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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.

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Week 223: Playing the Volatility

Portfolio Performance

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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.

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Week 2015: Maybe its just a bear market

Portfolio Performance

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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 don’t flash sensational headlines about bear markets for the sake of getting attention.  I get about 100-150 page views a day and given the frequency and technicality of my writing I don’t expect that to increase materially regardless of the headline I post.

When I raise the question of whether we are in a bear market, its simply because even though the US averages hover a couple of percent below recent highs, the movement of individual stocks seems to more closely resemble what I remember from the early stages of 2008 and the summer of 2011.

A breakdown of the performance of the Russell 2000, which is where a lot of the stocks I invest in reside, was tweeted out this week by 17thStrCap and I think illustrates the pain quite well:

us market

The Canadian stock averages have been made respectable by Valeant and not much else. In a Globe & Mail article appropriately capsulizing my comment here called “The market is in much worse shape than the TSX index suggests” the following comparison was made between the TSX Composite and an equal weighted version of it that dampens out the Valeant effect.

tsxperformance

When the Federal Reserve ended its quantitative easing program last year I was concerned that the market might revert back to the nature it had demonstrated after first two QE endeavors.  But for a number of months that didn’t happen.  Stocks kept moving; maybe not upwards at the speed they had previously but they also did not wilt into the night.

I am starting to think that was nothing more than the unwinding of the momentum created by such a long QE program.  Slowly momentum is being drained from the market as the bear takes hold.

A week late

I am a week late getting to this update.  We were on vacation last week, which made it tough to write.  As well I was in no mood to ruin my vacation and write with my portfolio going through significant perturbations to the downside.

It is frustrating to see my portfolio doing poorly.  My investment account is being saved by two things:

  1. Shorts
  2. US stocks in Canadian dollars

As I mentioned last month I have had a number of technology shorts, some shorts on Canadian banks and mortgage providers, and hedges on energy and small caps via the XOP and IWM.  I actually took a bunch of the tech shorts off in the last few days for the simple reason that they are up so much.  I had some decent gains from INTC, SNDK, MU, ANET AVGO, RAX, HIMX and TSM.  I also ended my multi-year short on YELP.

I am covering my shorts because with earnings season over I think there could be a counter rally resulting from the news vacuum.   The China collapse angle has been beaten up and priced in; I could see the perception shifting towards the positive outcomes of the stimulus. And I’ve read that Apple is increasing orders for the iPhone 6s and 6s+ which may or may not be warranted (I suspect not) but could lift tech results in the short term.

I would put these shorts back on if the stocks recovered.  But I don’t feel like I know enough about tech to be pressing my luck on the names.  And as I reduce my long portfolio and raise cash, I feel less need to have what feel like stretched shorts to hedge those positions.

Without the benefit of short hedging this blog’s online tracking portfolio has done worse.  I’m down about 5.6% from a brief peak I hit in mid-July (when the tankers were at their highs) and I am essentially running flat for the last 4 months.

At the center of my frustration are tankers, airlines, small caps and the REITs.  So pretty much everything.  Let’s talk about each.

The Tankers

With oil oversupplied and refiners working at record capacity producing gasoline, jet fuel and heating oil, one would expect that the market would turn to crude and product tankers as a natural beneficiary.

No such luck.

The recent moves by my favorite tanker plays: DHT Holdings, Ardmore Shipping and Capital Product Partners, have been to the downside.  There was a brief move up towards the end of July that coincided with earnings (which were outstanding) but it was quickly unwound and now we are back to levels seen a few months ago.  While I sold some along the way up, it wasn’t (and isn’t) ever enough.

Ardmore Shipping

Particularly with the product tankers (specifically Ardmore Shipping), I just don’t get why the behavior is so poor.  I found it difficult to come away from their second quarter conference call with anything but an extremely bullish take on the company’s prospects.

The product market is benefiting from extremely strong refinery utilization and strong demand for products.  It is also benefiting from the move by Middle East nations to add refining capacity with the view of exporting finished products.

