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Week 246: Hidden in Plain Sight

Portfolio Performance

week-246-yoyperformance

week-246-Performance

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

Thoughts and Review

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

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

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

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

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

Takeovers!

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

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

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

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

Radisys, Radcom, Willden, and what the Market Misses

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

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

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

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

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

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

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

The stock has moved straight up since this press release.

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

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

Radcom

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

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

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

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

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

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

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

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

Willdan Group

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

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

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

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

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

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

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

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

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

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

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

DSP Group

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

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

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

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

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

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

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

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

Vicor

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

forecast

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

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

Tanker Stocks

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

orderbook

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

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

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

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

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

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

Portfolio Composition

Click here for the last five weeks of trades.

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Week 223: Playing the Volatility

Portfolio Performance

week-223-yoyperformance

week-223-Performance

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

Monthly Review and Thoughts

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

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

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

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

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

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

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

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

A Position in Mitel

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

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

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

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

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

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

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

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

recurringrevs

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

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

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

mobilerevs

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

Mitel provides the following roadmap for earnings in 2017.

earningsroadmap

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

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

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

Wading into the Biotech Controversy

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

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

acquisitions

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

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

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

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

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

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

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

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

A Few Small Bets on Gold Stocks

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

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

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

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

yoycomp

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

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

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

Oil

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

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

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

What I sold (and one more I added)

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

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

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

Portfolio Composition

Click here for the last four weeks of trades.

week-223

Week 202: Better Late than Never

Portfolio Performance

week-202-yoyperformance

week-202-Performance

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

Monthly Review and Thoughts

I am a week late getting this portfolio update out due to a really busy weekend that kept me from doing any writing.   Fortunately very little is pressing.  I only made a handful of portfolio changes and added two stocks, small positions at that.

Given the relative dearth of transactions, I thought this would be a good post to give an overall update on some of the stocks I own. I have stepped through my thoughts on a few positions, giving a brief summary of why I own them and what I expect going forward.

But before I do…

This week I picked up the book Reminscences of a Stock Operator.  It is a book that, in addition to which this blog received its name, I read again and again, rarely from start to finish, usually just a chapter starting at whatever page I happen upon.  It has is so much knowledge and so much of my own investment philosophy is tied to its precepts.

This week I opened the book to the chapter about Old Partridge, an fellow with a thick chest who carried a big line and had been around the block a few times.  Its quite a well known chapter, mostly for two comments made by Partridge.

The first is perhaps the most famous.   Being one of the senior members of the house, and given the propensity of speculators to look for an outside influence to sway their opinion, Partridge was often asked for his opinion on tips and whether they should be bought or sold.  When asked such a question he would always respond with the same answer: “You know, its a bull market”.

The weight of this statement is the simple recognition that in a bull market the general trend of stocks is up and if you are confident of the general condition of the market, you can’t go too terribly wrong.  The general trend will  lift most boats.  A precept to be taken seriously for sure.

The second well known passage occurs when Partridge is being presented with advice from a tipster who had given him an idea that had worked out well and was now suggesting that Partridge sell and wait for a correction. To this tipster Partridge replies that he cannot possibly take the man’s advice, for if he were to do so he might lose his position, and he could not bare to do that.

This is really a statement about our own fallibility and our own psychology.  Regarding the former, if the correction does not materialize, then where are is poor Partridge now?  Without a position and up against his own mind’s wrongness to get it back.

As for the latter, are we really so sure of our own emotions that we can stomach either A. buying back the stock at a lower price only to have it fall further or B. waiting too long for the bottom so as to miss it entirely and not being able to stomach a later purchase at a price more dear?

Anyone who has played with real money will know that the mind plays tricks in each of these circumstances.

So this is what is well-known and often quoted from the chapter.  But I was struck by a less often, if ever, quoted passage that is, in my opinion, equally or more important.  I will quote this exactly since it is less well known, with emphasis on one sentence in particular:

“In a bull market your game is to buy and hold until you believe that the bull market is near its end.  To do this you must study general conditions and not tips or special factors affecting individual stocks.  Then [when the bear market comes] get out of all of your stocks; get out for keeps!

Now step back and think about this for a moment.  Livermore is not saying that one needs to be cautious in a bear market, or flee to safety stocks, or go net short.

He is saying sell it all.

How easy would it be to sell every position tomorrow if you had to?  Forget about the logistics, think only of the psychological strain.  Could you really let go of every stock you owned?  Or are reasons already creeping into your mind about why this one or that one should be different, should be held onto, will persevere through the carnage.

I know those reasons are abound for me.

My point is this.  This is not a precept to be taken lightly, and not one to be first dwelled upon at the time when action is required.  To follow it requires training the mind to ruthlessly let go of all your former beliefs and go to 100% cash (or as close as is possible) when the time comes.  This is something that requires practice, and something I am trying to ingrain in myself right now.

