Adib Motiwala's  Instablog

Motiwala Capital LLC

2015 Loma Alta Drive

Irving, Texas 75063

www.motiwalacapital.com

Third Quarter 2012 Letter

Dear Friends,

During the third quarter of 2012, US equity markets were very strong with index levels higher than the previous highs seen in Q1. None of the issues that market participants worried over the previous months have been resolved yet Mr. Market was in the mood to buy stocks. The Fed announced a third round of purchasing assets such as treasuries and mortgage backed securities. The Fed has promised to keep short term interest rates low till mid- 2015.

Portfolio activity

We had a very busy quarter. In the Generals portion of the portfolio, we bought three new positions while adding to another. We sold out of two positions while reducing another position. We participated in 15 special situations in the quarter and by the time of this letter, we had closed or received cash for all but one position.

Special Situations:

We are always on the lookout for special situations - mainly tenders and mergers. This portion of the portfolio has achieved excellent results boosting portfolio performance while reducing volatility. These positions have low correlation to the rest of the market and investment period is in weeks.

Share and Closed End Fund (CEF) tenders

We participated in eight CEF tenders and five share tenders, including HTA, AOL, SRDX, DCAQP and CCRT. We had another successful run with 12 of the 13 tenders being profitable. Our only loss was in CCRT (-11%). Our mistake in CCRT was that we looked at the large % upside in the tendered portion of the shares, while underestimating the downside of the pro-rated shares that would be returned to us post tender. Shares came under pressure right from our purchase and we exited the position prior to the expiry of the tender.

Merger Arbitrage

We bought shares of CIC Energy in Canada as the spread on the pending acquisition by Jindal Steel (a large Indian company) was ~10%. As the spread reduced to 5%, we exited the position.

The Shaw Group (SHAW) is being acquired by Chicago Bridge & Iron Company (CBI) in a cash and stock deal worth $3 billion. The spread was about 8-10% on the day of the announcement. We initiated our position when the spread ballooned to ~20%. As the weeks went by, the spread reduced significantly to ~5% and we reduced our position.

Generals:

Portfolio exits:

We closed our position in UFP Technologies (UFPT) for a 20% return under a year. We had expected 5-10% free cash flow (FCF) growth from UFPT and results since purchase did not live up to our modest expectations. UFPT does not buy back shares or issue dividends despite the ample cash balance and FCF. Finally, there has been share dilution over the years via options. We bought UFPT at a 10% FCF yield and despite lack of growth, we benefited from multiple expansion. We took the opportunity to book profits and raise cash.

CSG Systems (CSGS) experienced an excellent run since April 2012. We bought CSGS for a FCF yield of 20% in Q4 2011. CSGS had two poor quarters in 2011 and investors were unhappy with the Intec acquisition. Prior to the Intec acquisition, CSGS had been generating $90 million in annual FCF. At a market cap of $450-$500 million, we felt the shares were significantly mispriced. While CSGS carried net debt of $175 million, it was very well covered by predictable FCF. The other risk was the heavy customer concentration with top three customers making up 45% of revenue. CSGS reported a couple of good quarters and investors took notice and bid the shares up. While CSGS remains relatively cheap, the risk reward is not as favorable, especially with the upcoming contract renewals with two large customers. We feel these contracts would be renewed with possibly some discounts offered. We sold for an average price of $21.5 for a 40% gain under a year.

New Positions:

Sauer-Danfoss (SHS) is a global leader in the manufacture of hydraulic systems used in mobile equipment. The company's products are sold primarily to the agriculture, construction, road building, turf care, material handling, and specialty vehicle markets. SHS is majority owned by Danfoss Group. SHS was hit in the financial crisis of 2008-2009. SHS under CEO Sven Ruder underwent a remarkable turnaround which can form an excellent case study for business schools. Several actions were taken to right size the business including (1) dividend suspension, (2) capital expenditure reduction, (3) closing or consolidating plants, (4) exiting unprofitable businesses, (5) lay-off of 40% employees (for a primarily European company!), (5) salary freeze for all employees and (6) reduced executive salaries by 15%. SHS had $500 million in net debt at the end of 2009 and by Q4 2011 SHS had net cash of $50 million! At the time of our purchase, SHS was trading at $34 with a market cap $1.65 billion. FCF in the last two years was $225 million and $310 million. Management also re-instated the dividend which is $1.4 annually. SHS ended the quarter around $40.

