Hazelton Capital Partners commentary for the second quarter ended June 30, 2017.
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- Finding Reinvestment Moats
Hazelton Capital Partners, LLC (the “Fund”) gained 2.0% from April 1, 2017 through June 30, 2017, gained 8.1% year-to-date and has returned 99.1% since its inception in August 2009. By comparison, the S&P 500 gained 3.1% in the same quarter, increased 9.34% year-to-date and has returned 175% since the Fund’s inception.
The Quarter in Review – Position Updates
Hazelton Capital Partners ended the 2nd quarter with a portfolio of 17 equity positions and a cash level equivalent to nearly 24% of assets under management. The top five portfolio holdings, which are equal to over 41% of the Fund’s net assets, are: Western Digital (WDC), Micron Technology (MU), Apple Inc (AAPL), USA Technologies (USAT) and Renewable Energy Group (REGI). Throughout the quarter, the Fund pruned its portfolio, selling its Enernoc (ENOC) position, scaling back on Softbank (SFTBY), and redeploying some of the capital back into current holdings. No new positions were added to the portfolio in the 2nd quarter.
Providing guidance or meaningful commentary on the current market is a bit like forecasting the weather in Palm Desert, California during August. Each day is very similar to the previous one until one day it isn’t. Moreover, with the VIX trading at 10-year lows and the indexes hitting new highs, it appears that the equity markets have become complacent to any rising geopolitical issues impacting the world: North Korean aggression, rising tensions with Russia, and Trump still believing that his presidency is a reality TV show complete with daily tweets and firings.
“Everybody wants happiness, nobody wants pain, but you can’t have a rainbow without a little rain.” - Unknown
With US equity markets hitting new highs, many market pundits are calling for caution - advising investors to move into cash and/or hedge their current positions. A market decline is not a bad thing. In fact, as long as a company’s fundamentals have not changed, Hazelton Capital Partners often takes advantage of market sell-offs as an opportunity to enter into or add to a current holding. It is important to remember that a market decline does not mean that every position will decline or decline in tandem with the market. Hazelton Capital Partners positions itself for a possible decline in the market the same way it prepares for a potential market rally by pruning back positions, selling out of companies whose investing thesis has failed or has been achieved, and redeploying the capital into new or existing positions. The first line of defense against a downturn in the market are the positions in the portfolio and the level at which those positions were purchased. Cash levels in the portfolio are an indication of market opportunities, not its future direction.
When focusing on a long-term investing strategy, one must understand that the path to financial success is littered with potholes, twists, and turns. The journey is not a continuous smooth trajectory higher. Sometimes, share prices need to go lower, allowing for capital to flow from weak to strong hands, before it can regain its momentum higher.
Besides running a concentrated portfolio, another major component of Hazelton Capital Partners’ portfolio management is to maintain a long-term investment outlook. A good deal of thought went into determining what constitutes a “long-term” investment horizon, especially in today’s short-term focused environment. A 5-year time horizon was chosen, in part, because it reflects a classic business cycle: 1-1.5 years of contraction, 1 year of recovery and roughly 3 years of expansion. Early into an investment, it is difficult to differentiate between an investment thesis that was “too early” or one that was “just plain wrong.”
Maintaining a 5-year investment horizon not only provides adequate time for an investment thesis to develop but after 2 years, it should become clear to an investor whether one’s investment thesis is accurate or unsound. The Fund recognizes that not every position will be held for at least 5 years; however, having a long-term outlook encourages investing patience and ensures that the expected investment return is commensurate with a long-term holding period. Currently, the average holding period for our top five positions is 3.5 years.
Western Digital Update
Over the last few months, Western Digital and Toshiba Corp have been embroiled in a legal dispute over their joint venture (JV) that manufactures NAND flash. The battle began soon after Toshiba recorded huge cost overruns and losses from the nuclear power division it purchased from Westinghouse. In order to cover those losses and underpin its balance sheet, Toshiba has been forced to sell its prized NAND Flash business that is jointly owned with Western Digital. According to Western Digital, the terms of their joint venture require Western Digital’s approval before Toshiba can sell its stake. Even though Western Digital is also one of the bidders for Toshiba’s portion of the JV, Toshiba has ignored Western Digital’s claim and has chosen a consortium that includes Bain Capital, and rival NAND manufacturer SK Hynix as its lead bidder. In May, Western Digital began arbitration proceedings over a potential sale, stalling the transaction.
With all this uncertainty, why continue to own Western Digital?
Western Digital has been a centerpiece of the portfolio for 7.5 years and a top 5 holding for the past 4 years. Over that period of time, uncertainty has consistently hung over this company like the Sword of Damocles. At the time of our initial investment in 2009, Western Digital was a hard disk drive (HDD) manufacturer with a 30% market share. The major reason why the company’s stock was so cheaply priced was because the market believed Western Digital would follow the same path as Kodak and Motorola, pioneers and innovators of their industry, who failed to transition to the new burgeoning mobile world. NAND flash storage is the technology used in all mobile devices and is a more advanced technology than HDD: It is faster, lighter, has a smaller footprint, and uses less energy - perfect for mobility. In late 2015, to remedy its dependence on HDD, Western Digital announced the purchase of SanDisk (a leading manufacturer of NAND and JV partner with Toshiba).
