Value Investing

Stanphyl Capital December 2015 Letter To Investors – Short Tesla Motors

Stanphyl Capital letter to investors for the month ended December 31, 2015.

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Friends and Fellow Investors:

For December 2015 the Stanphyl Capital fund was down approximately 1.6% net of all fees and expenses. By way of comparison, the S&P 500 was down approximately 1.6% while the Russell 2000 was down approximately 5.0%. For the full year 2015 the fund was down approximately 11.1% net while the S&P 500 was up approximately 1.4% and the Russell 2000 was down approximately 4.4%. Since inception on June 1, 2011 the fund is up approximately 73.4% net while the S&P 500 is up approximately 67.6% and the Russell 2000 is up approximately 42.8%. (The S&P and Russell performances are based on their

“Total Returns” indices which include reinvested dividends.) As always, investors will receive the Stanphyl Capital fund’s exact performance figures from its outside administrator within a week or two.

By several key metrics the broad market is now even more overvalued that it was at the peaks of 2000 and 2007…

Stanphyl Capital
Stanphyl Capital

…while Q4 S&P 500 earnings are expected to decline significantly year-over-year:

Stanphyl Capital
Stanphyl Capital

Stanphyl Capital's portfolio holdings

The Stanphyl Capital fund thus remains broadly hedged with significant short positions in the S&P 500 (SPY) and Russell 2000 (IWM), as well as (to our detriment this month) in the biggest equity bubble I can find, Tesla Motors Inc. (TSLA). Meanwhile I continue to buy, hold and add to interesting and inexpensive microcap long positions that I believe have considerable upside potential, many of which were down a bit this month due—I believe—to year-end tax-loss selling, as although I’ve bought these companies at prices well off their highs, others haven’t been as fortunate and have thus likely been booking some losses. Here then are the specifics…

New to the fund this month is a position in MRV Communications Inc. (ticker: MRVC; basis; $12.23; December close: $12.22), a pure-play optical networking company that just completed the sale of a low-margin network integration division. So this is now a roughly break-even, debt-free company with $92 million of 53% gross margin revenue (on an annualized run-rate basis) growing 5% a year with $37 million in cash and $380 million (!) of NOL carry-forwards (combined federal, state & foreign) for which we paid only a bit over 0.5x revenue on an EV basis (attributing no value to the NOLs), and I think it’s a potential buyout candidate at a multiple of several times that. In fact an activist tech investor (Raging Capital Management) recently upped its stake to over 30% of the company, and with MRV’s board chairman also being a partner at Raging Capital I think some shareholder-friendly actions could take place in the relatively near future.

Also “new” to the Stanphyl Capital fund this month is a position in Broadwind Energy (ticker: BWEN; basis: $2.09; December close: $2.08), whose primary business is manufacturing towers for the wind industry. We made a lot of money on Broadwind back in 2013 and now with Congress having renewed the Production Tax Credit with a gradual phase-out into the early 2020s (including project completion times), I think this company can do around $16 million in EBITDA for each of the next seven or so years, based on the $24 million the wind division did back in 2013 and then subtracting $7 million for corporate overhead, $1 million for stock-comp and assuming that the gearing division is EBITDA-neutral; a 5x multiple on that number would make BWEN a $5+ stock. One hitch is that the company needs to hire a new CEO, as the previous one was recently terminated for not fixing a series of production snags. (The CFO is temporarily serving in that position.) However, with the wind now at Broadwind’s back (no pun intended), I think it can begin announcing some very significant orders and the stock should move accordingly.

