Stanphyl Capital commentary for the month ended May 31, 2020, discussing the stocks hit by the COVID-19 Pandemic and its affect on the Q1 earnings.
Friends and Fellow Investors:
A decade ago, no one talked about tail risk hedge funds, which were a minuscule niche of the market. However, today many large investors, including pension funds and other institutions, have mandates that require the inclusion of tail risk protection. In a recent interview with ValueWalk, Kris Sidial of tail risk fund Ambrus Group, a Read More
For May 2020 the fund was up 5.9% net of all fees and expenses. By way of comparison, the S&P 500 was up 4.8% while the Russell 2000 was up 6.5%. Year-to-date 2020 the fund is down 3.3% while the S&P 500 is down 5.0% and the Russell 2000 is down 15.9%. Since inception on June 1, 2011 the fund is up 48.6% net while the S&P 500 is up 173.2% and the Russell 2000 is up 86.4%. Since inception the fund has compounded at 4.5% net annually vs 11.8% for the S&P 500 and 7.2% for the Russell 2000. (The S&P and Russell performances are based on their “Total Returns” indices which include reinvested dividends. The fund’s performance results are approximate; investors will receive exact figures from the outside administrator within a week or two. Please note that individual partners’ returns will vary in accordance with their high-water marks.)
Our strategy during this economic depression is simple: own stocks that are cheap (typically on an EV-to-revenue basis) with great balance sheets that are turnaround and/or acquisition candidates, and hedge that exposure by being short a roughly equal-dollar amount of very expensive stocks (currently the Nasdaq 100, via QQQ). This month that worked well for us, although it would have worked a hell of a lot better if we had no hedge at all, as QQQ was up a lot. That said, the day I’m comfortable being long-only with the stock market near all-time highs at the beginning of a depression is the day I should be committed to a mental hospital.
The COVID-19 Hit
COVID-19 will have a terrible economic impact for several years, initially via altered behavior (crowd & travel avoidance) leaving the world in a severely depressed economy until there’s a vaccine widely available (hopefully in 12-18 months), followed by a still weak economy (relative to 2019) for a couple of years after that as the confidence necessary to start or expand businesses is slowly regained.
I thus wouldn’t want to own any business that’s overly consumer-facing or real estate-related (restaurants, theaters, etc. can’t make money if “social distancing” caps their capacity at 50%); instead we hold cheaply priced stocks involved with technology upgrade cycles that will happen regardless of how “the consumer” is doing—in fact, some of these companies (due to the 5G upgrade cycle) may benefit from the increased bandwidth requirements of working remotely, while others may do “just okay” but we’re buying them cheaply enough that (as noted above) I think they make terrific strategic acquisition targets in a world starved of “organic” growth.
In valuing these cash-rich, non-consumer-dependent stocks I’m assuming their numbers are from this summer forward (i.e., after the lock-downs end) and estimating that some of them will have suffered four bad months of business during and immediately after those lock-downs, and thus have lowered their cash piles accordingly (net of any forgivable loans from the Paycheck Protection Program) when calculating their enterprise values.
Here then are the fund’s specific positions; please note that we regularly add to or reduce position sizes as stocks approach or recede from our target prices…
We continue to own Aviat Networks, Inc. (ticker: AVNW), a designer and manufacturer of point-to-point microwave systems for telecom companies, which in May reported a terrific Q3 for FY 2020 (shooting the stock up roughly 60% from its April close), with revenue up nearly 14% year-over-year and a significant improvement in gross margin and operating earnings, as well as a reiteration of full-year guidance and expectations for growth in FY 2021 (beginning July). In January Aviat’s board (controlled by activist investor Warren Lichtenstein) appointed a new CEO and the accompanying press release made it quite clear (based on his experience) that he was brought in to dress up the company and get it sold. Aviat’s closest pure-play competitor Ceragon (CRNT) sells at an EV of approximately 0.65x revenue. If we assume $240 million in run-rate revenue for Aviat, $30 million of net cash and a $10 million valuation on a combination of $400 million of U.S. NOLs, $8 million of U.S. tax credit carryforwards, $212 million of foreign NOLs and $2 million of foreign tax credit carryforwards, we get an acquisition valuation of 0.65 x $240 million = $156 million + $30 million net cash + $10 million for the NOLs = $196 million divided by 5.4 million shares = $36/share.