The digital storage industry has historically been plagued with technology obsolescence, fierce competition, and quick, repetitive business cycles. These factors still exist, but their impact is muted as the industry has matured and consolidated. With the speed of technology innovation slowing, and the cost to retool becoming more expensive, the duration of a digital storage business cycle has expanded. As many in the industry have become “rational” about their investments, the peak to trough of the cycle has also become less dramatic.
Western Digital is currently trading around 7x earnings and below that for earnings projected out to 2018 - Not quite the levels when the Fund initially invested in the company, but cheap nonetheless. The company’s current free cash flow run rate is $3 billion and it expects to add another $300 million from ongoing integration of both HGST and SanDisk by year end. Hazelton Capital Partners still believes there to be significant upside opportunity with our investment and is comfortable holding the position.
EnerNoc Inc. (ENOC) – Closed Position 15% Loss
Hazelton Capital Partners was researching the renewable energy sector when we discovered Enernoc, a provider of energy intelligent software and demand response solutions. From 2005 to 2014, Enernoc increased its revenues from $10 million a year to over $470 million, by participating in a niche segment of the electricity industry - Demand Response. Demand Response is a tool employed to reduce electricity usage during times of peak demand. For 8 months out of the year, an electrical grid will operate around 60% of its peak capacity. However, from June through September that number will often spike up to and above 100% during periods of sharp demand (heat waves), making the grid unstable. In preparation for higher electricity demand, grid operators will conduct a yearly forward capacity auction. The auction brings together suppliers of electricity and companies like Enernoc, who are willing to provide a reduction in demand. Suppliers indicate how many megawatts of electricity they will add to the grid and at what price, while Enernoc will offer to reduce megawatt capacity at a specific price. When the grid operator achieves the number of megawatts needed (both from supply and demand reduction), a clearing price is set.
Knowing the exact amount of megawatts it will need to reduce when called upon, ENOC reaches out to its 6500 commercial and industrial (C&I) clients to see who is willing to reduce their electrical consumption, by how much, and for what price. During a Demand Response event, Enernoc will be contacted and told the start time, the number of megawatts of reduction and an approximate end time. The company will communicate with its clients and execute preestablished protocols (example: turn down lighting, shutting down elevator banks, reducing air conditioning usage to 70%). In total, demand response events take place between 5-6 times a year and last, on average, for less than three hours. ENOC gets paid both for agreeing to provide capacity reduction and for the actual reduction. The revenue earned is then split with Enernoc’s C&I clients. Since capacity auctions happen 2 years in advance, Enernoc and the market have clear optics into its future revenue streams. Having grown quickly over the past 10 years, Demand Response has become a mature market of approximately $1.4 billion and is expected to continue to grow by 6% a year. With its 35% market share representing 80% of its yearly revenue, ENOC began to diversify by expanding both internationally and into energy software.
In 2014, Enernoc, through acquisitions and organic growth, expanded its software solution programs into a newly launched Energy Intelligent Software (EIS) suite. This reconstituted EIS platform was designed as a SaaS (software as a service) subscription model focusing on how a company procures its electricity, how much it procures, and when it uses the electricity. Energy software is approximately a $5 billion market in the US and $20 billion globally. Recognizing a similar growth trajectory to that of the early days of Demand Response, Enernoc decided to ramp up its offering and establish a strong foothold. Hazelton Capital Partners’ investing thesis was centered around the belief that Demand Response would continue to drive Enernoc’s revenues in the short-run, but within 4-5 years, EIS contribution would help double revenues by representing 50% of its revenues.
Unfortunately, Hazelton Capital Partners’ investing thesis was ill-fated, mistimed, and wrong. The expected EIS growth never materialized as software revenues declined in 2016. What was not fully appreciated in our investing thesis was the significant negative impact a sharp decline in energy prices would have on the EIS business model. Throughout 2015 and into the first quarter of 2016, both oil and natural gas prices declined to levels not seen since 2002. The reversal in energy prices made Demand Response less appealing and the need for EIS a much harder sell.
Many of the companies that were already piloting Enernoc’s software in a limited number of locations decided to delay any further deployment. The steady decline in energy costs caused businesses to focus on improving sales and margins which have a more significant impact on their bottom line than upgrading energy procurement or monitoring usage. Prior to launching its EIS platform, ENOC ramped up its sales and marketing team in anticipation of the flurry of demand. By the end of 2016, facing the anemic growth of its software suite, Enernoc reduced its sales and marketing staff by 40%. Some of that decline was from overlapping roles from previous acquisitions, but the majority was right sizing the company’s current staffing needs.
Over the 2 years that Hazelton Capital Partners held shares of ENOC, the fund opportunistically bought and sold shares reflecting our lowered intrinsic valuation while improving our overall cost basis. However, given that our investment thesis was no longer valid, the Fund began looking for an exit strategy and found it on June 22nd, when Enernoc announced that it had agreed to be acquired by the Enel Group for $7.67/share. In total, Hazelton Capital Partners lost approximately 15% on its investment.
Investing in Hazelton Capital Partners
Hazelton Capital Partners was created as an investment vehicle, allowing those interested in longterm exposure to the equity market to invest along-side me. With a substantial portion of my own capital in the fund, I manage Hazelton Capital Partners assets in the same manner in which I manage my own capital. The best source of introduction to potential investors in the Fund has come from those that have invested or followed Hazelton Capital Partners progress over the years. Introductions are both welcome and appreciated.
If you are interested in making or increasing your contribution to Hazelton Capital Partners or just learning more about The Fund, please feel free to contact me.
Please do not hesitate to call me at (312) 970-9202 or email me email@example.com with any questions or concerns.