With that said, on to the stocks.

New Positions – Enernoc and others

I had a few new positions in the last month.  I bought Enernoc (ENOC) I bought Chanticleer Holdings (HOTR) and I bought some gold stocks for another swing.  I’m not going to talk about the gold stocks.  I bought a few very small one’s on the recommendation of a friend that I agreed not to talk about on the blog and so I won’t.  I bought a few larger one’s for the online portfolio that I have talked about before and really have nothing new to add other than that gold looked ready to break-out (it did) and so I thought the stocks would follow (they did).

The idea behind Chanticleer came from this SeekingAlpha article, which I found to be quite good. But to be honest I bought the stock as more of a short-term momentum play than a long-term hold.  I have to spend more time on it to know whether it is anything more and if I do and decide favorably, I will write more about it later.

On the other hand I expect to hold Enernoc for at least the immediate term.

Enernoc operates two businesses, a legacy demand response power management business and an evolving energy intelligence software (EIS) business.

The demand response business is very lumpy, and that lumpiness leads to the kind of stock reaction that happened in February and again a few weeks ago.  The company partners with enterprises to provide load reductions in times of high power demand.  By pre-buying into generation capacity that is no longer required (and thus no longer needs to be delivered) they split the winnings from the savings derived thus profiting from the result.  The difficulty is that the company’s profitability depends to a degree on the volatility of the power market, which is cyclical and hard to predict.

This year Enernoc is experiencing this negative cyclicality in Western Australia.  In addition, a contract they have with PGM cannot have its revenue recognized until fiscal 2016.  This combination led to revenue guidance in 2015 of about $100 million below 2014.  The market didn’t like that.

It is the second business, an EIS software platform, that really has me interested.  The EIS platform is sold to enterprises and utilities and allows for the centralized monitoring, analytics, reporting and most importantly management of energy to reduce consumption and manage supply.  From what I can tell they have one of the leading solutions on the market.  And I really like the market.

As a general rule I’m not much for technology story stocks but this makes sense to me.  I believe that the electricity grid is in the early stages of a pretty profound transformation.  Anyone can pull up a graph of solar costs and see that while we are not there yet, we are headed for a world where solar will be cheap enough to be competitive in say the next 5-10 years, if not sooner.  As that time comes upon us the management of energy, both to and from the grid  and at the level of each individual enterprise or consumer, is going to be much more important.

Meanwhile, the evolution of the industrial internet means a general trend toward the greater use of measurement and analytics in all areas of business.  Energy consumption and distribution will be forefront of this shift.

Enernoc says that right now their primary competition to their EIS platform are spreadsheets and apathy.  I believe both of these impediments will become less viable as the electricity grid evolves.

I would urge readers to give a listen to at least the first 45 minutes of the investor day presentation, available here.  I thought they painted a compelling picture.  Please tell me if you think I’m on crack.

Of course one look at the stock and the numbers and they are terrible.  So terrible that I am not going to roll out any spreadsheets or models because they are just too ugly.  I think 2015 guidance was for -$3 per share in earnings or something like that; I can’t even remember the exact number because it was so bad that it wasn’t even  worth remembering.  Cash flow isn’t quite so bad because much of the earnings hit is due to the revenue deferral.  The company expects break-even cash flow in 2015.

The stock delivered crappy numbers in the first quarter and got smacked and it could easily deliver crappy numbers in the second quarter too.

Nevertheless I think at some point we see the EIS business overshadow the results.  The key metric is annual recurring revenue (ARR), which the company reports for both utilities and enterprises.  ARR growth will reflect annual subscriptions to the software.

In 2015 Enernoc is expecting 70% ARR growth for enterprises and 15-20% growth for utilities.  If they hit or exceed those numbers I don’t think the stock will continue in the single digits.

This is the kind of story that could get a silly valuation if things turn out right.   It is a somewhat un-quantifiably large opportunity that could be extrapolated to a big number if it starts to work.  Its not working yet and that’s why the stock is in the $9’s.  I think there is a reasonable chance that changes in the next 6-9 months.

Revisiting some existing positions

Air Canada

I made this my largest holding after first quarter earnings were announced.  Air Canada continues to get very little respect from the investor community.  With estimates that top $3 for the full year 2015, the stock trades at around 4x earnings.

Even after accounting for the relatively difficult business of air travel, and recognizing that free cash generation hampered in the near term by the build out of the fleet, I have trouble believing the stock isn’t worth more than this.

I was talking to a twitter acquaintance about Air Canada and WestJet.  He was making the very valid argument that WestJet was an easier position for him to make larger because it was A. less leveraged and B. had lower cost.

The conversation made me revisit a comparison I made of the two airlines.  One thing I looked at was analyst estimates for the two companies.

epscomp

Air Canada trades at a discount to WestJet on both and EBITDAR and EPS basis, but the discount is far greater with regard to the latter because of the leverage that Air Canada employs.  Air Canada has about $5.5 billion of net debt while Westjet debt is  around $1.1 billion.

