Skip to content

Posts from the ‘Fifth Street Asset Management (FSAM)’ Category

Week 206: The Thin, Steep Line

Portfolio Performance

week-206-yoyperformance

week-206-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’ve been listening to interviews with traders.   I found two interesting podcasts, one called Chat with Traders and another called 52 Traders.  I go through an episode a day on my bike ride into work.

The interviews are generally at odds with my own investing style.  These guys don’t pay attention to fundamentals and they are short-term in nature (mostly day trading).  Nevertheless I have found the interviews insightful.

One concept that comes up a lot is “edge”.  An edge is essentially the advantage that allows you to beat the market more than it beats you.  For many of these traders understanding their edge; a system, a pattern, a money management technique; has been a major step toward consistent success.

So what’s my edge?

I have been pretty good about beating the market for the last 10 years.  I don’t know if you can chalk it all up to luck.  Though there is much I do wrong, there must be something I’m doing right.

I’m not going to dissect the details of what specifically I do “right”.   I’ll leave that to a future post.  I bet that if you read the last 3 years of writing you’d get a pretty good idea.

I want to talk more generally.  I’m going to hypothesize about what I believe to be some general characteristics of my edge.

First, I doubt you could boil my edge down to a single thing.  I think its more likely there are a number of small things I do right that together add up to decent out-performance.

If true, this means that I have to be careful about cutting corners.  Not being sure exactly what aspect of my process leads to out-performance means that leaving out any one piece could be critical.

I also don’t think that these tiny edges act together linearly in an independent fashion.  Let’s say I have 6 things that I do that contribute to the overall edge I have.  I highly doubt that if I do 5 of these 6 I will get 83.3% of the returns.  It will likely be significantly less.  Maybe even I don’t outperform at all.  The sum of my edge is greater than the parts.

Finally, I think that the slope of out-performance to edge is likely quite steep.  In other words, if I am off my game, my performance deteriorates quickly.

As the chart below illustrates, the degradation of performance due to small changes in edge is closer to vertical than to horizontal.  Think of the right side of the curve in the chart below as being the execution of maximum edge.  In other words you are doing everything right.  As you do more and more wrong; less due diligence, cutting corners on a spreadsheet, not following a stop rule, adding to a losing position, etc; you slide to the left of the curve and with your dwindling edge comes dwindling performance.

edge

The point I am trying to illustrate is that small deviations from what make me successful will likely result in outsized drops in performance.  If I don’t do everything right: do the mounds of research up front, follow my buying patterns, follow my stops, correctly discern when I should not listen to my stops, etc; I will see my edge decline and my out-performance will drop significantly when it does.

It’s a bit like I’m balanced above the ground on a pole, and the slightest wrong move, one way or the other, and I’ll fall off back down to earth.  This is quite analogous to how each day on the market feels to me.

Continuing on with updates of some of the stocks I own

Hawaiian Holdings

Hawaiian got hammered along with the rest of the airline sector over the past couple of weeks.  The hammering was precipitated by A. raised capacity guidance from Southwest Airlines, B. comments from the American Airlines CEO that they would defend their market share against competitors pushing forward with capacity increases and C. reduced passenger revenue (PRASM) guidance from Delta Airlines.

There is a good article on SeekingAlpha discussing the severity of these factors here.

What is frustrating about the above developments is that they should only be peripherally correlated to Hawaiian Holdings.  Hawaiian runs 3 basic routes:

  1. Inter-Island
  2. Island-Mainland
  3. Island-Asia

None of these really have much to do with mainland capacity.

I think Hawaiian is cheap in the low $20’s.  A move above $25 and I look to lighten up as I did earlier this month.  Below is my 2015 earnings estimate based on the company’s high and low guidance.  All of the inputs come directly from guidance with the exception of RASM, which I estimated as -2% year over year on the high side and -4% year over year on the low side.

guidancetoeps

When I look at analyst estimates they trend to the low end of guidance. The average analyst estimate (per Yahoo! Finance), is $2.79.  The high estimate is $3.05.  If the company hits the high end of their own guidance they are going to blow away these numbers.

I’m hoping that a combination of earnings beats and what has so far proved elusive multiple expansion for the airlines combine to send the stock price up closer to $30, which would be a nice gain from current levels.

DC Payments

I’ve spent a lot of time debating what to do with my position in DirectCash Payments.  After a lot of thought but still without consensus (of my own mind), I added slightly to my position at $14.

The stock has dropped from about the $16 after reporting weaker results in the first quarter.  The market is concerned about poorer revenue and gross margin decline.

I am somewhat sympathetic to the spirit of these concerns.  DCI is in the ATM business.  They buy an ATM, sign an agreement with the owner of a space to place that ATM into a space for a fixed period, and then depending on the agreement they either split the profits with the owner or lease the space for a fee.  Clearly, this is not a growing sector.  You would expect pressure on revenues and margins as society moves towards the use of less cash.

However I think the market is making a mistake to think that the first quarter results are evidence that this transition is accelerating.  There were a lot of one-time items and events that impacted the first quarter.  The company lost revenue from its CashStore ATMs, which has been going through bankruptcy proceedings.  They lost 120 ATMs as Target exited Canada.  In Australia, the recent implementation of cash-and-pay technology (something that has been in Canada for a while) led to steeper than usual declines (though not out of line with the declines experienced when the technology was introduced in Canada).  Finally year over year comparisons were impacted by a one-time GST gain in 2014.  On the expense side, they saw one-time accounting expenses due to the Australia acquisition as well as expenses related to the upgrade of the Australia fleet.

