Meson Capital Partners letter for the first quarter ended March 31, 2016.
Meson Capital Partners net performance for Q1 was 2.5%, vs. indices (in order of relevancy for comparison) of: (1.7)% HFRI Hedge Fund Equity Index, (1.5)% Russell 2000 and 1.4% S&P 500. Our portfolio was approximately 20% net long and by quarter end our longs contributed 7% to returns while shorts detracted 4.5%. Last year our short book contributed nearly 2,000 bps of alpha so we are happy to have this capability to protect our purchasing power in the current frothy market.
It was a very unusual quarter around the world with the March 31 numbers masking major declines including a 15% drop in the Russell 2000 by mid-February before things reversed sharply. At that point in time our performance was dramatically better than the market as our shorts are higher-beta, low quality businesses. By design, our portfolio components will complement each other so we rarely get too excited or too worried. When the overall market moves sharply upward, the (short term) winners tend to be those that take the most imprudent risks.
We are pleased but not satisfied with our performance this quarter. We continuously work to improve our research process and portfolio management to protect our capital regardless of market environment and to set ourselves up for success when opportunities are available. Our short positions we hold now will help us finance bargain purchases the next time there is a broader market drawdown that lasts longer than a week or two before ‘steroids’ are applied by coordinated central bank action. Our core longs are improving their business fundamentals every quarter under the leadership of capable and owner-oriented managers.
Meson Capital – Book Review – Short Stories
Our core long ideas performed well during the choppy Q1 market. Notably, InfuSystem reported record Q4 revenue and EBITDA that has now doubled in the 4 years that we have been involved with the company. Improved financial results are a direct consequence of the servant leadership approach from the top that has improved the culture step by step over time, empowering and promoting the best people within the company. SIGA Technologies, a special situation we have patiently had in the works for some time has made tremendous progress recently and was just approved to exit bankruptcy.
The SIGA – PIP lawsuit is a complex special situation we have elaborated on in past letters. The lawsuit has dragged on since 2005 including SIGA using the protection of bankruptcy to battle the suit under the automatic stay. So far SIGA has had a perverse incentive to make the company look as weak as possible in order to reduce any judgement amount during the lawsuit. Now there will be a confluence of factors that should bring light to the value that exists at the company – removing the bankruptcy stigma, recapitalizing the balance sheet, and adopting more normal revenue accounting. This combination makes it an extremely attractive situation for us going forward through the rest of the year.
We realized gains from several company-specific events in our short book. We have been short CTIC BioPharma for nearly two years, enduring a 100% rise in the interim. This experience and the challenges of shorting highlights the need to a) Don’t try this at home unless you are a professional investor and b) Have a very process-driven method for finding and managing many shorts, otherwise it can consume a huge amount of time and stress. We spent years building software systems for tracking thousands of companies and managing the research process that entailed a large fixed cost but that we can now amortize in a market environment that demands good risk management.
We were attracted to CTIC as a short due to the heavy and continuous issuances of new shares combined with large losses and massive insider compensation to the CEO and his brother who served as the CFO. In fact, CTIC may have a stock market record of the most dilutive stock of all time having declined from a (reverse) split adjusted $80,000 per share to $0.50 while accumulating over $2 Billion in losses since 2000. We greatly admire those who chase their dreams but when CTIC announced that it has to cease a clinical trial for a recycled cancer cure because it may in fact cause harm, the stock plummeted and we covered with the stock down about 80% from our initial short entry 2 years ago. Most of our shorts are slowly burning capital but a material business update every now and then shows that the Emperor has no clothes and the timeline is hastened in our favor.
We covered our Aeropostale short after they reported continued negative same store sales for Q4 and are now at the brink of bankruptcy. Retail businesses are notoriously sneaky for the hidden leverage they employ which can create fantastic returns during growth periods but once sales-comps decline it is very difficult to rebound. Less than 3 years ago ARO looked like a solid value investment with net profits and $230mm of net cash and growing sales. However, operating leverage along with the decline in demand has made the business unviable in its current state.