I believe that the discount Air Canada receives is due to historical biases that are beginning to close.  There is evidence that Air Canada is taking market share from Westjet.  Costs are coming down and CASM declines nearly every quarter.

The nature of their network is that it is always going to be higher cost, but what matters are margins and margins have been increasing.   In the first quarter operating margins reached 6.3% and return on invested capital rose to above 15%.  If they continue to roll out their plan, expand margins while increasing capacity, it will be harder and harder to justify a 3-4x earnings multiple on the stock.

Axia NetMedia

Axia is one of about  five stocks that I rarely look at.  I have no intention of selling my position.  I have confidence in the long-term direction of management.  And I think they provide an important service to rural residents and businesses (high speed internet access) that has, if I were to steal the term of a value-investor, a wide moat.  I’ve also lived in Alberta all my life, grew up in one of the small towns that Axia provides service to and know the family of their CEO and Chief Executive Officer to be stand-up people.

The business is not without its faults: it requires large up-front capital expenditures to lay fiber to mostly out of the way places.  In Alberta it is dependent on a somewhat complicated agreement between Bell (which owns the fibre backbone connecting the 27 largest communities), the Alberta government (which owns the backbone to the rest of the communities) and Axia (which operates the backbone owned by the Alberta government as well as owning branches to individual communities and businesses off of the backbone).

The stock has appreciated over the last couple of years but still trades reasonably at around 7x EBITDA.  Once the build-out of fibre in France and Alberta is complete and capital expenditures trend into maintenance, the business should produce ample free cash.

Its a stock I hold without concern and add to on any of its infrequent dips.

DHT Holdings

This is my biggest tanker holding.  DHT owns a fleet of 14 VLCCs, 2 Suezmax and 2 Aframax vessels.  They have another 6 VLCC vessels scheduled for delivery in 2015.  I like that they have growth on the horizon and I do not feel like I am paying up for that growth.

In the first quarter DHT reported earnings of 25c.  They booked VLCC rates of around $50,000 per day and Suezmax rates of about $30,000 per day (note that in the press release DHT referenced $60,000 per day for its VLCC’s but this referred to spot exposure only).

Along with the first quarter results the company gave guidance on new builds, saying on the conference call that “under a rate scenario, say, $50,000 per day, we estimate that each of these ships will add some $3.7 million of additional EBITDA per quarter.”

Take a look at my model below.  Those 6 additional ships, delivering $3.7mm of EBITDA at $50,000 day rates, are going to double earnings to around 50 cents per share quarterly.  This is comparable on a per share basis to Euronav, yet Euronav trades at $13.

newforecastLike the other tanker companies reporting earnings DHT had mostly positive things to say about the future.  The company pointed to a 2 year plus wait to get VLCC delivered from Korean or Japanese yards.  They also don’t think the strength in the tanker market has anything to do with contango – instead that it’s a function of higher demand, longer routes and limited order book bringing on little new supply.

Empire Industries

I was really happy when I found out that the Canadian government had decided to support the 30 meter telescope.  As I’ve written in the past, Empire had significant contract work lined up for the telescope, but the work was contingent on financial support for the telescope from the government.    The company expects the 30 meter telescope contract to add about $80 million to their backlog.

Even without the $80 million, Empire’s backlog has been increasing.  Backlog at the end of the first quarter was $155 million versus $93 million at the end of the fourth quarter.  The increase in backlog due to orders for the Media Attractions group, which continues to make inroads in Asia and the Middle East for its amusement park rides.

So with all this good news, why is the stock languishing?  Oil.   The Hydrovac truck business is getting squeezed on volumes and margins and the steel fabrication segment is weak:

hydrovacandsteelfabbizSo the problem with the stock is that some business are doing quite poorly.  Even with positives from the telescope revenue things remain a bit up in the air because of these other lagging businesses.

Finally I have read on Stockhouse that there is the Chinese seller trying to get out of their position.  I have no idea whether this is true, but it makes some sense particularly given the pressure on high volume that the stock experienced after earnings.   Earnings day is often a good opportunity to liquidate in these low volume venture stocks.

Teekay Tankers

This was my third largest tanker position (behind DHT Holdings and EuroNAV), but after being downgraded by Deutsche Bank on concerns about supply in the second half of 2016, I hemmed and hawed, modeled what looked like it was going to be a very strong quarter and after a whole lot of consternation, I added to my position.

I actually got a copy of the Deutsche Bank report thanks to one of my very helpful twitter pals.  It’s a reasonable report.  Deutsche Bank expects higher supply growth in 2016 than they had previously estimated.  This is because of a pull-in of 2017 new builds into the second half of 2016, and lower scrapping of ships.

