MOI Global | The Membership Community of Intelligent Investors

Why We Invested in Oxford Square Capital

May 6, 2018 in Equities, Ideas

This article is excerpted from a letter by Jim Roumell, partner and portfolio manager of Roumell Asset Management, based in Chevy Chase, Maryland.

Oxford Square is a publicly-traded business development company (“BDC”) primarily engaged in providing debt capital to a wide-range of U.S.-based companies. It holds assets in syndicated bank loans and debt and equity tranches of collateralized loan obligations. OXSQ’s focus is primarily on small to mid-sized companies. OXSQ generally invests between $5.0 million and $50.0 million in each of its portfolio companies.

OXSQ has a good track record in underwriting credit risk. It is impressive that it has maintained a growing to relatively consistent net asset value (NAV) per share over the last two years. During this period many other credit BDCs saw NAV declines. At the end of the first quarter of 2016, OXSQ’s NAV per shar was $5.89. The NAV per share grew throughout 2016 and remained relatively consistent throughout 2017. At December 31, 2017 the NAV per share was $7.55. This NAV performance is particularly impressive given the fact that OXSQ pays a large quarterly distribution to shareholders that reduces NAV. This means that OXSQ had earnings and/or capital appreciation that either grew or maintained the NAV even after the large quarterly distributions to shareholders. The distribution was $0.29 per share in each quarter of 2016 and $0.20 per share for each quarter during 2017. The current $0.20 quarterly payment represents an annualized distribution yield of 13% based on the current $6.15 stock price.

As credit spreads remain tight, many credit BDC’s have chosen to reduce their quarterly distributions. Should OXSQ choose to do the same, to say $0.16 per quarter, the yield would still be slightly over 10%. While we find the yield attractive, that was not the primary basis of our investment thesis. Rather, it was the significant discount that the stock trades at relative to the underlying NAV of the company. The primary assets of the business are syndicated bank loans and debt and equity tranches of collateralized loan obligations which are carried at estimated market value. These market values are reviewed periodically by independent sources (external auditors) and filed quarterly with the Securities Exchange Commission on form 10Q and annually on form 10K. As such, we have confidence in the reasonableness of the reported market values. As noted above, the NAV per share at December 31, 2017 was $7.55. We purchased shares during the quarter at an average price of about $5.50. This represents a very attractive discount to NAV of approximately 27%. Even at the current higher stock price of $6.15, the discount to NAV is about 19%.

We have met with CEO Jonathan Cohen and have confidence in his leadership. We are particularly comforted by the fact that he has a substantial personal investment in OXSC and has never sold any shares. In summary, our thesis here is to purchase an asset trading at a substantial discount to its underlying NAV and get paid a double-digit distribution yield while we wait for the discount to close.

download printable version

Disclosure: The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory clients, and the reader should not assume that investments in the securities identified and discussed were or will be profitable. The top three securities purchased in the quarter are based on the largest absolute dollar purchases made in the quarter.

Leucadia: Strategic Transactions Highlight Value

May 5, 2018 in Equities, Ideas, Letters

This article is authored by MOI Global instructor Patrick Brennan, portfolio manager of Brennan Asset Management.

As we have discussed in past letters, we followed Leucadia for years from a distance. While we were greatly impressed with value legends Joe Steinberg and Ian Cumming, we did not own the name until after the company purchased Jefferies and subsequently became deeply unpopular with its historical investor base. After examining Jefferies’ record over multiple market cycles, as well as evaluating some of the team’s early capital allocation decisions (including the HRG investment which we also own), we believed there was substantial upside in the company’s asset base and we believed the team could drive further value in the years to come. This viewpoint contrasted with the more negative consensus sentiment which essentially argued some combination of the following:

  • Joe and Ian created all the value…Rich and Brian are New York investment bankers/traders/ mercenaries and therefore are genetically incapable of being value investors (or something to that effect)
  • Jefferies and National Beef are lower quality assets and will unlikely earn much over an economic cycle
  • Investment banking is in cyclical decline
  • LUK has tons of assets, often looks weird on a GAAP basis and the entire business is far too complicated – who wants to simultaneously follow bonds, cows and car dealerships?

