Monthly Performance Review - May 2017

by: Jan Svenda

I believe in transparency when doing equity research; therefore, every month I publish performance of every ticker that I wrote an article on alongside the initial thesis.

Through this I want to build a strong habit of looking back at my own reasoning. The review will be heavily skewed to stocks where my thesis is not working.

This month my short ideas continued to get hammered, providing a great opportunity for me to learn more about how to set up a good short thesis.

Dear Followers/Readers,

First of all, I would like to thank you for your continued interest in my work and I hope you are getting value of out my research!

In order to increase the latter, in August, I introduced a monthly review of all of the tickers that I am actively covering alongside my initial thoughts about the stocks. I think this can be beneficial for the following reasons:

  • Learning exercise – I will primarily focus on stocks where my initial thesis was wrong. I will try to understand why, how to prevent this from happening in the future and what should one do about this fact.

  • Increased frequency of thesis updates – This will be beneficial for people that are following specific tickers and might be interested in the latest developments that are not necessarily asking for a full-blown update.

  • Creating a database – It is always fun, to look back and either laugh about failures or cheer about winners.

I am doing so through the following simple table, which I publish at the end of each month.

Notes: The price at the origin is the opening price on the date of the first publication and the current price is the closing price on last trading day of the month. The original thesis that is labeled Neutral (Long) is a thesis where I have a positive view on the stock, but for whatever reason, I do not believe it the right time to buy. The same goes for Neutral (Short). I do not judge neutral ratings unless the share price movement is significant and I missed an opportunity to be on the right side of the trade. This is slightly subjective. Feel free to address any neutral rating that you believe I got wrong.

I also add two indices that can be used to ‘benchmark’ the performance of the covered stocks. I chose Russell 2000 due to its small-cap bias and Russell 3000 in order to track the overall market.

During the reviews, I will not be talking about every stock, but rather ones that I started to cover in the past month, the ones I am wrong about, or that are undergoing significant developments.

May Highlights:

Spark Energy (SPKE)

My first-ever active short idea is still not doing well but I have to reiterate that the valuation is still dubious. The regulatory risks seems to be behind them, but the company still needs to show that they are able to generate free cash flow (after deducting acquisition costs and paying off leverage which they only temporarily solved by issuance of preferred shares) and that their core customer base is not shrinking and that they are going to be able to grow not just from acquisitions.

My learning outcome so far is that this is a ‘battleground’ stock with a significant short interest; thus, investors should think twice before shorting it as the share price can easily be caught in a short-squeeze (likely what happened so far due to the regulatory news). The catalyst in these stocks is of utmost importance.

I will try to write an update soon.

Trupanion (TRUP)

The share price of this pet insurance company is also doing well without any real fundamental news. The quarter that they filed did not counter any of my raised points and their growth rate is unlikely to be enough for them to be able to fulfill the managerial targets. Certainly, the quarterly results can hardly justify the increased valuation. This is an insurer trading at 14x book value without showcasing much free cash flow. Even if it's operating in the growing market of pets, there is no fundamental reason for this valuation yet.

I believe that the lesson here is that trying to set up a short thesis regarding a growth story without a clear short-term catalyst (only long-term subpar results) is not enough to tackle irrational expectations in the market, at least not in the near term.

PROS Holdings (PRO)

Almost the same comments can be attached to PRO. The shares continued to surge but the quarterly report from May was not something that would counter my initial points. Their managerial targets regarding free cash flow margin are still unlikely to be hit and thus current increased valuation does not make much sense, but again, this is a ‘growth story’ and thus, unless there is going to be a significant miss, the valuation is likely to stay irrational for a prolonged period of time.

World Acceptance (WRLD)

And rounding up the short ideas that went wrong is this lender which saw its share price increase when they showcased their quarterly results. As CFPB is taking significantly more time to act (some say it won’t act) there might be reason for the share price to go up (banks also relaxed their requirements regarding the credit facility), but until there is a certainty that the watchdog won’t act against the company, there is still a significant amount of risk.

In late May, there was a hearing about CFPB (regarding the litigation with PHH) which could result in a clearer picture regarding the outlook for WRLD. The lesson is again connected to the fact that WRLD is another ‘battleground’ stock which might easily go against the short thesis in terms of the share price (not necessarily fundamentals) and hurt short-term performance.

Leaf Group (LFGR)

My first article in May was about this holding company that owns various online properties. I believe that the possible current bull thesis (sum of the parts) is unreasonable due to the following points:

  • It relies on the PE market to remain willing to value Leaf Group's properties at metrics such EV/Revenue and disregard lack of cash flow.

  • The bullish thesis also relies on the need for interest in LFGR’s businesses, and I don’t believe that there are clear buyers for any of the websites or platforms.

  • Even if each property could potentially be sold at prices close to Cracked’s transaction, I believe that this thesis not only relies on the fickle PE market but it also lacks margin of safety (i.e. what happens if nobody buys the properties and LFGR will have to continue to operate the way it does now).

If one attempts to value the company as a going concern, the free cash flow picture does not look enticing due to the following points:

  • While the revenue from Society6 continues to grow, it is unlikely to be enough to fundamentally change the company’s profitability. Moreover, the growth of Society6 is clearly slowing down year over year; thus, LFGR is still unable to create a substantial amount of cash flow from operations.

