Hazelton Capital Partners letter for the third quarter ended September 30, 2016.
Hazelton was profiled discussing small cap positions not in this letter – in our recent edition of under the radar small caps – check it out here if you are interested
Hazelton Capital Partners, LLC (the “Fund”) gained 9.3% from July 1, 2016 through September 30, 2016, gained 15.5% year-to-date, and has returned 97.3% since its inception in August 2009. By comparison, the S&P 500 gained 3.8% in the same quarter, increased 7.8% year-to-date and has returned 136.5% since the Fund’s inception.
Hazelton Capital Partners Performance – The Quarter in Review
Hazelton Capital Partners ended the 3rd quarter with a portfolio of 20 equity positions and a cash level equivalent to 20% of assets under management. The Fund’s top five portfolio holdings, which are equal to slightly under 35% of the Fund’s net assets, are: Western Digital (WDC), Apple Inc (AAPL), Micron Technology (MU), Softbank Corp (SFTBY) and USA Technologies (USAT). Hazelton Capital Partners increased its cash level from 10% to 25% at the beginning of the quarter primarily when it sold out of its DreamWorks Animation position. Some of that capital has been redeployed into existing positions as well as new holdings, keeping the number of positions within the portfolio steady at 20.
Except for DreamWorks Animation, which accounted for nearly 1/3 of Hazelton Capital Partners’ year-to-date return, most of this years performance has been driven by recent additions to the portfolio and not the legacy positions responsible for last years portfolio downturn. Many of our legacy holdings are still represented by our top five holdings, as we feel there remains a significant gap between the positions current stock price and its future value.
Plus ça change, Plus c’est la même chose
(The more things change, the more they stay the same) – Jean-Baptiste Alphonse Karr As we turn our sights to the final quarter of the year, there is an ever-growing list of headwinds that seeks to derail the already feeble economic growth. The potential for rising interest rates and oil prices, global unrest and, of course, the pending US election all highlight the current investing anxiety. Uncertainty has always been a variable when investing. Most of the time, the presence of uncertainty is shrouded in a cloak of optimism and hidden from plain view. However, one needs to be mindful that uncertainty is also the catalyst for investment opportunity and, without it, life would be predictable and markets efficient. Even though Hazelton Capital Partners is less than inspired about the current market conditions, the Fund remains optimistic about our portfolio holdings. It is important to remember that our current cash position is less a reflection of our overall macro view of the economy and more a reflection of the opportunities we are finding in the market. With that in mind, our list of potential investments has been growing over the past few months and Hazelton Capital Partners stands ready to deploy its cash.
USA Technologies, Inc. (USAT) – Current Holding
In the third quarter, USA Technologies became one of the Fund’s top five portfolio holdings. USA Technologies, Inc. is a machine-to-machine (M2M) transaction and payment processing company. The company focuses primarily on the unattended retail market of vending, laundry, and remote kiosks machines. The vending machine industry is a mature industry, dating back over 120 years, with approximately 6 million machines in the United States and generating roughly $45 billion in annual revenues. Characterized by slow changing technology and sales growth, vending machine revenues are, for the most part, uncorrelated to economic cycles. The biggest structural change the industry has witnessed over the past 20 years was the widespread adoption of the dollar bill reader to transact sales. Currently, the vending machine industry is being dragged into the 21st century as it transitions from analog to digital, joining the rest of the economy by offering cashless transactions.
USAT was one of the first companies to recognize the transition to cashless transactions and began providing point-of-sale (POS) units that would allow the use of credit cards and NFC enabled devices like mobile phones. Initially, the company rented these POS units to the vending machine owners in order to capture the recurring licensing and transaction fees on items sold, the lion share of its revenues. Achieving scale was critical to the company’s longterm profitability, as the more transactions processed translated into lower negotiated fees with processing companies and the cellular companies responsible for the machine-to-machine communications. However, renting the POS machines meant that USA Technologies was leveraging its own balance sheet, and the faster its growth, the more levered it became. In 2015, USAT changed course and pivoted to using a third party leasing agent to distribute its POS units. This transition allowed the USAT to recognize revenue from its POS sales, de-lever its balance sheet, and with the help of its leasing agent, lock-in the vending machine operator into a 5 year contract.
