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Posts from the ‘Acacia Research (ACTG)’ Category

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  By Wednesday I was selling some positions and adding to others, so my original write-up seemed out of date.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.

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Week 231: Tax Loss Buying

Portfolio Performance

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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