JDP Capital Management Q4 And Full Year 2015 Letter to Limited Partners
For the fourth quarter the Fund was up 5.60% net, and down 3.22% net for the year. Including dividends the S&P 500 was up 7.04% for the fourth quarter and up 1.38% for full year 2015. Since inception in October 2011, we have earned 82.57% after all fees and expenses, or 15.22% annualized.
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JDP Capital Management – Review and Outlook
The fourth quarter return was driven by ALJ Regional Holdings (OTC:ALJJ) +16%, and CyrusOne (NASDAQ:CONE) +15.6% adjusted for dividends. C&J Energy Services (NASDAQ:CJES) was up 30% before we sold out in early December. The balance of the portfolio was flat in terms of stock price, despite reporting overall impressive Q3 business results.
The full year return was primarily driven by Carrols Restaurant Group (NASDAQ: TAST) +54%and CONE +41.2% adjusted for dividends, offset by declines in our Bank of America warrant basket -28.5%, CJES -64%, and a flat-ish ALJJ +5%.
In December we sold half our stake in CONE due to valuation, realizing a compounded annual return of 31% over three years. We also sold CJES for a 64% loss after roughly the same period. This capital was redeployed into TAST, Bank of America, and two toehold positions in special-? situation French and Mexican small caps that I will detail if the ideas evolve further.
CJES was a multi-?year holding (3 years) that we wrote about in multiple letters. Ultimately we became too concerned about the disconnect between oil prices and the cost to service even the least-?intensive wells. We still believe in the company’s vision, best-?in-?breed management, and that the majority shareholder Nabors Industries could contribute new equity if needed. But today C&J is a
zombie company and its economics are not within the company’s control.
JDP Capital Management – Our strategy
It has been a while since I wrote about our strategy and how we think about investing. As in any business, it is important to revisit, reiterate, and discuss your strategy because it helps identify mistakes, and learn from them. This process also helps keep you grounded and on track, especially when the crowd tells you otherwise.
The greatest competitive advantage we can have in investing is time. Our willingness to take a longer-?term view than the market will produce sporadic returns when measured in months or quarters, but
should outperform over time with less risk. This does not mean we ignore market concerns, or that we believe something has to go up just because it went down.
Among the ~8,500 US-?headquartered public companies there is always a large degree of permanent value destruction occurring under the sheets any given time: bad management, poor capital allocation, disruptive competition, etc. Our job is to try and handicap this uncertainty and get paid appropriately for the business risk we take.
But real business is lumpy, full of uncertainty, and dependent on a human element that is often overlooked. Understanding global-?macro economic factors that affect the fundamentals of our portfolio is always part of the investment process. But these inputs tend to carry less weight in our strategy because they can dangerously oversimplify the decision making process and lead to knee-?jerk reactions.
We look for companies where we think earning power is greatly mispriced due to a transition that we understand and identify with. Transitions we like are often spawned by a degree of distress. The value opportunity comes when investors (ourselves included) misjudge the time that big changes take to bear fruit, if at all. So markets often prefer a “sell now, wait and see” attitude which can lead to very attractive pricing.
Our approach to investing rewards a focus on studying business challenges that specific companies are facing, and not necessarily the broader market. Examples include strategy shifts, mergers, financial restructuring, and changes in capital allocation and/or management quality.
The price we pay for anything is a justified by a multiple of estimated future cash flow, varied based on a degree of outcome certainty, compared to other opportunities on our desk. We target an unleveraged return of 100% over 2 to 5 years per idea. This filters out the traditional higher risk ”15% to 20% potential upside” ideas that are more market driven than fundamental.
We prefer ideas that have the potential to become large, concentrated positions. The dominating characteristic we look for here is a demonstrated runway for a company to continuously recycle its own earnings back into the core business and earn a predictable return that we think the market will eventually pay up for. This package needs to come protected by a reasonable competitive advantage, a shareholder friendly board, and an appropriate capital structure for the business’s size and industry.
We generally find these qualities in companies that have emerged out of a transition into a much stronger position than the market is willing to pay for ”today”. These are pre-compounders where we can deploy lots of capital, without paying retail.
Identifying investments takes time, and often starts with a ”toehold” or small position that gives us a front seat to get to know the company better after our initial research. When we get an investment wrong, it is generally around being too early in a recovery, or simply misjudging the situation altogether.
Managing an investment is a balance between long-term patience and close monitoring. Once we own something, we build a funnel of information flow around that company and industry. This part of the process helps us track business progress versus our thesis and timeframe. In the end, the decision to sell is valuation driven, not volatility driven.
JDP Capital Management – Selected Portfolio Update
ALJ Regional Holdings-(OTCBB: ALJJ) FY 2015: +5%
ALJ continues to transform itself into a diversified investment vehicle fueled by excellent deal making, unique management incentives, and multiple years of federal NOLs that minimizes tax expense. Q3 earnings had only ”45 days of contribution from the Phoenix Color acquisition in August. But it is clear that the transaction was transformational, and the market is ignoring it. We think ALJ’s cash flow could more than double in 2016 bringing leverage down from the current 2.5x and setting the foundation for a favorable future refinance. Part of this potential comes from Faneuil, the call center subsidiary purchased from McAndrews & Forbes.