I don’t totally agree with their numbers; in one case in particular they assume scrap of 0.5% for 2015 and 2016 while the actual year to date numbers for 2015,which have been extremely low, are 0.3% over the first four months.  It seems a little to pessimistic.  Nevertheless the themes are reasonable.

The question I wrestled with through the day on Tuesday was whether the tanker rally would end prematurely on the basis of an expected re-balancing of ship supply in year and a bit down the road.  My conclusion was that it’s too far to see; too far to expect the market to discount.

What is the new equilibrium price of oil?  What is the new demand level at that price?  How many new-builds are going to get out on the ocean?

We are already seeing the EIA increase oil demand estimates and we know they are typically behind the curve.  We are already seeing costs come down for oil services, suggesting a lower price of oil will deliver similar margins.  Deutsche Bank assumed a 38% non-delivery of the order book.  This is probably reasonable, but after listening to comments from Euronav and DHT about the composition of the order book its conceivable that the number could be higher.

I get the feeling that Deutsche Bank, and presumably many others, are basing their conclusions on the narrative that tankers are a fragmented industry that has never and will never get their shit together.  The problem with this narrative is that its not really historically accurate.

Below is a chart from the Euronav roadshow giving historical VLCC rates, followed by one from Teekay Tankers investor day giving historical Suezmax and Aframax rates:

vlccrates

historicalratesThe VLCC, Suezmax and Aframax markets went through a 4 year period, from 2004-2008, where rates were extremely profitable.  In fact they were higher than today.  Yet the narrative is that at the first sign of positive earnings, tankers will flood the market and so the current cycle will be 12 months tops.

I’m not so sure.

I’m not suggesting that the questions and history paint a clear picture for tankers.   I’m simply suggesting the picture is not convincingly dark.  And the valuations, in particular Teekay, reflect a lot of darkness.

Rather than give you my model for Teekay, just take a look at the following slide of the company’s cash flow.

freecashflowThe company’s cash flow increases by 57 cents for every $5,000 increase in day rates.  Its extraordinary leverage.   Now albeit their definition of “free cash” is a little suspect – free cash for tankers is basically, “we’ve bought all our ships and don’t plan to buy any more”.  But nevertheless a cash flow multiple  of 3x, when that cash will go straight to the balance sheet in one form or another absent further ship purchases, seems inexpensive to me.

Extendicare

Sometimes you just have to wait out the speculators.  When Extendicare announced the sale of its US assets in November, my first instinct was to sell my position.  It was a poor deal, though maybe not as bad of a deal as the market reaction insinuated.  I did a lot of work in the days after the deal, basically distilling what remained of the thesis into a simple observation: the current market price at the time (around $6.50) was essentially assuming that Extendicare did nothing right going forward: that they remain underleveraged and that they don’t put the cash from the deal to work in a accretive manner.  When I thought about the chances of this happening, I saw it as a real possibility, but not a certainty.  I also suspected that there were some very large shareholders who had been betting on a positive outcome to the US divestiture and they were now forced to sell shares of an illiquid stock with no momentum at the end of the year.

The picture was thus one of abnormal and perhaps unwarranted weakness. Thus I concluded that I would hold onto my shares and in fact added to them when the stock got as low as $6.20.

Since then we have had a recovery.  Extendicare has proven that it can put the cash proceeds towards a positive end, having purchased Revera Home Health homecare business for $83 million.  The acquisition is expected to add 10 cents to Extendicare’s AFFO.  This has allayed concerns that the dividend may need to be cut to what is sustainable for the Canadian only operations.  Also in the first quarter the company bought back 978,000 shares, or a little over 1% of shares outstanding.

Perhaps most importantly, the Ontario government amended its subsidies for redevelopment at the of February.  The base subsidy for large homes was increased to $162,000 per bed from $121,000 per bed over a 25 year life.  Also the revised design standards no longer include LEEDs certification, which should bring down construction costs.  Below is the outcome of Extendicare converting 1,876 of its Class “C” beds (the lowest type) into 1,972 Class A beds.

newontsubsidies

The amendment of subsidies is a big deal for Extendicare.  The vast majority of their beds are in Ontario.  When asked on the call whether the latest changes by the government would make it economically attractive to redevelop their Class-C beds, Extendicare responded that while there are still practical details to iron out, in theory the economics are there.

Given that Extendicare now has multiple options for its cash including further acquisitions in the homecare segment, redevelopment of existing Class C facilities, and new developments in the independent living/assisted living space, investors can begin to look forward at possibilities rather than backward at missed opportunities.  I’m holding my shares.

Hammond Manufacturing

Taking the what they do statement right from their MD&A: “Hammond Manufacturing Company Limited manufactures electronic and electrical enclosures, outlet strips and electronic transformers that are used by manufacturers of a wide range of electronic and electrical products. Products are sold both to OEM-direct and through a global network of distributors and agents.”  Simple business. No real moat.  But the type of business that can see a very positive impact from a change in their cost structure such as that brought on by the current weakness in the Canadian dollar.

