In Q4 Lakewood Capital recorded a net profit of 5.6% while the hedge fund was up 2.7% for 2015 in what was a tough year for many hedge funds, according to a letter to investors reviewed by ValueWalk. Anthony Bozza’s Lakewood Capital detailed a new long position in Comcast, but as is usually the case, the shorts are more interesting. The Lakewood Capital letter details short positions in Adeptus Health, Dycom Industries, Dean Foods and PRA Group (we discussed the PRAA short in a recent article)

Below readers can find in-depth analysis by Lakewood Capital on their current short positions.

Lakewood Capital did not respond to ValueWalk’s request for comment.

Also see Lakewood Capital Opens Shorts In Seagate, Diplomat Pharmacy, Ziopharm Oncology

Lakewood Capital

Lakewood Capital – Adeptus Health (Short)

In our last letter, we discussed our short position in Diplomat Pharmacy, a recent healthcare IPO that became a market darling despite a limited history of profitability and an uncertain growth outlook. Shortly after doing our initial work on Diplomat, we turned our attention to Adeptus Health, the nation’s largest operator of freestanding emergency departments (FSEDs). Like Diplomat, Adeptus completed its IPO in 2014, and by August of last year, the shares were up more than five-fold. At its peak, the company’s enterprise value exceeded $2.5 billion, an impressive feat for a facilities-based service provider with less than $150 million of invested capital. While the stock is down almost 60% from its summer highs, the shares are still more than double the IPO price and in our view are significantly overvalued given the limited growth opportunities and pressures facing existing facilities.

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Adeptus operates 74 FSEDs, primarily in Texas and Colorado, under the First Choice banner. Unlike a traditional emergency room, Adeptus facilities are not attached to hospitals and generally occupy previously vacant retail storefronts in strip malls. These emergency rooms do not accept ambulances and do not have surgical capabilities. Texas and Colorado have regulations in place that have allowed for the proliferation of FSEDs while most other states restrict the opening of FSEDs to existing hospital systems.

Between 2010 and 2015, the number of FSEDs in Texas increased from 22 to 162, with Adeptus accounting for nearly 40% of that growth. The major metropolitan areas have been blanketed with First Choice facilities, and we believe that the company’s existing markets are now effectively saturated. A simple search on Google Maps reveals facilities in cities like Houston, Dallas and Denver just minutes apart from one another. This desire to show investors significant growth has led to some troubling consequences. Since going public, Adeptus facilities have registered same-store volume declines in every single quarter with declines exceeding 10% in each of the first three quarters of 2015. This deterioration in volumes is even more remarkable when considering the high-single-digit same-store growth reported by for-profit acute care hospital systems. For example, Adeptus reported a same-store volume decline of 11% in the third quarter of last year, while HCA, the largest for-profit hospital chain, reported a same-store increase of 6% in its emergency rooms.

While we believe the volume pressure is largely a function of cannibalization, we think customer dissatisfaction is also a growing contributor to same-store declines. FSEDs have higher out-of-pocket costs than urgent care facilities, and consequently, patients are often stuck with exorbitant bills. This has not only led to several critical news reports and a countless number of negative online reviews, but now, an increasing number of customers are refusing to pay their bills. In the most recent quarter, bad debt expense as a percentage of revenues increased to 18%, a 400bp increase over 2014 and a 700bp increase over 2013.

Investors have largely overlooked these concerns as a recent one-time price increase (to bring reimbursement levels in-line with hospital ERs) created the illusion of solid financial performance. We believe the room for further price increases is limited, and the company’s underlying issues will soon become apparent. Declining volumes and increasing bad debt is undoubtedly a toxic mix in a high fixed cost business, and we expect unit economics to deteriorate meaningfully this year. Given these ongoing pressures and our concerns about the durability of the business model, we do not believe the company is worth a significant premium to the capital invested in the business of approximately $150 million. Even at a valuation of two times invested capital, Adeptus shares would be worth less than $10, over 80% below current levels.

Lakewood Capital – Dycom Industries (Short)

Over the years, we have found some of our best short opportunities in mundane, lower quality companies that have experienced a dramatic surge in their stock price following an unsustainable increase in earnings. During the quarter, we initiated a short position in Dycom Industries, a company that digs ditches for fiber installation, following a rise in its stock price of more than 125% on the year. Dycom, whose stock trades at around $65 per share, never earned more than $1.20 per share from 2002 to 2014. However, the company suddenly became an investor favorite in 2015 as earnings doubled (with solid gains also expected in 2016) due to strong demand from telecom networks (particularly AT&T) upgrading their copper networks to fiber.

We are generally skeptical of how many homes will actually be upgraded to fiber given questionable unit economics. While bulls are excited about a government program called Connect America that is aimed at increasing internet speeds in rural areas, our diligence suggests it is very difficult for contractors to make money in these markets. Connect America actually just replaces another FCC program, and many telecom providers may simply choose a wireless solution instead of a fiber solution to meet mandated speed requirements. However, even if our fiber estimates prove to be too low, Dycom’s earnings will almost certainly retreat to a lower level when the build-out is complete given its revenues largely represent the growth capital spend for telecom and cable operators. Ongoing maintenance revenue on fiber will actually be lower than the maintenance revenue on copper.

Dycom has also seen a healthy increase in profitability in the past year as gross margins have increased to above 23% in the most recent quarter after consistently averaging 19% from 2006 to 2014. We believe this sharp spike in profitability results from a temporary supply shortage as many competitors have shifted resources to the wireless side of the market in recent years. While a large player like Dycom was in a perfect position to win business in recent quarters, we believe competitors are returning resources to these markets, which should lead to intensifying pricing pressure.