So I’m not convinced this is a secular decline story just yet.  The second quarter is going to benefit from an additional 340 BMO ATM’s in Canada and 120 ATMs being installed at Morrisons in the UK.  Some of the one-time expenses are going to roll off.  Increased surcharges are being implemented in both Canada and Australia.  And finally, beginning in the second half we will see some of the intangible amortization related to acquisitions begin to run off, which will result in a better income statement.  So we’ll see.

New Positions

PDI Inc

I like to find companies with one of the following attributes:

  1. A market capitalization that is a fraction of their annual revenue
  2. A small but growing segment that is being obscured by a larger mature business

I really like it when a company has both of these attributes, which PDI Inc has.

PDI’s mature legacy business is a outsourcing sales force for the pharmaceutical industry.   This is a 20% gross margins business that has seen some headwinds in the last year.  These headwinds are responsible for the poor stock performance.

The growing business is molecular diagnostic tests.  PDI entered molecular diagnostics via a couple of acquisitions, Redpath and some assets from Asuragen. They now offer diagnostic tests for malignancy of pancreatic cysts (PancraGen), and of thyroid nodules (ThyGenX and ThyraMir).

marketopp

The molecular diagnostic test segment generated very little revenue in 2014. They have been ramping up the business through acquisitions since the summer of 2014.  Below is a timeline, taken from the investor presentation, of their progress so far.

timeline

The company points to a recent report from Visiongain estimating that the molecular diagnostics market is around $6 billion and that it is growing at a 15% CAGR.

In the first quarter of 2015 revenue from molecular diagnostics was a little over $2 million.   Guidance for the segment is $13-$14 million, which suggests that they think they can grow the segment by nearly 100%.   Keep in mind that the company has a captive, experienced sales force at their disposal to help them reach that goal.

The company has significant net operating loss carryforwards of over $240 million so there will be no taxes paid for quite some time.

As part of the acquisition deals they also granted significant contingent considerations.  In addition to two milestone payments of $5 million, they pay a net revenue royalty of of 6.5% on annual net sales above $12.0 million of PancraGen, 10% on net sales up to $30 million of PathFinderTG and 20% on net sales above $30 million of PathFinderTG.

While I like the direction and I like the leverage to gross margin improvement, I caution that even with growth from the molecular diagnostic segment profitability remains somewhat distant. If they meet their guidance for 2015 they will still have an operating loss for the year.

However the bet is that if they show some success the market will reward them for the potential of their acquisition strategy, rolling up new treatments and integrating them into their sales platform.  Its not hard to see that strategy being worth significantly more than the current $25 million market capitalization.

Versapay

Versapay is another tiny market capitalization company ($29 million).  They have a newly launched SAAS offering that could scale quire quickly.

In the past Versapay’s product offerings have revolved around point of sale solutions: point of sale terminals (basically the little hand helds that you use at every shop), payment gateways for online purchases, app’s for mobile payments, and virtual terminals.

Margins on the legacy business are north of 60% but it is not a high growth business; it grew at around 5% in 2014 and showed flat revenues in the first quarter of 2015.  The business generated $2.1 million of EBITDA in 2014, so at the current market capitalization Versapay is probably slightly expensive if valued on this business alone.

Recently though Versapay expanded their offering to include a B2B e-commerce platform called ARC, or Accounts Receivable Cloud.  ARC is aimed at small to medium sized business and provides an accounts receivable process for business to business transactions.  Below is a slide from the company presentation that gives a high level overview of ARC’s functionality.

howarcworks

The company says existing offerings on the market either focus on accounts payable (so on the buyer), are geared towards large enterprises, or are accounts receivable applications for business to consumer transactions.  ARC fills a niche that is largely unaddressed.  The slide below depicts ARC’s target market:

arcmarket

The company says that its biggest competition are excel spreadsheets and inertia, for which, coming from a small business whose accounts receivable management consisted of a large excel spreadsheet with many tabs that had been maintained in the same way for years and emails sent out by salespeople with PDF invoices, I can sympathize with.

So I think there is a market here if Versapay can prove that their software is more efficient and can create more timely payments than the alternative.

What I really like about this idea is that if it does begin to take off the nature of the application could cause it to snowball quickly.  When a supplier uses ARC for invoicing, all of their customers are introduced to the platform via their bill paying portal.  If the portal is perceived as suitably impressive, these customers become natural targets for Versapay.

ARC also has synergies with Versapay’s existing point of sale solutions.  Both can leverage the same payment backbone for processing transactions.

synergiesWhile the platform is in its infancy (basically at a pilot/early adopter level), the early results show what could be in store.  As of the May conference call, Versapay had 16 suppliers signed up, 8 who are live, but already there are 14,800 buyers invited and 2,450 buyers who had signed up and registered.  This was up by 1,000 buyers in past 20 days.

The numbers of the buyers who are somewhat incidentally being introduced to the system is impressive.  It illustrates the need for quality before a full roll out.  Just as it is extremely beneficial to Versapay if these buyers have a positive experience, it will be a disaster if they don’t.

So far the early response is positive.  Two of the eight early adopters, Metroland and Teachers Life, went so far as to give positive testimonials at the Versapay investor day.  Versapay also announced on their first quarter call that they had signed up a large commercial real estate firm subsequent to the quarter.

