Breach Inlet Capital Management letter for the second quarter ended June 30, 2016.
Breach Inlet Capital Management – Performance Attribution
During 2Q16, Breach Inlet Capital, LP (“Partnership”) returned 3.3%, net of fees and expenses1, surpassing the Russell 2000’s (“Russell”) gain of 3.2%. Although this is only a slight outperformance, it was achieved while sitting on an average cash balance representing 46% of NAV and holding hedges with notional values totaling ~30% of NAV. Since inception (March 1st), the Partnership has generated a net return of 6.2% compared to 11.5% for the Russell. The relative underperformance is the result of having only 35% of our capital deployed in our inaugural month when the Russell rose 8.0%. However, since inception, the Partnership’s net return on invested capital2, which measures our effectiveness at security selection, was 17.1% exceeding its benchmark by more than 550 bps. Also, since inception, the Partnership’s net return of 6.2% has outpaced a comparable hedge fund index (HFRX Equity Hedge Index)3 by more than 400 bps. The primary contributor (DRII) and detractor (TAST) to results are discussed below.
Diamond Resorts (“DRII”)
DRII was identified as Company C in our 1Q16 letter, when we stated the catalyst for share price appreciation to likely be a “completion of strategic alternatives – expecting a sale”. It is the second largest timeshare company. Many potential DRII shareholders hear “timeshare” and stop listening due to the misconception that only the uninformed, financially irresponsible are pressured into timeshare ownership. However, 65% of the company’s sales are to existing resort members and another 15% are to members of acquired resorts, while the average FICO score of the customer is 756. Thus, the primary buyer of timeshares is quite the opposite – those most intimately familiar with the experience and supported by a strong credit history.
The company has two segments contributing ~evenly to earnings. The first is the management of 109 resorts through evergreen contracts resulting in a perpetual cash flow stream. The second segment is the sales and financing of timeshare points providing access to its network of 425+ vacation destinations. The company revolutionized the industry with the asset-light “inventory recapture” model, which entails recovering points of defaulting customers and then reselling those points at a ~10x ROI as opposed to developing new resorts and then filling that capacity over time at a ~3x ROI. This strategy has led to an attractive organic growth rate, which has been augmented with acquisitions that ~doubled its managed resorts since 2009. The recent result has been a tripling of FCF per share in less than three years.
One year ago, DRII peaked at ~$34.50 equating to a valuation of ~11x FCF. Then, negative rumors and misleading articles permeated the market and caused its share price to decline 50%+ within ~six months. The primary short thesis centered on expected increased regulation and DRII’s financing model falling apart. Greater regulation will always be a risk, but seems unlikely as the industry is already heavy regulated. As far as fears about DRII’s financing sources, the company has the same model as its peers and better credit metrics. However, the masses sided with the shorts and the stock stayed depressed, so the board announced plans “to explore strategic alternatives to maximize shareholder value” in February. This resulted in a buyout offer of $30.25 from Apollo Global Management last week.
We are happy to see our investment thesis playing out and DRII trade closer to fair value, but believe Apollo’s offer is a far cry from fair as it only values the company for ~7x FCF. As mentioned, DRII traded for ~11x FCF before the overblown mirage of the short sellers came to life. Its closest peer, Marriott Vacations (“VAC”), also trades for ~11x today. This valuation multiple would imply that DRII is worth ~$50 per share or ~65% above the offer price, so a higher bid could surface and we are therefore holding most of our shares for now.
Carrols Restaurant Group (“TAST”)
We provided our thesis on TAST in last quarter’s letter, but want to give an update since it has generated the largest unrealized loss to date. During the quarter, it reported record results and the stock was up ~5% that day. It subsequently fell by more than 15% despite zero company-specific or relevant industry news. Our speculation is that investors are concerned about the pace of TAST’s acquisitions, which have only totaled 18 restaurants YTD. However, these have historically been lumpy and management is currently evaluating several large transactions, so we do not share the market’s concern. Since August 2015, it has increased its pro forma EBITDA by nearly 75% yet its shares are back to their price at that time of ~$12. Stated differently, the company currently trades for ~8x EBITDA, while high-growth peers are valued for ~12x.
Over the past two years, TAST has acquired ~200 restaurants paying an average per unit of ~3x for ~$150k of EBITDA. Assuming TAST’s historical valuation of 10x, multiple arbitrage yields $1mm+ of value per unit ($150k X (10-3)). In addition, management’s goal is to expand margins of acquired units by 300 bps and they have historically surpassed this. The combination of multiple arbitrage and margin expansion implies that each acquired restaurant creates $1mm to $1.5mm of value. With a target of purchasing 100 units annually, this equates to $100mm to $150mm of annual value on a ~$500mm market cap company. As TAST announces acquisitions and continues to beat conservative earnings guidance that does not incorporate future acquisitions, we foresee its share price rebounding and compounding our capital for many years thereafter.
The Partnership entered the quarter owning shares in six companies and now has investments in ten, including six core positions. We discussed three in the previous quarterly letter (FIG, TAST and TRS) and describe another above (DRII), while the remaining two are presented below. In addition to these new positions, the Partnership increased exposure to FIG and TAST, while also beginning to purchase shares of one company and warrants of another that will be discussed in greater detail in the future.
MED sells weight loss products, primarily shakes and other meal replacements, that when combined with the company’s dieting schedule has proven to be an effective program. It serves a large and growing market of $18b that is also highly fragmented resulting in a tremendous growth opportunity. In addition, it has an attractive business model with 75% gross margins, a highly variable expense structure, and low capital requirements leading to steady cash flows and high returns on invested capital through cycles.
Its predecessor was born out of research at John Hopkins University in the early 1980s. Twenty years later, the company added a direct sales model called Take Shape for Life (“TSFL”), which is a network of independent contractors called “Health Coaches” that distribute MED’s products and act as the personal support system for clients. After helping them lose weight, Coaches will often “sponsor” clients to become Coaches and then these new Coaches will eventually sponsor some of their clients. The result is a powerful and expanding network of walking billboards for MED’s products. TSFL is very different than Herbalife and