Peter Rabover, CFA
Artko Capital LP
July 16, 2017
For the 4th fiscal and 2nd calendar quarter of 2017, a partnership interest in Artko Capital LP returned 8.3% net of fees. At the same time, an investment in the most comparable market indexes - Russell 2000, Russell Microcap, and the S&P 500 - gained 2.5%, 3.8%, and 3.1%, respectively. For the 12 months of our fiscal 2017, an interest in Artko Capital LP returned 28.5% net of fees, while investments in the most comparable aforementioned market indexes were up 24.6%, 27.6%, and 17.9%, respectively. Our monthly results and related footnotes are available in the table at the end of this letter. We are excited to finish our second year as a partnership while maintaining a 20.4% internal rate of return (IRR) for our partners. As always, we are thankful for your long-term commitment to the partnership's success.
Return On Invested Capital (ROIC) and how it fits into our process
If we were to pick an investment process topic that we suspect we will return to many times in the coming years, Return On Invested Capital (ROIC) or Cash Flow Return On Assets (CFROA), is probably one that will come up more frequently than others. During a recent Fourth of July small-town parade in 90-degree weather, we came upon a simple business with the greatest ROIC in the world: a lemonade stand powered by a little girl on a busy corner. A girl with a (likely borrowed) folding table that can be bought for $10 on any website and a $10, 136-serving Country Time Lemonade mix was selling those cups like gangbusters for 50 cents a cup (a price we suspect could have been doubled without much trouble). In a few hours she ran out of lemonade mix and went home with at least a $60 bounty or a whopping 200% ROIC in one afternoon!
While this example is shown in jest and no little girl's lemonade stand will likely survive the onslaught of the inevitable Amazon (NASDAQ:AMZN) lemonade drone delivery business, analyzing a potential business in the public markets isn't dissimilar. We tend to look for simple to explain business models that can generate substantial and sustainable returns using little capital. Easier said than done, since most of these businesses tend to already trade at justifiably high valuations. While the small- and micro-cap space offers more opportunities to find these, they tend to be few and far between. As such, a big part of our investment process focuses on those companies that have significant opportunities to expand their ROICs from depressed levels, in addition to having a valuation- or asset-based margin of safety. There are many formulas that show how to calculate various definitions of ROICs or Economic Value Added (EVA) and even more showing a theoretical value of a company based on its growth and ROICs.
Nevertheless, a simple truth holds: A company that is expanding its ROICs is going to expand its valuation multiples and value. In other words, the little girl's business would be worth more if she could make more than $60 using the same table and lemonade mix the following week.
Of course, low capital requirements and high returns on capital present a different challenge: the attraction of competitors. Seeing the success of our adorable lemonade-peddling friend is sure to attract her classmates setting up tables on nearby corners within a few days. Therefore, the second half of any ROICs analysis should always include an analysis of sustainability of these returns and the length of the competitive advantage period (CAP) where a company can reinvest its profits at similar rates of return.
It's no surprise that software has the highest returns and tends to have the shortest competitive advantage periods due to its low capital requirements and "winner take all" characteristics. In comparison, staples like food, drugs, and transportation tend to have longer CAPs due to higher capital intensity and higher barriers to entry via regulation. If our friend had cheapest source of lemonade, was the only one with $20 among her friends, or had the exclusive permission from all of her neighbors to set up shop on the block, she is likely to continue to earn her $60 dollars for many town holidays to come. We believe our newest addition in Spartan Motors, discussed below, as well as most positions in the Core Portfolio, fits the narrative of simple, high incremental ROIC opportunity companies and a majority of our investment theses will continue to focus on investing in companies with high sustainable ROICs.
Core Portfolio Additions
- Spartan Motors (NASDAQ:SPAR) - We added an initial 6% position this quarter, which we later increased to 8%, in a fantastic manufacturer of "last mile" delivery vans, emergency vehicles (think firetrucks!) and chassis for large scale Recreational Vehicles (RVs). Spartan, a $300 million market capitalization company with no debt, has a leading position in a duopoly delivery van market, which should continue to grow above historical trends with ecommerce and package delivery set to grow in double digits in the near future.