Vending machine operators soon discovered that being digitally connected to their vending machines meant that they could manage their machine’s inventories in real-time, design a more comprehensive restocking schedule, identify and adjust which products to carry based on sell through, and change product prices for their machines remotely. Additionally, cashless transactions meant that there was less cash to collect which reduced vandalism and/or theft when the cash is collected. But the greatest benefit vending machine owners were noticing was the increase in revenue each machine was generating. By having the ability to transact cashless sales, vending machine operators witnessed between a 30 to 40% increase in revenues. Part of the increase came from servicing customers who do not carry cash or “loose change.” But more telling is the fact that cashless transactions have a higher dollar sale amount than items purchased with cash. This behavior reflects recent studies that found consumers are willing to pay over 20% more for an item if purchased with a credit card. Spending cash is tangible, representing a decline in net worth; a credit card transaction delays the impact until one’s monthly statement is received, and even then, there is another delay until tangible cash is needed to pay it off. Using a credit card has the added benefit, unlike cash, of a rewards program. In its most recent quarter, USAT reported that the average cashless transaction from its POS units was $1.90 versus ~$1.30 average cash transaction for the vending machine industry. Vending machine operators are keying in on consumer behavior when it comes to cashless transactions and are now stocking their machines with higher priced items such as energy drinks, items that
were once the impulse purchase domain of convenient and drug stores.
Hazelton Capital Partners initially looked at USA Technologies in 2012 when they were operating under the old business model of renting out its POS units. We were attracted by the recurring and growing revenue the company was generating from cashless sales and recognized that USAT was building a respectable market share in a very niche segment of the retail industry. Our concern remained centered around the leverage being placed on the company’s balance sheet which ultimately meant that USAT would have to either add more debt or dilute equity shareholders by issuing more shares, and so we decided to pass on the investment. After learning about the change in its business model in early 2015, Hazelton Capital Partners reviewed the company and its financials and decided to add USAT to our portfolio in November of 2015. Even though we were purchasing shares of the company at more than double its 2012 share price, we felt much more comfortable with the long-term growth and financial strength of the company. During USA Technologies recent run higher, Hazelton Capital Partners trimmed its holding. Our investing thesis for the company has not changed and we believe there is more upside potential for USAT, as only an estimated 10% of all vending machines in the US are currently cashless. But, we also feel that the market’s short-term valuation of USAT might have gotten a bit ahead of itself and we stand ready to repurchase those shares if USAT were to sell-off.
LifeLock (LOCK) – Closed Position — +110% Return
LifeLock is a leading service provider of identity theft protection. The company monitors new account openings and credit-related applications for unauthorized use of its member’s personal identification information. For an annual subscription, members receive alerts of unauthorized identity use, and if necessary, help in restoring a member’s identity. As demonstrated by Yahoo’s recent cyberattack that compromised over 500 million of its members’ accounts and personal information, cybercrime is a growing problem that is not going away anytime soon. High profile attacks, like Yahoo, keep identity theft fresh in people’s mind and is the best type of advertising for a company like LifeLock. The company believes that there are over 78 million people in the United States that fit its members profile. And even though LifeLock is the leading provider of identity theft protection, with only 5% market share, there is still significant room for it to grow.
In July of 2015, LifeLock shares plunged over 50% in the course of three days; the market reacting to news that the Federal Trade Commission (FTC) was taking action against LifeLock for allegedly violating a 2010 order surrounding deceptive advertising and insufficient security required to protect its member’s sensitive information. The market was fearful that the negative publicity along with the rumored $500 million fine would be the death knell for a company whose business is to prevent its members’ identity from being misused.
Being familiar with the company and its business model, Hazelton Capital Partners revisited LifeLock focused primarily on the potential fine, the company’s brand, and the long-term impact on both earnings and cash flows. Over a number of weeks, our research led us to believe that the company was not only viable, but that the market’s knee-jerk reaction had provided a meaningful investment opportunity. There was no doubt that the FTC allegations were going to have a negative impact on the company’s short-term expenses and profitability, but much of the expected earnings decline was more than reflected in the current stock price. As for the FTC fine, the rumored $500 million was not commensurate with the violation, given that the actions took place over a two year period (between 2012 & 2014), and the company had already taken steps to correct its deceptive advertising and lack of security protocols 12 months prior to the FTC bringing the case. Hazelton Capital Partners purchased shares in three tranches, with an average cost basis of $8.14/share, as our continued research provided increased comfort with company and its long-term earnings. By December of 2015, LifeLock had settled with the FTC, paying a $100 million fine.
In August 2016, a little over a year since the FTC charges and the steep decline in LOCK’s share price, both LifeLock’s revenue and membership had grown by over 15% and the company’s share price had rallied over $17/share. Given the recovery in the share price, Hazelton Capital Partners decided to exit its LifeLock position. An argument could be made that there still was more upside available if Hazelton Capital Partners were to be more patient. The decision to sell out of the LOCK position was not predicated on lack of patience but rather portfolio management. Hazelton Capital Partners is steadfast about limiting its portfolio holdings to just 20 positions, and at the end of August, a new position was slated to enter the portfolio. LifeLock was chosen to be replaced not only because it was the holding closest to it intrinsic value, but also because the new holding’s balance sheet closely resembled that of LifeLock.
Hazelton Capital Partners
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