Gravity (GRVY) makes a second appearance in our portfolios. GRVY is a tiny Korean game developer that offers multiplayer online games, casual and social games. Their main game is Ragnarok Online that was a success several years back but its next generation game had been delayed for several years. The sequel was recently launched and the reception in Korea has been weak. We sold our shares too soon earlier in the year and price appreciated strongly as the catalyst of the sequel launch came to fruition. However, soon after the price came down and after a poor Q2, shares once again trade significantly below cash and securities held on the balance sheet. That said, there is no clear path to value realization as there would not be any buybacks or dividends. This is not a typical investment for us and hence we have sized the position accordingly.

Mind CTI (MNDO) is an Israeli company that provides convergent end-to-end billing (80% sales) and customer care product based solutions for telecom service providers as well as telecom expense management solutions. Sales are about $18-$20 million annually with $4-$5m in FCF. The balance sheet is pretty with $17.7 million in cash while the market cap at the time of purchase was $32.2 million ($1.72 share price). So, essentially at an enterprise value of $15 million, the company has produced an average FCF of $4-$5 million for a 25% FCF yield. Management is very shareholder friendly with 100% of FCF being paid out in the form of dividends. The dividend yield based on last years' $0.24/share payout was 14%. Management has announced a buyback which makes a lot of sense at recent prices. The founder CEO owns 20% of the shares outstanding.

Reduced positions:

We reduced our position in UK based Tesco (TSCDY). We booked a small capital gain combined with the dividend we received earlier.

Increased positions:

Big Lots (BIG) suffered a large decline in the quarter after disappointing Q2 earnings, a management shuffle, weak Q3 guidance and reduced cash flow guidance. Management continues to reduce share count, though the recent purchases were odd - both in size, price and the fact that they borrowed money to do so. The Canadian acquisition is on track to break even earlier than expected and could provide a boost to the bottom line. We added to our existing position despite the bleak near term outlook, as we think the current valuation discounts the negatives.

Mistakes with Aeropostale (ARO)

ARO reported several weak quarters last year with negative SSS and rapidly declining margins and the share price declined by more than 50%. At that point, I felt all the negativity was priced in and selling at that point made no sense. We wanted to give ARO a chance to recover in late 2012/early 2013 as cotton prices would eventually subside. Early in 2012, ARO had a superb run, more than doubling from the lows and touching low $20s and vindicated our patience. However, the Q1 report did not reveal drastic improvement in the business and Q2 guidance was weak. In the previous two quarters, management had played the game of low balling guidance and then beating those tempered down expectations. This analysis combined with sharp increase in price and a 10% position were valid reasons to scale down the position. However, I put in a limit order at a higher price, and our order was never executed. This is a mistake that I will endeavor not to repeat in future transactions.

What happened next: Q2 pre-earnings were pathetic with flat SSS, negligible net profit, weak Q3 guidance and ARO shares took a 30% hit.

I took another fresh look and concluded that the current valuation seems quite cheap. With 81m shares outstanding and a share price of $14, market cap is $1134 million. Ex-cash of $170m, enterprise value is $930 million. Average FCF of last four years is $150 million. Even at FCF of $100 million, ARO is valued ~9x FCF.

Other lessons learnt

I usually average down on a position if it declines in price after the initial purchase, all other things unchanged. Hence, we now take smaller initial positions to leave room to average down. What I learnt is that I need to space out my 2nd purchase by time and/or significant price decline. If the price declines but fundamentals have also weakened, then I should be very confident before adding to the position.

