HVS 3Q19 Unique Small Cap Ideas: Featuring Tollymore and Rowan Street

Hidden Value Stocks issue for the third quarter ended September 30, 2019, featuring interviews with Stanphyl Capital’s Mark Spiegel and Global Quality Edge Fund’s Quim Abril.

Quim Abril

Welcome to the September 2019 (Q3) issue of Hidden Value Stocks. This issue introduces interviews with two fund managers as well as recent updates from Stanphyl Capital and the Global Quality Edge Fund interviews, which were part of the September 2018 issue.

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Q2 hedge fund letters, conference, scoops etc

The first interview is with Mark Walker, the Managing Partner of Tollymore Investment Partners. Tollymore is looking for exceptional quality businesses that have the potential to compound investors’ capital at an attractive rate over the long-term. The firm doesn’t put itself in the ‘growth’ or ‘value’ bracket, rather Mark says his approach is based on a company’s return on capital, which allows him to better understand and estimate the owner earnings of a business and how these earnings could grow over time. Tollymore’s annualized net return since inception (May 2016) is 24%.

The second interview is with Alex Kopelevich, CFA, the founder and managing partner of Rowan Street Capital LLC. Rowan Street Capital describes itself as a “go-anywhere” fund. It’s not constrained by market cap, sectors or geographical location. This means Alex and his team are not constrained in their hunt to find companies with “exceptional economics” and “capable management teams” that have the potential to give “double-digit CAGR compounding over the next 5-10 years.” Over the past 15 months from January 1, 2018, until March 31, 2019, Rowan Street Capital returned 25% gross to investors.

At the end of this issue, there’s also a table of all the stocks profiled in previous issues of Hidden Value Stocks.

We hope you enjoy this issue of Hidden Value Stocks, and if you have any questions or comments, please feel free to contact us at support@hiddenvaluestocks.com.

Sincerely,

Rupert Hargreaves & Jacob Wolinsky

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Catch Up With Mark Spiegel - Stanphyl Capital

Mark Spiegel’s Stanphyl Capital was one of the first funds profiled in Hidden Value Stocks back in March 2016. Mark picked out four deep value stocks for the issue: MGC Diagnostics Corporation, Lantronix, Echelon and Broadwind Energy Inc.

These companies went on to return 98%, 139%, 47% and 102% respectively. (full performance figures are at the end of this issue). For this issue, we asked Mark for some insight into how he goes about selecting his deep value plays and his two most recent value ideas:

When I buy tiny companies such as these as a generalist, I don’t have an electrical engineering degree in order to assess their range of products; rather, I use “revenue” as de facto proof that their products are marketable, and then just look to buy that “revenue” so cheaply that if something goes “further wrong” with the company (they’re inevitably “fallen angels” when I initially buy them- that’s why they’re so cheap), there will be a strategic buyer to take me out at a profit in order to acquire that revenue (even if it’s in decline) for itself. That’s the whole strategy in a nutshell!

Of course, I do my best to verify that the revenue is real-- making sure there’s a legit auditor, the products exist out in the field, etc. I also make sure that when I’m buying insiders aren’t selling, and if the company has been “a disaster” for years, I won’t invest in the management team that got them there; I wait for a change so at least there’s some hope it will be fixed.

Here are Stanphly’s two latest deep value small-cap ideas, as published in the firm’s second-quarter letter to investors:

We continue to own Aviat Networks, Inc. (AVNW), a designer and manufacturer of point-to-point microwave systems for telecom companies, which in June reported an interesting deal to be the exclusive North American distributor for NEC’s microwave products. In May Aviat reported a lousy Q3 for FY 2019 (with revenue down 13% year-overyear), but guided to a very strong Q4 (ending June 30th) with revenue and income up substantially year-over-year. For all of FY 2019 the company cut guidance to $246-$251 million of revenue (a $4 million reduction from previous guidance) and non-GAAP EBITDA of $11-$12 million (a $1 million reduction), and because of its approximately $330 million of U.S. NOLs, $10 million of U.S. tax credit carryforwards, $214 million in foreign NOLs and $2 million of foreign tax credit carryforwards, Aviat’s income will be tax-free for many years; thus, GAAP EBITDA less capex essentially equals “earnings.” So if the non-GAAP number will be $11.5 million and we take out $1.7 million in stock comp and $6 million in capex we get $3.8 million in earnings multiplied by, say, 14 = approximately $53 million; if we then add in approximately $29 million of expected year-end net cash and divide by 5.4 million shares we get an earning-based valuation of around $15/share. However, the real play here is as a buyout candidate; Aviat’s closest pure-play competitor, Ceragon (CRNT) sells at an EV of approximately 0.6x revenue, which for AVNW (based on the low end of 2019 guidance) would be 0.6 x $246 million =$148 million + $29 million net cash = $177 million. If we value Aviat’s massive NOLs at a modest $10 million (due to change-in-control diminution in their value), the company would be worth $187 million divided by 5.4 million shares = just under $35/share.