There is enough potential here for me to take a position.  But I have to be careful.  I’ve talked before about companies whose product is a bit of a black box, where I can’t really be sure whether its going to be a hit or miss and so I have to judge it based on the evidence but show humility if things go south.   Radcom is a name I own that fits in this category.  Radisys is another, as is Enernoc.  The idea makes sense, the sector makes sense, but there is a bit of a leap as to whether the solution will be the best fit for the niche being marketed.  I just can’t be sure.

I am being careful about position sizing and will be on the look out for any adverse developments, comments or even just poor price action that may imply things aren’t going rosily.  This risk is justified by the reward; while the downside is that I get out at $1 after some poor results, the upside is likely multiples of the current price.

These are exactly the kind of bets I’m looking for, even if they all can’t pay off.

Transat AT

When I sold Transat AT at the beginning of the year it was always with the intention that I would get back in.  As I wrote in the comment section of my February post (after it was pointed out to me that I had neglected to mention my sale):

I sold the stock because I think the weak CDN dollar is going to make Q1 and Q2 difficult. They also hedge fuel so in the very short term they are going to be hit by the dollar over the winter but not going to gain from fuel to the same extent yet. The winter routes also have a lot of added capacity from Air Canada and such so that is making it more competitive.

I still really like Transat though in the medium term. I think once we get Q1 released I will look to adding it back, because the summer is going to be stronger, they will begin to benefit from fuel more, and presumably the dollar will stabilize… I’m just stepping aside until the uncertainty has passed.

With the release of second quarter results last week the uncertainty has passed.  And really, the results weren’t too bad.  Because Transat runs a very seasonal business, it is useful to compare quarterly results from year to year.  Below are second quarter results for Transat over the last 7 years.

Q2compThe company guided that its summer quarters (Q3 and Q4) would be similar to 2014.  That means that for the year they are going to have earnings that are pretty close to last year.  Income adjusted for one time items and for changes in fair value of fuel hedges was $1.16 per share last year.  The company has mounds of cash on the balance sheet and will also begin to benefit more from lower oil prices in the second half.  I believe that things are setting up for another run at double digits here.

Ship Finance

I added a position in Ship Finance after they announced an amended agreement with Frontline along with their first quarter results.  The new agreement gives Frontline lower time charter rates ($20,000 for VLCC and $15,000 for Suezmax instead of $25,500 and $17,500 respectively) and higher management expenses (Ship Finance will pay $9,000 per day instead of the previous $6,500 per day) in return for a larger profit share (50% rather than 25%) and 55 million in Frontline stock.

I bought Ship Finance on the day of the deal because the stock wasn’t moving significantly (it was a little under $16) and I thought the deal was accretive by at least a couple of dollars.  At the time I also bought July 17.50 options for 10c as I liked the short-term outlook.

Even though I don’t expect to hold Ship Finance for the long run, I did do a background check on the company before buying the stock.  In addition to the Frontline charters, Ship Finance has 17 containership charters, 14 dry bulk charters, and 10 offshore unit charters (consisting of 2 jack-ups, 2 deep water vessels and 6 offshore supply vessels).

The supply/demand dynamic of these 3 other industries is not great but Ship Finance has very long term charters locked up in most cases.  With the exception of 7 Handysize dry bulkers, everything is locked up until at least 2018 and most of the charters extend into the next decade.  I don’t see anything particularly concerning about these other lines of business that would interfere with my thesis, which revolves around Frontline.

As I have been thinking more about the deal this weekend, I think I was wrong with my original conclusion that the deal was very one-sided for Ship Finance.  Ship Finance is giving up a lot of guaranteed income for the speculative upside of much higher rates.   I still think its a good deal for Ship Finance, but its also not a bad deal for Frontline.  While I sold my Frontline position on Friday, I am very tempted to buy it back.

The dynamics of the new deal will lead to lower guaranteed cash payments for Ship Finance.  They receive $5,500 less for the charter and pays $2,500 more to Frontline for operating the ships.  This $8,000 is offset by the 25% increase in profit share and the 55 million shares they receive.

Under the old agreement at a low charter rate of $30,000 for VLCC’s Ship Finance would have gotten about $25,500 for the charter and paid back $6,500 of operating expense for Frontline management.  They would have received 25% of the profit of $4,500 per day (I realize the profit calculation may be more complex than this but I’m ballparking here) that the ships made.  So the total profit per ship per day would have been about $20,000.

Under the new agreement Ship Finance gets a charter rate of $20,000 per day, pays Frontline $9,000 in operating expense and Ship Finance receives 50% of the profit, which is now $10,000 per day.  Total profit per ship is $16,000.

If you work through that math at higher rates, earnings accretion of the new deal doesn’t begin until somewhere around a $45,000 per day charter rate.  Above that level every $10,000 per day increase in charter rates adds $0.16 per share to Ship Finance’s annualized earnings.

That means that at current VLCC rates in the mid-60’s, the accretion is around 30c.  Pricing the deal at a 10x multiple would mean Ship Finance is worth about $3 more than it was before the deal.  None of this includes potential upside from the 55 million Frontline shares they received.

Even though the deal isn’t quite as one-sided as I originally thought, I am inclined to hold onto my Ship Finance shares for another month or two and hopefully get $18+ for them.  I came close to selling my shares at $17.50, which turned out to be unfortunate given the down draft in the stock over the last two days.   Having sold my Frontline shares on Friday (something that I am looking at this weekend as a mistake)  I’m inclined to hold onto my Ship Finance shares a little bit longer to see if they take part in a move up from Frontline that the chart is suggesting may occur and fully reflect the impact of the new agreement.

