Mark Spiegel’s Stanphyl Capital letter for the month ended January 31st, 2016.
Friends and Fellow Investors:
For January and year-to-date 2016 the Stanphyl Capital was up approximately 9.1% net of all fees and expenses. By way of comparison, the S&P 500 was down approximately 5.0% while the Russell 2000 was down approximately 8.8%. Since inception on June 1, 2011 the fund is up approximately 89.2% net while the S&P 500 is up approximately 59.3% and the Russell 2000 is up approximately 30.2%. (The S&P and Russell performances are based on their “Total Returns” indices which include reinvested dividends.) As always, investors will receive the fund’s exact performance figures from its outside administrator within a week or two.
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Believing the broad market to be extremely overvalued within the context of declining earnings…
…which I expect to further decline as the world enters a recession…
…we came into January with very large short positions in the S&P 500 (SPY), Russell 2000 (IWM) and what I believe to be the biggest single-company stock bubble, Tesla Motors Inc. (TSLA). The fund was up in January’s downdraft because these shorts went down more than our longs did, and some of our longs even went up. Here are the specifics…
Stanphyl Capital Remains Short On Tesla Motors
We remain short Tesla Motors (ticker: TSLA; January close: $191.20) for myriad reasons. In January General Motors formally introduced its new Bolt EV which offers true five-passenger seating, a range of over 200 miles and a 0-60 time of under 7 seconds for HALF the price of the least expensive Tesla while matching its interior passenger space (albeit with less storage). Seeing as studies show that 15% of Tesla buyers come from a Prius and many others come from other inexpensive “eco-favorable” cars, I expect the Bolt to grab back a significant number of them—what I call the “stretch buyers” who paid up for a Tesla because they wanted an electric car with 200-miles of range; those people can instead now choose the much less expensive/easier to park Bolt which will be available late this year, a year before Tesla CLAIMS its “Model 3” will be available and—realistically—at least two years before it will REALLY be available. Additionally, as I pointed out two years ago and another Seeking Alpha author pointed out recently, there’s no way Tesla will be able to profitably sell its “mass market” car at the $35,000 (pre-tax credit) price it has claimed—a base price well into the $40,000s seems much more realistic, which would automatically make it much less “mass market.” Perhaps the most interesting thing about the Bolt is that its 60kWh battery pack (made by LG) weighs just 960 pounds while the 60kWh Tesla pack (when it was offered) weighed 1125 pounds, a significant disadvantage for Tesla. Even if the Tesla pack’s housing was somewhat handicapped by needing to be large enough for the 85/90kWh models and thus as a 60kWh “pureplay” its weight might be closer to the Bolt’s, the Bolt’s energy density-per-pound at the pack level seems to show that the assembly, housing and cooling complications of
Tesla’s method of wiring together many thousands of separate Panasonic cylindrical batteries vs. Chevrolet/LG’s much simpler use of just 288 prismatic cells makes Tesla’s first-to-market approach obsolete. As de facto proof of this, every manufacturer currently developing an EV has the option of using Tesla’s “thousands of cells” approach yet (as far as I know) none of them are; it thus seems clear that large-format prismatic batteries—not available with sufficient energy density at an attractive price when the Tesla Models S&X were designed—are now the superior approach and thus may render Tesla’s Gigafactory obsolete even before it opens.
Meanwhile, Tesla’s rollout of its new Model X is shaping up to be a disaster, with various enthusiast forums reporting myriad problems with its “falcon-wing” doors, seats and general build quality, as well as a very low confirmation rate for the refundable “orders” the company claims to have. And those orders that do exist are being delivered in ultra-slow motion as Tesla—which despite years of delays clearly did inadequate Model X testing—attempts to fix the vehicle’s problems (although of course its massive size problem is unfixable). In addition to these design and build-quality issues, the X’s $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 less expensively than its premium sedans. For instance, the most basic “X” with no options and only 220 miles of range (and unavailable until late this year) starts at $81,000 with only five seats standard; by comparison, a seven seat Mercedes GL starts at $65,000, a five-seat Porsche Cayenne at $58,000, a BMW X5 at $55,000 and the beautiful new (and award-winning) Volvo XC-90 at just $44,000.
In February Tesla reports its year-end financials and I expect Q4 free cash flow to have again been hugely negative, albeit somewhat improved from Q3 due to heavily discounted inventory liquidation in China (and thus at terrible gross margins even by Tesla’s phony metric which excludes engineering costs) and a one-time sales rush to beat an expiring tax incentive in Denmark. I thus expect Tesla to deliver 15,000 or fewer cars in Q1—at least a 14% sequential decline for this alleged “hyper-growth” company. Meanwhile in November Tesla reported a disastrous 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 monthly): 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, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t , doesn’t and doesn’t in cars (in fact LG now offers a complete turnkey electric drivetrain to any manufacturer who wants one) and many of these EVs will be sold at or below cost (subsidized by the profits from their makers’ conventional cars), thereby creating intense pricing/margin pressure on Tesla; it doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t, doesn’t and doesn’t in car batteries (where even its sole supplier Panasonic is going into direct competition with it via a factory unrelated to Tesla’s still 90% unfunded Gigafactory); 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 storage batteries (where its supplier Panasonic is going into direct competition with it both at utility scale and in the home) and the Tesla PowerWall has no business model anyway; 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 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 recently 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 some time in 2016, thus making yet another near-term major capital raise inevitable. TSLA is worth vastly less than its current roughly $31 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:
As noted at the beginning of this letter, we remain short the S&P 500 (via the SPY ETF) and the Russell 2000 (via the IWM ETF) for fundamental reasons (overvaluation in the context of declining earnings) and as somewhat of a hedge against our extensive long positions. And now for those longs…
Stanphyl Capital’s Long Position In Radisys Corporation
I added in January to our position in RadiSys Corporation (ticker: RSYS; basis: $2.59; January close: $2.70) which in January pre-announced terrific Q4 numbers (with the full report coming in February). 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 recently showing 35%+ annual growth) should be well north of 60% this 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 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.