I added a bit this month to our position in RadiSys Corporation (ticker: RSYS; basis: $2.60; December close: $2.77) which in October reported a solid Q3 and gave excellent guidance for Q4 and—in general terms-- 2016. RadiSys recently underwent an extensive cost-cutting restructuring while simultaneously rapidly growing its high-margin software business, most excitingly to serve wireless carriers’ shift into voice-over-LTE. Although overall gross margin is only around 30%, the margin on the fast-growing software business (currently around 35% of overall revenue and showing 30%+ annual growth) is around 59% and should be well north of 60% next year. This "hidden growth" doesn't show up in the company’s overall revenue because RadiSys is deliberately allowing sales of its low-margin legacy products to decline, and once the market better understands this I think the stock can climb substantially. Perhaps most interestingly, the company has minimal (only a small amount of overseas) tax liability “forever,” as it has $170 million in federal NOLs, $90 million in state NOLs and a $17 million tax credit. Meanwhile, it’s cash-flow positive (with some quarterly fluctuation) and has over .20/share in net cash, and we bought it at an enterprise value of less than 0.5x estimated 2015 revenue before putting any value on those massive NOLs. Apparently the insiders think the stock is cheap too, as in August they bought a lot of it.

I added this month to our position in Echelon Corp. (Ticker: ELON; basis [following December’s 1:10 reverse split]: $6.16; December close: $5.64), an “industrial internet of things” networking company (now primarily focused on “smart” commercial LED lighting) that has been in a long decline, with a slowly eroding fab-less chip business and a stock price down roughly 98% (!) from its 2007 peak. We bought this $40 million revenue, 56% gross margin company for almost nothing, as its roughly $25 million in net cash is only a couple of million dollars below its market cap. The catch of course is that it’s burning that cash-- currently at a rate of around $4 million a year-- but with extensive restructuring and extremely fast growth in its nascent LED networking business, it looks as if it’s on a path to being cash-flow break in perhaps two years. If it gets there on $48 million of revenue with $19 million of remaining cash, at a strategic acquisition price of 1.5x revenue plus a reasonable value for its nearly $240 million of NOLs it would be worth over $20/share. If it doesn’t get there but cuts the burn enough to be profitable for a strategic acquirer (say, down to $1 million a year but with an additional $4 million of potential cost eliminations), it should still be worth around $10/share, as I think there would be some buyer out there who would pay 0.5x-0.75x revenue plus the remaining cash plus something for the NOLs for a $40 million/year, high gross margin business. I know there are some big “ifs” behind these numbers but considering that the cash in the bank gives the company at least six years to get to break-even, I think it’s an interesting proposition.

I added a bit this month to our position in Lantronix, Inc. (ticker: LTRX; basis: $1.58; December close: $1.13) after it hired a new and accomplished CEO. In October Lantronix reported an encouraging Q1 for FY 2016, finally halting its decline in quarterly sequential revenue and running roughly break-even on an EBITDA and cash-flow basis (with the latter adjusted for working capital fluctuations). With $42 million of annual run-rate revenue and $4 million in net cash and 15.1 million shares, at 1.13/share this is a 48% gross margin company selling for a bit over 0.3x revenue, and additionally, Lantronix has a massive $88 million of federal NOLs and $30 million of state NOLs. So an acquisition price of just 1x revenue plus the net cash plus something for the NOLs (even heavily discounted for the change-in-control limitations) would value Lantronix at over $3/share. I thus think this is worth holding as sort of a “non-expiring call option” on either a business turnaround or a sale of the company, and apparently the insiders agree (even the subsequently ousted CEO!) because in August they bought a lot of stock on the open market.

We continue to own MGC Diagnostics (ticker: MGCD; blended basis: $5.86; December close: $6.60) which in September reported a terrific fiscal third quarter, showing year over year organic revenue growth of 18% and overall growth of 39%, while losses from its Medisoft acquisition were slashed drastically and that division should be profitable by year-end. Thanks to its 53% normalized gross margin and potential for large SG&A eliminations, I think MGCD should be sell-able (hopefully in 2016) to a strategic buyer at a significant premium to the current price; for example, an enterprise value of 1.5x revenue would be roughly $13/share. MGCD reports its fiscal fourth quarter and year-end numbers in early January, and as Q4 is its seasonally strongest those numbers should be solid.