Closed Positions

Gold Stocks

I had a couple of gold stock positions (Timmins Gold, Argonaut Gold and Primero Gold) that just haven’t done well.  The price of gold seems to be languishing below $1,200 and I’m not sure what the catalyst will be that will move it higher in the near term.  Both Timmins and Argonaut hit my 20% stop loss and I couldn’t think of a good reason to hold onto either of them.

TC Transcontinental

Transcontinental is one of those stories that would fit into the bucket of “cheap stock with a little bit of earnings momentum so let’s see if something goes right here”.  I buy these sorts of names all the time and sometimes they work out and sometimes they don’t.  What I have learned is that if they don’t seem to be working out its best to dump them before they become “clearly not working out”.

Transcontinental is in a declining industry (printing flyers, packaging materials, newspapers, magazines and books) that will continue to produce a headwind that the stock will have to overcome.  While I didn’t think the second quarter results were that bad, probably not justifying the 10+% drop in the stock the last couple of days, I also didn’t see a lot in them to give me confidence the price will bounce right back.  So I sold.

I wrote about my purchase of Transcontinental TC here.

Fifth Street Asset Management

One strategy that I’ve employed in the past but gotten away from recently is the “sell now ask questions later” strategy.  If a stock begins to sell off heavily I am better off getting out of it now and figuring out the right thing to do later rather than staying in it, dealing with the sell-off and taking a potentially larger loss in the future.

I think this is a common bias of investors.  We believe that because we hold a stock we have to keep holding it until we are certain we should sell it.  But this is false.  There is nothing necessary about what we should do predicated on whether the stock is or isn’t already in our portfolio.  If I do not hold a stock and news comes out that makes me uncertain about whether I would purchase that stock I certainly wouldn’t go out and purchase the stock.  Why should that logic not work just because I already hold the stock?

So when Fifth Street came out with a crappy first quarter I sold it at the open.  On my list of things to do is to revisit Fifth Street in more detail and look at whether my assumptions about assets under management growth outside of the BDC’s was unrealistic or just a little delayed.  Until I have time to do that though, I would rather be out of the stock than in.

I wrote about my purchase of Fifth Street here.

Portfolio Clean-up

As I have discussed in the past, the portfolio I follow in this blog is based on a practice account that is available through one of the Canadian banks.  While I do my best to track my actual portfolio transactions, from time to time I do forget to buy or sell positions to coincide them.  Therefore I periodically have to clean-up the online portfolio to better reflect the actual securities I hold.

I haven’t done a clean-up in a while and so when I finally on Friday I noticed I was missing a number of positions that should be included.  Thus I added Canacol Energy, Red Lion Hotels, Adcare Health Systems, Radisys, and Ardmore Shipping.  Fortunately with the exception of Radisys and Red Lion none of the other positions had moved significantly from my actual purchase level.  I bought Radisys at a little over $2 and Red Lion at around $6.25 so I did miss out on some gains there.  But in the grand scheme of things the differences are minimal and now the tracking portfolio for this blog is much more closely aligned with my actual positions.

Portfolio Composition

Click here for the last five weeks of trades.

week-206

Week 193: On getting from here to there

Portfolio Performance

week-193-yoyperformance

week-193-Performance

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

Updates

This is a difficult investing environment.  Valuations are high and the market is choppy.  Even as I do my best to limit my exposure to the gyrations by keeping 25% of my portfolio in cash, reducing the size of all but my favorite ideas, and parking cash in dividend paying investments, I still find my stomach churning on days like some of those this week, as I found myself down 2% after Tuesday’s close.

Many stocks that might appear attractive in their own right are difficult to own in this environment.  It is a situation I find unpleasant. While I am still a relatively young man, in markets like these I find myself too old for this.

Like most Canadians I have two accounts.  I have an investment account, and an RRSP account.  Through most of the last 10 years, which constitutes the extent of my productive investing career, these accounts have seen similar allocations.  What I did in my investment account, I did in my RRSP.  However 4 months ago I changed this strategy.  I cleaned my RRSP out of anything speculative, anything small cap, and what I own now are primarily dividend paying companies and REITs.  And a lot of cash.

I just can’t justify the chase given the circumstance and intent of the account and where the market is right now.

In fact, I would expect that at some time in the next couple of years this blog is going to undergo a facelift. Its going to become the ‘how to make money on dividends and not lose your principle’ blog. That happens about 30% from now, so you can put a timeframe to that depending on the returns you think I can manage.

People write blogs like this for different reasons.  Some are looking to make a name for themselves by finding the next big zero or riding a name on the discard heap to the sun.  Others are hoping to parlay their knowledge into a career or at least a few mentions on network cable.  I’m in this for two reason. First, I actually enjoy writing. Second, I want to get to my goal and be done with it, and writing this blog speeds up that process.  How can I get from here to there in the shortest time possible?  That is my trajectory.  While the arrival time is getting close, I’m not quite there yet.

It is this purpose that allows me to exercise as little conviction to my ideas as I see fit.  I’m not interested in appearing consistent.  If an idea is not working I sell it.  If I read or learn something that changes my mind, I change it.  That may be even after I have said only a week before that I loved the idea like a son.   I learned soon after starting this blog that I would have to decide whether I wanted to be right and look good or make money. If I chose the former then I would have to either A. be perfect, or B. show a herculean ability stand by my convictions in the face of adversity and a willingness to stick things out for the long haul through inevitably lags in performance.  Well I’m certainly not A, and B is a little too risky given that A is not likely to be achieved.

Onto my chariots.