Other news

I participated in the 1st Value Investing Challenge competition sponsored by SumZero and Value Investors Congress. My submission for our portfolio holding Western Digital made it to the semi-finals.

Most of our accounts are under $100,000. The smaller accounts have benefitted quite a bit from the special situations portion of the portfolio. Based on nine months results, the special situations strategy could contribute 3% to 7% annually for accounts under $100k. Potential clients with investable capital of under $100k could benefit by having us manage a 'special situations only' account. If you have an interest in us managing a part of your investment capital, please feel to call me to have a discussion. We can go over our investment process in more detail.

We would like to thank our clients for placing your trust in Motiwala Capital.

Sincerely

Adib Motiwala

Portfolio Manager

Motiwala Capital

817.689.5115

This commentary candidly discusses a number of individual companies. These opinions are current as of the date of this commentary but are subject to change. All information provided is for information purposes only and should not be considered as investment advice or a recommendation to purchase or sell any specific security. While the information presented herein is believed to be reliable, no representations or warranty is made concerning the accuracy of any data presented. This communication may not be reproduced without prior written permission from us.

Past performance is not indicative of future results. Actual returns may differ for each client from the returns presented. Each client will receive a monthly statement from the custodian. Portfolio level performance numbers have not been reported in this letter. If you wish to receive this information, please contact me at adib@motiwalacapital.com

Disclosure: I am long SHS, BIG, ARO, MNDO, GRVY, TSCDY.PK.

Motiwala Capital LLC

2015 Loma Alta Drive

Irving, Texas 75063

www.motiwalacapital.com

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January 2012 - March 2012 Report

Dear Friends,

This is our quarterly letter to clients for the period from January 2012 to March 2012. Global equity markets remained extremely bullish since October 2011. Most US indices were up 10%+ in the first quarter of 2012. Motiwala Capital completed its first year of operations. At the end of the quarter, assets under management (AUM) were about $1 million. All accounts are of friends and family and we appreciate the trust placed in me and my firm. I have invested a six figure amount which is 90% of my liquid net worth in the same investments as my clients. As a reminder, we manage separate accounts and not a single commingled fund.

Portfolio activity - Summary

We had another busy quarter. Our portfolio is broken up into two parts. The bulk of the portfolio is invested in long equity positions we refer to as 'Generals'. These investments are longer in duration. We took on 4 new positions and closed two. One portfolio company (GME) initiated quarterly dividends and is now fully debt free. We also added to four existing positions and reduced two positions. We ended the quarter with 15 positions.

We took on eleven new special situations in the quarter and subsequently closed seven of these for modest gains. We received cash payment for three special situation positions from the previous quarter.

Portfolio activity - Detailed

Generals: 2 closed, 2 reduced, 4 new positions, 4 increased. Ended with 15 positions.

Portfolio exits: We closed our positions in Bolt (BOLT) and Gravity (GRVY).

GRVY shares appreciated sharply during the quarter. We initiated our position at $1.2 per share in the last quarter. In our Q4 report we wrote "While investors have been disappointed, at the price we took the position we feel there is limited downside. Shares trade significantly below cash and securities held on the balance sheet". As the company launched private and public beta testing for its next generation game, the price appreciated strongly. We exited as the share price moved from trading significantly below cash to near cash levels. We booked a 40% gain in the stock. We sold early and the stock rose 50% since our sale. While one can be upset at selling too early, we would gladly take 40% gains in such a short period of time. This business is often one of disappointments - you don't buy enough or you buy too much too early or you sell too early or you sell too late or you sell too much too soon…you get the point!

BOLT shares appreciated strongly on the special dividend announcement. We took smaller gains in this medium size position as we were not very sure about the acquisition Bolt did a few quarters back. We exited around $13.2. Our total return (capital appreciation + dividend) was ~15%. Bolt went on to announce a regular dividend as well and shares have held up pretty well with oil prices continuing strong north of $100/barrel.