The stock has so far been a bit of a disappointment.  They had a great quarter on the top line – revenue was up to $30.5mm from $24.5mm in 2014, which is inline with my thesis that they would be one of the manufacturers to benefit from the lower Canadian dollar.  The revenue gain was partially due to foreign exchange gains and partly due to market share gains.

Income from operations was also up significantly:

q1

The problem with the quarter, and what was unexpected for me, is that they had a really big foreign exchange loss of $623,000 versus $145,000 last year. $380,000 was due to a USD loan for their US subsidiary. This really depressed the bottom line.

Excluding the foreign exchange loss, Hammond actually didn’t have a bad quarter.  The stock remains reasonable.  Below are the trailing twelve months results for the company.  The free cash generation (below computed before changes in working capital) is compelling and I see no reason for a return to parity for the Canadian dollar and thus no reason to think this level of cash generation can’t continue.  I am considering adding to the position, even as I am down fairly significantly on it.

ttm-results

Euronav

Euronav had a very interesting conference call, which unfortunately has no transcript via Seeking Alpha, so it is difficult to quote.  I’m paraphrasing.  Euronav said they believed we are at the beginning of a multi-year run for the market.  They see the catalysts for this run being:

  1. limited vessel supply
  2. increasing demand for oil
  3. rising tonne-miles as cargo moves over greater distances and ships reposition over greater distances

One of the most interesting points that Euronav made, and one that I had not heard before, is that there is a significant amount of vessel tonnage available for sale.  They estimated that 10% of the tanker fleet is up for sale from private owners, distressed entities, and opportunistic speculators.  Of that 10% a significant number of the vessels are in the 0-5 year range.  The point here is that the quality of available fleet is not far off of new builds, and so if capital begins to come into the tanker market looking for a home, there are plenty of places for it to go without adding to supply via new build orders.

Another interesting comment that Euronav made was that you need 40 new build VLCCs per year to keep up with oil demand.  Returning to the Deutsche Bank analysis I mentioned in my Teekay Tankers remarks, Deutsche Bank is estimating an increase in 30 VLCCs in 2016, followed by only 10 in 2017.  Again, I’m not so sure that their analysis is as bearish as their price target changes suggest it is.

Euronav’s bottom line is the same one I have already stated for DHT Holdings and Teekay Tankers.  Its too cheap if you think rates in the current range can sustain themselves.  The company can generate earnings north of $2 per share at current rates (earnings were 55 cents in the first quarter).  At $13, which is where I was buying it, it trades at 6x earnings.   If that multiple goes to 8x you are looking at a 36% upside in the price.

Stocks I sold

I exited a number of positions in the last month.  I sold out of Handy & Harman (HNH), Ellington Financial (EFC), Hooper Holmes (HH), Amdocs (DOX), Ardmore Shipping (ASC), Impac Mortgage (IMH) and Avid Technologies (AVID).

In the cases of Amdocs, Ardmore, Impac and Avid, I sold out because the stocks had risen to a level that I thought closely reflected a fair price.   With Impac Mortgage in particular I caught the top with the on-line portfolio sales, but I regret to say that in my real dollars portfolio I only sold half at $27, and had to let go of the rest at $22.  I may revisit Ardmore in the future if it dips but I just have so many shipping plays in my portfolio right now I thought it prudent to take profits on some of them.

Handy & Harman and Hooper Holmes both just weren’t working out, I was down about 20% and so I had to make a decision of what to do.  I decided to cut the positions because I am simply less certain about their future direction than I am with other stocks in my portfolio.

I still own Ellington Financial in my other account where I hold mostly dividend payers.  I just didn’t think holding a stock where the upside is mostly yield makes much sense in a portfolio that does not track dividends.

Portfolio Composition

Click here for the last five weeks of trades.

week-202

Week 189: Playing the oil trade from all angles

Portfolio Performance

week-189-yoyperformance

week-189-Performance

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

Updates

One of the themes  over the last few months has been a shift in methodology towards taking what I can get.  Less have I been holding out for the big gain, and more have I been booking 10-20% gains when they materialize.

The change arises from my confidence, or lack thereof.  I know we are in a bull market and still at all-time highs but it doesn’t feel like that and so I remain somewhat cautious.   I’m just not comfortable waiting for upsides to play out in full.  So I take what I can get.

Sticking with the Airlines for now

This business of scalping, for lack of a better term, worked quite effectively with Hawaiian Holdings.  Leading up to Hawaiian Holdings earnings report on January 29th I held a fairly large position.   But believing that caution is the better part of valor, I reduced that position to its shadow in the days leading up to the earnings release.   The stock was subsequently pummeled after reporting lower guidance than anticipated.  While I still took some lumps, it was not nearly to the degree it would have been and I was left to decide where to go from here.

