Greenhaven Road Capital Q2 2016 letter to investors
Dear Fellow Investors
The fund was up just under 6% in the second quarter, which brings YTD performance to just under 3%; this compares favorably to the Russell 2000 return of 2.2% and is approximately 1% below the S&P500, an index with which we have minimal overlap. This letter covers a lot of ground, please sure to read about some operational changes we are making in the housekeeping section near the end. Our results this quarter were aided by the performance of our largest position: the timeshare company Diamond Resorts International, which was discussed in great detail in the last letter. I outlined the possibility of a buyout taking place before management’s options for 5 million shares had to be exercised in July. At the end of June, a private equity firm made an offer to buy the company for a 25% premium.
As part of the investing process, I look at multiple companies each day. To gain access to investing communities such as Sum Zero where dozens of ideas a month are presented, members have to contribute ideas every six months. Since I had already written the thesis for owning Diamond Resorts in the letter, I posted it to Sum Zero to keep my access to the site. I knew that Diamond Resorts and timeshares were controversial, and I knew that there was a high short interest in the stock. I had no idea how unpopular the idea would be to Sum Zero readers. This was an idea that returned almost 50% in less than three months and received an offer to be purchased in the timeframe predicted. If this was an academic exercise, the thesis would garner an A if just evaluated on the outcome. On Sum Zero the idea got a one-star rating from the community out of a possible five – or a virtual F. Eventually the rating rose to a three stars. The idea was also the “most discussed” idea on the site for a week. I learned the hard way that “most discussed” really means that a lot of people engage in a combination of constructive criticism and attack of the idea and the author has to address their concerns. For me the whole episode was a helpful reminder that our investments will often not resonate with the “crowd.” The easy thing to do was to pass on Diamond Resorts and just purchase a popular blue chip company. In the case of Diamond Resorts, passing would have been a mistake.
I realize that, as an investor in Greenhaven Road, you by definition are an independent thinker and willing to step outside of the herd and invest in an emerging manager instead of an index or the largest Fidelity funds. In the case of Greenhaven Road, only time will tell if this was the right decision, but I wanted to thank you for your support and reiterate that I continue to unequivocally believe that being small is a great asset in the investment management world. It gives us flexibility, and a broader opportunity set to consider than big funds. And because asset gathering is not our breadwinner, we have to be laser focused on generating returns. As a smaller emerging manager, just like Diamond Resorts, we may not be popular, but we intend to be highly profitable.
TOP 5 POSITIONS
Careful readers will notice that none of the investments in the top five are new investments. These are all companies that have been discussed in previous letters. As such I will keep this section brief:
Diamond Resorts: The company received an all-cash buyout offer from Apollo Group right before the end of the quarter. There is still a small chance of an “overbid” from a strategic buyer such as Wyndham. On a dayto-day basis, the shares are a proxy for cash, trading within a very narrow range. As a shareholder we have the option to exercise “appraisal rights”. This means that we have a right to have a judge determine if the price paid by Apollo is fair. Several funds were successful in obtaining a higher payout in the Dell private transaction by exercising their appraisal rights. We may pursue this strategy. The deadline to decide is August 10.
Fortress Investment Group: The thesis remains the same: the market is undervaluing the quality of the management fees and ignoring the cash and investments on the balance sheet. This year the company tendered for shares and paid a “top off” dividend of more than 4%. The largest shareholders are the employees. The setup remains constructive on this sub-$5 stock; with more than $3.50 in cash, investments, and embedded incentive fees, there is significant downside protection. There is also a stable base of $70B in fee-paying assets. There have been headwinds in the price performance of permanent capital vehicles, which have made raising additional capital a challenge. This investment continues to appreciate materially.
Halogen Software: There have been no major developments since the last quarterly letter. I have heard anecdotally of both customer wins and losses. There remain multiple ways to “win” here, with the most likely being the sale to a payroll company. Insider ownership remains high at more than 40%, the valuation on an Enterprise to Revenue basis is less than 2, which implies a business in decline. The company is experiencing double-digit growth and has a new CEO with reasonable and promising customer retention and growth strategies. Time will tell with this unloved Canadian technology company, but the risk/reward remains compelling.
Radisys: We have owned Radisys since the first quarter of 2015. It began as a smaller position as there was uncertainty as to the future of the company. The company operates in the telecommunications space. As you may remember, there was a declining hardware business masking the growth of a high-margin software company. The shares have appreciated in price more than 100% from our initial purchases as the hardware sales are no longer declining, the software continues to grow, and the company has launched new hardware offerings that incorporate the software. This small company has secured Verizon as a customer, which is both a tremendous reference account as well as material from a revenue perspective. Interestingly, based on hiring activity, Verizon is likely not the final large customer. Management, which has historically been conservative in discussing the company’s prospects, has shifted to worrying about execution and meeting demand. The quarterly results will be “lumpy” for Radisys, but there is still an opportunity for substantial share appreciation as their software-based products gain traction. Radisys would be a logical acquisition for Cisco and a number of larger telecom hardware manufacturers.