Oil Stocks

I took a position in Jones Energy, and I now have exposure to 3 North American E&Ps (with RMP Energy and Rock Energy being the other two).  I am likely too early; WTI continues to fall and the storage builds continue to mount.  But I have a good memory, and I know that trying to predict the stock price turn is not the same as predicting the turn in the underlying conditions.  Remember that things were not necessarily all that rosy in April of 2009 when the stock market decided enough was enough.  Besides, as I will point, this is only one side of a 3-way hedge.

Sometimes you have to lose a little money to make money, and that is the perspective I am taking with Jones Energy.  I will talk more specifically about why I chose Jones below, and give a little update into some of the work I have seen on RMP Energy, a second position of mine. But first a little perspective on oil and how I think about my positions.

At worst what I have here is a hedged bet.  I have my oil stocks one the one side and my airlines and tankers on the other.  At some point, one, or maybe two of these guys is going to be a winner.

The best case outcome is that I have 3 winning bets with staggered payoffs.  Here is how I think this plays out.

First, oil continues to be under pressure in the short-term.  This is already happening. Storage continues to rise, production grows, albeit at a slower pace.  The contango widens and once again the tanker stocks come into favor.  I do not believe that the tanker story is merely a storage story but the market does, so a short term move in these stocks depends on some negative developments on the oil price side and a positive move in the contango.  Tanker rates are already at elevated levels.  If rates move up during what should be the weaker spring season there will undoubtedly be calls that after a 6 year hiatus, the tide has finally come back in for the tankers.  As these stocks move back up, hopefully to their highs or beyond, winning bet #1 pays off.

Next, oil settles as it becomes clear that production has peaked and nobody is drilling any more.  The current narrative of collapse and fear is replaced by a narrative of the “new normal”.  The new normal narrative will be that low prices are here to stay.  This is what is going to set off the airlines.  They have been in a holding pattern since the beginning of the year, digesting some really large gains and wrestling with whether the boon in fuel costs is actually something that can be priced in for the long run.  Once the market decides it can be, they move up another leg and I get winner #2.

Finally for the last winning bet; the E&Ps.  Getting to here might be a shit-show or it might not.  The market is already starting to show signs that it discerns the survivors from the wreckage.  Of the three E&Ps I own, Rock Energy has no debt, RMP Energy has $115 million on a market capitalization of over $500 million (so very low debt), and Jones Energy, which does have a healthy amount of debt, has done such a good job hedging their production until the end of 2016 that by the time they realize spot prices most of their lessor hedged brethren will have already succumbed.  Rock and Jones have done secondaries.  These companies are in good shape.

I don’t think oil prices have to go back to $100 for stocks like these to rise.  At some point a legitimate new normal will assert itself and prices will go back to a $65 or $70 level where supply and demand are balanced.  Now I know there is a lot of talk that E&P’s are already pricing in $70 oil or $80 oil.  While I think this argument is being reserved for the larger entities, the EOG’s of the world, and not these smaller players who have actually taken a very hard fall, I also think this argument is flawed.  I simply ask you this: If some of these companies are pricing in $70 oil, are they also pricing in $70 oil service costs?

As I will explain below using Jones as the example, service costs are collapsing.  And that means $70 oil is no longer actually $70 oil.  $70 oil is maybe $85 oil when you look at in terms of margins, which is what matters.  And not operating margins, not the somewhat irrelevant costs that are used to put together all the break-even forecasts you hear about.  I’m talking about the half-cycle margins that include the primary cost associated with producing oil: drilling the well.  Those costs are coming down big.

The beauty of it is that $70 oil is still going to be $70 oil for the debt laden and high operating cost producers and so the cash flows of many will continue to be constrained.  But for the operators with the financial flexibility to drill and the land positions to achieve attractive returns, they will inherit this new earth.  And that is when my third bet pays off.

Why Jones?

So I bought Jones and I think they have a very good chance to be a big winner when we eventually come through this morass.  Reason #1 for my optimism is that Jones has a very good hedge book for 2015 and 2016:
hedges
Compare the above hedge positions to the company guidance below:

guidance

So to put everything in like terms, guidance is suggesting oil production of about 2,518MMbbl, natural gas production of about 21,000MMscf and NGL production of about 2,300MMbbl.  That means they have about 92% of oil production, 93% of natural gas production and 66% of NGL production hedged at decent prices for 2015.  The volumes hedged for 2016 are not far off that.

On their fourth quarter conference call Jones said that their drilling and completion costs are coming down substantially. Wells that used to cost them $3.8mm are down to $2.9mm.  They think that will come down to $2.6 million in short order.  That is a huge change that has moved the profitability curve down substantially.

While all operators are seeing costs come down, Jones is in enviable position being the major operator in the area – I think they have more leverage over their suppliers than some.

Unlike my other two E&P picks, Jones has debt.  They have also taken on more debt recently. At the beginning of February they sold $250mm of 9.5% senior unsecured notes due 2023 to the market.

Jones has also issued shares, but worth noting, the offerings were at substantially higher prices than what the stock is trading at today:

A. 4,761,905 shares at $10.50 to Magnetar Capital LLC and GSO Capital Partners LP
B. 7,500,000 shares at $10.25 via an underwriting with underwriter option for additional 1,125,000 shares

In total Jones has offered 13.4 million shares if underwriter option is exercised. It will raise a little over $130mm in proceeds from the offering.