After much review I decided to add back, at least part way.   Here’s what I think.  The stock was hit because their revenue per average seat mile (RASM) is being squeezed on a couple of fronts.  First, on their Asian destinations fuel surcharges are shrinking down to nothing because of the drop in the price of oil.  Second, the strength in the US dollar is hurting their competitiveness to book flights from Asia; naturally the majority of Hawaiian’s customers on their Asian routes are traveling from these destinations and flying to the US: Hawaiian’s US dollar cost structure is hurting them here.  Third, the company said that North American capacity would be at a record high this year, with capacity growth peaking in the first half and this would put some downward pressure on prices.

The bottom line of all of this is a year over year total RASM decline of 3.5%-5.5% in the first quarter (including 3% that is attributable to currency and fuel surcharges).  I think that the market looked at that and said, whoa that’s a lot of headwinds for a stock that is up some 100%+ in the last year, and promptly sold it off.

While it’s a fair assessment, they are a lot less of a concern now that the stock is down some 30% in the last few weeks.   What is easily overlooked is that all of the negatives are more than made up for by the drop in jet fuel prices.  Using the company’s 2015 fuel guidance I calculate that the savings will be $230-$240 million for the entire year.  That is over $4 per share.

If the experts are right and oil prices are going to stay in the $50-$60 range for 2015 I simply do not see how a company like Hawaiian Holdings, or for that matter the other airline stock I continue to own, Air Canada, will continue to trade at such low PE multiples.  I have based this discussion on Hawaiian but I could have made similar arguments with Air Canada, with the primary differences being different events leading to a perceived earnings miss (in Air Canada’s case it was employee benefits, adjustments to pension assumptions and a lower Canadian dollar) and that the stock has quickly gained back its losses.  But Air Canada, like Hawaiian, will see gains from the lower price of jet fuel that far exceed any currency or revenue headwinds they encounter.

Getting back to Hawaiian, using the company’s guidance leads to earnings of about $2.75 per share.  Do they really deserve a mid-single digit multiple in a market where the average multiple of an S&P stock is somewhere north of 20?  I feel like the upside potential is, as they say, asymmetric to the downside risk.

The downside risk, of course, is that the price of oil rises  significantly.  While this is something to keep a close eye on, particularly with disruptions in Libya and Iraq, I feel well hedged by the oil stocks I own in my portfolio.  My positions in RMP Energy, Mart Resources, and my recently taken position in Rock Energy will all do very well if the price of oil spikes.  And as always, if things start to go south, I plan to exit my positions quickly to limit my losses.  But I don’t think I will have to.  I think this is probably at least a somewhat new paradigm for oil, which means its also a new paradigm for the airlines, something that even with the run up in the fourth quarter last year I don’t think the market has fully appreciated.

New Position: Willdan

I got the idea for Willdan from a couple of SeekingAlpha articles that outlined the investment case for the company (here and here).

Willdan provides consulting services.  They separate their business into four segments: engineering services (Willdan Engineering), energy efficiency services (Willdan Energy Solutions), public finance services (Willdan Financial Services) and homeland security services (Willdan Homeland Solutions).  Of these, the energy and engineering services make up the bulk of the revenue.

revenue_breakdownTo get a sense of the sort of consulting Willdan performs, its worth taking a closer look at a few of their contracts.  In 2009 Consolidated Edison awarded Willdan with one of if not the largest contract, $67 million to perform the role of “program implementation contractor” for an energy efficiency program directed at small businesses.  The contract was extended in August of last year.  Willdan’s role as contractor includes:

providing outreach to small businesses, completing on-site energy efficiency surveys, implementing energy-saving projects, and partnering with the community and local businesses.

As another example, Willdan provides engineering services to the city of Elk Grove California. After a bit of investigation I found that the services Willdan provides are things such a road construction and repair, drainage construction, lighting design and maintenance and traffic engineering.  Basically all the civil engineering tasks that one would associate with maintaining a city.

So this gives you an idea of what Willdan does.  Its probably not a bad business, not terribly reliant on the economy, but not really much of a moat beyond the skills of the individuals you employ who do the work for your customers.

Willdan is a small company, trading at a market capitalization of about $100 million.  When I first stepped through their historical results, Willdan looked somewhat interesting to me but I could have easily passed.  But what caught my attention were two recent acquisitions for $21.2 million. Both of these businesses are complimentary; typically Willdan provides energy audits and consulting but does not perform the engineering services for energy efficiency projects; these companies will expand that offering to the latter.  The businesses also expand Willdan outside of their core areas of California and New York and into the Pacific Northwest and Midwest.

So Willdan benefits on two fornts: they can expand their energy services auditing into new territory, and can market the engineering services of the new businesses within their own operating regions, presumably for energy efficiency audits they already have under contract.