We continue to own Westell Technologies Inc. (WSTL), which in May reported a terrible FY 2019 Q4, with revenue down 12.5% year-over-year and a drop in gross margin from 45.5% to 37.6% and negative free cash flow of around $1.4 million. About the only good news here is that the company ended the quarter with $25.5 million in cash and no debt, and (as gleaned from the conference call) normalized FCF burn at Q4’s revenue level is “only” around $900,000. Westell now sells at an enterprise value of only around 0.1x (i.e., 10% of) revenue, so on that metric it’s clearly dirt cheap but the business needs to stabilize and grow. On the conference call management was confident that later this year there should be enough revenue growth to cut quarterly burn to around $500,000 but “breakeven” now sounds like more of a “next year” possibility. Westell also suffers from a dual share class with voting control held by descendants of the founder; however, management has often stated that the controlling family is open to merging the two share classes, and the company is so cheap on an EV-to-revenue basis that if management can’t start generating meaningful profits it seems primed for a strategic buyer to acquire it. An acquisition price of just 0.8x run-rate revenue (on an EV basis) would be around $3.70/share.”

Catch Up With Quim Abril - Global Quality Edge Fund

In the September 2018 issue of Hidden Value Stocks, Joaquim Abril, founder of the Global Quality Edge Fund picked out Ituran Location and Control (ITRN) and Straco Corporation (SGX: S85) as his two undervalued small-cap picks. 12 months have passed and he’s still bullish on these two stocks.

ITURAN LOCATION AND CONTROL

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Since our last discussion, shares in Ituran have fallen around 25%. What has gone wrong?

There could be different possible reasons. The first one could be that the purchase of Road Track for $92 million has generated some dilution in the operating margins because they have lower margins and lower ARPU, since Road Track presents a more cyclical business profile (Its customers are mostly OEMs) but it has a greater growth.

The second reason could be that the base currency of the Ituran consolidated is USD, therefore, there is an impact by the exchange rate even though the correct way to analyze Ituran is to analyse the income statement in local currency. And third, Ituran is an Israeli company that trades in the U.S. but their main business is in Israel and Brazil, so some time investors don’t understand how FX impacts the company.

How is the integration of Road Track Holding progressing?

The main reason for the Road Track acquisition is to be a major telematics player through Latin America, not only in Brazil as was the case prior to the acquisition. The operations in Latin America also have subscribers in Israel but are more linked to OEM agreements. The company expects growth from penetrating additional OEM customers in the existing and new territories and from cross-selling Ituran portfolio of products. So Ituran is expecting to extract some synergies for 2019, 2020 and beyond.

EBITDA growth isn’t keeping up with sales. Are margins under pressure?

For Q2 and in local currency terms, revenues have grown 33% and EBITDA 24%. When we analyze Ituran, it is key to look at the company with local currencies and follow the trend in the subscribers’ growth. Also, GAAP EBITDA included some costs related to the purchase price allocation, so in this case, it is better to use adjusted EBITDA. In any case, as I previously stated, the Road Track business has a lower margin than the rest of the business, so margins are expected to be close to at least 20%.

In our valuation, we are using a 20% EBIT margin that includes the expected margin dilution from Road Track and is close to the 2009 EBIT margin that reflects a worst-case scenario.

Why did non-GAAP EPS slump 20% in Q2?

Well, in local currencies, EPS is down 13% and the main reasons are primarily related to the acquisition of Road Track and the increasing losses in Bringg investment that is equity consolidated.

Financing costs are weighing on earnings, yet the company appears to have plenty of cash on paper. Does this signify a red flag for you?

No, remember that Ituran bought Road Track last year and the total cash consideration was $92 million. The split for the cash acquisition was: $76 million debt facility, 12 million share issuance, and $4 million were earn-outs. As of June 30, 2019, total cash and equivalents were $62.8 million and total debt of $76.2 million, so total net debt is $13.4 million or $0.64 per share.

There has been an increase in losses at Bringg as well, which is one of Ituran’s early-stage company investments. How does this business fit into your thesis?