As far as the operations go, things look solid.  The company is going ahead with three drilling rigs all focused on the Cleveland.  They’ve settled on a frac design and will be going back to an openhole completion with 33 stages.  This is expected to give them the oil uplift that had been the intent of all the experimentation that they did in 2014, but without a lot of added cost.  Production is going to fall as they cut back on drilling, but I think we are all past the point of worrying about what happens to production in the short term.  They didn’t have a lot to say about their Tanaka wells on the last conference call, but given the opportunity for additional lands that is likely to open up in the Cleveland, I’m not sure if the viability of the Tanaka is relevant any more.

Basically, I think Jones will weather the storm here. They have ample liquidity to increase their position in the Anadarko basin with cheap assets. You can pick up the shares at a 20% discount to the underwriting less than a month ago. The near term commodity price risk is greatly mitigated given the hedge book. The move down to $8, which unlike many of their peers is a significant new low, seems to me to be unjustified given all of these factors.

Reviewing RMP Energy

Since I the discussion revolves around  E&P’s in this post, I wanted to give a few thoughts on RMP Energy.  In the last couple of weeks I spent some time reading through and analyzing a recent report put out by Peters.  In the report Peters raised some concerns about the extent of Ante Creek play and the recent decline in Ante Creek production.  Production at Ante Creek is down to 8,300boe/d from around 10,200boe/d in the summer.  Peters lowered their target price on the stock.

To some extent their concerns are valid.   The Ante Creek wells drilled in the south aren’t as productive as those in the core 8 sections.  In the recent March presentation the company the company said as much, delineating between the core, the infill of that core, and regional development.

ror

With that said, I don’t know if I would worry too much about the production declines.  I think that it has more to do with facility capacity constraints than anything else.   The problem is that as the reservoir pressure declines the wells are producing a higher gas content.  Pretty typical behavior.

If you look at the numbers, at 10,200boe/d the volumes were 63% liquids, so gas production was about 22.6MMscfd.  At 8,300boe/d gas production is now up to 48%, or about 23.9MMscfd, so even as the overall production has declined, gas production has ticked higher.  And its started to hit the ceiling.  According to the March presentation the facilities at Ante Creek can only handle 24MMscfd at current gas plant capacity:

gascapacity

Fortunately more capacity should be online shortly, at which time we will see what production can really do.

Peters NAV in the report was $4.25. Its pretty easy to come up with a higher NAV than that and in fact some of the other analysts do, but lets go with this number for sake of comparison.  At the time of the report, at a $5 price, RMP was at a 20% premium to NAV.  This was at the upper end of the peer comparison below:

nav

At the current price, a little under $4, RMP trades at less than 90% of NAV which is pretty closely inline with their peers.  But should RMP really trade at the same level as LEG or DEE? Probably not. So I think the stock has probably come down too far.  I traded some RMP when it got into the $5’s, waited patiently for it to correct like this, and now I’ve jumped on it here sub-$4.

The other leg to the story is that RMP has had excellent initial results for the two Waskihagan wells drilled with their new slick water frac design.  You’ll note in the table above that the Waskihagan wells don’t have a great return with the oil based fracs.  RMP is testing out slick water based fracs and the first two have performed admirably so far.  Another poster on InvestorVillage posted a list of the top performing wells in the WCSB in December-January and the two water based frac wells from RMP made the list.

Fifth Street Asset Management

I tweeted this one out on Thursday.  Fifth Street Asset Management is a fairly small, recently IPO’d asset management company.  They manage a little over $6 billion in assets, with about 90% of those residing in two business development corporations (BDCs).

aumThe stock did an IPO in November at $17 per share.  Since that time it as sunk in price, for what I believe are two main reasons.  First, both of their BDC vehicles trade below book value, and the company has come out and said that they will not raise capital at their BDC’s below book.  This invites the assumption that growing assets under management (AUM) is off the table.  Second, the larger of the two BDC’s, Fifth Street Finance, put out some fairly crummy results in February, including a reduction of the dividend and news that the existing CEO, Leonard Tannenbaum, would be resigning to focus on Fifth Street Asset Management and their new hedge fund.

This feels to me like one of those stories where yeah, the news is bad, but chances are it is transitory and as it is digested and conditions improve the stock could quickly go from dog to darling.  While they are unable to expand their AUM via the BDC’s Fifth Street does have other options for growth.  The company recently closed on a $309 million CLO.   They are starting a hedge fund (which as I mentioned will also be run by Tannenbaum), are expanding into aircraft leasing, and starting a Japan focused fund.  So there are other ways to grow.  And while the BDC’s are below book right now things change.

I think they can do $1+ earnings per share this year.  The company distributed 30c quarterly dividend in January.  On the conference call where they announced the dividend they warned that it would exceed 100% of income in the fourth quarter and possibly exceed 90% of net income for 2015.  As was picked up on by one of the analysts on the call this implied managements expectations of earnings, that they think $1.20 per share is reachable.

I think there is a reasonable chance that the concerns about the FSC subside, the company shows further evidence that they can raise capital outside of the BDCs, and the market begins to focus on the growth potential rather than the lack thereof.  And the stock comes back to its IPO price.

Patriot National

This is another recent IPO that I think has some upside if they can execute and the market gets comfortable with them.  The IPO price was $14 and I have bought the stock at a significant discount to that in the low $11’s.  The IPO prospectus can be viewed here.

Patriot handles the procurement and management (including claims management) of workers compensation insurance.  They basically sign a contract with a client for a set book of workers compensation business, then procure that business through affiliated insurance agents and manage it.  The contract will define the risk parameters, geography, premium size, etc that they want in their book.   Patriot’s system distributes the data to its agents who then look for opportunities to sell into it.   Patriot doesn’t take on any of the claims risk.

