Stanphyl Capital Management letter to investors for the month ended February 29, 2016.
Friends and Fellow Investors:
For February 2016 the Stanphyl Capital was down approximately 8.6% net of all fees and expenses. By way of comparison, the S&P 500 was down approximately 0.1% while the Russell 2000 was unchanged. Year to date the fund is down approximately 0.2% net while the S&P 500 is down approximately 5.1% and the Russell 2000 is down approximately 8.8%. Since inception on June 1, 2011 the fund is up approximately 73.0% net while the S&P 500 is up approximately 59.1% 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.
Value Partners Asia ex-Japan Equity Fund has delivered a 60.7% return since its inception three years ago. In comparison, the MSCI All Counties Asia (ex-Japan) index has returned just 34% over the same period. The fund, which targets what it calls the best-in-class companies in "growth-like" areas of the market, such as information technology and Read More
Stanphyl Capital – Market commentary
February was a hellish month that unwound all the great gains we made in January. Here’s what happened and why I think we’re positioned corrrectly going forward…
- The yen soared against the dollar (we’ve been steadily long USD/JPY via the YCS ETF since early 2012) in what I believe was a short-term carry-trade unwind within a massive long-term downtrend as the Bank of Japan continues to print nearly 30% of its monetary base per year. Thus, this month I added to the position @ around USD/JPY 112 (it’s in the 112s as I write this) as I believe the yen could as easily be the cause of the next major financial crisis as its beneficiary, with an increasingly desperate BOJ likely to either declare the trillions of dollars of debt it bought to be “retired” or attempt “helicopter money” (i.e., printing yen and handing it out to the citizenry), either of which would be disastrous for the currency. In fact, this month even a partial advocate of the BOJ’s crazy policies said he now expects to see Japanese hyperinflation.
- We had large, low-volume moves down in several of our deep-value microcap long positions, most egregiously LTRX, BWEN and ELON after they reported lousy—but not entirely unexpected—quarters. These companies—and many of our other long positions, all discussed in detail later in this letter– are turnaround candidates that we were able to buy extremely cheaply on an EV-to-revenue basis because few investors care about them until after they’ve turned around, and yet while we wait these kinds of companies often drift lower. However, by being “early” (admittedly– and unavoidably for this strategy– sometimes too early) we typically own them for a lot less than we’d have to pay “in size” once they start moving up. I expect that eventually many of these positions will return two or three times our investment, thereby more than compensating for any that might lose us money.
- Perhaps surprisingly, despite the market’s huge rally in the latter half of February our large short positions in SPY, IWM and TSLA were collectively roughly flat on the month as the market essentially just made a big round trip from the end of January. Meanwhile, I haven’t reduced these positions at all because…
…I believe the broad market is now even more overvalued within the context of declining earnings and revenue…
…which I expect to further decline as both the US and the world enter recessions. To quantify this, Q4 S&P 500 GAAP earnings came in at an annualized run-rate of just $77 and a 16x multiple on that (generous if earnings stay flat or worsen and yet some “generosity” is probably warranted considering how low interest rates are) would put the S&P 500 all the way down in the 1200s. The fund thus continues to maintain large short positions in SPY, the Russell 2000 (IWM) and what I believe to be the biggest single-company stock bubble, Tesla Motors Inc. (TSLA). Here then are the specifics…
Stanphyl Capital remains short in Tesla
We remain short Tesla Motors (ticker: TSLA; February close: $191.93) which in February reported a horrendous Q4 for 2015, with normalized free cash flow of negative $660 million (-$30 million from operations, $414 million in capex and subtracting the one-time $216 million of cash created by liquidating finished-goods inventory by selling several thousand more cars than the company produced. In fact, the free cash flow number was so bad that in the earnings release the company actually omitted it (after including it in previous ones) and instead substituted several completely nonsensical self-created metrics of its own. Then on the conference call Tesla said that under one of its whacky definitions of “cash flow” it would be cash flow positive for 2016 including the borrowings on its credit line. In other words, Tesla is trying to define “borrowed money” as “cash flow”– just par for the course for this highly deceptive company. But of course when you’re desperately trying to pump up the stock price of a business that (as depicted in the graph below sent to me by a friend) shows negative scale…
…you’re liable to try anything. Meanwhile, Tesla’s rollout of its new Model X has been 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).
Stanphyl Capital – Elon Musk tells GS analyst that he can not understand the Telsa Model X production rate
As a particularly hilarious example of this, here’s an excerpt from the conference call transcript in which Elon Musk essentially tells the analyst from Goldman that he (the analyst) isn’t smart enough to understand the current Model X production rate:
Patrick Archambault – Goldman Sachs & Co.
