David Water‘s Alluvial Capital Management client letter for the third quarter ended September 30, 2016.
Dear Alluvial Clients,
[drizzle]Alluvial strategies recorded solid gains this quarter, though these returns were largely in line with market indexes. Year-to-date, Alluvial’s all-equity strategy continues to trail these benchmarks. I am very satisfied with the operating results that our portfolio companies have delivered this year and I am confident that the market will eventually recognize these successes.
An Update on MMAC Capital Management
Alluvial’s largest holding continues to be MMAC Capital Management, LLC. Alluvial clients hold roughly 1% of MMACM’s shares outstanding. MMACM stock failed to move upward in the third quarter, though the company’s fundamentals and strategy remain strong. In the quarter ended June 30, MMACM bought back another 3.9% of shares outstanding and book value per diluted share increased by $1.00 to $19.62.
Shares have trended downward thus far in October, likely on fears that rising interest rates will reduce the value of the company’s leveraged loan portfolio. These fears have some merit, and we may see a downward adjustment to the value of the company’s bond portfolio in this quarter’s report. This would be more concerning to me were MMACM’s bonds valued at a large premium to their unpaid balance or principal value, but this is not the case. At June 30, MMACM’s bond portfolio was valued at 102.4% of the unpaid balance of the 35 bonds, or only marginally more than the stock of principal payments that MMAC Capital Management expects to receive. The balance sheet value of these bonds may experience volatility as interest rates meander, but will inevitably converge to the unpaid balance over time, assuming the financial performance of the underlying properties remains steady.
Higher interest rates will also increase the earnings contribution of the company’s growing solar construction lending venture.
While the valuation of the company’s bond portfolio may be a drag on book value growth this quarter, I still expend MMACM to report further gains in book value per share based on recognized income from the new domestic low-income property management business, potential workouts in the non-performing loan book, increasing interest income from bonds and from solar construction lending, and from continued share repurchases.
I continue to value MMA Capital Management’s operating businesses, investments, and NOLs at more than $30 per share and growing with every discounted share the company repurchases.
Alluvial Capital Management – Tailwinds From Europe
Alluvial’s European holdings were big contributors to returns this quarter. Umanis SA announced and completed a significant tender offer for its own shares and Moleskine SpA announced it would be acquired (somewhat puzzlingly) by a Belgian automotive supplier, D’Ieteren.
Umanis has a long history of repurchasing its own shares, and has now bought back 40% of the shares outstanding since 2010. With insiders now holding 66% of Umanis shares, it’s a wonder that the company remains public at all. I would not be surprised to see a buyout proposal in the next year or two. Whether or not the company is eventually bought out, it trades at only four times EBIT with high single digit organic revenue growth, hardly a rational valuation despite the company’s tiny size and limited trading liquidity.
The acquisition of Moleskine SpA breaks my heart. This is a company I had hoped to hold for years. I believe the company has only just begun to make its mark in North America and revenues could double or triple in 7-10 years. Moleskine’s operating margins are a thing of beauty, and I cannot understand how D’Ieteren was able to buy a 41% stake in a company of this quality and growth potential for only 15x trailing EBIT. Not only that, but just as the company finished up multiple years of heavy investment in expanding its distribution channels. However, the story may not be over. D’Ietern is making the legally-required tender offer for the remaining 59% of Moleskine at €2.40 per share, but will only be able to delist the company from the Milan exchange if it can achieve 90% ownership. At the current trading price, the downside to €2.40 is minimal, so it is worth sticking around to see if we can remain shareholders in a publicly-traded Moleskine.
In general, I continue to discover more compelling new investment opportunities overseas than in US markets. The macroeconomic clouds that continue to hover over the Eurozone create opportunities to invest in fine companies at very attractive valuations.
The Bank Basket
Our basket of cheap community banks has been built out. As a reminder, the idea of this diversified basket is to gain exposure to small banks that are over-capitalized, sub-scale, exhibiting good credit quality, and trading at a large discount to liquidation value. I expect continued consolidation among small banks in order to gain scale and keep up with rising regulatory costs and continued compression in net interest spreads. As I write, the median bank in this basket has a $370 million balance sheet, a 14.3% common equity to assets ratio, and trades at 83% of tangible book value. Mergers and acquisitions in the small bank universe have historically taken place at meaningful premiums to tangible book value and recent transactions are no exception.
While none of these banks has received an acquisition offer since I began purchasing them, several have conducted significant share repurchases. Others have raised their regular dividends or declared special dividends. Short of outright selling to a larger competitor or merging with an equal, repurchasing discounted stock or increasing the dividend payout are often the best moves an under-valued bank can make. Repurchasing shares is more tax-efficient than paying dividends, but both are effective ways of returning capital to shareholders.
One of Alluvial’s newer holdings is Calloway’s Nursery, an upscale vendor of plants, seeds, and garden supplies with 19 locations in the Houston and Dallas-Fort Worth markets. Calloway’s is similar to another Alluvial holding, Rand Worldwide, in that it is controlled by noted investor Peter Kamin, one of the founders of ValueAct. Now, name recognition is not an investing thesis. But Mr. Kamin has an exemplary track record of turning around under-managed micro-caps and he and his team are doing the same at Calloway’s.
Mr. Kamin first achieved board representation in 2013, and results have improved markedly since. Trailing twelve months operating income is up 86% since 2012, book value per share is up 148%, and the company’s indebtedness has been slashed. The plunge in oil prices has impacted top-line revenue growth, but the company has actually held up extremely well despite the decline in discretionary income for many of its customers. Calloway’s shares trade at just 5.5x trailing operating income, and this ratio should compress as operational improvements continue to take hold. In addition to its profitable and improving operating business, Calloway’s also holds significant real estate value with multiple nurseries located in bustling commercial districts. Calloway’s management continually evaluates each unit’s profitability and is happy to sell off properties when redevelopment promises a superior return.
Introducing Alluvial Fund, LP
I am very proud to announce Alluvial’s newest venture, a private investment partnership. Sitestar Corporation has agreed to seed the new limited partnership with $10 million.