Hazelton Capital Partners commentary for the third quarter ended September 30, 2018.
To: Hazelton Capital Partners, LLC
From: Barry Pasikov, Managing Member
Date: October 21, 2018
Re: 3rd Quarter 2018 Letter to Investors
Hazelton Capital Partners, LLC (the “Fund”) declined 1.6% from July 1, 2018 through September 30, 2018, gained 7.0% year-to-date, and has returned 144% since its inception in August 2009. By comparison, the S&P 500 gained 7.7% in the same quarter, gained 10.6% year-to-date, and has returned 238% since the Fund’s inception.
The Quarter in Review – Position Updates
Hazelton Capital Partners ended the 3rd quarter with a portfolio of 17 equity positions and a cash level equivalent to 10.5% of assets under management. The top five portfolio holdings, which are equal to roughly 42% of the Fund’s net assets, are: Micron Technology (MU), Renewable Energy Group (REGI), Western Digital (WDC), Apple Inc (AAPL), and Spirit Airlines (SAVE). During the quarter, Hazelton Capital Partners meaningfully reduced its holding in USA Technologies (USAT), previously the Fund’s 2nd largest position. The decision to scale down was based purely on the share price hitting one of the Fund’s valuation objectives. Just as Hazelton Capital Partners will often scale into a position, the same holds true when exiting a position. Nearly three weeks after reducing the holding, USA Technologies announced it had been forced to delay filing its annual report while it investigates the bookings and customer contracts related to a handful of small customer accounts. Whenever a company is forced to delay its filings, it creates uncertainty that leads to a flight to safety. In USAT’s case, the sell-off of its share price was both quick and punitive, leading to over a 50% decline in a two-week period. The company was not a blameless victim, nor was the market’s “sell first ask questions later” reaction was out of line; the main question, which is yet to be answered, is whether the sell-off was a measured response. Just as USAT’s share price had overextended itself to the upside, the same could hold true to the downside. As for now, Hazelton Capital Partners remains on the sidelines, waiting to hear the outcome before deciding the next course of action. It is important to remember that even when including the recent swoon in USAT’s shares, Hazelton Capital Partners’ investment is still up over 350%. Unfortunately, that is of little comfort when parsing out USA Technologies impact on the quarter.
USAT was not the only position that negatively impacted the quarter’s performance; shares of Micron and Western Digital also played a role. I have written a great deal in past letters about Micron and Western Digital, and I am not looking to rehash my investment thesis other than to say the Fund remains resolute in its investments and the size of the investment in both holdings. With a decline in both MU and WDC shares of 17% and 25%, respectively, over the past quarter, it appears that the market is bracing itself for a protracted decline in the average selling price (ASP) for both NAND and DRAM. When the fears of an ongoing supply-demand imbalance are overlaid on top of a historically cyclical industry, the consensus view becomes one of a company whose earnings have peaked and is ripe for a cyclical downturn. However, before throwing in the towel on an investment, an investor needs to consider two key questions: Whether the current market reflects a long-term opportunity for the company and its industry, and what is a “reasonable downside” valuation for the company?
In 2017, it is estimated that 1 zettabyte of storage (combination of HDD and NAND) was shipped, a storage capacity representing only 4% of the data that was created during the year. One can expect that not only will the amount of data created increase annually, but so will the demand to store a larger percentage of that data. By 2025, IDC estimates that the world will be creating 163 zettabytes of data annually. Whether you are texting, streaming, surfing, or surveying, digital data is constantly being created, accessed, processed and saved. In addition to the increasing amount of data being stored in “the cloud,” industries such as autonomous vehicles, internet of things, machine learning, and video surveillance are also adding to the perpetual demand for storage and memory, promising a very long runway for growth.
However, the lessons of the past are hard to forget. From the early days of Fairchild Semiconductor, the semiconductor industry has been notoriously cyclical as stiff competition for market share drove down ASPs faster than production costs. The recent decline in NAND and DRAM prices is more reflective of a supply-demand imbalance rather than competition for market share. Declining ASPs are expected to continue (although at a slower rate), but much of those declines are expected to be offset by reduced production costs. Today, with only three manufacturers of DRAM and five manufacturers of NAND, industry behavior has become more “rational,” as demonstrated in recent reduction of capital expenditures and delays of expansions announced by many of the manufacturers. It is also important to remember that lower NAND and DRAM pricing spurs demand.