On the conference call to discuss the acquisitions management said they paid 4.3x EBITDA for the guaranteed portion of the acquisition price.  The acquisition structure is tiered, by which Willdan pays 60% of the price (about $12.7 million) up front, with the balance contingent on the performance of the acquired businesses.  In particular each business has to grow operating earnings by 25% to obtain the full payment. It seems to me like a great structure for Willdan.

The acquisition price implies that businesses are generating about $3 million of EBITDA in the trailing twelve months.  Before the acquisitions Willdan said they could grow their top line organically by 15% in 2015.  Below is a rough estimate of earnings per share assuming that Willdan achieves their top line growth, maintains their existing margins, and that the acquired businesses perform sufficiently to achieve the full acquisition price.

earningsIts not unreasonable to assume that a company with $1.30 earnings and a growth profile over the last few years would be given a multiple of greater than 10x.

This is a small company and small position for me, and not one I am likely to add to.  I think there is a decent chance I will make a few bucks on it as it has a run to $17 or $18 or if I’m lucky even $20.

One new Energy Position: Rock Energy

As I mentioned in my last update, I had been in and out of Penn West a couple of times during the first month of the year.  I held Penn West for perhaps the last time a couple weeks ago when I bought the shares for a little under $2 (Canadian) and sold them at $2.60.  Regretfully I sold much too soon, the stock kept roaring all the way up to $3.30. But consistent with my theme this month and with the thesis I presented in my last update, the nature of my purchase was a short term scalp and to stray from the nature of my intent would have been little better than a blind gamble.

But having some conviction that oil prices have hit bottom, and as I mentioned already, having an eye on the production shut-ins in Libya and Iraq, I did peruse the energy universe for other names that I might want to take a position in.  I am by no means convinced that oil prices have bottomed, we may have, may not have.  Thus I was looking for companies that could weather a continuing storm but still pose a decent upside to a stabilization in price.

A lot of the stocks I looked at had gone too far too fast; reviewing Baytex, Suncor, the larger Canadian names, and they all seemed to be already pricing in an oil recovery.  Ditto for smaller names like DeeThree Energy, which I should have been looking at $2 ago.  Others, like Penn West and Lightstream, certainly have a lot of upside if a truly bullish scenario develops, but they run too much risk of a big drop on some bad news event driven by lenders getting skittish.  I don’t want to have to worry about that.

I settled on Rock Energy, a name I used to own at prices not far off what I bought it for now. Here are the reasons I like Rock:

  • Their debt is nearly non-existent at $20 million as of the end of third quarter and now, after a recent $13.2 million bought deal (done at $2.32 per share) debt is even lower.  There is no question that this company survives.
  • Rock revised their 2015 guidance and cut capital expenditures to the bone, to $25 million for the year, down from their original guidance of $90 million.
  • At an average price $40 USD WCS, with a US/CAD exchange rate of 1.25, they will generate $35 million of cash flow for the year, more than covering capital expenditures.
  • At this low level of capital expenditures the company would exit the year at somewhere in the neighbourhood of 4,600 boe/d. That values them at $28,000 per flowing boe upon exit.

The sensitivity analysis I did below shows how the company will cover its capital expenditures even at current WCS prices and illustrates the upside to an increasing oil price.

earnings-forecast

Rock will rise when the price of oil rises.  If the price of oil does not rise, Rock will flounder, but I doubt it will crash much further.

Hammond Manufacturing

I’ve been on the look-out for Canadian manufacturers that stand to benefit from the dramatic fall in the Canadian dollar. I haven’t had a lot of luck.  There aren’t a lot of manufacturers left in Canada, and most of the big one’s move dramatically in November, anticipating the move, and I wasn’t quite so quick to the trigger.

However I did find one overlooked name a couple weeks ago.  Hammond Manufacturing.  Hammond is engaged in the heavily moated business of electronic enclosure manufacturing.  I’m kidding of course, but when your business is one of commodity manufacturing there is little more that could be asked for than for a 20% currency devaluation to bring down your unit costs.

Hammond is a pretty simple story so I’ll keep this short.  The company manufacturers electronics enclosures, so racks, cabinets, wire troughs and a few more technically complicated items like air conditioners and heat exchangers.  They manufacture these products in Canada (Guelph) and thus they incur their costs in the Canadian dollars.  That means their costs have declined significantly of late, and that puts them at a competitive advantage.  The company is expanding production to meet the increased demand brought on by what is likely increasing market share.

The stock is also cheap.  Looking back at the trailing twelve months, at the current price the stock is at 6x free cash flow.  That free cash flow is going to decline in the upcoming quarters as the company looks to expand their business which means an increased level of capital expenditures.  I think there is a reasonable chance that capital translates into meaningful growth, and in turn, a higher stock price.

