Value Investing

Laughing Water Up 8% In Q1 Goes Long Bluelinx Holdings

From Laughing Water Capital’s 2018 letter to investors

Laughing Water Capital (LWC) returned +7.7% net in the 1st quarter of 2018, which compares favorably to the S&P500 and R2000, which returned -0.8% and -0.1% respectively over this inconsequentially short period. Please check your individual statements for your personal return. We have begun reporting net returns of our normal class as the close of our lowest cost fee option is imminent. If you know of investors that would be good additions to our partnership, please make them aware of the pending close.

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New Positions Bluelinx Holdings (BXC) – Bluelinx Holdings is a wholesale distributor of building products (40% structural / 60% specialty) with 39 distribution centers, primarily in the Eastern U.S. and Mississippi River Valley. Originally, the company was the captive distribution arm of Georgia Pacific (GP), the country’s largest producer of plywood and other sheet goods. However, the business was carved out of GP by a private equity buyer in 2004, who promptly took it public and saddled it with debt just in time for the real estate bubble to burst. We first purchased shares in late 2017 shortly after the private equity sponsor – who was apparently focused on liquidity rather than price – dumped their shares on the market at a large discount. At the time, it was a small position for us solely because we did not have more cash on hand, but as new capital came into the partnership in 2018, we made BXC a mid-sized position. While buying from a seller that is not concerned with price is a good place to start, by itself this is not sufficient for investment. We were further attracted to the business because of its mis-leading GAAP balance sheet, which we believed under-stated the value of the company’s real estate by almost $200M.

Importantly, the company had been monetizing their real estate through sale-leaseback transactions, which allowed the company to paydown debt. While the mechanical screeners that rule the markets were viewing the company as levered ~8x, we believed the company had already reduced its leverage to ~6x, and could be theoretically almost debt free if they simply continued to monetize their real estate. More important than this theory however, is the reality: they just don’t need all of the land they have.

Because the company started as a part of GP, their footprints were designed to accommodate storage of plywood and other sheet goods. Storing plywood requires a lot of space for a small amount of margin, and is thus not a good business to be in. Additionally, a look at BXC’s product mix vs. public competitors showed significant room for margin expansion through moving into more value-added aspects of the building supply distribution business.

 

Combining the above elements, I felt that BXC was significantly mis-understood by the market, and that there were multiple ways to win in the years to come. What I did not consider was that BXC would announce a merger with a competitor that has a highly complementary business and footprint only months after our purchases. S

hares more than doubled on the news, driving BXC into a top 5 position for us. While it may be tempting to just take the money and run after a move of this magnitude, reviewing the transaction indicates that the combined company may be cheaper now in the low $30s than it was below $12 just a few months ago. This is a business where scale matters, and the opportunity to take costs out of the combined business and drive revenue through consolidating the footprint to more fully utilize square footage, leveraging purchasing power, leveraging administrative resources, and cross-selling complimentary products is very real.

It is not difficult to envision scenarios where the combined company can generate $8 to $12 in free cash flow per share looking out a few years, which when combined with a likely de-leveraging of the balance sheet leads to the potential for significant additional upside. Andrew Jakubowski of Adestella Management deserves a mention for first bringing BXC to our attention.

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Iteris, Inc (ITI) – Iteris, which has been volatile throughout our 2+ year holding period, traded down ~30% in the first quarter, and an additional 10% in the early days of the 2nd quarter, and has been a significant drag on our results. I believe this weakness represents a compelling opportunity, and have added significantly to our position. There are 4 reasons for the weakness, 2 one of which are legitimate, but short term, 1 one of which is unfortunate, but exciting for the long term, and 1 of which is just part of life when pedaling in small cap stocks. First, on the fundamental side, the company got bumped down to a subcontractor position with the Virginia Department of Transportation.

If this demotion was for any good reason, it would be reason for concern. However, the demotion is tied to an effort by the VADOT to consolidate their vendors. This effort caused the original contract to be rolled into a larger contract that includes less attractive elements such as providing road side assistance and rest stop maintenance.

This is business that ITI rightly does not want to compete for as they are focused on building a software centric platform, not cleaning toilets. The revenue loss tied to this demotion is unfortunate, but the company continues to grow, and the revenue hole should be filled in by new projects shortly. Also on the fundamental side, a mix shift to Texas, where there is a middle man in the sales process has weighed on gross margin recently. Further weighing on margins, the company is investing in a centralized procurement team so that they can pursue bigger contracts. In my view, willingness to take short term margin pain in pursuit of long term gain tied to larger projects and the operating leverage that come with them is a sign of a thoughtful management team. On the non-fundamental side, Lloyd Miller, owner of ~15% of the company and perhaps the world’s greatest investor that most people have never heard of passed away, and his estate has sold shares. It is unclear if they will sell more, which is likely acting as an overhang. To be clear, Miller’s death does weaken our thesis as his presence provided comfort on an investment where management does not own much stock.

However, the present CEO and CFO who are relatively recent hires have proven themselves to be capable, and morbidity aside, buying shares from someone who is only selling because they are dead is attractive. Also on the non-fundamental side, a fair amount of ITI’s shares are owned by quantitative investors, and slowing revenue and declining margins – even if both are temporary – will typically cause quantitative investors to head for the exits. This selling led to a breakdown in share price that surely caught the eye of short term focused technical sellers that take their cues not from the businesses at hand, but the charts. These factors are the type of things we look for when considering new investments. It is unfortunate that they all developed in a company in which we already owned shares, but the opportunity presented by them is exciting for the future.

In my view, the transportation businesses alone more than justify current market prices, and have the potential to be worth multiples in the years to come as the move toward smart cities accelerates. This says nothing for the agriculture business, which is admittedly difficult to value, but if recent ag-tech deals are useful for comparison, they suggest that this business alone could be worth ~$250M, well more than the company’s current ~$150M enterprise value. As a reminder, this business was carved into a separate entity last year, and the recently hired President of this business saw the company sold during his last 4 jobs, which seems to set the stage for an eventual sale.