Stanphyl Capital New Positions: MGC Diagnostics, Broadwind Energy, MRV Communications & Echelon Corp
I added in January to our position in MGC Diagnostics (ticker: MGCD; basis: $5.99; January close: $6.86) after it reported a terrific fiscal fourth quarter and fiscal-year 2015, showing full-year revenue growth of 24.9% and Q4 year-over-year growth of 9.3%, while losses from its Medisoft acquisition were again cut significantly and that division should be profitable this year. Thanks to its 52% gross margin and potential for large SG&A eliminations, I think MGCD should be sell-able to a strategic buyer at a significant premium to the current price; for example, an enterprise value of 1.5x estimated 2016 revenue would be roughly $14/share.
I added in January to our position in Broadwind Energy (ticker: BWEN; basis: $2.08; January close: $2.237), whose primary business is manufacturing towers for the wind industry. We made a lot of money on Broadwind buying it in 2012 and selling it 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 in January to our position in MRV Communications Inc. (ticker: MRVC; basis; $11.66; January close: $11.60), a pure-play optical networking company that recently completed the sale of a low-margin network integration division. This is now a roughly break-even, debt-free company with $92 million of 50% 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 less than 0.5x revenue on an EV basis (attributing no value to the NOLs). I think it’s a potential buyout candidate at a multiple of several times that, and in fact when presenting at January’s Needham investment conference the CEO said outright that the company is too small to remain independent. As activist tech investor Raging Capital Management recently upped its stake to over 30% 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.
I added a bit in January to our position in Echelon Corp. (Ticker: ELON; basis: $6.06; January close: $5.98), 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.
Stanphyl Capital’s Continued Positions
We continue to own Lantronix, Inc. (ticker: LTRX; basis: $1.58; January close: $1.17) which in December 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 outstanding, at 1.17/share this is a 48% gross margin company selling for a bit over 0.3x revenue with $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.
New to the fund this month is a position in Data I/O Corporation (ticker: DAIO; basis: $2.43; January close: $2.18). This is a high gross margin (51%) maker of custom flash programming machines used in a variety of industries. The company has $1.13/share in cash (with no debt) and we bought it for approximately 0.45x revenue and 8x EBITDA (on an EV basis). Although that EBITDA metric doesn’t sound “dirt cheap,” this is a small company ($24 million in revenue) that—due to the costs of being independent—is a natural acquisition candidate, and the elimination of $1.5 million in “independent public company costs” would bring our EBITDA purchase multiple under 4x, leaving plenty of room for a much higher takeout price.
We continue to own Sangoma Technologies (ticker: STC in Canada; basis: CAD 0.303; January close: CAD 0.28) 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), @.28/share the company is selling for only a tad over 0.4x revenue and 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.
We continue to be long natural gas via the US 12-month Natural Gas ETF (ticker: UNL; basis: $9.50; January close: $9.56), which equal-weights each of the next twelve monthly natural gas contracts, thereby minimizing short-term volatility/weather effects. An unusually (and unsustainably) warm winter drove gas prices down far below its replacement cost (inclusive of drilling expenses) while underlying demand for gas appears to be increasing.
Stanphyl Capital’s shorting Japanese Yen as well
We remain short (since early 2012) the Japanese yen (via a long position in the ProShares UltraShort Yen ETF (YCS) although in mid-January I closed out our position in the “Powershares DB 3x Inverse Japanese Government Bond ETN” (JGBD) when it didn’t get the bounce I thought it might from the announced non-issuance of new shares while simultaneously becoming increasingly uncertain about the solvency of Deutsche Bank, its sponsor. (If there were a simple alternative way to remain short Japanese sovereign debt without using the Tokyo futures market and the necessary continual contract rollovers I’d do it, especially as in late January the BOJ introduced negative interest rates and drove the 10-year JGB yield down to just 0.1%.) Meanwhile we remain short the yen (a position aided in January by those negative rates) because Japan is currently printing them at a rate that increases its monetary base by nearly 30% a year and I believe 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. So I believe that in its desperate attempt to simultaneously suppress those rates while raising the price level enough to inflate the debt away, the BOJ will send the yen into a death spiral.
Finally, as usual the 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 I think we have a portfolio that can get us there and further.
Thanks and regards,