Can you just tell us, what is the current run rate of Model X production, you know, where we stand today, towards the middle of February? And can we talk a little bit about how you get to the ramp. It sounds 1,000 is the target that would obviously mathematically get you to think about half your production. So, that’s pretty much full ramp, but it seems like that’s a pretty big distance from where you are now. And maybe if we can walk through the pieces that get you there, you know, in terms of training employees, getting the supply base in order, getting some of the quality issues resolved. That would be my first question.
Elon Reeve Musk – Chairman & Chief Executive Officer
I don’t think we want to comment with that level of granularity. Unless people actually understand how production works, they reach incorrect conclusions. We stick to what our projections are, and leave it at that.
In addition to its design, manufacturing and quality problems, 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, the all-new seven seat Mercedes GLS starts at an estimated $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.
A particularly amusing lie from Musk on the conference call was this one:
Elon Reeve Musk – Chairman & Chief Executive Officer
“…Tesla does not advertise. We don’t pay for any endorsements. We do not discount our cars for anyone, including me.”
Earth to Elon Musk: when you make your car $1000 cheaper if you buy it via a referral or $12,5000 cheaper if you trade in a non-electric car or offer a generous lease deal or a $1200 credit towards a home charging installation YOU ARE DISCOUNTING YOUR CAR! Additionally, taxpayers are discounting them for you with massive direct tax credits and subsidies. (And as long as I’m addressing Elon directly, if I may I’d like to take a moment to congratulate you for Tesla having just made Consumer Reports’ coveted “Used Cars to Avoid” list with “much worse than average reliability.” I look forward to your self-congratulatory Tweet!)
Stanphyl Capital – Tesla Motors vs General Motors
Meanwhile, 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—so it will either lose a lot of money on the car (which it’s already doing on a GAAP basis on the S & X) or it will require a base price well into the $40,000s, 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.
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 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, 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, 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, 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.
In summary, TSLA is worth vastly less than its current approximately $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:
Stanphyl Capital – Portfolio Review
As noted earlier in this letter, we also remain short the S&P 500 (via the SPY ETF) and the Russell 2000 (via the IWM ETF) both 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 added a bit this month to our position in RadiSys Corporation (ticker: RSYS; basis: $2.59; February close: $2.58) which in February announced solid Q4 and year-end numbers and guided to a strong 2016. RadiSys recently underwent an extensive cost-cutting restructuring while simultaneously focusing on its high-margin software business, most excitingly to serve wireless carriers’ shift into voice-over-LTE. Although overall gross margin is only a bit over 30%, the margin for the software business (currently around 35% of overall revenue and conservatively guided to grow at least 10% in 2016) is north of 60%. Surprisingly, the company is also now guiding to modest 2016 growth in its legacy embedded products business (which previously had been in gradual decline) and overall non-GAAP EPS at a midpoint of around .25/share. Additionally, the company is cash flow positive and has around .25/share in net cash (corrected for a single project temporary drawdown) and minimal tax liability “forever,” with $170 million in federal NOLs, $90 million in state NOLs and a $17 million tax credit. We bought RadiSys at an enterprise value of less than 0.5x estimated 2016 revenue before putting any value on those massive NOLs, and I think the break-up value here (assuming 0.75x $130 million in annual revenue for the embedded products business and 2.5x $60 million in revenue for the software business) is roughly $7/share.
I added this month to our position in wind tower manufacturer Broadwind Energy (ticker: BWEN; basis: $2.03; February close: $1.83) after it reported a disastrous Q4 along with a disappointing full-year 2015. However, the conference call provided a much more positive outlook and with Congress having renewed the Production Tax Credit late in 2015 with a gradual phase-out into the early 2020s (including project completion times), beginning in Q2 and going forward I think Broadwind can average 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 break-even for the gearing division (and without assuming any of the $8 million in annual cost reductions promised on the call); a 5x multiple on that EBITDA plus the existing $10 million in net cash would value the stock at around $6/share. In addition, the company has over $200 million (!) in NOLs; if they’re worth, say, $20 million on an NPV basis that equals an additional $1.30/share. Broadwind still needs to appoint a CEO to replace the one who was fired– the CFO is temporarily serving in that position—but with the wind now at its back (no pun intended), I think it can begin announcing some very significant orders and the stock should move accordingly.
