Denali Investors letter to investors for the second quarter ended June 30, 2016.
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During the second quarter, our portfolio did not perform in a challenging environment. Our performance is attributable to a number of our positions simply not working during this window. The market experienced significant volatility which impacted both our names and the market more broadly.
We have had success in taking advantage of opportunities created by volatile markets. We remained consistent to our process throughout and acted quickly to capture new opportunities. We were able add to existing positions and initiate new ones including CIT Group (CIT) and Fiesta Restaurant Group (FRGI), among others. The special situations pipeline for 2016 remains robust and continues to expand. Our portfolio contains numerous specific and understandable catalysts with attractive risk/return profiles.
Select Portfolio Positions
CIT Group Inc. (CIT, “CIT”) – CIT, a mid-market commercial bank, is at an interesting juncture that we believe will unlock significant value. The company expects to complete a sale or spinoff of the aircraft leasing business C2 Aviation Capital (CTWO) by the end of the year. The new management team has stated the separation is the number one priority. The initial spinoff filing was submitted at the end of June.
Importantly, there is a dual track process underway. A sale of CTWO would be a positive outcome and there are numerous interested parties with discussions already taking place. Interestingly, aircraft leasing comparables trade at approximately 1x book value and CTWO has a book value of approximately $3b. CIT itself is currently valued at 0.6x book value and 0.7x tangible book value. Due to substantial NOLs, there would be no tax leakage on a sale, which would accelerate the present value of the NOLs. With the tax advantaged proceeds, management has indicated a strong desire to return capital to shareholders. This would likely take the form of an outsized buyback. The potential buyback of $3b on the $7b market capitalization is meaningful. Assuming a successful modified dutch tender offer at the current share price, 43% of shares outstanding would be bought in and the pro forma book value per share would rise to approximately $70.
Importantly, but of less magnitude, CIT expects to complete the sale of the Canada and China platforms by year-end. The next update will be provided on the upcoming earnings call later in July. We believe that, given the spinoff not occurring until the fourth quarter and uncertainty about whether a sale will materialize, the market is not appreciating the potential upside that results from either outcome.
Fiesta Restaurant Group (FRGI, “Fiesta”) – FRGI announced in the spring of 2016 that the company would spinoff Taco Cabana (“TC”) and rename the parent to Pollo Tropical (“PT”). FRGI was originally a spinoff by Carrols Restaurant Group (TAST) from May 2012. We were investors during the 2012 spinoff and had followed the TAST since 2006 when the company returned to the public markets.
On the spinoff, FRGI was given a high growth multiple by the market of as high as 20x EBITDA in 2015 based on the expected growth assumptions. Although PT still achieved ~20% unit growth, the high growth expectations did not satisfy the market. In addition, the growth of PT is obscured by the TC concept, which can be characterized as low growth but a cash cow. During the second quarter, FRGI fell to a valuation of approximately 7x EBITDA, which drew our attention. At this valuation, we believe that TC, worth approximately $12 to $18 per share, is being created for free.
Beneficially, both TC (Texas based) and PT (Florida based) have cult like followings. PT has 161 company-owned and 31 franchised units, with $2.6m AUV and 16% EBITDA margins. TC has 162 company-owned and 4 franchised units, with $1.9m AUV and 13% EBITDA margins. We believe the both PT and TC will rerate higher upon the spinoff. The market should assign a more appropriate multiple on high growth PT concept and a higher multiple on the cash flow from TC. Interestingly, Net Debt is less than one turn at only $70m. The true cash flow generation has been hidden due to reinvestment into the PT expansion. If the company were to decide to reduce the growth profile, the embedded free cash flow would increase dramatically. Given these characteristics, we believe FRGI could be prime target for either a financial or strategic acquirer.
Liberty Global PLC LiLAC (LILA/LILAB/LILAK, “LILA”) – We previously discussed LILA in the Q3 2015 letter. LILA was the largest detractor of performance during the second quarter. At the end of June, Liberty Global (LBTYA) distributed the 67% stake in LILA. This distribution, in large part, caused the price of LILA to fall ahead of time in anticipation of the expected selling pressure on the order of a 25% drawdown. Usually, the selling pressure occurs after the distribution. In contrast to the atypical pre-distribution activity, LILA has performed well post distribution and recovered most of the price during July.
Operationally, LILA was transformed during the second quarter with the completion of the CWC/Columbus transaction. The pro forma company is at ~7x EBITDA valuation which we believe is a low multiple for a high growth business at the beginning of its consolidation opportunity.
Denali Investors LLC
Denali Investors = Value + Special Situations + Hedges
H. Kevin Byun founded Denali Investors in 2007. The firm employs an opportunistic special situations and value-oriented framework. Denali seeks to identify catalyst driven situations that will unlock value and produce market agnostic returns. Mr. Byun has a triple major from Rice University and an MBA from Columbia Business School.
Value + Special Situations (Catalysts): Denali seeks to identify value-oriented and special situation investment opportunities at substantial discounts with definable catalysts or by being the catalyst through proactive methods. Our special situations focus and experience has generated outstanding market agnostic returns.
Fundamental Research + Analysis: Denali’s research and analysis have consistently produced a high rate of success. Our investment process uses a combination of thematic and rigorous fundamental research on individual companies and catalyst driven situations.
Portfolio Construction + Risk Management: Denali invests in only its highest conviction ideas. Concentration into 5 – 15 very attractive, non-market correlated investments is an advantage. Our opportunistic style of investing allows the firm to select investments with highly favorable risk-reward profiles. We structure the portfolio to have favorable asymmetric characteristics that we believe will provide substantial upside yet preserve capital in a downturn.
Flexible & Opportunistic Mandate: Denali has a flexible mandate that allows the firm to look at opportunities across the spectrum. Unlike other funds that are designed to fit into a limited ‘style box,’ we are opportunistic generalists focused on special situations. Our flexible approach has resulted in numerous outstanding investments.
Net Cash = Fortress: Cash is a valuable strategic asset. Our cash has typically averaged 20% to 35%. Cash remains the default in the absence of greater opportunities.