Patriot currently provides services to Guarantee Insurance, Zurich Insurance Group Ltd. and Scottsdale Insurance Company.  Scottsdale is a relatively new relationship that should continue to add reference premium growth during 2015.  They recently began a relationship with AIG, of who they will begin to provide services to in 2015 and expect to become one of their “primary insurance carrier clients over time”.

They are a small company compared to many of their peers.  with 26.4 million shares outstanding, the market capitalization sits at $290 million.  The company will likely do around  $23-$25 million of EBITDA in 2014, which doesn’t make them seem particularly cheap.  So the story here is growth and I think there is a good chance they can achieve that.

One of the interesting elements of the business model is that Patriot has quite good visibility into its future revenues, because the contracts are signed up front and then Patriot goes out and fills them.  I managed to get a hold of the BMO report on Patriot. Being the underwriter of the IPO, presumably BMO has a close line with management.  In the report, they expect reference premiums to grow from $375 million in 2014 to  over $500 million in 2015 as the relationships with AIG and Scottsdale mature.  That would be 30% growth.

In the company can put together that kind of growth the 14x EBITDA multiple would be justified. If you apply the multiple on the higher level of business, its easy to come up with a lot of upside from here.  Also worth noting, this is a low cash use business.  Maintenance capital is in the low single digits, and the company only has about $40 million of debt, so the vast majority of EBITDA falls down into free cash generation.

Anyways much like Fifth Street I think that Patriot is suffering from the post-IPO uncertainty.  No financials, no track record, no conference call, and the only information it buried deep in a prospectus that most people don’t want to bother with.  I think there is a decent chance they continue to execute on the business and grow reference premiums, and that the stock runs up into the high teens.

TC Transcontinental

TC Transcontinental is a pretty simple story.  They are the largest printer in Canada.  Their printing operation is diverse and includes flyers, packaging materials, newspapers, magazines and books.  Of those lines of business, the main driver of revenue is from retail flyers for customers such as Superstore and Canadian Tire.  Flyers and related services make up a little over 50% of their total revenue. In addition Transcontinental owns an array of local newspaper and magazine publications in Quebec.  They recently expanded into flexible packaging with the purchase of Capri.  The table below illustrates the primary customers in each of their segments.

customers

While the print operations are by no means a growth industry, the company has done well to stabilize revenues while improving EBIT from the business.  EBIT has shown continuous improvement for the last 5 years.

ebitOver the long-term, print remains a challenged business.  Maybe flat to a down couple percent a year.  Transcontinental is offsetting the declines by pushing growth from within their media segment (via a growing online presence) and through the expansion into flexible packaging.

The company has made a couple of acquisitions over the last year and a half to facilitate some growth.  First, in December 2013 they bought a number of Quebec local newspaper and magazine assets of Sun Media.  They paid $74 million for these assets, which generate annual EBITDA of about $20 million.  In April they entered into flexible packaging with the purchase of Capri for $133 million.  Capri generates EBITDA of about $17 million, and 75% of revenue comes from a 10 year contract with Schreiber Foods.

While neither of these acquisitions are revolutionary, I believe they are paying a reasonable price to grow and expand in new directions.  And they aren’t growing via debt.  Like United Online, the print business may not be a great growth business but it does generate a lot of cash.  And that is really what made me look twice at the company.  Transcontinental is really cheap on a free cash basis.  Based on the 2014 year (ended November), the stock trades at 5x the free cash generated.  In 2015 they have to start paying cash taxes again so multiple will jump to around 7x.  There are not a lot of companies left these days that trade at single digit free cash multiples.

So TC Transcontinental is inexpensive and has plenty of cash available for acquisitions  to offset declines or to further facilitate moves into other growth areas.  There are the pieces there for something to go right.

An update on United Online

United Online has been a reasonable winner for me so far, going from $12 and change to $17 since I bought it back in November.  I did some more work on United Online a couple of weeks ago and I thought I’d put it out there for anyone interested.

United Online is not my largest position.  I am not convinced of its prospects and to be honest I don’t even really understand the demand for its StayFriends and Classmates products.  Yet I think the stock has a reasonable chance of going higher.

United Online operates a number of legacy businesses that, while in decline, are producing an increasing amount of free cash flow as United attempts to milk them for the cash.  These businesses are:

  1. Social Networking Services – they operate the classmates.com, StayFriends.com and Trombi.com (France) brandssocialnetworking
  2. Loyalty Marketing – operate a loyalty marketing service called MyPoints.  MyPoints is an online shopping membership that provides discounts and rewards to usersmypoints
  3. Internet Access – operate the brands NetZero and Juno, providing dial-up and mobile broadband servicescomm

While these businesses are all declining, and they hardly exemplify the large moat stability that a value investor typically craves, they are generating more and more cash as United squeezes down the cost side.  In the fourth quarter free cash generation was $8 million.  In the last 9 months its been a little under $15 million.

I’ve listened the last few United Online conference calls and its clear that management understands the predicament they are in.  They know that the existing business lines are essentially in either a stasis or prolonged run-off and that they need to do something to generate growth.  To that end, United Online is in the process of rolling out three new products: a low cost cell phone, a cloud based shopping list app called List+, and a gift card management app called Swappable.  While I don’t really get the cell phone angle, both List+ and Swappable fit well with the existing MyPoints customer base. There is a decent SeekingAlpha article that describes the new products, but its only available for a couple more days.

