volatile it can be (especially met) and I also have experienced that when the coal price is declining it doesn’t necessarily matter how cheap the company appears, the stocks will follow the price of the commodity. Maybe that won’t happen in this case, maybe Contura is “cheap enough”. But I couldn’t ignore the precedents I had seen.

Even with these changes I still don’t have enough cash in the practice portfolio. I’m running about 20% cash in my regular portfolio and am a little less than flat with the online account.

As for my remaining positions…

I still have reasonably big positions in Radcom and Radisys, but along with many other stocks I reduced these positions as well. I am balancing my expectation that the first and second quarter results from each of these names will likely be modest with the awareness that positive news in terms of new contracts could happen at any time will send each stock much higher. However I did decide to add a little Radcom back on Monday, which is not reflected in the update.

I also reduced Willdan. Its just gone up so much. I took some off at $27 and $29, which turned out to be a little early as the stock briefly hit $31. I don’t plan to sell any more; I still really like where the company operates (energy efficiency), they should see some benefit from infrastructure plans, have the ability to pull together cheap accretive acquisitions and will also benefit from changes to the tax code (their tax rate has typically been above 40%).

Finally I reduced my positions in Attunity, Hudson Technologies and Nimble Storage. I’m not completely confident that the results for these companies in the next quarter are going to be stellar. I prefer to wait to see the results an add back depending on the reports.

And a few new positions…

I took five new positions in the last month. I wrote up two of them, Ichor Holdings and Nuvectra.

I tweeted that I took a position in Vaalco Energy (hat tip to @teamonfuego)

Also h/t @teamonfuego for pointing out $EGY, small offshore Gabon producer, not big growth but very cheap, operational issues under control

— LSigurd (@LSigurd) January 27, 2017

And I tweeted that I took a position in Combimatrix:

bought 2 new small biotechs $NVTR, trading at ~cash, ramping neurostim therapy, $CBMX h/t @teamonfuego, also low EV, ramping diagnostics

— LSigurd (@LSigurd) January 27, 2017

I have a write-up in the works about Combimatrix and have plans for one on Vaalco after that.

The last position that I took was in Gigamon. I have written in the past that I been waiting for this stock to correct and continually regretted not buying it when it was lower. The company announced poor numbers for the fourth quarter and the stock took a massive beating. I was happy to step in. The stock could go lower but I am not convinced that their announced portends a trend so I wanted to get at least started with a position here. If the stock dipped into the $20’s, I would double down.

Last Thought

I’m very edgy about Trump and his economic agenda. Given the role that Steve Bannon has taken on, its worthwhile to read and listen to what he has said. I might do a more detailed write-up on this in the future, but for now consider this speech. Bannon’s ideas remind me of what you hear from gold bugs and all those economic podcasts that portend the financial end of the world. He talks about the contingent liabilities, the trade deficit with China, its all those things you hear from the newsletter writer/economic podcast cohort. Some of what he is saying has merit, but if he is going to attack what he sees wrong I don’t know if this plays out well.

Portfolio Composition

Click here for the last four weeks of trades.

Jan 28

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Nuvectra: New position, didn’t even know it was a spin-off

I don’t go out of my way looking for spin-offs. I read Joel Greenblatt’s book You Can Be a Stock Market Genius years ago, I even did a take-off on the title a few years back, so I understand the value that can be there, but it has seemed like a saturated niche since value investing has gone mainstream.

Maybe the best way to find a spin-off is to unwittingly stumble upon one. That’s what happened to me with Nuvectra. I came up with the idea from a retweeted tweet by @ValuewithaCatalyst pointing to their large cash position and $0 enterprise value.

