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Week 401: Treading Along

Portfolio Performance

Thoughts and Review

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

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

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

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

Smith Micro

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

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

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

And the valuation is still not expensive at all.

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

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

Mission Ready Solutions

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Overstock

Overstock announced fourth quarter results on Monday morning.

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

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

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

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

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

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

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

There are two pieces of good news here.

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

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

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

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

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

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

Evolus

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

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

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

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

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

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

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

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

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

A few comments on stocks I sold

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

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

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

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

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

Portfolio Composition

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

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A Bit of an Update and Kindred Biosciences

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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