Well, the path has been far from smooth and both the beef business and bond business have faced greater challenges than we anticipated over the past couple of years. Both businesses, however, produced record results in 2017 with nearly $1 billion in pre-tax income between them. Importantly, Jefferies has also started upstreaming dividends to the parent company to repurchase shares or to acquire other businesses. Yes, there will be volatility associated with these dividends, but last time we checked, the wind sometimes blows in unexpected ways for property and casualty insurers who invest underwriting profits. National Beef struggled far more than we anticipated, but its earnings have also rebounded far faster and ultimately higher than we ever would have guessed. We won’t detail every LUK investment decision over the past 3 years, but we would argue that the hits (HRG, FXCM rescue, KCG sale, Jefferies turnaround, partial National Beef monetization) far outweigh any misses. These early results (not to mention Handler’s track record when Jefferies was a standalone company from 2000-2013) might suggest that it is not a metaphysical impossibility for certain bankers to be decent capital allocators. So, given the favorable Jefferies/National Beef results, Jefferies dividends and market rumors concerning a National Beef sale, investors (naturally) sold and drove shares down -14% in the first quarter.

Given the number and variation in holdings, many investors typically look to book value (~$27) and tangible book value (~$20) as a rough approximation of value. But, this range of values considerably understates the favorable risk/reward in the name, considering the low or nonsensical marks of some of the businesses. By far the most glaring discrepancy was National beef, which was marked at -$37 million on a tangible book basis despite earning over $500 million in EBITDA during 2017. It does not take hours of studying herd levels to ascertain a discrepancy. While not as large as National Beef, other investments (Berkadia, Garcadia, Linkem, Homefed) were marked at levels sometimes 50% or more below realistic market values and even HRG, which team LUK successfully liberated, looks cheap relative to the possible value of Spectrum Brands. As the quarter ended, shares traded below our best estimate of liquidation value and nearly 50% below fair value. And of course, this would be a static estimate. What happens if LUK’s management finds other opportunities? In our opinion, enormous buybacks were warranted.

In early April, LUK simultaneously announced the following:

  • Selling 48% of its National Beef business for $900 million in cash plus an additional $150 million in recent profits/acquisition adjustments. LUK retained 31% of the business (Implied value of over $1.9 billion vs. -$37 million tangible book value).
  • Selling Garcadia ($425mm equity value vs. $200 million marked tangible book value)
  • $190 million acquisition of Bakken assets by Vitesse Energy Finance, doubling its asset size
  • Increased buyback program to 25 million shares from 12.5 million. Pro-forma for the transactions, LUK will have a whopping $2.8 billion of liquidity at the holding company
  • Jefferies announced preliminary Q1 results (during a rocky market period) of ~$120 million pre-tax
  • Proposal for a name change to Jefferies Financial Group Inc. (New ticker JEF)

The sales were obviously far above marked book value and suggest that other assets (Berkadia/Linkem/HomeFed) may very well have meaningful upside to marked value. More importantly, the moves confirm that management is attempting to create a more focused company and narrow the gap between price and value. The National Beef transaction was a complete homerun as LUK paid $868 million to acquire 79% of National Beef, received cash of $1.6 billion and still retains a 31% interest. LUK has jumped since the initial announcement, but it is still down for the year and trades roughly 25-35% below our best estimate of current value, which gives no credit to possible value creation optionality. If shares continue to languish, we hope LUK quickly exhausts its buyback program.

download printable version

Disclaimer: BAM’s investment decision making process involves a number of different factors, not just those discussed in this document. The views expressed in this material are subject to ongoing evaluation and could change at any time. Past performance is not indicative of future results, which may vary. The value of investments and the income derived from investments can go down as well as up. It shall not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities mentioned here. While BAM seeks to design a portfolio which reflects appropriate risk and return features, portfolio characteristics may deviate from those of the benchmark. Although BAM follows the same investment strategy for each advisory client with similar investment objectives and financial condition, differences in client holdings are dictated by variations in clients’ investment guidelines and risk tolerances. BAM may continue to hold a certain security in one client account while selling it for another client account when client guidelines or risk tolerances mandate a sale for a particular client. In some cases, consistent with client objectives and risk, BAM may purchase a security for one client while selling it for another. Consistent with specific client objectives and risk tolerance, clients’ trades may be executed at different times and at different prices. Each of these factors influences the overall performance of the investment strategies followed by the Firm. Nothing herein should be construed as a solicitation or offer, or recommendation to buy or sell any security, or as an offer to provide advisory services in any jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction. The material provided herein is for informational purposes only. Before engaging BAM, prospective clients are strongly urged to perform additional due diligence, to ask additional questions of BAM as they deem appropriate, and to discuss any prospective investment with their legal and tax advisers.