Ardmore had earnings per share of 30c.  They achieved those earnings with 18.4 ships. By the end of the year, once all of their newbuild fleet is delivered, the company expects to have 24 ships.  If newbuilds had been operating in the second quarter, earnings would have been 43c for the quarter.

In the second quarter Ardmore saw spot rates of $22,400 TCE.  So far in the third quarter spot rates are up again to $23,500.  At current $23,500 spot rates and with 12 MR’s in the spot market, EPS would be $1.85.  The stock has been trading at around $13.

Yet the stock sells off.

DHT Holdings

Likewise, I couldn’t believe it when DHT Holdings traded down to below $7 on Wednesday.  At least the crude tanker market makes some sense in terms of rates.  Voyage rates have come off to $40,000 TCE for VLCC ships.  This is seasonal and if anything rates have held up extraordinarily well during the slow third quarter.

DHT stated on its conference call that they had more than 50% of their third quarter booked at $80,000 per day.  The company has a net asset value of around $8.50 per share.

While I already had a pretty full position heading into the last move down I held my nose and added more at $7.15 (i never catch the lows it seems).  I’m not holding these extra shares for long though.  In this market having an over-sized position in anything seems akin to holding an unpinned grenade.

The Airlines

While Hawaiian Airlines has been an outperforming outlier, responding well to strong earnings, Air Canada has languished.  The stock got clobbered after the company announced record earnings and great guidance.

Air Canada reported 85c EPS and $591 million EBITDAR.  In comparison, BMO had been expecting 90c EPS and $618mm EBITDAR and RBC had been expecting 77c EPS and $558mm EBITDAR.

The story here really boils down to the Canadian economy.

Both WestJet and Air Canada are increasing capacity.  The market is worried that they are going to flood a weak market and pressure yields.  On the conference call Air Canada addressed the concern by pointing out that A. the capacity they are adding is going into international routes and B. they have yet to see anything but robust demand for traffic.

What’s crazy is that while investors have responded negatively, analysts have been bullish to the results.  I read positive reports from RBC, TD and BMO.   Only Scotia, which I don’t have access to, downgraded the stock on concerns about no further upside catalysts.

Its rare to see multiple upgrades accompanied by a 7% down move in a stock.  I would love to see one of the darling sectors, tech or biotech, respond in such a manner.

So the analysts are bullish and the company is bullish but right now the market doesn’t care.  As is the case in general, the market cares about what might happen if some negative confluence of events comes to fruition.  And it continues to price in those worries.

Its just a really tough market.

Trying to find something that works

Another contributor to my poor performance has been that what has worked over the last five years is working less well now.

In particular, over the last give years I have followed a strategy of buying starter positions in companies where I see some probability of significant upside.   In some cases I will buy into companies that do not have the best track record or are not operating in the most attractive sectors.  But because the upside potential is there I will take a small position and then wait to see what happens. If the thesis begins to play out and the stock rises, I add.  If it doesn’t I either exit my position or, in the worst case, get stopped out.

This has worked well, with my usual result being something like this.  I have a number of non-performers that I end up exiting for very little gain or loss, a few big winners, and a couple of losers where I sell after hitting my stops.

I’ve had a lot of winners this way over the last few years: Mercer International, Tembec, MGIC, Radian, Nationstar, Impac Mortgage (the first time around in 2012), YRC Worldwide, Pacific Ethanol, Phillips 66, Nextstar Broadcasting, Alliance Healthcare Yellow Media and IDT Corp are some I can think of off-hand.  In each case, I wasn’t sold on the company or the thesis, but I could see the potential, and scaling into the risk was a successful strategy of realizing it.

Right now the strategy isn’t working that well.  The problem is that the muddling middle of non-performers is being skewed to the downside.  Instead of having stocks that don’t pan out and get sold out at par, I’m seeing those stocks decline from the get-go.   I am left sitting on either a 5-10% loss or getting stopped out at 20% before anything of note happens.  Recent examples are Espial Group, Hammond Manufaturing, Versapay, Higher One Education, Willdan Group, Acacia Research, Health Insurance Innovations and my recent third go round with Impac Mortgage.