$NVTR – Not sure what it’s worth, but certainly more than cash… I really like the optionality here: https://t.co/s7IOIq39bw

— ValuewithaCatalyst (@ValuewaCatalyst) January 17, 2017

I looked into the company and found that Nuvectra is indeed trading at cash but that they also are burning through it. The company is in the early stages of a ramp of a new neuro-stimulation therapy, called the Algovita SCS system. They’ve hired a salesforce (headcount of 42 at the end of the third quarter and expected to reach 50 by year end) to begin marketing the product across the United States. They have kept up a decent sized R&D program (run rate of $3.5 million per quarter) and they are only just starting to generate revenues.

The consequence is they have a fairly significant cash drain of $5-$6 million per quarter. This plays against a market capitalization of around $60 million and an enterprise value that, up until Friday, was close to zero (I’m using the numbers based on my purchase price below because I started this post before the stock moved the last couple of days):

Their Algovita SCS system reduces back pain by stimulating the spinal column with small pulses of electricity. These pulses stimulate the nerves and override the pain sensation, replacing it with a tingling that eventually disappears entirely.

The system consists of a pulse generator, leads that are surgically inserted into the spinal column, and programmable GUI devices for the patient and physician.

There is a good video that describes the procedure in general here.

Algovita was approved in late 2015 and began to launch in the US in 2016. So its early in the ramp. Because Algovita is in the early stages, the market is not giving much credit to the product yet. There is also a lot of competition. The incumbent products are made by Boston Scientific, Medtronics and St. Jude, and a more recent newcomer is Nevro. From what I have read, Algovita’s feature set stacks up well against the incumbents but Nevro has a very good product that may or may not be superior to Algovita. Without question this is a very competitive landscape and that is at least partially responsible for the low enterprise value.

At this price, I think its worth seeing how the sales ramp plays out. The company said late last year at the Piper Jaffrey conference that within 12-24 months of the beginning of a sales ramp they expect a sales territories to generate $1-$1.5 million. This works out to 75 trials resulting in 50 permanent implants at $20,000-$25,000 a pop. Thus the expectation from the current hirings should be at least $50 million in annual revenue. The vast majority of their reps were hired in the third quarter and after, so we should start to see their benefit in the upcoming quarters.

The total addressable market (TAM) is fairly big, so reaching $50 million is only taking a sliver of market share away from their competitors (note that SCS stands for spinal cord stimulation):

Algovita revenue was $1.1 million in the third quarter. This was up from $569,000 in the second quarter. The third quarter was the first real quarter with any sales traction in the United States. The company is still mostly in the trial stage with its early adopters. At one of the conferences management said that trial revenues were only a fraction of permanent implants.

There are likely to be bumps in the road. In addition to the newly trained salesforce, Nuvectra is making slow progress to get insurers on-board and work through hospital approvals. The process entails agreements on doing business, payment terms, etc. It takes time. In smaller settings this happens in 1-3 months, while in larger regional systems it can take 3 months to a year.

In addition to Algovita the company has a strategic development agreement with Aleva Therapeutics that allows Aleva to market Algovita for use in the direct brain stemp (DBS) market for the treatment of Parkinson’s disease.

DBS is $600 million market today, dominated by Medtronic, Boston Scientific also in market. Nuvectra will receive $6 million in aggregate payment, and recognized $1.1 million in the third quarter related to this. Once in production Nuvectra will receive a royalty, though I actually wasn’t able to find the details on the royalty payment yet.

Finally, Nuvectra has a “world class group of neuroscientists” that they refer to as Neuronexus (interesting website here). This group “creates probes and other neuro-technology for clinical applications and labs around the world.” The company expects sales from Neuronexus, would be around $5 million in 2016. I don’t get the sense that the business will be a huge revenue driver, but their research gives insights into the latest developments in neuro-stimulation.

So there is a lot of innovation, and hopefully some of that innovation translates into revenue growth. Its not a perfect investment case of course, none of my ideas are; there is a cash drain, there is plenty of competition, and there are insurance approval hurdles that could take months. I am prepared for a lumpy ride, and as usual I have kept my position small until I can see sales get more traction.