As mentioned in past letters, when valuing a company, Hazelton Capital Partners spends most of its energy determining a “reasonable downside” valuation for its investment. Micron, with its $9.2 billion of free cash flow, $2 billion of net cash, a share repurchase plan committed to buying back $10 billion over the next 2 years, and a share price trading at approximately 3.5x 2019 projected earnings, is cheaply priced. Those fearful of a prolonged decline in ASPs would caution that MU’s 2018 net income represents peak earnings. However, if one were to reduce forward earnings by over 35%, what many consider to be trough earnings, Micron is still undervalued, trading at roughly 5.5x earnings. It is understandable how investors can remain cautious about investing in a company achieving peak earnings in a cyclical industry as interest rates are on the rise. But for a company whose products are essential to nearly every electronic device that is connected to the world wide web, one can confidently feel it is unlikely that long-term demand will be waning anytime soon. Of course, this does not mean that Micron and Western Digital’s share price cannot go lower.
Hazelton Capital Partners’ top three holding did not achieve to their respective rankings overnight; they grew into those positions. The reason they continue to occupy their ranking, even after their share prices appreciated, is that they remain cheaply priced. On aggregate, all three positions are trading at roughly 4.0x current year earnings and roughly 6.0x forward earnings.
Renewable Energy Group (REGI) Current Holding
During the quarter, shares of Renewable Energy Group continued their upward momentum as the company announced stronger than expected profits and guided for continued strength throughout 2018. Renewable Energy Group is a biofuel refiner that is paid not only for the biodiesel it produces but is also rewarded (mostly through tax incentives) for helping reduce the impact of carbon emissions from transportation fuel. Since Hazelton Capital Partners’ first invested in Renewable Energy Group approximately 4 years ago, the company has done an outstanding job of incrementally growing its earnings through consistent reinvestment, acquisition, and expanding into downstream outlets. Not only has the company expanded its nameplate refining capacity from 257mmgy to 575mmgy (million gallons per year), upgraded most of its refineries to accept multi-feedstock, increased onsite refining storage, extended its logistics system, enlarged its refining footprint to include Europe, and invested in fuel terminals to capture more downstream profits, but it has done so without leveraging the balance sheet which is net cash positive. Although Hazelton Capital Partners’ investing thesis for REGI has not materially changed, its upside objective has evolved to reflect the positive improvements in both the company’s operational strength and the demand for biodiesel.
The Blenders Tax Credit ($1 federal tax credit for every gallon of biodiesel blended with petroleum diesel) was established by Congress in 2005 with the goal of incentivizing the blending of biodiesel with petroleum diesel for the benefit of the environment, the economy, and national security. Just like with the wind and solar industry, the objective of the tax incentive was to quickly scale a nascent industry, encourage mass adoption, and eventually make the industry selfreliant. In 2005, the United States had a nameplate production capacity of roughly 200mmgy of biodiesel.
Today, domestic production has ballooned to over 2500mmgy. However, for a segment of biodiesel refiners, the Blender Tax Credit has turned into corporate welfare, making those refiners completely reliant on the government’s assistance just to break even. Moreover, Washington’s consistent political gamesmanship surrounding the BTC (allowing it to expire every year only to be retroactively reinstated the following year) has hurt the credibility of the biodiesel industry, making it difficult for companies to borrow money, expand operations or encourage outside investment. It is believed that to avoid this ongoing political chess game, some members of Congress are set to propose a BTC that will run for five consecutive years. There is even talk of establishing a BTC that will start at $1/gallon for the first 2 years and then step down to $0.80 in year three, $0.60 in year four, and $0.40 in year five, before settling between $0.20 and $0.40/gallon for the foreseeable future. Of the two BTC plans, I think the “stair-step” plan is the best for the industry. Not only does it provide a roadmap that feedstock producers, refiners, and blenders can follow, but it is also a healthy way to wean the industry off the government’s support. Ultimately, I would like to see the BTC eliminated. It has served its purpose of underpinning an industry during its infancy but is now only encouraging bad behavior from both Washington and from a segment of the industry it was designed to benefit.