Data I/O Corporation
We continue to own Data I/O Corporation (DAIO), a manufacturer of semiconductor programming devices. (Here’s a great recent overview published in Seeking Alpha.) We previously owned this stock in 2016 when we bought it in the $2s and sold it a year later in the $4s and $5s (it eventually ran to the $16s before collapsing, as it got way ahead of itself as new holders failed to account for its cyclicality), and now we’ve repurchased it in the $2s for another run. In 2019 (a year that without COVID would have marked a cyclical low for the company), DAIO did $21.6 million in revenue with a 58% gross margin. In April it reported its first COVID-19 affected quarter (Q1 2020), in which it did $4.8 million in revenue (still with a 58% gross margin) and ended the quarter with $13.8 million in cash and no debt. Using 2019’s revenue and valuing DAIO at 2x that cyclically low figure (this company is much more levered to customer technology cycles than economic cycles), then adding in $13 million of cash (after assuming $800,000 of COVID-related burn) makes this stock worth over $6.80/share.
We continue to own Communications Systems, Inc. (ticker: JCS), an IOT (“Internet of Things”) and internet connectivity & services company, which in April reported a COVID-affected Q1 with revenue down 18% year-over-year (roughly in line with my expectations). Normalized (ex-COVID) run-rate revenue for this company is around $47 million a year (inclusive of $3 million from a small acquisition announced in May) with a gross margin in the low-to-mid 40%s. If we value JCS at 0.8x normalized revenue plus its $27 million of net cash (inclusive of the $4 million spent for the May acquisition and just under $1 million spent for a May partnership investment) and assume 9.3 million shares, we derive fair value of around $7/share. The company also pays a .02/share quarterly dividend and is in contract to sell its headquarters building for $10 million which, if it closes late this year or early next, will add another $1.07/share in cash to the balance sheet.
We continue to own Amtech Systems, Inc. (ASYS), a manufacturer of semiconductor production and automation systems. Amtech recently sold its unprofitable solar divisions and is now a 38% gross margin company that does around $80 million a year in normalized (ex-COVID problems) revenue with around $4 million a year in operating income (again, ex-COVID) and around $44 million in net cash and over $80 million in NOLs. If we subtract $1 million from Amtech’s cash to account for two more quarters of "COVID hit," then value the company at 1.5x revenue with $8 million for the NOLs, we get fair value of around $12/share. The biggest risk here (other than underestimating “the COVID effect”) is that management—which *is* acquisitive—blows that cash pile on something stupid!
We continue to own Westell Technologies Inc. (WSTL), which in February reported a substantially lower normalized cash burn (negative adjusted EBITDA plus capex) of around $800,000 for Q3 of FY 2020 vs.Q2, despite a 5% revenue decline. The company ended the quarter with $22 million in cash (let’s assume $20 million currently including a $1 million IP payment due and a $1 million "COVID-19 hit" offset by a forgivable $1.6 million CARES act grant while the company remains open as an “essential business”) and no debt, and thus has over six years of remaining cash runway to grow revenue and return to break-even (it’s projecting to do so in 2021), and obviously much more than that if it cuts the burn along the way. (Along with the earnings report the company posted a new investor presentation.) We continue to own Westell because it’s a $29 million/year, 39% gross margin business with around $1.25/share in cash that currently sells for a severely negative enterprise value. Assuming 15.8 million shares, an acquisition price (by a cost-eliminating strategic buyer) of just 0.6x revenue would (on an EV basis) be around $2.35/share. Preventing such an acquisition is that Westell suffers from a dual share class, with voting control held by moronic descendants of the founder who refuse to sell company despite the stock’s horrible performance. However, I’m hopeful that someone will knock enough sense into their small brains to inspire them to salvage what’s left here, and thus walk away with at least something from what they’ve squandered. If they do the stock should be at least a double from here, and possibly more. In other words, it’s too cheap for me to sell but the board is too incompetent for me to buy more.
We continue to own Evolving Systems, Inc. (EVOL), a small telecom services marketing company that generates nearly $1 million/year in free cash flow on $26 million of 65% gross margin revenue. This company would make a great buy for a strategic acquirer, as $1.5 million/year in savings from eliminating the C-suite and cost of being a standalone public company would mean around $2.5 million/year in free cash flow. Thus, at an acquisition price of just $2/share (a roughly 100% premium to the current price) a buyer would be paying only around 10x free cash flow and 1x revenue. Also, management made clear on the May conference call that Evolving has been relatively unaffected by COVID-19 as it was already a highly decentralized business; thus the virus impact will be to draw out the sales cycle for new contacts, but shouldn’t affect revenue from existing ones.
Finally on the long side, as central banks increase their money-printing to ever higher levels in order to fund multi-trillion-dollar annual deficits, we now hold a substantial long position in the gold ETF (GLD).
Finally, in May I covered our short positions in the Vanguard Total International Bond ETF (ticker: BNDX) and the TLT long-term Treasury Bond ETF as they no longer pay a short balance rebate and I wanted to focus on our equity positions; our bet on the certainty of central bank currency destruction is now covered by our GLD position.
Thanks and stay healthy,