While the high ROIC van business segment is arguably the jewel of the empire, with expanding 10% EBITDA margins, and at current relative valuation levels accounts for the entire value of the company, we believe the real opportunity lies in the turnaround of bigger emergency vehicles segment by the reputable CEO Daryl Adams. When Adams joined the company two years ago, he found a historically mismanaged and culturally inefficient enterprise. Since then, Adams, who recently bought $3 million worth of SPAR stock on the open market to add to his $2 million holding, has made great strides in improving operations in every segment. In our experience of investing in turnarounds of small industrial manufacturers, we believe the company's problems are easily fixable under Adams' leadership and should drive company-wide EBITDA margins from 4% today to above industry averages of 10% in the next two to three years. Included among some of the easy fixes are consolidating facilities and purchasing departments, investing in hereto non-existent Enterprise Resource Planning software, implementing a culture of lean manufacturing, and compensating the new slate of impressive managers on ROIC enhancing metrics, such as operating income growth and working capital improvements.
We expect SPAR's EBITDA to grow from $30 million in 2016 to over $90 million by 2019 and with low additional capital investment requirements and a substantial portion of those profits to convert to Free Cash Flow. As the company improves its Cash Flow Return on Assets (CFRA) and ROIC from low single digits to potentially 20% or higher, we expect the valuation multiples to expand from 8x to over 10x and for the potential return on this investment to exceed 200% from our initial $8.55 per share purchase levels. In the meantime, the Sum Of The Parts valuation of at least 100% higher than today's stock price and a CEO willing to monetize the company assets for the right price, provide the right margin of safety for this investment.
Core Portfolio Sales
- CSW Industrials (NASDAQ:CSWI) and Graham Corporation (NYSEMKT:GHM) - We sold our combined ~7.0% position in the two small industrials this past quarter to make room for our investment in Spartan Motors. In the end, there was nothing wrong with CSWI or GHM. They were good investments each earning over 20% during our two-year holding period. However, with our expectations going forward of low double-digit returns from these investments, they just did not meet our hurdle for staying in the portfolio, as we generally look for at least a 100% potential upside from our investments. We have not been adding to the positions for some time now with new partnership asset inflows and their size in the portfolio has shrunk from 12% to below 8%. Finally, we felt that while GHM's cash-laden balance sheet provided a strong margin safety, the current struggling energy environment would prevent the business from thriving in the foreseeable future. In the end, we will keep our eye on these high ROIC businesses and would look to potentially enter again at lower prices.
Other Portfolio Updates
- Hudson Technologies (NASDAQ:HDSN) - In a reversal of last quarter's 20% stock price drop where we added an additional 2% on the dip, Hudson came roaring back 30% higher in 2Q as unfounded fears of the Environmental Protection Agency (EPA) repealing the R-22 phase-out began to dissipate. The company also reported solid results during the quarter with refrigerant pricing ticking up in double digits as supply problems ahead of a hot summer continue to manifest and very strong gross margins, above 32% from 27% a year ago, showing how pricing power can quickly translate to significant profitability. Finally, the stock was added to the Russell indexes this past quarter, which increased liquidity and visibility for the company. While at current $9.30 stock price, the stock is up 180% from our initial purchases a year ago, we still believe there is significant value left in this investment and continue to hold it as a 9.0% portfolio position.
- Destination XL (NASDAQ:DXLG) - Destination XL has been our biggest underperformer this quarter, swinging wildly from $2.85 to $1.95 back up to $2.75 and closing the quarter at $2.35. The stock performance of this low liquidity stock driven by broad market fear factors on the overall retail sector does not match the fundamental reality of the company's performance. While the 1 st quarter results came in line with our and the company expectations of flat revenues, by April 2017 the company had ramped up its announced advertising campaign resulting in a 6.4% comparable same store sales increase for the first month. The company is on track to deliver 2-4% same store sales growth for the year and over $30 million in pre-growth capital expenditures Free Cash Flow. While we are mindful of the competitive environment, we believe that 3x Free Cash Flow multiple is just too low for a quality company with its own significant online business boasting an incredible 8% return rate. We've been adding to our position on the dips, lowering our overall cost basis to below $2.50 per share, though these adds should be viewed as temporary as this is likely to remain, a smaller, 6% to 7%, core portfolio position. (Further discussion of the impact of macro-economic uncertainty factors is discussed in our Market Outlook section.)