All of these stocks have hair.  But none has had anything materially crippling happen since I bought them.  In the old days of 2012-2014, these positions would have done very little, while others, like Patriot National, Intermap, Photon Control, Red Lion Hotels and most recently Orchid Island would run up for big gains and overall I’d be up by 20% or so.  Instead this year the winners still win, albeit with less gusto, but its the losers that are losing with far more frequency and depth.

So the question is, if what has worked is no longer working, what do you do?

You stop doing it.

I cleaned out my portfolio of many of the above names and reduced a couple of others by half.

So let’s talk about some of what I have kept, and why.

Health Insurance Innovations

HIIQ announced results that weren’t great but the guidance was pretty good.  Revenue came in at $23 million which is similar to Q1.  In the first quarter the company had been squeezed by the ACA enrollment period, but in the second quarter this should have only impacted April.  So I had been hoping revenue would be a touch better.

The guidance was encouraging though.  The company guided to $97-$103 million revenue for the year which suggests a big uptick in the second half to around $28 million per quarter.  In my model, I estimate at the midpoint they would earn 40c EPS from this level of revenue if annualized.

Also noted was that ACA open enrollment would be 90 days shorter next year, which should mitigate the revenue drag in the first half of the year.  And they appear to be doing a major overhaul of management – bringing on people from Express Scripts (new president), someone new to evaluate the web channel and a number of new sales people.

Its been a crappy position for me but I don’t feel like there is a reason to turf it at these levels, so I will hold.

Impac Mortgage

As usual Impac’s GAAP numbers are a confluence of confusion.  The headline number was better than the actual results because of changes to accretion of contingent expense that they incurred with the acquisition of CashCall.

The CashCall acquisition had contingent revenue payout and that payout expectation has decreased leading to lower accretion via GAAP.  Ignoring accretion the operating income was around $8 million which was less than the first quarter.

The decline was mostly due to lower gain on sale margins, which had declined to 186 bps from 230 bps.

While origination volumes were up 8% sequentially (see below) I had been expecting better.  The expansion of CashCall into more states was slower than I expected.  In the second quarter CashCall was registered in 19 states.  I actually had thought that number was 29.

q2volumesBy the third quarter CashCall is expected to be compliant in 40 states.  And really that is the story here.  Volume growth through expansion.

CashCall is a retail broker dealing primarily with money-purchase mortgages (mortgages to new home owners).  Therefore Impac is not as dependent on refinancing volumes as some other originators.

While it was not a great quarter the company still earned 70c EPS.  Its lower than my expectations but in absolute terms not a bad number.  On the conference call they said that Q3 margins looked better than Q2, and while July production was only about $700mm, they expected better in August-September as the pipeline was large.

I made a mistake buying the stock at $20 on the expectation of a strong second quarter.  But I think at $16 its reasonable given earnings power that should exceed $3+ EPS once CashCall is operating nationwide.

PDI Inc

The response to the PDI quarter is indicative of the market.  The company released above consensus earnings on Thursday along with news that their molecular diagnostic products were being picked up by more insurers.  In pre-market the stock was up 20% and it looked like we were off to the races.

It closed down.

Recall that PDI operates two businesses.  They have a commercial services business where they provide outsourced sales services to pharmaceutical companies looking to market their product.  And they have the interpace diagnostics business, which consists of three diagnostic tests: one for pancreatic cysts and two for thyroid cancer.

I suspect that the market decided to focus on the one negative in the report: reduced guidance for interpace revenues from $13-$14 million to $11-$12 million.  The guidance reduction was caused by a delay in receivables from some customers.  The metric by which to judge the growth of the actual operations, molecular diagnostic tests, increased from 1,650 in the first quarter to 2,000 in the second quarter.

But in this market you gotta focus on the negative.  At least on Friday.

Patriot National

When I bought Patriot they were a new IPO whose business was a platform that allowed them to procure and aggregate workers compensation policies for insurance carriers.  They sign a contract with a carrier for a bucket of policies with particular characteristics and then distributed that to their pool of agents, collecting a fee in return.

But over the last couple of months Patriot seems to be expanding that role to something more holistic.  Among their nine acquisitions in the past six months is an insurance risk management firm, an auditing and underwriting survey agency, an insurance billing solution platform and a beneits administration company for self-funded health and welfare plans nationwide.