New positions: We added four new positions to the portfolio in the quarter.

We often hear commentators talking about valuations of entire markets and comment that the markets are undervalued or overvalued. At Motiwala Capital, we invest in one company at a time. We look to buy good quality businesses (strong balance sheets, consistent free cash flow generation, high ROIC) at attractive valuations.

For two of our new positions, we went across to Europe (though listed in the US via ADR). We purchased positions in primarily UK retailers Tesco and Halfords. The other two positions were companies headquartered in the US. Shares of Iconix Group came under pressure after the company announced Q4 and 2011 earnings and issued guidance for 2012. While Lear shares were not purchased at the lows seen in last fall, we feel the shares trade at a significant discount to their fair value and also to the industry despite having one of the best balance sheets in the industry.

Lear Corporation (LEA) is a leading global supplier of automotive seating and electrical power management systems. Lear came out of bankruptcy in late 2009 with a solid balance sheet and closed down under performing operations. With 100 million shares outstanding and a share price of $46, Lear has a market cap of $4600 million. Lear has $1 billion in excess cash on the balance sheet and will generate FCF of $400 million. Lear returned excess cash to shareholders in 2011 via buybacks and dividends and plans to do more of the same. We think Lear should continue to do well as the demand for cars/trucks should be robust as world economies improve and the average age of cars in US is about 11 years.

Tesco Plc (TSCDY) is one of the world's largest retailers with operations in 14 countries including UK, South Korea, Thailand, China, Japan and the US. In FY 2011, Tesco had sales of £61 billion and generated profit before tax of £3.5 billion. Tesco had a market cap of £26 billion with a P/E of 10x and a dividend yield of 4.5% (that has grown for many years). Tesco owns about 75% of the land beneath its stores and this acts as a large margin of safety for our investment. Tesco has stumbled recently in the UK market but it has a leading market share of about 30%. Tesco is also growing rapidly and profitably in Asia and is number one in Thailand and South Korea.

Iconix Brand Group (ICON) is a brand management company that has a portfolio of 27 different brands. Their brands do roughly $12 billion in sales at the retail level. Iconix receives royalty payments from its partners for these sales. It has a superb business model with no inventory, no manufacturing, no capex -- an extremely asset light model producing gobs of free cash flow and high operating margins. In FY2011, ICON had revenues of $370 million and generated $180 million in FCF. ICON has more debt than we usually like in our investments. However, with the stable FCF, interest is well covered and Icon could chose to pay off the debt in 2-3 years if it wants to. We purchased ICON at P/FCF of 7x and think there is lot of room for growth as it increases partnerships globally.

Halfords Group Plc (HLYDY) is the UK's leading retailer of automotive and leisure products and leading independent operator in garage servicing and auto repair. Halfords has 467 retail stores in the UK and 250 car repair centers. Last year, Halfords had sales of £870m and generated operating profit of £130 million. Halfords has excellent share holder friendly management and pays out 50% of profits in the form of dividends. Last year, Halfords began to buy back shares aggressively and spent £59m by the end of December 2011. Halfords has a market cap of £600 million and enterprise value of £740 million. Despite some headwinds over the next one or two years, we feel the business is resilient and should continue to reward long term shareholders over time. Halfords has a P/E of 8x and dividend yield of 7%.

Reduced positions:

We reduced our positions in Big Lots (BIG) and Western Digital (WDC) as the stocks appreciated strongly and closed in on our initial target prices. See Appendix for a discussion on Big Lots which is one of our biggest winners so far.

Increased positions:

We added to four existing positions as either a falling share price made valuation attractive in the case of GME and UFPT (before the recent run-up) or despite higher prices, our confidence in the company increased after owning for a period of time in the case of CSGS and CNRD.