  • The management mentions that Saatchi Art is routinely growing around 20%/30% but that is from a low base as the current revenue from the site is around $1.2 million per quarter. This then won’t change the profitability either.

  • Finally, the revenue connected to the websites which matter the most due to the high margins is struggling as mentioned in the previous points.

  • All this then can be compared to the current implied expectations (market capitalization less tangible book) which currently stand at $131 million. By building a simple free cash flow picture for the next five years, I believe that a reasonably optimistic scenario shows that the free cash flow is likely to only match the current expectations, thus potentially limiting the upside.

  • If the company’s growth story does not reach the needed fundamentals in order to rationalize the current market expectations in a year or so, then investors could be presented with a shorting opportunity as it would mean that the lack of margin of safety would shift the risk/reward scenario to the downside.

You can read the whole article here.

Macro Enterprises (OTC:MCESF) (MCR.CAN)

My second article published in May was about this Canadian pipeline business. While it is exposed to the volatile O&G sector, I believe that investors might benefit from initiating a position due to the following points:

  • Most importantly, their balance sheet is providing investors a strong downside protection. The stock is currently trading at a steep discount to tangible book, 25% of which comprises of net cash.

  • While the uncertainty regarding long-term projects and management might call for a slight discount, the current operations are not stretched and offset this. MCR produced a significant amount of free cash flow last year.

  • This year, its long-term master service agreements will again support the core revenue stream and the new project, silently added to the backlog, will ensure improvement.

  • Thus, it is likely that the company is going to showcase strong earnings this year and will create a meaningful amount of cash flow.

You can read the whole report here. So far, the shares moved upwards.

Tower Properties (OTCPK:TPRP)

This was the last article published last month and it was first published in Safety in Value’s Microcap Review (as was MCR). I believe that Tower Properties should be on every investor's watch list, and if the opportunity arises (due to scarce liquidity), they should buy the shares due to the following points:

  • The company owns a significant amount of real estate predominantly located around Kansas City in Missouri, which is carried on the balance sheet at overly depreciated amounts. TPRP owns several office buildings and multi-family complexes around the area, some of which have been bought in the early 1990s and 2000s.

  • Further upside is also present in the cash flow stream of the business as the company is well managed and is able to currently rake in approximately $9 million of ‘free’ cash flow per annum (including CapEx). This number is also likely to meaningfully increase this year as the company finished refurbishing one major office property and finished constructing a smaller multi-family project. While they scarcely pay the cash flow out to the shareholders, it certainly helps the balance sheet as they pay down the mortgages with it and acquire new properties.

You can read the whole report here.

Mikros Systems (OTCQB:MKRS)

MKRS traded slightly down from its highs of around $0.6 per share during most of May, but I would not assign the price action to anything fundamental (likely profit-taking). The quarter showcased in May was positive and confirmed most of the thesis. The company is able to maintain margins and cash flow which are, for now, the most important fundamental strengths given the premium on tangible book. I would say that there is still a significant amount of optionality left as per the last month’s comments.

HMG/Courtland Properties (HMG)

The 10-Q filed this month was positive. They received the first distribution from the Orlando real estate project which is now 92% occupied (and thus, is in compliance with the loan covenants). This also means that they could either start to slowly receive more earnings or maybe they could sell their stake in order to realize the value. The distribution (plus the usual other income) helped to offset the operating expenses and fund the dividend and thus the company did not burn any cash this quarter.

Therefore, the thesis remains unchanged as there is plenty of margin of safety and due to the success of the Orlando real estate project also a meaningful upside.

P&F Industries (PFIN)

This stock is still down due to the results in March which showed that the company did not renew its Sears contract which will result in lost revenue stream. While this is clearly negative I believe it changes little regarding the overall thesis. The relatively stable operations (the produced free cash flow) continue to be burdened with the management expense but the margin of safety remains in place. Thus, the stock remains to be a pick for long-term investors that are willing to stomach the volatility.

Willi-Food (WILC)

WILC had a nice month on the back of news regarding the corporate governance but I would not say that all of these were entirely positive. The most important piece of information is that Willigers (brothers that used to run the company before 2014) have been able to gather enough support to elect themselves as directors of BSD Crown. This therefore gives them also power over WILC and they stated that they called a special shareholder meeting on which they want to change the board of the company.

The situation regarding Ta’aman is not entirely clear as they did have a MoU and might be able to try to change the developments, but so far, they have not made anything public. If the whole saga ends with Willigers being back in control of WILC, I would say that the thesis certainly changes as the unlocking of the value would become uncertain (they made WILC a perennial net-net) even despite the consistent results.

Paradise Inc. (OTCPK:PARF)

PARF new 10-Q was rather neutral. The candied fruit sales continued unchanged, as was the cash flow, but the revenue from molded plastics ended up lower due to the loss of one contract. The positive fact though is that the revenue stream was roughly $1.2 million which is not overly material especially given the still dominant candied fruit sales. We will see what the company will do regarding the smaller molded plastics operations, but the margin of safety (PARF's balance sheet and candied fruit business) is unchanged.

I don’t have any stock to discontinue.

Once again, thank you for reading my research!



P.S. Please do let me know if you think that the way I present the review is missing something.

Disclosure: I am/we are long WILC, AEY, HMG.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.