Patriot describes themselves in their latest presentation as follows:

whattheyarePatriot has shown solid growth since their IPO, both through their roll-up strategy of small insurance businesses and organically.  They have increased their carrier relationships from 17 to 82.  They are expanding their relationship with a few big carriers like AIG and Zurich.  They have grown their agent pool from 1,000 to 1,750.

I’m not really sure what it was about the second quarter that caused the stock to sell-off like it has.  It was down 16% at one point on Wednesday, which is about the same time I tweeted that this is crazy and pulled the trigger.  I suspect its simply another case of a bad market, a run-up pre-earnings and a release that didn’t have anything clearly “blow-outish” about it.

Nevertheless the company provided guidance along with its results and for 2016 predicts 37% revenue growth and 55% earnings growth.  These numbers make no allowances for further accretive acquisitions, which undoubtedly will occur.

The stock trades at 6.5x its 2016 EBITDA multiple.  From what I can tell its closest peers trade at around 10x, and they aren’t growing at a pace anywhere near Patriot.  As I said I added under $16 and would do so again.

Orchid Island

I have followed Orchid Island for a long time having been an investor in its asset manager, Bimini Capital, in 2013.  I never bought into Orchid though; it seemed small, it always trade around or above book value and being an mREIT it seemed that you had to have more of an opinion on the direction of rates than I have had for a while.

But when the stock got below $8, or a 30%+ discount to book value, it just seemed to me like the opportunity was too ripe to pass up.

There have been a number of good SeekingAlpha articles by ColoradoWelathManagementFund on Orchid where he describes the MBS investments and also the Eurodollar hedges.  These hedges, which require a different GAAP accounting then other more commonly used hedges, seem to be at least partially responsible for confusing the market and leading to the massive discount to book.

However I don’t plan to wait this out until book value is realized.  When the stock hits double digits again I expect to be pulling the trigger.

Higher One Education

I bought back into Higher One after it got clubbed down to $2.20, where it seemed to be basing.  Upon buying the stock was promptly clubbed down again to below $2.

Like many other names I am not sure if the clubbing is warranted.  The company’s second quarter results were better than my expectations.

Adjusted EBITDA in the second quarter came in at $8 million versus $7.2 million in Q2 2014.  While the disbursement business EBITDA was down, both payments and analytics were up (46% and 38% respectively).  EPS was 8c which again was better than last year.

They lost 6 clients representing 86,000 signed school enrollment (SSEs), signed 4 new clients with 16,000 SSEs and renewed 59 clients with 675,000 SSE’s.  Their total SSEs were 5mm at the end of Q2.  Given the headwinds in the industry, Higher One is holding their own.

The overhang in the stock is because the DOE proposed new rules that ONE and others are pushing back on, with the biggest issue being that you can’t charge fees for 30 days after deposits.  From their conference call:

The way the rule is proposed every time there is a disbursement made into the students accounts, we’d have to freeze all fees for 30 days.

This of course would severely impair Higher One’s ability to be profitable with these accounts.

On Friday after writing this summary I decided to sell Higher One.  I’m waffling here.  I like the value but don’t like the uncertainty and if the market can knock it down to $1.90 then why not $1.50?  Uncertainty reigns king.  I might buy it back but its difficult to know just how low a stock like this can go.

My Oil Stocks

I’ve done a so-so job of avoiding the oil stock carnage of the last few months.  After the first run down in the stocks I added a number of positions in March and ran them back up as oil recovered to the $60’s.  Then oil started dropping again and in May I began to sell those stocks.

oiltweetBy mid-June I was out of all my positions other than RMP Energy.  By July I had reduced RMP Energy down to about a percentage weighting in my portfolio.

So far so good.

Unfortunately I started buying back into the oil names in mid-July, which was too early.  I bought Jones Energy in the mid to high-$7s but sold as it collapsed into the $6’s.  I tried to buy RMP again at $2.20 but got pushed out as it fell to $2.  I bought Baytex and Bellatrix which was just stupid (I sold both at a loss).  I’ve probably given back half of the profits I made on the first oil ramp.