Dycom currently trades at over 16x its tangible book value of just $4 per share, an aggressive multiple for a business that was described to us by one of Dycom’s competitors as a “capital killing machine” due to the enormous working capital requirements. Over the past five years, Dycom has converted just 20% of adjusted net income to free cash flow. Even assuming aggressive peak revenues of $3 billion (versus $2 billion today) with a 10-year build cycle at elevated margins, we calculate the discounted cash flows from the business are worth around $1.4 billion today at an 8% discount rate. After subtracting over $700 million of current net debt, we believe the stock is worth around $18 per share or 70% below the current stock price.

Lakewood Capital – Dean Foods (Short)

During the third quarter, Lakewood Capital initiated a short position in Dean Foods, the largest processor and distributor of milk and other dairy products in the U.S. We believe milk processing is a competitive and secularly challenged business, but currently, investors are attracted to a spike in Dean’s profits that we believe will normalize in the coming quarters.

The milk processing industry is beset by a number of structural challenges including shrinking volumes, chronic overcapacity, low margins and powerful customers. Milk volumes have declined by about 2% annually over the past five years primarily due to the rise of non-dairy milk alternatives and decreased consumption of breakfast cereal. Dean has no exposure to the faster growing categories of organic, soy and almond milk as those businesses were spun-off into a separate company called WhiteWave Foods in 2012. The steady decline in volumes has driven industry capacity utilization to 65%, and we believe this structural overcapacity will persist as volumes remain under pressure. Furthermore, since milk is often used as a loss leader, customers frequently bid out the business to ensure the lowest possible costs (Dean lost a significant amount of business with Wal-Mart in 2013).

Dean purchases commodity raw milk and earns a margin by processing and selling it in private-label (65% of volumes) and branded form (35% of volume). In general, the spread earned on private label sales is a fixed amount per gallon that is negotiated with the retailer, and changes in raw milk costs are treated as a pass-through. Dean Foods sets the price of its branded products at a premium to the prevailing private label price. From 2011 to 2014, the average quarterly gross spread that Dean earned across its businesses was $1.55 per gallon. However, the spread has averaged $1.70 per gallon over the past couple of quarters. While this may not sound like a material increase, the impact to the bottom line is enormous as operating profit is currently only $0.10 per gallon.

Importantly, we believe that the recent elevated spread is temporary and will normalize in the coming quarters. The largest driver of the increase was a dramatic decline of over 30% in raw milk costs in the past year, and while this cost is contractually passed through to retailers on private label sales, there is a lag before branded prices catch up. Dean also has been intentionally slow to adjust its branded price leading to a historically high price premium versus private label. Furthermore, Dean has a higher-margin ice cream business that has benefited from competitor Blue Bell’s listeria outbreak and subsequent recall. While Dean was able to take advantage of the recall and increase market share, we believe Dean’s unbranded ice cream products will revert to more normal market share levels next year.

Based on our assumptions of normal gross margins, continued declines in volumes and fixed cost deleveraging, we expect Dean Foods to earn around $0.40 per share in 2017 (versus $1.20 currently). Using a 15x earnings multiple, which we believe is quite generous given the secular issues and financial and operating leverage, our target price for Dean Foods is $6 per share or about 65% below the current price.

Lakewood Capital – RA Group… Revisited (Short)

In our second quarter 2014 letter, we outlined our short thesis for PRA Group (formerly Portfolio Recovery Associates) (“PRA”), a debt collector that was trading at high multiples of both book value and earnings while enjoying what we believed to be a temporary and unsustainably high level of profitability. Since our original write-up, the stock is down over 50%. During the quarter, we added to the position as the fundamentals continue to deteriorate, and we believe there is significant additional downside from the current price of $30 per share.

PRA’s earnings rose from $0.96 in 2009 to a peak of $3.80 in 2014, driven primarily by opportunistic purchases of consumer debt portfolios made during the last downturn (mainly in 2009 and 2010). More than five years after the purchase of these extremely high-return vintages, most of the earnings from those portfolios have been realized, and PRA is now left with a book of less attractive investments made during the past several years. For context, the high-return 2009 and 2010 vintages represented 60% of 2011 PRA revenues but just 9% of revenues in the most recent quarter.

Importantly, we believe the company’s historical strategy of increasing financial leverage through acquisitions and portfolio purchases to stem the earnings decline has largely been tapped out. Since the end of 2013, PRA’s net debt has risen from $290 million to $1.6 billion today, while earnings have essentially been flat. Internally generated cash flow will not be sufficient to support the levels of portfolio purchases required to offset lost earnings from prior vintages as 2015 year-to-date free cash flow has been negative $224 million. With current net debt of approximately 4.5x EBITDA, we think PRA will be forced to slow its portfolio acquisitions, exacerbating the significant upcoming earnings decline.

We also believe the market continues to underestimate other upcoming earnings headwinds. Since we first discussed our views on the company, regulatory pressures have increased, as evidenced by a recent fine from the Consumer Financial Protection Bureau and increased compliance-related operating costs. Furthermore, the company’s earnings have been pressured by the negative foreign exchange impacts relating to a recently acquired European business.

We believe investors may soon start to question why they are paying 4.5x the current tangible book value of $7 per share for a highly levered financial company with deteriorating fundamentals. We expect returns on tangible equity will stabilize in the low teens by 2017, and even at a generous multiple of 1.5x next year’s book value, the stock would be worth $15 per share or approximately 50% below the current price.

Lakewood Capital
Lakewood Capital
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