At the time being, I’m not considering Bringg in my valuation because it’s an early stage affiliate investment. The first investment was in December 2013 with $1.4 million and the total investment (equity method) amount until December 2018 was $4.82 million for a total holding of 46%.

Your current price target for the stock is $49, down from $52 for 2020 you gave in your base case scenario last year. Why have you downgraded the PT?

Adjusting the EBIT margin to 20% as a conservative scenario is consequential. Also, I will add the new buyback program for a total amount of $25 million before December 2020.

Is there any reason that would cause you to sell?

Not for now, because the company is growing again with subscribers in its aftermarket business. In Q2 Ituran grew with 21.000 new subscribers, in the range of 20k to 25k. It is important to remember that Ituran is continuing to grow its customer base each year from 2004.

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STRACO CORPORATION

The company recently had to close one of its biggest attractions. How has this impacted earnings?

On January 25, 2018, operations at the Singapore Flyer have been suspended indefinitely after a technical issue which led to 61 passengers being alighted. This is the main risk of this kind of business so if you invest in Straco you should prepare for it. In terms of financial results, there was a negative impact on the 1Q18, with sales down 32% and profit 60% because the Singapore Flyer was closed for two months until April 1 when it reopened.

In my valuation, I was adjusting accordingly my revenue growth number for 2018 to reflect the negative effect but I still think that it was a clear one-off and a great opportunity to increase our holdings in Straco.

When do you expect income to normalize?

Well, on a quarterly basis it normalized in 2Q18 except for a few days at the beginning of April. On an annual basis, there’s a negative effect for 2018 but a better comparative effect for 2019.

The last time we spoke, you said the most significant risk to the company’s success was the new Shanghai aquarium (Competitor). How has this been playing out?

It is important to remember that before 2015, Shanghai and Xiamen aquariums contributed more than 90% to the group revenue but in December 2018 it was lower than 65% mainly reduced because of the Singapore Flyer acquisition on May 2013.

For 2018 and the last two quarters, Straco Corporation reported lower earnings as a result of lower visitor numbers and the trade war between China and the U.S. But more importantly, the average ticket yield remains constant. The latest attractions built in Shanghai are Shanghai Disneyland (opened in 2016) and Haichang Polar Ocean Aquarium (opened in 2018).

For now, these two new attractions have not resulted in a significant decline in visitor numbers for Straco Corporation, but competition remains a constant risk for Straco. Straco Corporation’s total built-in area is 20,500 square meters over five levels and has a capacity of around 7.6 million people per year. This is significantly higher than the current 2.38 million visitors per year to Straco Corporation and signals the good potential for visitor numbers to rise in the future.

At the time of our first interview, you said rising tourist numbers and acquisitions were key for the company’s growth. What’s the current trend in tourist numbers and are there any deals expected ahead?

For the second quarter of this year, overall visitor numbers to all the attractions decreased by 11.4% from 2Q2018 to 1.08 million visitors as visitor numbers to our China attractions decreased. The main reason for this negative performance is the trade war with China and the U.S. but we’re expecting a normalized pattern in the following quarters because a trade deal is on the horizon.

We’re estimating end cash for 2019 close to 200SGD million, so it should be reasonable to expect some asset (attractions) acquisition for the next quarters/years.

Have buybacks helped the stock? Are there more cash returns on the horizon?

Straco Corporation has an opportunistic share buy-back plan in placement intending to acquire a maximum of 10% of its market capitalization.

The stock liquidity is very low so it would be difficult for the stock to trend down.

Do you still see a 70% chance of a 1.14 price (base case) by 2020? If not, why not?

Yes, our target price today is 1,16SGD with a 60% potential return. We are confident with this stock, but we need to be patient. Straco Corporation has many ways to increase shareholder value: 1) Normalized visitor numbers in China for the next quarters, 2) Increase prices in their main attractions, 3) Increase expense in promotion and advertising, 4) Buy some interesting attraction asset with the 200 SGD million cash in balance sheet, 5) Increase dividend payout and 5) increase the share-buyback.

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Interview One: Mark Walker - Tollymore Partners

Mark Walker is the Managing Partner of Tollymore Investment Partners. Prior to founding Tollymore Mark was a global equity investor for Seven Pillars Capital Management, a long-term global value investing firm based in London. Mark joined Seven Pillars from RWC Partners, where he was part of a two-person team managing a newly launched, long term global equity fund. Prior to that Mark worked as an investment research analyst for Goldman Sachs and Redburn Partners. He is a qualified chartered accountant, and graduated from Edinburgh University with a First Class MA Honours degree in Economics, graduating first in his class.

