Snyder Brown Capital Management’s fourth quarter letter to partners.
Dear Partner:
Snyder Brown Capital, LP (the “partnership”) returned -4.4%, net of fees and expenses, in the fourth quarter of 2014.
Snyder Brown Capital Management: Investment Process
Our goal is to build a portfolio of investments that will outperform both the broad equity and bond indices over the long term. To accomplish this, we search for securities that are dramatically mispriced by irrational or uninformed investors. The greater the magnitude of this mispricing, the greater our potential gains on an investment and the lower our potential risk if we are wrong and/or unlucky. While we currently have low net exposure to the stock market, we are not market timers. Our primary method of risk management is and always will be to carefully select individual investments which we believe will perform well even if the overall stock market does not.
Snyder Brown Capital Management: Fourth Quarter Performance
As we have stated before, the trading prices of our investments are much more volatile on a monthly basis than the underlying value of these investments. Our focus is on making absolute returns through a repeatable investment process, which cannot be reasonably evaluated over a period as short as nine months. With that being said, we appreciate that the poor performance of the partnership over these first nine months is likely to be frustrating for some of our partners. Per the terms of our partnership agreement, no management or performance fees were paid to the general partner in 2014.
Despite having only nine months of data, we can certainly evaluate the performance of the individual investments we have exited as well as the positive and negative developments at the businesses which drive the long-term investments we have made. We believe an important part of any investment process is a rigorous and intellectually honest evaluation of how investments develop versus the expectations underlying our investment thesis. A summary of this evaluation follows.
On the long side, the majority of our losses were caused by Enhanced Oil Resources and Fortress Paper, a company in which we own debentures we have previously written to you about. These are two investments of which we have never sold a share (or debenture in the case of Fortress) and there remain specific fundamental reasons to believe that these positions will be our best performers in 2015.
Snyder Brown Capital Management: Fortress Paper 6.5% Debentures due 2016
Much has been written lately about the strength of the US dollar and the falling price of oil and gas. These trends are excellent news for Fortress Paper in 2015 – and for our position in the debt securities of this company. Fortress’ major operating subsidiary manufactures cellulose pulp in Canada and has seen its input costs fall roughly 10%, in line with the decline of the Canadian dollar over the last three months. We have invested roughly 1/3 of our portfolio in this CAD$40 million debt issue that comes due in December of 2016. This position is more than triple the size of our largest equity positions, not because of the high likelihood of making large returns on Fortress in 2015, but because of the safety of this investment. We believe that even in a disastrous scenario, we will still make a positive return on this investment.
Because Fortress sells its product in US dollars, but costs are in Canadian dollars, we now expect this company to produce positive cash flow in 2015, on top of the $50 million in unrestricted cash the company already holds. In addition, the company’s largest debt issue is at a subsidiary that does not have recourse to the parent company (where our debt resides) and that lender has just granted the company a moratorium on paying both principal and interest on the subsidiary debt until after our debentures come due. We stand to make more than double our money from here on this very large investment by simply holding these debentures until they mature in 22 months.
We have been actively engaged with management and other stakeholders in this company on a regular basis to both ensure that our concentrated investment in this distressed debt is safe and to work towards a debt reduction strategy that will create value for all stakeholders. We think it is likely that the company completes a voluntary restructuring of some of the outstanding debt in the first half of this year, which should result in these bonds trading up to at least 80 from the current level of the low 50s. This would result in an increase in the mark-to-market value of our entire portfolio of nearly 20%, more than erasing the mark-to-market losses we experienced in 2014. Even at a price of 80, we believe this security would represent an attractive investment.
Snyder Brown Capital Management: Enhanced Oil Resources
Unlike our investment in the Fortress Paper debentures, in which the fundamental value improvements are not yet reflected in market prices, a lot went wrong at Enhanced Oil Resources in 2014. We invested in this company at a valuation of $7.5 million dollars because it owned producing oil properties worth $35 million that produced $3.5 million in annual cash flow. We recognized that we were able to purchase this company at only two times cash flow because of a bloated cost structure in which the managers of the company were paying themselves the entire cash flow each year, but we believed that situation could be improved upon by engaging with the board of directors. We had a number of communications with both management of the company and the board of directors during the course of 2014, not all of which were collegial.
Unfortunately, during the course of our sometimes contentious engagement with management, two major wells had down-hole failures and stopped producing. After embarking on a disastrously expensive effort to re-drill these wells at a cost of millions, management decided to sell the majority of the producing assets for cash, rather than address the bloated cost structure. In no small part due to our efforts to prevent this sale and, even more troublingly in our view, management’s intention to reinvest the proceeds, the board of directors resigned one by one and a new team has come in that has cut corporate costs from $3.5 million per year to less than a fifth of that amount.