In this last week I made another attempt but I am already questioning its efficacy.  I took small positions in RMP Energy and Jones Energy and a larger position in Granite Oil.  The former two have done poorly, while the latter had an excellent day on Friday that provides some vindication to my recent endeavors.

One thing I will not do with any of these names is dig in if the trend does not turn.  I’ve learned that commodity markets can act wildly when they are not balanced, and the oil market is not balanced yet.  So its really hard to say where the dust settles.

Even as I write this I wonder if I should not have just waited for a clear turn to buy.

These positions are partially hedged in two ways.  First, I shorted XOP against about a quarter of the total value of the positions.  And second by having so much US dollar exposure (still around half my account) as a Canadian investor they act as a bit of a counter-weight to the wild moves I can see from currency changes.

Jones Energy

One of the interesting things happening right now is that natural gas production is flattening, in many basins it’s declining, and yet no one cares.  When natural gas first went to new lows in 2012 many pointed to the declining natural gas rig count, believing prices would quickly bounce back.  They didn’t, in part because of the associated gas coming from all the liquids rich plays.

With the oil collapse much of the drilling in those liquids rich plays is no longer as attractive.  You have to remember that even as oil has fallen, natural gas liquids like propane and butane have fallen even further (ethane, which is the lightest of the liquids, is now worth no more than natural gas).  Many producers that were labeled as oil producers, because they produced liquids, really produced these lighter liquids that are now trading at extremely depressed levels.  Drilling in light-liquids rich basins (the Marcellus but also the Permian and parts of the Eagleford) has declined precipitously, and with it all of the associated gas being produced.

Meanwhile much needed propane export capacity is on the horizon and expected to arrive en-masse in 2016.

Jones Energy has too much debt (around $770 million net) but they also have oil and natural gas that take them out into 2018.  I think they are a survivor.  They have reduced their drilling and completion costs in the Cleveland from $3.8 million to $2.6 million.  They actually increased their rigs in the Cleveland in June, though I have to admit that might be dialed back again with the prices declining.  I bought back into the stock for the third time this year when it was clobbered on what seemed to be pretty good earning results (a beat and guidance raise).  Its a play on oil, but also on falling natural gas production, as natural gas makes up 43% of production and much of the associated liquids are light.

RMP Energy

I think that the miserable performance of this stock is overdone, but I have thought that for some time and down it continues to go.  RMP gets punished over and over again for essentially the same concern – Ante Creek declines.  This latest pummeling seems to have been precipitated by the disclosure that August volumes at Ante Creek were around 8,500 boe/d.   This is a decline from April volumes of 12,200boe/d but similar to end of June volumes.  Below is a chart from Scotia that details Ante Creek production:

antecreekvolumes

The April increase coincided with the new gas plant.  The subsequent fall was because the company drilled no new wells in the second quarter.  That production has stabilized from June to August without any new wells being drilled is encouraging.

But the market sees it differently.

Lost in the shuffle (with nary a mention in any of the reports I read) is that RMP has reduced its drilling and completion costs by 30% and that operating expenses were down from $5.26/boe to $3.89/boe.  Also forgotten is that the company is experiencing positive results at Waskahigan with it new frac design.

RMP trades at about 2x Price/cashflow and has debt of about 1.35x expected 2015 cash flows.  Its not levered like many peers and its not expensive.  These constant concerns about Ante Creek need to be priced in at some point.

Granite Oil

Of the three names I own, this is the one I am going to stick with the longest.  Granite has a $150 million market capitalization and $50 million of debt.  Their asset is a large position in the Alberta Bakken (350,000 net acres).  They can drill 240MBBL wells that are 98% oil for $2.8 million per well.

And they are beginning a gas injection EOR scheme that is showing promising results.  Below is company production as gas injection has increased.

alberta-bakken-eorThe results are well above expectation and show minimal decline even as the number of wells drilled has only increased marginally.

The result is some pretty strong economics even at lower oil prices.

economics

Granite management had been loading up on shares in the $4’s.  I did too.  The company announced earnings on Friday and is probably the only oil company to announce a dividend increase.  Like I said, this will be the last oil position to go for me.