Interactive Brokers: This remains a business with a very long runway for growth, healthy margins, and high insider ownership. You can find more than 20 pages of detail on the company on our website at www.greenhavenroad.com. The “Investor Letters” section has a long presentation I did for the Manual of Ideas Wide Moat Conference discussing our thesis. While not the least expensive company we own, the quality of the management, the growth runway, and the value proposition to customers are heavily weighted in our favor.
With our long bias, there was very little activity on the short side. We currently do not have any “index” shorts and have six very small (less than 2%) short positions in individual companies, including a retailer that has endured a management change and strategy change that appear to have a low likelihood of success. With the high level of debt, it may well turn out to be a profitable short. Other shorts include a fitness company, a pipe manufacturer, a semiconductor company, and an automobile manufacturer. For those of you who are curious, Code Rebel a short position the fund held earlier in the year and discussed in previous letters, has filed for bankruptcy. Code Rebel was valued at hundreds of millions of dollars in the past year. It is a helpful reminder that markets are not efficient and the “market does not know” – particularly with smaller companies with no analyst coverage.
Like many fathers, I think my children are special. My oldest daughter has the ability to have a sincere and deeply held opinion and the ability to change her mind almost instantly when new facts emerge. While in political circles changing one’s mind is called flip-flopping and frowned upon, in the Miller household it is celebrated as flexible thinking and my oldest daughter is a master.
This quarter we sold our position in JW Mays. This was a company that fit so many criteria we look for in an investment. For those who have forgotten, the company has the worst website in the world www.jwmays.com but has a valuable collection of assets. JW Mays was a regional department store that did not survive the consolidation in retail. JW Mays, however, holds the real estate of the old store chain. In particular, they hold two properties in the heart of the rebirth of Brooklyn near the Barclays Center, seven subway lines, and a large new retail complex. Two properties have substantial air rights. These gems are buried inside a company doing nothing to advertise this to the world – no website, no investor presentation, no analyst coverage, no conference calls. This is exactly the type of off-the-beaten path investment I love. The company is quiet, and the value is not showing up on the balance sheet since the buildings have been owned for decades. Throw in high insider ownership and the tailwind of gentrification and I don’t regret the initial decision to invest. There are multiple ways to win with JW Mays. As property values go up in Brooklyn, rents are rising, so property income should rise. The other way to “win” would be to sell to developers who can build condos or higher-end properties. Given the air rights and prices paid by condo developers, more than the entire market cap of the company could be in just the Brooklyn buildings. In general, developers like vacant buildings since they speed up the construction process. Tenants can block development. In fact, JW Mays received $3M to temporarily vacate a storage space held in a non-JW Mays building to allow the developer to proceed.
IDW Media ($22) Our purchase of IDW Media is very much in the vein of focusing on the journey of the company, which is very promising, as opposed to the quarterly earnings, which are not particularly promising or indicative of the future of the company. Since IDW has no analyst coverage, does not do quarterly conference calls, and historically has not done any investor presentations or investor relations, there is arguably not a consensus view of the company. IDW Media is a large holding of Adam Wyden of ADW capital. He was helpful in both highlighting the trajectory of the business as well as providing historical context. Adam generally holds fewer than 10 positions, so he knows as much about what is going on beneath the surface as is possible for his companies and was a far better guide than the whale watching captain.
IDW Media has several attributes that we look for in an investment, including high insider ownership. In fact more than half of the company is owned by Howard Jonas. Howard’s name may be familiar, since IDW Media is a spinout from IDT, another Howard Jonas company. In the past we made several multiples of our money on our investment in Straight Path (STRP), was also a spinout from IDT and yet another Howard Jonas company. In addition to the Jonas family ownership, management owns another 15% of the company. In addition, the company has been able to grow revenue by more than 50% and EBITDA by more than 100% the last five years without raising additional capital through a combination of frugalness, execution, and the asset light nature of the industries they operate in. There is also an “ick” factor. Specifically, IDW Media trades “over the counter” or on the “pink sheets,” which is a non-starter for many investors. For me, the bar is higher with a pink sheet company. It requires more diligence as the likelihood of fraud is just higher. In the history of the fund, we have made one other pink sheet investment (Taro Pharmaceutical), which was ultimately a very profitable investment.