Nevertheless, if they prove that they can meet their goal of $1-$1.5 million in sales per territory in the next year or two, the stock should trade at a decent multiple to revenue, which is multiples of what its trading at now. And the cash drain will be no more.

Jan 19

Taking a position in a recent IPO moonshot: Ichor Holdings

Over the last couple of weeks I spent my spare time listening to presentations from the Needham conference.

Most of what I heard was pretty boring. A few were from companies that I own (Radcom, Radisys, DSP Group, Oclaro, Nimble and BSquare) and I adjusted a few of my positions upon review (I reduced Radcom a little, added to Oclaro). But most were new companies that I haven’t heard of before.

I was on the lookout for a good idea and I think I found one. The company is called Ichor Holdings. They provide fluid delivery systems for semi-conductor equipment manufacturers. In particular they produce two products, one a gas delivery sub-system and a chemical delivery sub-system.

The stock was an IPO in December (here is the prospectus). The IPO went for $9, which was a steal. It’s over $15 now, which means its traded up significantly.

I bought some at $14. I haven’t mentioned the stock until now because I kept waiting for a correction so I could buy more (well it came briefly one morning when it dipped into $12’s for a couple minutes but I was at work and not available – argh). So now it broke out and I’ve given up. I probably am rushing this write-up out a little, but given the move in the stock I feel like if not now then maybe never.

So you are looking at a stock here that is up almost 50% in the last couple of months. Caveats apply. Nevertheless, here’s what I think, why I bought it at $14 and you can choose if you want to wait for a correction or not.

There is a narrative for not waiting.

There are two big players in the outsourced semi-conductor equipment market that manufacture fluid delivery sub-systems: Ichor and Ultra Clean Holdings. These are fairly similar companies. I think that Ultra Clean also does some more general component manufacturing and Ichor has a chemical delivery business, but overall the two companies are comparable.

Ichor and Ultra Clean compare favorably based on TTM results.

Everything seems reasonable so far. But here is where it gets interesting. Both companies pre-announced very strong fourth quarter revenues in the last few weeks. Here is Ichor’s announcement and here is Ultra Cleans.

Ichor’s revenue growth in the fourth quarter was a rather incredible 104% year over year. There was a small acquisition (Ajax, which contributed $13.4 million in revenue since it was acquired in April 2016) that brought the company into the chemical delivery business but apart from that it was all organic growth. Ultra Clean had an impressive 67% year over year growth. Again, organic.

Ichor said that revenue in the first quarter would exceed the fourth quarter. So we have at least three more months of this tremendous growth.

There are a couple of takeaways from Ichor’s and Ultra Clean’s Needham presentations (here and here) that help explain the growth. First, both are benefiting from decent wafer fab equipment demand growth, around 6%.

Second, as chip complexity increases and moves to “multiple patterning, tri-gate, or FinFET, transistors and three-dimensional, or 3D, semiconductors” (eg. 3D NAND), deposition and etch sub-systems growth becomes even stronger (Ichor says 15%). Each layer that is added to the chip requires another etch, deposition and CMD step. Ichor says this dynamic in the market only began in the second half of last year and is “still in the early innings”. The following is a slide from Ichor’s presentation:

Finally, their customers, the OEM process tool providers (LAM, Applied Materials, etc), are outsourcing more of the equipment manufacturing, so Ichor and Ultra Clean are gaining share that was previously held by their customers.

Ichor has the added bonus that they are growing their chemical delivery business at an even faster rate. I think that the acquisition of Ajax earlier this year brought them into the business, but they may have had a small footprint prior.

The chemical delivery business (via Ajax) was a single digit million revenue business a few years ago but has grown 10 fold the last few years. They currently have 10% market share so there is room for further growth.

Ichor doesn’t provide a detailed breakout of revenue between their gas delivery and chemical delivery businesses but did say at Needham that Chemical was about one-ninth of revenue and they could see it getting to one-third.