Portfolio Composition

As I’ve said a number of times in the past, I sometimes forget to mimic my actual trades with the online RBC portfolio I track here.  After a while these differences get too out of whack and I have to re-balance.  I did some of that on Friday, and so the transactions on that day are simply me trying to square up position sizes.  I don’t have things quite right though; the cash level of my online portfolio is negative while my actual investment account is about 15% cash.  I looked at why this is and its the contribution of a number of positions that are all slightly larger in the online portfolio than they should be.  I didn’t have time to adjust everything exactly so I’ll just try to reduce this discrepancy naturally over time.

Click here for the last five weeks of trades.

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Week 210: All about the 5-baggers

Portfolio Performance

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week-210-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

A few weeks ago I was talking to someone who works at a large fund.   He was telling me about a retail clothing chain that their fund was interested in.  To help evaluate the opportunity, they commissioned a research firm to canvas and scout locations across the country.

That is amazing intel.  It is also wholly impossible for me to replicate.

I generally have a pretty good idea about a business before I buy into it.  I do a lot of work up front, far more than the highlights that go into these posts.  But I’m always left with elements that are uncertain.   For an individual investor with access to limited information and with limited time, certainty about one’s beliefs is more hubris than reality.

In the face of such disadvantages, my strategy is to take smallish positions and add to them if they begin to work out inline with my expectations.  If they don’t, I cut them.

By keeping my positions small until they start working and cutting my losses before they get big I guard against the big hit to my portfolio.  On the winning side of the ledger I generally end up with a similar number of winners that cancel out the losers.  But I also end up with 2 or 3 big winners that lead to out-performance.

It’s the 5-baggers that make the engine go.

Another portfolio year has passed (I started writing this blog on July 1st 2011) and you can see from the results that the last year was not as good as the previous few.  I still did better than the market, but I didn’t do that great.

In part the under-performance was caused by not sticking to my rules.  I have already rehashed my failures with Bellatrix and other oil names in past posts so I won’t go into that again here.

But I also attribute it to my lack of “5-baggers”.  I haven’t had a big winner in the last 52 weeks.  I’ve had a lot of good picks (Air Canada, Axia NetMedia, PNI Digital, Extendicare, Radcom, Rex American, the second go around with Pacific Ethanol and so on) but only one true double and nothing that tripled or quadrupled.

Realizing how important multi-baggers are I’m sending myself back to the drawing board.  I’m not sure why I’ve failed to discover the big movers over the last year.  But I suspect that it is at least partially due to ignorance of the sectors that have had the momentum.

Up until recently I never owned a bio-tech.  I’ve stayed away from technology in all but a few exceptions.  I’ve only been in healthcare on a couple of occasions (one of those being Northstar Healthcare, subsequently Nobilis Health Corp, which I rather amazingly sold last October, at no gain or loss, literally days before it began a climb from $1.20 to over $10 in thee next six months).  Yet these sectors are where the big winners have been.

My attitude towards these and other outperforming sectors is going to change.  I have invested in a couple of bio-techs and in technology (shorts mind you, as I will explain later) and in the last couple of months.  More new ideas will follow.

What I Sold

Usually I discuss my new positions next.  While I have a couple of these, they are not significantly sized and my actions have been more weighted to the sell side of the ledger, so it seems appropriate to discuss what I sold first.

As I tweeted on a couple of occasions I have been skittish about the market over the past month and a half.  I sold out of some positions and reduced others when Greece went on tilt and announced a referendum two weeks ago.

Since that time as my worries have subsided I have bought some of those positions back. It doesn’t look like an immediate contagion is upon us, which was my main concern.  Still I’m keeping a healthy amount of cash (20%) and where I can I am short a number of stocks.

In what turned out to be an unexpected consequence of my recent research expansion, over the past month I spent a lot of research hours looking at short opportunities. Trying to take more of an interest in tech, I read through reports describing the state of business and dynamics at play in everything from telecom infrastructure to smartphone.  As I did I felt most of the near term opportunity was on the short side, and so I took positions there.