IDW Media has two distinct businesses. The first is a boring, cash-flowing brochure distribution business. The company owns and manages more than 14,000 brochure stands in hotel lobbies that have paper brochures for all of the local attractions. This is a business where scale and route density matter. To be profitable, having as many stands as possible in a tight geographic proximity is ideal. IDW has grown through acquisition and is the largest player east of the Mississippi. This business generates a couple of million dollars per year in cash flow. We did not go wading into the pink sheets to own a piece of the brochure distribution business. It is a fine business with recurring revenue and reasonable margins, but it does not have the potential to return multiples of our investment, which is what we really need to be compensated for the lack of liquidity that comes with trading on the pink sheets. The more dynamic segment of IDW is its media business. IDW Media is the fourth largest publisher of comic books in the United States. They publish comic books for some widely known characters such as Teenage Mutant Ninja Turtles, Transformers, and Star Wars, but most of the content is far more niche. The company produces approximately 70 comic books and/or graphic novels per month.
Two years ago, the company made a conscious decision to stop licensing its characters to others media companies and to attempt to produce television shows and movies themselves. While this would require more work and upfront expense, if successful it would provide the company with creative and business control, as well as improved economics. Over the last two years, the company has invested substantial time and millions of dollars into this effort, without offsetting revenue. Revenues from TV shows are not recognized until a show is delivered to a network, which typically happens a week or two before the show airs. Even though the media production efforts are not currently showing up in the financials, in reality, the TV effort is off to a very promising start. The small IDW team has sold two shows to networks with a substantial and promising pipeline of additional opportunities. This year, the first show, “Wynonna Earp,” aired on SYFY Network. The second show, based off of a British detective series, “Dirk Gently,” will air this fall. The “Dirk Gently” show will star Elijah Wood, who previously starred in “The Lord of the Rings.” In addition to the two shows that will air, there is a pipeline of other shows in different stages of development. It is quite possible the company will have three to five shows on air in 2017. This is impressive from a standing start and would imply a more than $25M increase in revenue for a media company that did less than $30M last year, or almost a doubling. The company has been slow to disclose financial details on specific shows. The exact economics are difficult to model because each show will have a different revenue and contribution profile depending on the network it airs on, where it is shot, and its international appeal. From looking at the margin structures of other small television production companies such as DHX Media, EBITDA in excess of $12M is possible for the television segment, implying a company-wide EBITDA in excess of $20M with the potential to grow another 50% in 2018 as international rights revenues are received for the shows.
n addition to television, the company is set to have success in movies and in games. For example, Stephen Spielberg’s Amblin Entertainment has announced a movie starring Jim Carrey based on IDW’s horror comic book title “Aleister Arcane.” The games division is small, with a little more than $2M in revenue for FY15 vs. an overall revenue base of just under $50M. The games division is attractive for a number of reasons. The first is that games can have a much longer shelf life than TV and comic books. This can lead to a base of more predictable earnings. It is also another way to monetize characters and fan engagement. The company recently announced that their Teenage Mutant Ninja Turtles game that will be released for the holidays will be the largest product in the history of the company.
The core thesis behind our investment in IDW Media is that content is being increasingly fragmented. As we have gone from a media landscape with three broadcast channels to cable systems with hundreds of channels and YouTube, Netflix, Amazon, and other video platforms, there is a dramatic increase in the need for original content. In addition, as outlets increase and production costs decrease, increasingly niche content is viable. There are hundreds of cable channels trying to differentiate themselves based on original content, and for quality content, the lifespan is longer as video on demand becomes a preferred way to consume content. In addition, there are international rights, which can be as big or bigger than the domestic rights for shows. If the company executes on the plan, IDW will be able to monetize its library and storytelling skills in movies, television, and games. Effectively, there is a much larger opportunity beyond comic books. Our share purchases were made with an enterprise value of approximately $100M. As the economics of multiple television and movie products with their domestic and international rights begin to flow through the income statement, earnings can easily grow more than three times.
In addition to earnings growth, the company may benefit from multiple expansion as management has indicated it will eventually “up list” and leave the pink sheets for the NASDAQ. Given all of the other Howard Jonas companies are trading on the Nasdaq in addition to several sound business reasons to “up list” I think it is matter of when and not if. Often when companies do this, a new segment of buyers who were either turned off by the pink sheet status – or even restricted from investing in companies listed on the pink sheets — will invest.
Interestingly, for investors who solely rely on Bloomberg, none of the progress in entertainment is evident. Not a single one of the press releases is listed in the news section. The pink sheets are littered with frauds and “story stocks.” Much like the minute-to-minute movements of a whale, the short-term economics of IDW Media are difficult to model as the company continues to invest in the division and the profitability is backend loaded after shows are delivered. Nevertheless, it is clear the company is headed in a very productive direction and, if Ted Adams and his team continue to execute, there is substantial upside in IDW Media’s journey from the pink sheets to the NASDAQ.
Full letter below