We covered the majority of our Odyssey Marine (OMEX) short during the quarter after it had declined in excess of 90% since we originally shorted the stock in September 2013. The company appears to have embarked on a paid stock promotion in March which tripled the stock and dragged on our performance on paper. Today their final project, the undersea phosphate mine “Don Diego” was denied environmental approval by SEMARNAT in Mexico. It seems hard to imagine how they will avoid a bankruptcy filing at this point given their heavy debt load, ongoing losses and no apparent prospects for future revenue.
Meson Capital – Turnarounds are Not Easy
Within our profitable long portfolio this quarter, one loss we realized this quarter was Violin Memory, a designer of enterprise-level solid state storage systems. This was a small position that ultimately impaired only about 1% of our capital but it is illustrative to understand our process. The investment setup for VMEM was attractive: their product had great reviews and price/performance vs competitors. The product was designed with flash storage from the ground up, ostensibly leapfrogging others that had modified spinning disk architecture to the new paradigm. After a hot IPO and stumbling with the stock down to a bargain price relative to revenues and net cash balance sheet, new well incentivized management joined. The idea was that if they couldn’t get sales traction then they could sell VMEM for the IP value to a big competitor. If they could get sales traction it was not hard to see a 5-10X return in 2-3 years given the bargain purchase price and the rapidly growing market they participate in.
This is the type of pattern we love to see and may motivate us to recruit new board members and management when we have resources to add value. In VMEM’s case, we were happy to let the new management play things out themselves given there are many more opportunities out there to coattail turnaround artists than do everything ourselves. That said – we also were wary of the risk profile in VMEM’s business – the fast changing market and shorter product cycles meant that the time lost during a turnaround might mean the window of opportunity was missed. This ended up being more or less the case and is why we are very strict on our large activist positions to avoid businesses that have external or concentrated risks such as customer concentration, fast changing market dynamics, or regulatory “stroke of the pen” risk. These kinds of risks are not an issue when they can be part of a basket of more diversified 5X opportunities where even one success can carry the rest home. We learned early in our history how the inside of a struggling business can require much more heavy lifting than the trailing financial metrics may warrant.
Meson Capital – Driving Operating Improvements to Ignore a Challenging Market Environment
The data continues to indicate the market is at or near all-time high valuations which means low return expectations for the average investor going forward 5-10 years. The supply/demand balance of financial capital is not favorable to those that can merely move paper around. A more proactive approach to generating value is required. As the IMF warns of slowing global growth, our approach of focusing on investing in the right people at smaller companies can charge forward regardless of macro issues.
We have spent our career building a cumulative toolkit and reputation to be anything but average, with multiple exceptional demonstrations of value creation along the way. While the opportunity set for passive investors has shrunk with the rising market, our ability to actively create business value while protecting ourselves with our short book gives us plenty to work on. I’m very excited about our positioning to make above average returns long term regardless of the overall market or economic climate.
We are working on two new small deeply undervalued companies where we are seeking board representation that we should be able to discuss publicly shortly. Both have a solid revenue base to build from and could return multiples if they can secure traction on new products in the pipeline. We continue to build our team and network of industry veteran operating partners and have several larger opportunities in our pipeline to improve solid but otherwise stodgy companies.
I continue to have virtually all of my investable net worth committed alongside investors in the Partnership and am excited to be growing the firm. We now have a full time COO and analyst. Please email me at [email protected] or call at 415-322-0486 if you have any questions or are interested in investing. As always, thank you for reading.
Meson Capital Partners LLC
Meson Capital 1Q16 Fact Sheet
Meson Capital, LP is an operational activist long/short fund that invests in small-cap public companies that are deeply undervalued relative to revenues, gross profits, and/or assets. Companies often have suboptimal but improvable governance, management, and operations but are not exposed to external risks such as commodity exposure, regulatory risk, or heavy debt loads. Meson also sells short overvalued stocks with poor management to generate uncorrelated returns and as a hedge to the overall market. Meson seeks target companies with 2-3X return potential over a 3 year period by improving revenue, margins, and trading multiple.