The Tanker Trade – DHT Holdings

I have remained patient with my position in Frontline even as it sank significantly from my original purchase.  When the stock hit $2.90 I reluctantly reduced because it had crossed my 20% loss threshold.  I held onto the rest as it sank further and subsequently added back as it recovered.  The thesis still seems intact and my position sizing is not so big as to make me uncomfortable with the wait for it to play out.  In addition to Frontline I continue to own Nordic American Tankers (which I mistakenly referred to as Navios Marine Acquisition Corp in my last update).

I added another name to the trade a week ago: DHT Holdings.  DHT is a bit safer way to play the thesis, insofar as any of these stocks can be considered safe.  Their ships are newer, they have a number of new builds scheduled for delivery over the next two years, they do not have the debt overhang, and with ~60% of their ships on the spot market they still stand to benefit from improved rates.

DHT has 14 VLCC tankers and another4 Suezmax tankers.  There are another 6 VLCC new builds that will be delivered over the next two years.  When I look at DHT’s earning performance at rates even slightly below today’s level, I am left to conclude there is significant upside in the stock if the thesis does play out as I expect.

forecast

A couple of weeks ago I posted Teekay Tankers monthly update video onto twitter.  It is available here.  In the video it was noted that supply growth over the next year or two for the three classes of ships used for crude transport (VLCC, Suezmax and Aframax) is non-existent. Meanwhile demand is expected to increase, including further pressure given the fall in the price of oil, and a number of VLCC tankers are being taken off the market for 1 or 2 years for storage.  I think that what we have seen over the past month is a short attack on the tanker stocks from those that believe we are seeing a repeat of last year; a brief spike in rates that will soon be followed by a collapse down to marginal levels.  What I think the shorts are failing to realize is that the dynamic is quite different then last year.  Indeed as we move through February you are not seeing significant weakness in rates and as a consequence the tanker stocks are being to firm up again.  I suspect (and am anticipating) that this is the precursor for another move up.

Scaling back on US names

I sold out of a number of positions in the last month, most of them for reasonable gains.  Included on this list was Engility Holdings, Rosetta Stone, CGI Group, Electromed and ePlus.  Each is an excellent illustration of the scalper trade in action.

Of the group, I most reluctantly sold out of CGI Group.  I think there is a decent chance it continues to trade higher.  But I also note that they are predicting somewhat weaker results in the first half of the year, followed by strength in the second half, they may experience some currency headwinds with the Canadian dollar falling, because they trade in the US and its not clear to me whether it is the Canadian or US ticker that determines the price they may also face share price headwinds if the Canadian dollar rises, and they simply aren’t as cheap as they were when I bought them 20% lower.  But really, my primary reason for selling the stock is because when I bought it I assessed that there was an easy 20% of upside but that my outlook was cloudy after that. I’ve gotten that first 20%, so to hold on without a change in thesis feels like a bit of a gamble.

I was pleased with the results from ePlus but surprised that the stock took off to the extent it did after earnings.  Shares were up nearly 15% at one point.  Much like CGI Group, ePlus is coming up on weaker seasonality in the next two quarters.  Also much like CGI Group, the discount I saw originally has been eaten up with the 20% gain in the share price.  Were I convinced we were in a bull market I may have held out for another leg up.  I’m not so sure though, so I just took my profits and walked away.

I spent a lot of time thinking about Rosetta Stone.  You can read my comments on a couple of short articles that were posted on Seeking Alpha.  I finally sold out of the stock for about a 10% gain and with some reservations about whether I am doing the right thing.  I still don’t really buy the short argument.  But I also didn’t feel confident enough about the business to hold the stock through its fourth quarter results.  I think the fourth quarter is going to be good; seasonally it is the best quarter by far. I’m less sure about guidance.

My actual 2014 portfolio performance

As I have noted before, I write this blog based on the performance of a tracking practice portfolio that is made available from RBC.  This portfolio is intended to mimic the general trend of my most risky investment portfolio.  However the practice portfolio has some limitations, in particular that you can’t short stocks in it and you can buy and sell options.  Every year I try to give a quick update on my actual portfolio performance as comparison.  In this last year the gap between the real portfolio and the one I track here was a bit bigger than usual, and mostly for a single reason: Pacific Ethanol.  In my actual portfolio, when given the fat pitch that was ethanol back in the early months of 2014, I not only loaded up on Pacific Ethanol stock but on options as well, with the result being very large gains on the calls.  Thus below, you can see the discrepancy between my more speculative account, where the options were bought, and the more restricted retirement account where you can only buy stock.  I had a pretty good year in my retirement account, but my investment account flourished particularly well thanks in large part to our good friend Pixie.

actuals

Portfolio Composition

Click here for the last four weeks of trades.  Note that the name change of Yellow Media to Yellow Pages removed that ticker from the practice account so there are a couple of transactions there to add back the 1,000 shares that disappeared.

week-189