The Swappable app is a bit of a hot money area right now.  United is competing with another gift card app start-up so there is a gift card app star-up called Raise.   Raise raised $56mm from investors in January, which values them at a little under $1B.  They have “reported hundreds of thousands of customers had either bought or sold cards from around 3,000 brands via the site to date”.  While Raise hasn’t said how many users they have. They did say:

In addition, in 2014, the company sold over a million gift cards, and between November and the end of the year, Raise grew over 50% in revenue and other metrics. And user growth quadrupled.

Again according to media reports Raise “passed $10 million in monthly gross card sales several months ago and has been growing more than 10 percent a month since then”. The company takes a 15 percent cut when someone sells a gift card or store credit on their site.

From what I can tell, the Swappable app does pretty much the same thing that the Raise app does.  Moreover, United Online can leverage off of MyPoints.  From the recent conference call:

MyPoints already does millions of dollars of gift card revenue. It has primarily been desktop. It has been user, going to buy a gift card on MyPoints

So putting it all together, United Online has:

  1. A comparable product to Raise
  2. “An ecosystem in place with MyPoints and the other databases around the company”
  3. “9-plus million MyPoints members we can write and invite to this product”

With cash on the balance sheet exceeding $5.50 per share, United Online has an enterprise value of $160 million at $17.  So a lot less than Raise, even though they have a number of other irons in the fire, and an established means of generating capital to plow into the business.

So we will see.  But its enough of a story to keep me interested in the stock even as it has risen.

Gold Stocks

In continue to own small positions in Endeavour Mining, Argonaut Gold, Timmins Gold and Primero Mining. These positions are just a trade, premised on the supposition that we have once again gone too far to the downside, just as we went too quickly to the upside in January and before that went too far to the downside in December.  But even as I kept all of these positions small, they still led to gyrations in my portfolio, as they saw daily movements in the high single digit and low double digit percentage points.  More and more often it is occurring to me that owning gold stocks is not worth the trouble.

What I sold

Mart Resources

I bought Mart Resources at the trough of the last oil stock rout because of what I saw a lot of potentially positive news on the horizon.  The company was likely to release news about the purchase of the OML-18 block and show production gains after the commissioning of their new pipeline reduced the existing production bottleneck.

Unfortunately none of this is likely to materialize as the company has sold itself to its partner Midwestern for a paltry 80c per share.  This is a case study in why not to invest in a country like Nigeria.  Based on the publicly available information it is difficult to make a case for selling the company at this price.  This likely means that there is other non-public information that makes a sale of the company compelling, if not unavoidable.

One only has to look at the recent share price, which ticked down to 50c at one point, to illustrate the skepticism of the investor base about the legitimacy of the proceedings.  Quite honestly, at this point who really knows what is going on.  I sold my shares at a slight profit from my purchase but in relation to what I had expected, which was the opportunity to  sell these shares at $1+ within the year, it is a substantial disappointment.

magicJack and Radsys

I group both of these companies together because my motivation for selling was similar; a lack of conviction about their prospects.

In the case of magicJack, I keep coming back to the name as I compelled by its large cash position ($5 per share) and the potential for the company to behave in a manner similar to United Online, milking the legacy business for cash while developing new and perhaps complimentary businesses to facilitate growth.  Nevertheless management has disappointed once too often for me to hold my shares through earnings, particularly given that their largest retail vendor (Radioshack) went into bankruptcy during the quarter.   I will be listening closely to the conference call though, and could come back to the stock depending on what I hear.

I could be back into Radsys as well.  Honestly the problem with Radsys is really my problem.  I don’t understand the business that well.  The thesis is based on the 4G LTE products that Radsys offers and I just haven’t developed enough background on the offerings to feel confident holding the stock.  I’ll try to make time to learn a bit more and come back to the stock once I do.

Earthlink

I exited my position in Earthlink after the company announced fourth quarter results.  Its not that the results were particularly bad, its just that they also weren’t notably good, and its difficult for me to envision the catalyst that takes the stock materially higher in the near term.

The company announced flat revenue quarter over for the managed services business, and they really need this business to grow at a reasonable pace given that it is their only true growth driver.  And while they announced that they would be reviewing strategic alternatives for their fibre assets, they were vague about what might sold and for how much.  If the stock drops back to below $4 I will look at it again.

Transat

It was pointed out in the comment section of my last post that while Transat no longer appeared in my portfolio, I had not actually written about my sale.  This was an oversight on my part.  These updates get long and at times I miss transactions that I should mention.

To paraphrase my response to the comment, I sold the stock because I thought that the weak Canadian dollar was going to make the winter season (Q1 and Q2) difficult. When you run a business that has mid digit margins and the currency moves 10% in a few months, its difficult to respond fast enough.  Transat also unfortunately hedges much of its fuel so in the short term they are not going to benefit from the reduced jet fuel prices.  The winter routes also have a lot of added capacity from Air Canada this winter.

All of this came to pass when the company announced weak first quarter results.  Now I still really like Transat and I am looking to add my position back, but I’m not sure we are there yet.  The second quarter is likely to be just as weak as the first, and the Canadian dollar just keeps on falling.  The summer though will be stronger, they will benefit from the weaker Euro and the fuel hedges will begin to run-off.  At some point there is a buy here, but I haven’t jumped in yet.

Final Thoughts

Bad things tend to happen when the US dollar is this strong.

Portfolio Composition

Click here for the last four weeks of trades.

week-193