Your portfolio is mainly focused on platform/linear business models with underappreciated emerging platform elements.

Could you explain what that means and why you’ve decided to concentrate on these specific business models?

Around 40% of Tollymore’s holdings are platform companies, and of the remainder, a few have been investing in platform agencies. I am not seeking out platform companies. Rather I am trying to apply sound judgment in interrogating a company’s business model and appraising its long-run profitable prospects.

The “platform company” designation or otherwise comes due to an effort to understand something based on first principles. I don’t want the tail to wag the dog. Sometimes investors apply a ready-made label to the source of a company’s moat e.g. switching costs, network effects, intangible assets and so forth. Listening out for these buzzwords is a dangerous shortcut that may hinder a legitimate understanding of how a business generates value for its owners.

Having said this, I tend to be attracted to companies that enjoy genuinely interactive network effects. As the number of network participants increases arithmetically, the number of interactions between them increases exponentially, creating switching costs through the higher per-user utility of the platform. This can lead to winner-take-most outcomes, creating assets that are hard to replicate.

This is a barrier to entry that is crucial to preserving economic value creation.

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How do you go about finding ideas in this field? Which qualitative and quantitative factors are you taking into consideration whilst searching for potential investments?

There is no systematic magic formula. No proprietary idea generation funnel. Ideas are typically found by reading investment journals, company filings, transcripts, fund manager letters, and industry reports, attending investment conferences and having conversations with like-minded investors. These interactions must be energetic. They must be accompanied by adequate sleep and family time. The goal always is to exercise the right judgment when we encounter potential opportunities. A weary brain, used primarily to battle distraction, will not be well equipped to make good decisions. Idea generation is always ‘on’. The emphasis, however, is on intelligently recognizing an opportunity rather than maximizing time and effort looking for it.

I don’t screen. Screens may have helped the manager to outperform in the past, but there is no guarantee it will in the future, especially considering significant business model changes from the industries of history vs. those of the future. Screens can be marketing-led, driven by the desire to convey repeatability. Repeatability implies copy-ability. Predicating a source of investment edge on something that can be replicated tips the odds against you in achieving a satisfactory investment result. The capacity for contrarian thinking is limited by the preponderance of investors using screens as their primary or only idea generation filter.

What should be repeatable is the energy with which you manage your investors’ capital, and the judgment one can apply to investment decision making.

Finally, screens miss one of the most compelling sources of mispriced securities: Those companies whose reported financials poorly reflect the underlying cash earnings’ power of the business, due to for example high reinvestment rates, accounting convention or business model transitions.

I am trying to find businesses I can understand, with a capital structure that is appropriate for the business model, and are strongly positioned to preserve the economic value they create, have avenues for the profitable redeployment of capital, and whose stewards are aligned with the company’s owners.

Thinking about these business characteristics as they relate to platform companies. Building a successful platform necessitates solving a chicken-and-egg problem of having enough producers to attract consumers and vice versa. Without adequate scale and liquidity, the value to users will be lower than the cost of participation. It is this dynamic that makes platform businesses more difficult to build from scratch vs. their linear counterparts. I look for ways a business might be uniquely positioned to leapfrog this chickenand-egg problem. This may involve subsidizing either demand or supply, or better, leveraging a company’s existing demand or assets to accelerate its path to platform dominance. Uber is leveraging the supply side of its network to expand into food delivery with UberEATS. TripAdvisor is leveraging the demand side of its network to expand into attractions and restaurants.

I prefer supply which is fragmented rather than concentrated and demand which is, as Bill Gurley puts it, “Promiscuous rather than monogamous.” Restaurants are more fragmented than airlines.

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About the Author

Jacob Wolinsky
Jacob Wolinsky is the founder of ValueWalk.com, a popular value investing and hedge fund focused investment website. Prior to ValueWalk, Jacob was VP of Business Development at SumZero. Prior to SumZero, Jacob worked as an equity analyst first at a micro-cap focused private equity firm, followed by a stint at a smid cap focused research shop. Jacob lives with his wife and four kids in Passaic NJ. - Email: jacob(at)valuewalk.com - Twitter username: JacobWolinsky - Full Disclosure: I do not purchase any equities anymore to avoid even the appearance of a conflict of interest and because at times I may receive grey areas of insider information. I have a few existing holdings from years ago, but I have sold off most of the equities and now only purchase mutual funds and some ETFs. I also own a few grams of Gold and Silver