Special Situations: 11 new positions (4 open, 7 closed), 3 positions from Q4 closed

Some of you may be wondering how come we take so many positions in these so called 'Special Situations' and what are they. Special situation is a term used for any investment that has an ongoing corporation action of some kind that can unlock value. These could range from bankruptcies, spin offs, mergers, split offs, tender offers. So far, we have ventured in mergers and tender offers. Spin offs are in vogue off late but we have not yet participated in any of them --- there is only so much time in a day! However, we do own Abbott Labs (ABT) that has announced its own spin off, so we are participating before most others and already have a decent gain

Share tenders - 3 positions closed from Q4 2011

You may recall that in Q4 2011, we participate in four cash tender offers. We had already received cash payment for CRFN for a 5.5% gain. In January, we received cash for tendering our MCCK shares for a 13.6% gain. The two other tenders in progress at the end of last year were Nathan's Famous (NATH) and Seaspan (SSW). We received cash payment for these shares for a 5% and 15% return respectively. SSW shares are up sharply since the tender closed and we were intrigued to know that a Canadian Value Investor we follow was not going to tender his shares. However, we bought the shares as a special situation and kept our discipline and pocketed our gains.

Merger arbitrage - 2 positions, both closed.

Inhibitex (INHX) was being acquired by Bristol Myers (BMY) in an all cash transaction. There was no financing risk and we did not feel there would any anti-trust issues. The only concern was if something were to go wrong during the period of the tender offer. Having seen the Gilead Sciences acquisition close, we felt the probability of this one going through would be very high. To be clear, we acquired our shares after the deal was announced. The tender closed on time and we earned a 6% return for our shares of INHX.

Baldwin Technology (BLD) was being acquired in an all cash deal. We initiated the position as the spread reached double digits. However, as we realized that the payment per share (if the deal went through) was uncertain (unlike the INHX merger), we exited the position for a small 2% gain. The merger eventually closed at the high end of range (another 8% upside) but we do not harbor any regrets.

Closed end fund tenders - 1 position, closed.

We purchased shares of Korea Equity Fund (KEF) with the intention to participate in the tender offer. However, as the spread narrowed prior to the close of the tender and with better opportunities in other tenders, we exited the position for a small gain.

Share tenders - 8 positions, 4 closed, 4 active

Share tenders are similar to the closed end fund tenders above. However, in this case the underlying investments were equity positions v/s closed end funds. It seems it was raining tenders in this quarter! We participated in eight cash tenders. We initiated and subsequently closed our positions in Mastech Holdings (MHH), Hackett Group (HCKT), Weight Watchers (WTW) and FBL Financial (FFG) for an average 4% gain. Four tenders are in progress and we will disclose their outcomes in our next quarterly report.

The main attraction of this Special situation portion of the portfolio is the ability to cycle through many positions in a short definite period of time - albeit for smaller % gains and hence contribute in a meaningful way as a group to the performance of the portfolio. Also, these investments are not correlated with the rest of the market. As long as we can find good opportunities, we intend to continue investing in this area.

Discussion on Portfolio composition

If you have followed us from the beginning, you would have noticed we have been building our portfolio slowly over the last twelve months. We currently have 15 regular positions (Generals) in our portfolio. This makes up about 70% of the portfolio. The rest of the portfolio is currently in special situations or cash which can vary at any time. The top 10 positions add up to 52% of the portfolio.

Portfolio Characteristics

Weighted average P/E = 13.1 (Average P/E is 12.4) P/E are based on 12-month trailing earnings

Generals dividend yield = 2% (1.4% on the entire portfolio)

Weighted average Market Cap = $43 billion (Avg market cap is $39 billion)

Current Portfolio (some clients will not have all the positions and in the same weights)

Company name (Ticker)	% of portfolio
Aeropostale (ARO)	8.5%
Vodafone (VOD)	5.7%
Conrad Industries(CNRD)	5.5%
Western Digital (WDC)	5%
Abbott Labs (ABT)	5%
Tesco (TSCDY)	5%
Microsoft (MSFT)	5%
Gamestop (GME)	4.5%
Becton Dickinson (BDX)	4.5%
Iconix Group (ICON)	4%
UFP Technologies (UFPT)	3.5%
CSG International (CSGS)	3.5%
Halfords (HLFDY)	3%
Big Lots (BIG)	3%
Lear Corp.(LEA)	3%

Generals Portfolio by Market Cap (excludes special situations). Below makes up 70% of portfolio.