My tech shorts have been based on three-fold expectations: PC sales are declining faster than consensus, smart phone sales will grow slower than consensus, and rumors that the big data build out by cloud providers has been overdone will prove to be true and future spending will be scaled back.  Without going into the individual names, I’ve stuck mostly with the big players and mostly with semi-conductor providers, which seem to be the most susceptible to spending downturns.

I think however that this play has almost run its course.  I have been taking off some positions heading into earnings (for example I was short Micron going into their June quarter but took it off the day after earnings were announced), and plan to exit my remaining positions as earnings are released.  I don’t like to hold short positions too long.

While I have yet to take any short positions in healthcare, I get the feeling that the recent merger mania may be leading to valuations that prove difficult to justify once the feeding frenzy subsides.  I note that a top pick of Jerome Haas, who I have followed and found to be a solid thinker, was a short on Valeant Pharmaceuticals.

In my online portfolio, in which I cannot short, I sold out of my gold mining shares, my oil stock shares, some of my tanker shares (Euronav and Frontline), a hotel play (Red Lion), reduced my airline exposure in both Air Canada and Hawaiian Holdings as well as my Yellow Pages and Enernoc positions.

I also sold out of DirectCash Payments, though I subsequently added the position back later (at about the same price).  I really want to hold this one through earnings because its been beaten down so far and I still have doubts as to whether the first quarter is the secular harbinger that the market seems to think it is.  In the turned out to be an unexpected consequence of my recent research expansion

Similarly, while I sold out of RMP Energy, I bought it back (at a lower price) because I want to see their quarter before giving up on the stock.  Like DirectCash Payments, I question whether results will be as dire as the market suggests. In the same segment of his BNN appearance Haas also made DirectCash Payments another top pick.

I only added to a couple of positions in the last month.  Patriot National continues to execute on their roll-up strategy, buying up smaller insurers at accretive multiples.  The stock is up 40% from my original purchase (though in the online portfolio I forgot to add it when I originally mentioned it so its up somewhat less there) and I decide to add to the position since its working out.

Second, I added to my position in Capital Product Partners on what I believe is unwarranted selling on Greece.  The company is incorporated in the Marshall Islands, does not pay Greek taxes but does have offices in Greece, which is at the heart of the sell-off.  A scan of the company’s annual filings shows that their exposure to Greece is potentially some deposits in Greek banks and the risk that one or more of their subsidiaries could face higher taxes.  I don’t think that correlates to the 20% plus sell-off in the share price.

I also added two new positions to my portfolio.

Intermap

I have followed Intermap for years.  Its a company that my Dad owned. While it always held out the promise of a significant revenue ramp Intermap could never quite figure out how to monetize their world class geo-spatial data.

Then, a couple of weeks ago, the company signed a large contract with unnamed government for the implementation of a National Spatial Data infrastructure program.

For years Intermap was primarily a mapping services provider.  They owned 3 Lear jets equipped with radar technology that scanned and mapped large swaths of terrain.  They would land contracts to map out a country or region and be paid for providing that data.

The company always kept the rights to their mapping data and, over time, Intermap compiled a database of geospatial data for a large part of the earth.   This spatial database became a product called NextMAP.   The database can be accessed through commercially available GIS software like ArcGIS or web browser apps developed by the company. Customers can license either parts of or the entire NextMAP database for their use.

The latest version of the database, called NextMAP World 30, is “a commercial 3D terrain offering that provides seamless, void free coverage, with a 30meter ground sampling distance, across the entire 150 million km2 of the earth’s surface.”

Intermap has always had a leading technology.  But they have struggled with coming up with profitable ways of marketing that technology.   Over the last three years the company has been working on applications that can be layered over their basic mapping data.  They have a program for analyzing the risk of fires and floods (InSite Pro), a program for managing hazardous liquid pipeline risk (InSite Pro for Pipelines) and a program for assessing outdoor advertising locations (AdPro).

None of these niche solutions have resulted in significant revenue to the company.

The carrot has always been that they land a large government contract for the full implementation of a geo-spatial solution for the country.  Most investors have given up on this ever happening, but then it did.