Faneuil is a sleeping giant and is benefitting enormously under ALJ’s ownership. As of Q3 2015 backlog had risen to $290 million, up from $110 million last year. Using historical EBITDA margins of around 8% implies the subsidiary could boost ALJ’s total company EBITDA by 10 12% above our 2016 base case.
ALJ recently announced plans to list on a mainstream exchange in 2016. Up-listing will open the stock to mainstream investors, create more liquidity, provide a potential currency for future acquisitions, and allow for a larger scale buyback program.
We presented our thesis and history with the company at the 2016 ValueConferences Best Ideas conference on January 13, 2016. Our presentation was organized around an interview I did with ALJ’s Chairman Jess Ravich on December 23, 2015. Here are links to both presentations which are also posted on our website.
Presentation on ALJ Regional Holdings 2016
Interview with ALJ Chairman Jess Ravich, December 23, 2015
Carrols Restaurants-(NASDAQ: TAST) FY 2015: FY 2015 +54%
TAST is now our largest holding after adding to our position at $11 per share during the December market turmoil. We have owned the stock since May 2014 and have watched in awe as the company has demonstrated exceptional operational skill in turning around acquired stores, and aggressively managing their capital structure to maximize shareholder value. Between future acquisitions and store remodels, TAST has a long runway to recycle cash flow back into the core business and earn high-teens cash-on-cash returns.
The turnaround at parent Burger King (NYSE: QSR) has been nothing but spectacular since it was acquired by 36 Capital in 2010. TAST is the largest US franchisee and benefiting from a unique set of circumstances including the right-of-first-refusal on the sale of 1,000 franchisees, and adequate capital to remodel outdated stores fast and efficiently.
In December TAST acquired 46 stores bringing total store count to 705. Run-rate company sales and EBITDA has grown to $900 million (+30% YoY) and $70 million (+94% YoY) respectively. Store-level EBITDA is now over $130 million. Q3 sales were up 21% due to successful advertising, an improved value menu, acquisitions, remodeled stores, and lower beef prices. The company expects remodel expense to peak in 2016 with a push to complete ”100 stores. The result should be accelerated free-cash flow generation in 2017, to be used for more acquisitions and smaller-scale remodels. Wash, rinse, and repeat.
CyrusOne-(NASDAQ: CONE) FY 2015 dividend adjusted +41.2%
We have owned CONE for three years and have followed the idea since 2011 when it was a subsidiary of Cincinnati Bell (NYSE: CBB). CONE was spun out of C88 in a January 2013 IPO to pay down CBB debt. We bought the stock shortly after the IPO because we felt it was selling for an obvious discount due to fears around CBB’s stated plan to sell their stake over time.
CONE is a 3+ million square foot data center REIT that rents space to enterprises wanting to outsource their data centers but retain their core IT management. CONE earns high-teens unleveraged cash yields on its developed real estate portfolio. Historical topline growth of ”20% has been driven largely by existing customers taking more space. CONE also has a large owned land bank that could be developed into more than double the current operating square footage. We sold half of our stake in December because the position had grown to over 18% of assets. The price was in line with our assessment of fair but remains attractive. However CONE is less favorably positioned if long term outsourcing trends spill over to include IT departments at large companies (Goldman Sachs, Exxon, etc.) The threat is, that under a complete IT outsourcing scenario, current clients would lose control over their data center infrastructure provider.
CONE remains cheaper than the broader REIT sector on an AFFO/EV yield basis, and more attractive considering its growth pipeline to expand with existing customers in Phoenix, Dallas and Virginia.
Bank of America-(NASDAQ: BAC-WS-A) FY 2015 -28%
This was a high conviction idea with a 3+ year time horizon that has been very painful thus far.
We own a basket of TARP-era ”A” and ”B” warrants, primarily the TARP-issued ”A” warrants that give us the right to buy BAC stock in 2019 for around $13 per share. The ”B” warrants are convertible to BAC stock in late 2018 for $30.79.
The BAC post-crisis turnaround has been spectacular and we support their cost cutting strategy and technology-driven vision. We believed our timing for investing was conservative, and well past the uncertainty issues that had kept the stock depressed for so long: settling of government fines, passing stress tests, interest rate fears, etc.
Recent improvements and progress aside, the market is concerned about the bank’s exposure to oil and gas loans, and the potential spill-over into other industries. On the most recent call management highlighted that direct oil and gas exposure was about 2% of total loans. Of course the ultimate carnage is unknown, and the market is not waiting around to find out. However the bank is mega over-capitalized, and at this point we feel the worst-case scenario is an overly aggressive bad loan reserve build, that reduces medium term earnings. BAC stock now trades for a 15% discount to its liquidation value of $15.62 per share.
I encourage any reader interested in BAC’s progress to read the most recent earnings presentation to get a better perspective: BAC Q4 Earnings Presentation January 19, 2016 Thank you for your support.