Micro cap - 12%
Small cap - 28%
Mid cap - 16%
Large cap - 37%
Mega cap - 7%

As you can see, we have invested across the market cap spectrum. We are market cap agnostic. Our smallest company (Conrad Industries) has a market cap of $100 million and the largest is Microsoft with a market cap of $273 billion. While there is no conscious attempt to diversify across market caps, we certainly like having a good mix. The large caps add stability to the portfolio in times of distress and have solid competitive positions. However, the large caps like any other investment still have to meet our criteria of quality and cheapness to be considered for the portfolio.

If you like pie charts and sector allocations, the next chart is for you.

We do not go out seeking specific investments by sector. We make our investments one stock at a time. However, as part of risk management, we do want to make sure all of our investments are not in just one or two sectors. Currently we do not have any investments in 4 sectors - Materials, Energy, Financials and Utilities.

We would like to thank our clients for placing your trust in us. We are looking to grow our client base and we welcome referrals. If you have an interest in us managing a part of your investment capital, please feel to call me to have a discussion.

Sincerely

Adib Motiwala

Portfolio Manager

Motiwala Capital

Appendix: Big Lots (BIG)

We purchased shares in Big Lots in Q2 2011 at an average purchase price of $32. The company had a market cap of $2400 million with 75 million shares outstanding. Big Lots had an excellent balance sheet with $284 million in net cash (12% of market cap). With trailing EPS of $2.85, BIG sported a P/E of 11 (ignoring excess cash) and EV/EBIT of 6x. Pre-tax return on Invested Capital (ROIC) averaged 30-32% for the last three years. Free Cash Flow (FCF) in the previous year was $208 million.

Clearly, Big was cheap on valuation, a good business as seen by ROIC and free cash flow and had an excellent balance sheet. The management team led by Steve Fishman had done a tremendous job since 2006. It checked all the boxes we look for in an investment. There was no identifiable catalyst in sight. As they say in India, it was just 'Sasta' - or cheap.

In FY 2011, BIG spent $359 million on the repurchase of a whopping 11 million shares or 15% of the shares outstanding at an average price of $32.8 per share. This gave a nice boost to EPS which came in at $2.98 per diluted share. Big Lots made an acquisition in Canada to make it first international expansion. While the acquisition was and will be a drag on results in the short term, BIG paid only 13 million CAD for 92 stores of Liquidation World at a valuation of 0.1x sales. The EPS increase (which would have been even more without the aforementioned drag) combined with the re-rating of the stock from 11x P/E to 15x P/E meant we had a nice 40% return on the stock ($32 to $45). We trimmed our position at $41 and still hold a 3% position. We feel the company can reward share holders with a double digit return going forward from here.

Here are summary financials for Big.

Fiscal Year	Sales	Op Income	Net Income	Diluted EPS	OCF	Capex	FCF	Shares
2006	4,430	30	(10)	0.14	213	(67)	146	113.7
2007	4,743	185	124	1.01	381	(32)	350	111.9
2008	4,656	236	158	1.47	308	(60)	248	102.5
2009	4,645	255	152	1.89	211	(90)	121	82.1
2010	4,727	316	200	2.44	392	(78)	314	82.7
2011	4,952	357	223	2.83	315	(107)	208	78.6
2012	5,200	358	207	2.99	320	(120)	200	65

Note: All figures in millions except for EPS.

Generate dividends for your stocks (Covered Call option writing strategy)

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Read the rest of the article here


Disclosure: long aapl