- State National Companies (NASDAQ:SNC) - We couldn't be more pleased with the performance of this investment over the last year. It is up over 80% since our September 2016 purchase and 30% for the quarter. The company has continued to hit on all cylinders in its Fronting Services segment and Collateral Protection and continues to raise its guidance quarter after quarter. One of our bigger worries for this company was its concentration of big contracts on the Fronting Services side of the business. During the quarter, State National announced two big contract wins totaling $200 million in annualized premiums, which significantly boosted the company's Free Cash Flow generation and diversified its book of business to lower the aforementioned concentration worries. While we do not act on market rumors, the stock's performance this quarter was also helped by reports that the company was in the process of shopping itself to potential buyers. Despite the significant run up in the stock, we believe that at current valuation levels this excellent operator, with high incremental and sustainable ROICs, is still trading 40% below its current fair value and it remains one of our bigger positions at 10% of the portfolio.
- US Geothermal (NYSEMKT:HTM) - US Geothermal, another 10% position, continued its progress toward developing its pipeline of geothermal projects in the Western United States. While the company currently has approximately 40 megawatts (MW) of geothermal power in three plants under management in Nevada, Oregon, and Idaho, the real value in the investment is the development of its pipeline of additional projects that we expect to come on line in the near future. One is a 30MW project in Geisers, CA. and another one is an expansion of its Sam Emidio plant in Nevada. The good news that came out during the quarter and pushed the stock up 15%, is that the Nevada project, Sam Emidio II, has increased its proven reserve estimate from 10MWs a year ago to 47MW today. At this point, the company is in the process of bidding for Power Purchase Agreements (PPAs) with interested parties in California and Nevada, a drawn out and uncertain process. We believe that at current $4.50 per share price, the company's value is backed by its long-life assets and significant Free Cash Flow generation. Should these projects sign PPAs and begin construction, the upside is well over a 100%. The characteristics of the risk-reward of this investment (heads we win and tails we don't lose much) and its relatively small exposure to changes in the economy, is why it continues to be a significant holding in our portfolio.
- We've invested under 1% of our portfolio this quarter in put options of two companies where we determined near term events would lead to a fall in their stock prices. So far, they have both worked out well contributing approximately 0.5% to portfolio performance this quarter.
Market Outlook and Commentary
The most popular TV show in the United States throughout this bull market cycle has been the HBO-based fantasy drama "Game of Thrones." Over the last six seasons, set in the world of seemingly endless summer, the recurring phrase that continued to permeate the show has been "Winter is coming." The characters pay homage to the potential of winter but because it has been warm and sunny for such an unprecedented period, instead of truly preparing for winter it sort of devolved into a repeatable idiom whose original meaning has been lost. In a way, today's markets are not dissimilar. It has been almost a decade since we saw real economic- or market-based discomfort. The Great Recession and the stock market crash of 2008 have been replaced by an unstoppable bull market and an ever-expanding economy. The bogeyman of a bear market is something portfolio managers tell their young analysts to make them work harder, but he hasn't been seen or heard from in years, breeding incredible complacency as measured by the historically low volatility in the markets today.
Since we wrote our first letter to you two years ago, the broad market index, S&P 500 has returned 22.6%. In mid-2015, the expected 2016 S&P earnings were $130 and 2017 earnings expectations were around $146. Looking at the same earnings expectations today, 2017 earnings are expected to be $131.50 and 2018 earnings expectations are at $147. In other words, while the market and market multiples are climbing, from 15.6x Forward Twelve Months (FTM) in 2015 to 17.6x today, the hope for earnings growth keeps being pushed out further and further. It's been one off thing or another as to why this is happening, such as the energy sector getting hit or the dollar getting stronger resulting in negative earnings revisions. The economy continued to grow at a decent clip of over 2% during that time, interest rates were low and investment choices for real returns relative to the U.S. stock markets were non-existent allowing investors to shrug off the continuous push out of earnings growth.