Stanphyl Capital continue to own MRV Communications Inc. (ticker: MRVC; basis; $11.66; February close: $12.10), 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 $42 million in cash (including a February-announced favorable $4.8 million adjustment in funds received for the recent sale of a division) and $380 million (!) of NOL carry-forwards (combined federal, state & foreign) for which we paid well under 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 in February to our position in MGC Diagnostics (ticker: MGCD; basis: $6.13; February close: $6.88) which in December 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.
We continue to own Echelon Corp. (Ticker: ELON; basis: $6.06; February close: $5.33), an “industrial internet of things” networking company now primarily focusing its growth on “smart” commercial & municipal LED lighting, as its fab-less chip business has long been in gradual decline. Although in February the company presented a somewhat disappointing year-end report, guiding to an uptick in burn for the first half of 2016 as Enel—its single largest customer—goes away after Q1, its lighting business has grown extremely quickly with just a part-time sales staff and the plan for 2016 is to upsize that staff considerably. If the company pulls that off I think it can hit break-even by late 2017 at which point—assuming a $40 million revenue run-rate, $20 million of remaining net cash (vs. $26 million today) and 4.4 million shares outstanding, at the current share price of $5.33 it’s a 57% gross margin company selling at an enterprise value of just 0.08x that anticipated late-2017 revenue run-rate; meanwhile it currently has a negative enterprise value. Additionally, Echelon has roughly $240 million in NOLs which are worth tens of millions of dollars if it can utilize them. So if it can pull this off (and theoretically, the market for the networking of commercial and municipal LED lighting should be huge between the U.S. and Europe), this stock can be an incredible home run for us.
This month Stanphyl Capital added a bit to our position in Lantronix, Inc. (ticker: LTRX; basis: $1.52; February close: $0.83) which in February reported a quarter down somewhat on revenue but with minimal cash burn and, most importantly, a brand new management team consisting of a new and accomplished CEO with a turnaround plan that seems to make sense (I met with him in February), a new Chief Technology Officer and a new VP of Sales. With $38 million of annual run-rate revenue and $3.1 million in projected net cash at the end of the current (March 31) quarter (four years of normalized burn even assuming no improvement) and 15.23 million shares outstanding, at 0.83/share this is a 48% gross margin company selling for only around 0.25x revenue with approximately $90 million of federal NOLs and $30 million of state NOLs. So an acquisition price of just 1x revenue plus the net cash plus a few million bucks for the
NOLs (heavily discounted for the change-in-control limitations) would value Lantronix at over $3/share. Although this is by far the worst-performing stock the fund has ever bought, I think it’s worth holding for the reasons noted above and apparently several of the company’s board members agree with me as they recently bought stock in the open market.
Stanphyl Capital continue to own Data I/O Corporation (ticker: DAIO; basis: $2.43; February close: $2.27)– a maker of custom flash programming machines used in a variety of industries– which in February reported a decent 2015 Q4, with year-over-year revenue down a bit due to currency translation but EPS and EBITDA flat. Assuming approximately $10 million in net cash (adjusted for an unusually high reduction in Q4 A/R) and .12/share in EPS, $1.4 million in EBITDA, $20 million in revenue and 7.95 million shares, at $2.27/share this 52% gross margin company is selling for an enterprise value of only around 0.4x revenue and 5.5x EBITDA, and a bit over 8x earnings net of its cash. (DAIO also has approximately $20 million in NOLs, although a chunk of those would be used to repatriate the $6 million of cash held overseas.) Equally important is that due to the cost of being independent this is a natural acquisition candidate, and the elimination of $1.5 million in “independent public company costs” would roughly double the company’s EBITDA.
We continue to be long natural gas via the US 12-month Natural Gas ETF (ticker: UNL; basis: $9.50; February close: $7.965), which equal-weights each of the next twelve monthly natural gas contracts, thereby minimizing short-term volatility/weather effects. An unusually warm winter drove gas prices down far below its replacement cost (inclusive of drilling expenses) while the number of drilling rigs are at a record low and yet underlying demand ex-weather appears to be increasing. So far this has been a loser for us but I think it makes sense to be patient here.
Stanphyl Capital sold our Sangoma Technologies (ticker: STC in Canada) in February after it reported seemingly impressive revenue growth which on closer examination came entirely from currency translation and acquisitions, implying a worse-than-expected decline in its legacy business combined with inadequate growth from the acquisitions. In this (or any) environment, I don’t want to own a company (no matter how cheap it is on a run-rate basis) with a deteriorating underlying business and an inadequate turnaround plan with no net cash on the balance sheet, so I sold it.
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,