Eliminating the BTC would cause the marginal producers (those dependent on the BTC just to break even) to shut down. It is estimated that these refiners represent 100 - 150mngy. There would also be another group of producers, with no competitive edge, that would now fall into or near the break-even category, and eventually, exit the industry. In total, between 200 – 300mngy of biodiesel (~10% of domestic industry production) could be removed from the system if the BTC were eliminated. Over time, a large portion of that lost volume would be recovered as assets move from weak to strong hands. Companies like Renewable Energy Group would be able to acquire these plants at a discount and operate them more efficiently by using their established operational strength and pricing power (a business strategy REGI has successfully deployed when acquiring refiners in the past). The $1/gallon BTC that is currently split between refiners and blenders would be replaced by both lower input costs and a slight increase in biodiesel prices, allowing refiners to recapture approximately $0.15-$0.25/gallon, in line with the final level of a declining “stair-step” BTC discussed above.
It is important to understand that over the last few years support for the biofuels industry has not come from the EPA, Congress, or the BTC, but from states taking an active role to lower its greenhouse gas (GHG) emissions. Until recently, individual states relied solely on the EPA’s Renewable Fuel Standards (the amount of renewable fuel required to be blended with transportation fuel) to curb GHGs. Frustrated by Washington’s politics and inaction, states like Texas, Illinois, Minnesota, Iowa, New York, and Washington, which have some of the highest levels of interstate commerce, have acted to lower their GHG levels by encouraging the use of blended biodiesel through state tax exemptions/reductions. California and Oregon have taken it a step further and adopted a Low-Carbon Fuel Standard (LCFS), a policy targeted to reduce its GHG 10% by 2020, and in California’s case, continuing to 20% by 2030. And they are not alone.
States like Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, and Vermont, and countries like Argentina, Brazil, Canada, Germany, The Netherlands, and Sweden have either adopted, are in the process of adopting, or are developing a LCFS. It’s these states and countries’ desire to lower its GHG emissions that is driving demand and responsible for the recent “step change” in Renewable Energy Group’s earnings.
For the first half of 2018, Renewable Energy Group generated earnings of nearly $60 million without any benefit from the expired BTC; the second half of the year (without the BTC) is expected to be as strong if not stronger. The majority of REGI’s expanded profitability has come from a combination of its prior years of investment and increased demand for blended diesel. Renewable Energy Group is currently in the middle of another capital reinvestment campaign that is expected to increase earnings by $30-$35 million/year. Additionally, the company has outlined mid- and long-term investment strategies for its renewable hydrogen diesel facility (Geismar) which is expected to further increase earnings by $42.5 million and $130 million per year, respectively. All three projects have been designed to achieve a 20-30% return on invested capital. Historically, REGI has habitually under-promised and over-delivered on its reinvestment projects, coming in under budget, at a higher return on investment, and with weeks to spare.
Despite the recent strength in Renewable Energy Group’s share price, Hazelton Capital Partners remains comfortable with its investment, believing there to be continued upside opportunity. When adding up the current and potential earning increases just from its short- and medium-term expansion projects, while conservatively adjusting earnings to reflect either a future “stair-step” decline or the eventual elimination of the BTC, the Fund believes shares of REGI could more than double from its current price. Just like in the past, patience remains the key ingredient for success.
Armstrong World Industries, Inc (AWI) 87% Gain
During the quarter, Hazelton Capital Partners sold its position in Armstrong World Industries (AWI), a leader in the commercial ceilings systems market. In April of 2016, AWI spun-off its Armstrong Flooring division into a standalone company. Between the sales in both companies, Hazelton Capital Partners generated an 87% gain on its investment. The ceilings market has been in a state of recovery since the financial crisis with strength coming from the office segment while education and healthcare remain weak. AWI’s management team deserves the credit for the company’s strong performance. It has done an impressive job in strengthening the company’s balance sheet by improving operations while growing the company’s North American footprint through acquisition and organic reinvestment. Unfortunately, the company has had to scale back on its international operations, as it sold its subsidiaries servicing Europe, the Middle East, and Africa to its competitor, Knauf International.
Hazelton Capital Partners has been disappointed with the lack of revenue growth from the ceilings industry and does not see an opportunity for significant improvement anytime soon. Even though AWI’s management has performed well, the Fund recognizes that it is going to be an uphill battle to continue to grow earnings. Hazelton Capital Partners decided to take profit on its investment while the Fund continues search for future opportunities.
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.
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