If you've been reading the market commentary section of our investor letters, you know we've been a fan of comparing the real 10-year Treasury rate to the inverse of the S&P 500 Price to Earnings ratio, the earnings yield. Over the last two years, that spread, the equity risk premium, has gone from approximately 6% to closer to 4% on higher market valuations, and moving in line with historical averages. This analysis also required us to believe that earnings expectations will be correct; however, as we see today, those earnings expectations remain the same as they were two years ago so the true earnings yield may be even lower. However, the bigger signal coming through the macro data noise is the flattening of the yield curve. While the 10-year Treasury has remained consistently in place at around 2.35%, the shorter-term rates have gone from .05% to over 1.00% on Federal Reserve tightening actions. In the past, yield curve flattening or inverse movement signals have implied higher potential for economic and market trouble ahead. At the same time, we believe political uncertainty coming from the Trump administration on its tax and healthcare policies and the possibility that the Federal Reserve overshoots on macro policy create an environment of high uncertainty, for not only us, but also companies and consumers alike. As a partnership, we are likely to become more cautious in the near future and may look to hold 20% to 30% of our assets in cash in anticipation of better investment opportunities at lower prices or engage in hedging out market risk. Winter is coming. Don't expect us to be complacent in the face of increasing uncertainty.
We've welcomed 6 new partners to the partnership this quarter bringing our total to 21 by the end of July. With 90% of our assets having a lock up of over 3.5 years, we feel comfortable taking much longer term oriented investment decisions going forward. We are excited about the continued partnership growth and look forward to seeing you at our annual partner event on July 17 in San Francisco. We are likely to have our next event in early 2018, as we will move to converge our fiscal and calendar years in line with your tax reporting periods.
Next Fund Opening
Our next fund openings will be August 1, 2017, and September 1, 2017. Please reach out for updated offering documents and presentations at email@example.com or 415.531.2699
Appendix: Performance Statistics Table
The Partnership's performance is based on operations during a period of general market growth and extraordinary market volatility during part of the period, and is not necessarily indicative of results the Partnership may achieve in the future. In addition, the results are based on the periods as a whole, but results for individual months or quarters within each period have been more favorable or less favorable than the average, as the case may be. The foregoing data have been prepared by the General Partner and have not been compiled, reviewed or audited by an independent accountant and non-year end results are subject to adjustment.
The results portrayed are for an investor since inception in the Partnership and the results reflect the reinvestment of dividends and other earnings and the deduction of costs, the management fees charged to the Partnership and a pro forma reduction of the General Partner's special profit allocation, if applicable. The General Partner believes that the comparison of Partnership performance to any single market index is inappropriate. The Partnership's portfolio may contain options and other derivative securities, fixed income investments, may include short sales of securities and margin trading and is not as diversified as the indices, shown. The Standard & Poor's 500 Index contains 500 industrial, transportation, utility and financial companies and is generally representative of the large capitalization US stock market. The Russell 2000 Index is comprised of the smallest 2000 companies in the Russell 3000 Index and is generally representative of the small capitalization U.S. stock market. The Russell Microcap Index is comprised of the smallest 1,000 securities in the Russell 2000 Index plus the next 1,000 securities (traded on national exchanges). The Russell Microcap is generally representative of the microcap segment of the U.S. stock market. All of the indices are unmanaged, market weighted and reflect the reinvestment of dividends. Due to the differences among the Partnership's portfolio and the performance of the equity market indices shown above, however, the General Partner cautions potential investors that no such index is directly comparable to the investment strategy of the Partnership.
While the General Partner believes that to date the Partnership has been managed with an investment philosophy and methodology similar to that described in the Partnership's Offering Circular and to that which will be used to manage the Partnership in the future, future investments will be made under different economic conditions and in different securities. Further, the performance discussed herein does not reflect the General Partner's performance in all different economic cycles. It should not be assumed that investors will experience returns in the future, if any, comparable to those discussed above. The information given above is historic and should not be taken as any indication of future performance. It should not be assumed that recommendations made in the future will be profitable, or will equal, the performance of the securities discussed in this material. Upon request, the General Partner will provide to you a list of all the recommendations made by it within the past year.
This document is not intended as and does not constitute an offer to sell any securities to any person or a solicitation of any person of any offer to purchase any securities. Such an offer or solicitation can only be made by the confidential Offering Circular of the Partnership. This information omits most of the information material to a decision whether to invest in the Partnership. No person should rely on any information in this document, but should rely exclusively on the Offering Circular in considering whether to invest in the Partnership.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.