The announced contract is for $125 million over two years, during which time Intermap will implement the infrastructure solution.  This will be followed by an ongoing maintenance contract valued at $50 million over 18 years.

When I saw the number on the contract I knew immediately that the stock would jump significantly.  Including warrants and options Intermap has 127 million shares outstanding.  So at the closing price the night before the deal was announced the market capitalization was around $10 million.  When it opened around 25 cents I figured the upside was only about half priced in, so I jumped aboard.

The implementaton of a full geo-spatial solution as per the contract will involve the implementation of the company’s Orion platform, which includes the company’s NextMAP data integrated with other relevant third party data and with applications for accessing and analyzing the data.   The platform will be used to help with decision making with infrastructure planning, weather related risks, agriculture, excavation, and national security.  Because this is basically a new business for the company, its difficult to peg margins or profitability.  So I’m not going to try.

Nevertheless, just based on the rough assessment of what $125 million in revenue would mean, at this point, with the current stock price of 50 cents the contract is probably mostly priced into the stock.  I maybe should have sold on the run-up to 60 cents, but I decided not to.

The company has suggested in the past that they have a number of RFPs in the works and some of those they have already won but cannot announce until funding is secured.  The upside in the shares is of course a second contract. That could happen next week or next year.  Its impossible to predict.

The other consideration, and something I have always wondered about, is why some large company doesn’t pick up Intermap for what would amount to peanuts, securing what is truly a world class data set and a platform that would seem to be more valuable in the hands of a large company with the resources to sell large projects to governments.  Somebody like an IHS comes to mind.

Pacific Biosciences

This investment idea is a little out of my normal area of expertise and consistent with my desire to expand my investing horizons.   Its an idea I came up with after reading  this Seeking Alpha article which I think does a good job explaining the trend we are trying to jump on.

PACB has 74 million shares outstanding, so at $5.20 (where I bought it) the market capitalization is $385mm.   The company has $79 million of  cash and investments and $14 million in debt.

They are in the business of gene sequencing.  Pacific Biosciences sells gene sequencing machines and related consumables for running tests to map an individuals gene in hopes of detecting a mutation that will diagnose the future susceptibility to disease.  The machine of course is a one-time sale but the consumables are a recurring revenue stream so the business has a bit of a razor-blade type revenue model to it.

The big player in the gene sequencing arena is a company called Illumina.  This is a $30 billion market cap company that did nearly $2 billion in revenue last year.  They dwarf Pacific Biosciences, which did around $60 million of revenue last year.

In fact I read that Pacific Biosciences has only sold around 150 machines.  One interesting thing from their presentation is that for each of the machines Pacific Biosciences sells, they generate about $120,000 of consumable sales a year.   Thus the opportunity for significantly higher recurring revenues is there if they can sell a few more machines.

What seems to set Pacific Biosciences apart from Illumina is that their technology produces much longer gene sequencing strings which results in far lower error rates.  Below is a comparison between the two.

comparisonilluminaOne thing I am not sure of is where Pacific Biosciences sits compared to some of their non-public competition.  I was reading through some of the comments on a site called Stock Gumshoe that suggested that some private competition may have as good or better sequencing technology.

Pacific Biosciences also has an agreement whereby Roche will market their product for the diagnostics market in 2013.  In May Pacific Biosciences met the second milestone of that agreement.  The only thing that is a little disconcerting about this agreement is that Pacific Biosciences did not announce how much revenue they would be giving up once (and if) the product is commercialized.

My bottom line is that there are enough interesting things going on for me to speculate in the stock.  The key word being speculate.  There is a chance of wider adoption, there is a chance of an expansion of their relationship with Roche, there is maybe even an outside chance of a takeover.  And its an industry that is clearly growing, is in investor favor, and the stock was at a 52-week low when I bought it.

But I will flatly state that I would not take my comments about Pacific Biosciences too seriously.  My knowledge of this industry remains weak (though its improving as I read more).  They could be, or maybe even have been, surpassed by competition and I would not be the first to know.  So we’ll see how this goes and chalk up any loss to the cost of education.

Portfolio Composition

Click here for the last four weeks of trades.

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Week 202: Better Late than Never

Portfolio Performance

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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