We continue to own Sangoma Technologies (ticker: STC in Canada; basis: CAD 0.303; December close: CAD 0.26) which in November reported very promising results for its fiscal first quarter ending September 30th (its seasonally weakest), with year-over-year revenue growth of 70% and a 71% gross margin. Although most of that growth came from recent acquisitions, it seems that organic/synergistic year-over-year growth was nearly 20%, which is still terrific. So with 32.5 million shares outstanding and around $21 million of annualized revenue and $2 million in EBITDA (and also assuming $400,000 in cash net of an acquisition earn-out contingency and a tax credit receivable), @.26/share the company is selling for less than 0.4x revenue and less than 4x EBITDA, which is extremely cheap for a business with a gross margin of around 70%. And hopefully now that Sangoma’s annualized revenue is topping $20 million it might appear on radar screens as a possible acquisition candidate itself, especially in light of SG&A costs incurred as a standalone public company that would allow EBITDA to instantly jump by at least 50% if it were acquired by a strategic buyer.

Some of you may recall that several months ago I briefly positioned the Stanphyl Capital fund long natural gas (via the UNG ETF) at a spot price of around $2.70, then decided that production wasn’t declining rapidly enough and quickly sold the position, pulling out with minimal damage shortly before gas plunged into the low $2s. Well, in December I decided that production is declining rapidly enough to support higher future prices (which are currently far below the all-in cost of production) and thus got long gas again, this time via the US 12-month Natural Gas ETF (ticker: UNL; basis: $9.50; December close: $9.70), which equal-weights each of the next twelve monthly natural gas contracts, thereby minimizing short-term volatility/weather effects.

We remain short Tesla Motors (ticker: TSLA; December close: $240.01) which in November reported yet another disastrous quarter (Q3), with a record-setting $595 million of negative free cash flow and-- based upon ongoing costs vs. the amount set-aside for newly sold cars-- what looks like a severely inadequate reserve for future warranty expense. (In October Consumer Reports finally acknowledged Tesla’s widely known reliability problems, and it isn’t just Consumer Reports that noticed, while a study released in December was the most damning one yet. ) The big picture issues for Tesla are twofold (note: these links are updated each month): 1) The market is under the mistaken impression that it has significant & sustainable proprietary technology when it doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t and doesn’t in batteries (where even its sole supplier Panasonic is going into direct competition with it both at utility scale and in the home); it doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t , doesn’t and doesn’t in cars (in fact even Mercedes is ending its Tesla relationship and will build multiple direct competitors) and LG can now offer a complete turnkey electric drivetrain to any manufacturer who wants one; it doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t , doesn’t, doesn’t, doesn’t and doesn’t in autonomous driving (for example the new Mercedes E-Class—out this spring— has 23 sensors for autonomous driving vs. just 14 for Tesla and the CEO of Mobileye—Tesla’s autonomous driving technology supplier— recently said the hardware on the current Model S is inadequate for true autonomy while even the new $30,000 50+ mpg Prius has auto-pilot and self-parking); and it doesn’t , doesn’t and doesn’t in charging (Tesla has spent only around $175 million on its much-touted Supercharger network, a rounding error for the upcoming charging consortiums of big auto makers), and 2) The company’s management tells deception after deception after deception after deception after deception after deception after deception. Meanwhile, in June Tesla’s CFO "retired" at age 52 and dumped nearly all his stock (they finally found a successor for him in November) while the VP of Sales & Service was also just replaced (with the previous one dumping his stock on the way out) and the (so far not leaving) VP of Manufacturing has sold almost everything. Even the Chief Technology Officer-- the only remaining original C-level exec (besides Musk)-- is steadily dumping, as is Musk’s own brother. And despite encumbering nearly all its assets with a senior credit line and then doing an August follow-on stock offering, Tesla is on schedule to be out of cash by some time in 2016, thus making yet another near-term major capital raise inevitable. Meanwhile, in November Tesla finally revealed the pricing for its long-delayed Model X crossover/SUV, and its $5000-$7000 premium to a comparable Model S sedan will be a huge sales-limiting factor, as nearly all of the luxury competition prices its premium SUVs considerably lower than its premium sedans. (The most basic “X” with no options and only 220 miles of range starts at $81,000 with only five seats standard; by comparison, a seven-seat Mercedes GL starts at $67,000.) TSLA is worth vastly less than its current roughly $35 billion fully diluted enterprise value and—thanks to over $3 billion of debt plus its credit line—may eventually be worth “zero.” Meanwhile, here’s one chart that tells you all you need to know about this taxpayer-subsidized, Musk vanity project of a company:

Stanphyl Capital
Stanphyl Capital

We remain short the Russell 2000 small-cap stock index ETF (ticker: IWM; short basis: $114.15; December close: $112.62), both because it’s the most overpriced of all the broad-market indices with a current trailing PE over 100 and because I think it can serve as somewhat of a hedge for our deep-value microcap long positions. We’re also short the S&P 500 (to which I added a bit this month) via its ETF (ticker: SPY; short basis: $208.91; November close: $203.87) as multi-year lows in key commodity indexes (due to both a profit-crunching strong dollar and slack demand) and a plunge in world shipping prices tell me that this multi-national and expensive index may be in for a significant decline of its own.

We continue to be “short the Japanese financial system” with both a yen short (via a long position in the ProShares UltraShort Yen ETF; ticker: YCS; November close: $87.89) and a 10-year government bond short (via a long position in the “Powershares DB 3x Inverse Japanese Government Bond ETN”; ticker: JGBD; basis: $16.23; November close: $14.52). Japan is currently printing yen at a rate that increases its monetary base by 30% a year and is thus inching ever closer to monetary disaster as it remains stuck in a “catch-22” with far too much government debt (approximately 245% of GDP) to allow its interest rates to climb and yet that debt continues to increase. In its desperate attempt to simultaneously suppress those rates while raising the price level enough to inflate the debt away, the Bank of Japan’s yen-printing will send that currency into a death spiral, with massive recent losses in the nation’s largest pension fund providing even more incentive to keep printing. Here’s what an out-of-control central bank balance sheet looks like:

Stanphyl Capital
Stanphyl Capital

In line with our yen short we continue to hold our aforementioned JGBD position, which may show an “interesting twist” in January. I originally bought—and continue to hold—this position because with Japan’s 10-year bond yielding approximately 27bp, I think it’s one of the most favorably asymmetrical trades in the world. Who in his right mind would lend money for ten years at 0.27% a year to the most indebted country in modern history while that country is simultaneously printing 80 trillion yen annually? As traditional holders continue to depart, these bonds will increasingly be in the hands of either the money-printing BOJ (hence the yen short discussed above) or holders who won’t hesitate to “rush for the exit” at the slightest whiff of the huge inflation spike that the government is on the path to creating. And to those who say “Yes, that sounds logical, but people have been saying that for 20 years,”

I say that never before has the Japanese debt load been this high and never before has the bond been priced this close to “zero;” in other words, the beauty of this position is how little we can lose. Now here’s the “interesting twist”: JGBD is an ETN (not an ETF) that’s essentially a senior unsecured credit obligation of Deutsche Bank, and on the night before Thanksgiving Deutsche snuck in an announcement that beginning on January 1-- perhaps in an attempt to reduce its balance sheet-- it would no longer create additional units of JGBD. When this has happened in the past with other ETNs, due to a shortage of new units they’ve often soared much higher than their underlying value; if that happens here it may present an intriguing selling opportunity.

Finally, as usual the Stanphyl Capital fund has a long list of companies I‘d like us to own, but-- as always-- only at the right price. And meanwhile, nothing is more important to me than getting Stanphyl back above its high-water mark and again demonstrating performance commensurate with that of the many years (first personally and then after founding Stanphyl) prior to the most recent two, and I think we have a portfolio that will get us there and further.

Thanks and regards,

Mark Spiegel

Stanphyl Capital

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