The other consideration that applies for both companies is the business model has good leverage to revenue increases. While Ichor was a little vague on this, only saying that they have a “variable cost structure that drives highly leveraged earnings model”, and that their operating costs remain relatively flat as revenue increases, Ultra Clean was more specific, providing the following table in their slide deck at Needhams:

So I took a reasonably sized position at $14. I’m willing to watch how this plays out over the next few months. But I look at this as more of a trade. If the stock gets up to $20 in the next couple months, I’ll be a seller.

The thing is, I don’t know how long this cycle is going to continue. It will turn. I haven’t done a lot of work on the semi-equipment cycle and I don’t even know where to start to determine when that inflection occurs. And surely the kind of revenue increase we saw in the fourth quarter isn’t going to continue forever.

Nevertheless, with the fourth quarter numbers that Ichor has guided to, they are trading at well under 10x EBITDA (I didn’t run any scenarios yet so I can’t say exactly where I think that ends up). They are an IPO, which means they are under-followed and probably being estimated conservatively by analysts. And they have already forecast at least one more quarter of significant growth. So the runway is clear for another few months. I’ll look forward to any pullback.

Jan 8

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Revisiting Zargon after the debenture amendment

I wrote about my position in Zargon in my September update. I bought the stock because, after a large asset sale of their Saskatchewan properties at a favorable price, the company seemed poised to recover with an uptick in the price of oil.

As an aside, what a long post that update was! I really was cramming a lot of information into the monthly updates I used to focus on. Hopefully having the updates dispersed into smaller chunks will make for easier reading.

On Friday Zargon announced that their 6.00% convertible unsecured subordinated debentures due June 30, 2017 would be amended, pending approval of holders. The amendments are as follows:

When I looked at Zargon in the fall I did so with the assumption that they would have to dilute to raise capital to pay back the debentures. I was optimistically thinking that would happen at around a 80c share price.

With this deal Zargon is using the cash it has available to pay what of the debenture it can, and then, rather than issuing equity at the current level, its saying give us 3 years and we will issue equity at a 50% premium.

So its much less dilutive than I had been anticipating.

I took a look at what Zargon would look like if the debentures are converted. This happens at a stock price of $1.25, so I took a look at the company at $1.30. That implies over 50% appreciation from the current level. What I’m doing here is asking the question “is this is a reasonable valuation for this company?” – if it is, then there is a lot of upside in the stock.

If I assume that Zargon uses the $19 million to purchase the debentures at par (as opposed to 89% of par), which would be the worst case outcome of the put option, they end up diluting 31 million shares with the rest of the debentures (at $1.30 the debentures would be in the money). The capitalization and metrics look something like this:

(Note that my $52 scenario assumes a 1.28 CAD/USD exchange whereas my $45 scenario assumes 1.33 exchange. I am trying to be conservative by using an $18 differential between WTI and what Zargon realized. This differential was $10/bbl in the third quarter)

Total market capitalization is still only $80 million. There is no debt. And you have a company with a best in class decline rate of ~10%, producing 2,500boepd that is 75% oil.

On traditional metrics it looks reasonable. Even after the large price appreciation the company would still be trading at $31,000 per flowing boe and at a little under 8x EV/EBITDA, which is in-line with peers once you account for the fact that the resulting company has no debt. At $52 oil ($66 Canadian), they can keep production steady with capital expenditures of $6.3 million (in the recent corporate presentation they breakdown the $7.8 million of capital expenditures they expect to incur in 2017 and $1.5 million of it is for land retention). This leaves around $4 million of discretionary cash flow for growth.

I think Zargon could turn out to be a good idea in a rising oil price environment. It wasn’t, and isn’t a great company at $40 oil. Its barely treading water. At $50 it gets its head above. In the high $50’s there is real value there. I thought we were moving into a rising price environment in September and I am more convinced of that now. So I think there is more chance Zargon moves higher than lower.