As a result of the value destroyed by legacy management, bad luck, and declining oil prices in 2014, the market cap of this company fell by 2/3 since our initial investment to just $2.5 million currently, which is less than the net cash it holds in the bank. The company still owns two large oil fields with significant potential and has a net operating loss carryforward (a credit against future taxes for losses that have been incurred) of more than $100 million. This is still a very small company that is in crisis, but after a disastrous 2014 in which a great deal of value was destroyed, we believe this company could be liquidated for double or triple its current value. Rather than liquidate, the new management team is planning to find a low-risk way to develop or monetize the two fields the company still holds. We are once bitten, twice shy, and have voiced our concerns as a large shareholder to the new management team and board of directors, but we are cautiously optimistic now that the proverbial bleeding has stopped. This position is less than 5% of our portfolio and, despite the potential to make a huge return from this level, we have no plan to add to this position due to the elevated risk of this investment.
Snyder Brown Capital Management: Other Long Positions Contributing to Performance
We do not have space in this letter to go into detail about Sears Holdings and Chesapeake Energy, our two largest positive contributors to performance in 2014. After realizing gains on both of these positions, the equity prices of these two unloved companies declined towards the end of the last year. We believe both companies are positioned to be significant positive contributors again in 2015 and we will likely write about these companies in more depth in a future letter. One company we did write extensively about in our last letter, Nicholas Financial, announced plans in December to complete a Dutch tender for nearly 40% of the outstanding shares. This is something we had suggested to management as a way to improve both the share price and the capital structure of the company, and we have sold most of our position after this announcement.
Because shorting stocks is inherently more risky than buying them, we take significantly smaller positions on the short side. Overall our single-name shorts contributed 0.4% of positive performance in 2014, but we lost a total of 2.2% shorting in 2014 when our index puts are included. We consider our overall performance of the short side a success in 2014, given that the S&P 500 rose 11.5% in the same time period and we were largely protected from a downturn while losing only a small fraction of the S&P 500’s performance. Just because a flood doesn’t strike in any given year doesn’t mean you don’t want to own flood insurance, and we will be happy if we can protect our portfolio again in 2015 at such a low cost. On the positive side of our short performance was Wausau Paper, a company which we are still short.
Snyder Brown Capital Management: Wausau Paper
The equity of Wausau Paper was our largest short position in 2014 and, after rebounding towards the end of the year, is once again our largest short position as we begin 2015. This company is one of the manufacturers and distributors of the large rolls of recycled paper towels you encounter in commercial bathroom dispensers as well as other institutional grade tissue papers. Many market participants expect this company to be sold to a competitor at a premium after operations are improved, with these actions being pushed by a well-known activist investor. We have devoted a substantial amount of our time to analyzing this company as well as the away-from-home recycled tissue business it operates in and we confident in our thesis.
While many market participants believe this company is facing temporary operational headwinds that will soon be resolved, leading to much higher margins, we don’t think that is possible. The problem we see with this company isn’t with its operations, but rather with its industry. This is a commodity industry with low barriers to entry that is now oversupplied. To make matters worse, Wausau is an also-ran behind three huge players (Georgia Pacific, Kimberly-Clark, and SCA) which control roughly 70% of the industry.
We don’t believe there is material value to Wausau’s customer or dealer relationships and we think the company’s property, plant, and equipment are worth less than what the company paid for it. We have looked at every transaction and consolidation in this industry over the last dozen years and we believe this company’s replacement value is, at best, 50% of its current enterprise value. Because this company is leveraged, that would translate into a loss of 2/3 of the current market cap. Based on some of the lower priced transactions, we think we could build a competitor with similar scale from scratch for about $175 million, which is the amount of debt that this $510 million market cap company carries.
We expect Wausau will face serious headwinds in 2015, which will overwhelm any improvements that a competent new management team can achieve. Specifically, we believe that Asia Pulp and Paper will continue to aggressively price their “renewable” tissue and towels, which they are sending to North America to compete with recycled products, and that Cascades, Wausau’s closest competitor, will seek to take additional market share. The biggest problem for Wausau is the same issue we mentioned as a strength for our investment in Fortress Paper Debentures – the strong US dollar. Cascades has a portion of their operations in Canada and, like other foreign producers, will be in a better position to compete with Wausau after the 10% strengthening in the USD vs. the CAD over the last three months.
As with any good investment, we think that if we are wrong about Wausau, we are unlikely to lose money because of the extreme valuation (in this case overvaluation). However, if we are right about the headwinds this business faces this year, we are likely to see a dramatic decrease in the equity value of this levered entity that had negative free cash flow in 2014.
Snyder Brown Capital Management: The Year Ahead
We are excited heading into 2015, primarily because we believe some of our current investments are likely to behave like a “coiled spring” after experiencing declining prices despite positive fundamental changes over the last few months. In addition, we are seeing opportunities in the oil and gas space, but we will be patient in adding additional exposure to this sector. Our primary focus for new investments is in examining companies that are nominally part of the oil and gas sector but do not actually have much exposure to the decline in oil and gas prices.
As always, we remain available to our limited partners to discuss either our disclosed investments or our overall strategy.
Snyder Brown Capital Management: New Investors
We have continued to selectively welcome new limited partners who understand and agree with our investment philosophy in each of the last three months. Our primary concern is with finding the right investors who have a long-term focus. As such, we will continue to focus our efforts on investing rather than marketing in the belief that if we do our job correctly these investors will continue to find us.
Sincerely,
Nicholas C. Snyder, CFA
Tice P. Brown, J.D.