Why We Invested in Disney

May 4, 2018 in Equities, Ideas, Large Cap, Letters, North America, Wide Moat

This article by Francisco Olivera is excerpted from a letter of Arevilo Capital Management, based in San Juan, Puerto Rico.

Francisco was an instructor at Best Ideas 2018 (replay the session).

Read about the key pillars of Francisco’s investment approach.

We initiated an investment in Disney, which complements the Twenty-First Century Fox (“21CF”) investment initiated last quarter. As described in our previous letter, Disney is acquiring most of 21CF’s assets and 21CF shareholders will receive shares of Disney and “New Fox” when the deal closes. We decided to increase our exposure to Disney as the share price became more attractive and we grew more confident in Disney’s long-term business opportunities.

Disney has four (4) business segments1: Media Networks, such as ABC, ESPN and Disney Channel; Studio Entertainment, including Disney Animation, Disney Studios, Pixar, Marvel Studios, and Lucasfilm; Parks and Resorts, such as Disneyland and Disney World; and Consumer Products & Interactive Media, the licensing division for merchandise and games.

The heart of Disney

The studio business is the heart of Disney and creates momentum across most of the company’s business segments. Disney’s studios produce high-quality films and television programming, many which turn into valuable franchises. In addition to driving theatre box office sales, physical/digital video purchases and video licensing fees, these franchises also generate demand for consumer products and can be leveraged across the company’s theme parks and resorts.

As an example, Disney Animation’s Frozen, a 2013 film, generated nearly $1.3 billion in global theatre ticket sales, a very financially successful film (not to mention hundreds of millions of dollars in home video sales as well). For any other studio, Frozen would be a major hit (and it was for Disney), but only Disney – with its scale, entertainments assets, and marketing expertise – was able to further monetize the film. Disney’s Consumer Products & Interactive Media segment licensed Frozen content for dolls, toys, clothing, and other merchandise, providing high margin profits for the company (sales of Frozen dolls alone reportedly exceeded $500 million). Disney has also incorporated Frozen content in its theme parks and recently launched a Frozen Broadway show. A Frozen sequel is expected to be released next year.

Disney continuously executes this strategy: leveraging its high-quality content making capabilities with its scale, entertainments assets (including Parks and Resorts), and marketing expertise to monetize content at an unmatched level. Other examples of Disney franchises include: Pixar’s Toy Story, a new “Toy Story Land” in Disney World will open this summer and Disney will release a fourth film next year; Marvel’s Blank Panther, which has generated over $1.3 billion in global theatre ticket sales this year (in late February, the line to “meet” Black Panther at Disneyland was an hour long); and Lucasfilm’s Star Wars films, a Star Wars themed “land” and hotel will open in Disney World next year. Disney’s studio, parks and consumer products segments have continued to excel in spite of the changing media landscape.

Media Networks concerns

Concerns over Disney’s value as a company have grown over the past few years as new internet-based content creators and distributors (mainly Netflix, Amazon, Hulu and YouTube) have changed consumer behavior and disrupted the pay television content bundle, the main profit generator for Disney’s largest division, Media Networks. A decline in pay TV households in the U.S. is likely to continue, as quality content is cheaper and easier to access on Netflix (and other streaming services) versus the traditional +100 channel cable bundles. This does not mean Disney’s media networks (the largest and most important being ESPN) are doomed towards extinction.

According to 21CF’s Chief Financial Officer, 83 of the top 100 shows on television2 in 2017 were sports or news. In 2007, 90 of the top 100 shows were scripted entertainment shows, such as Lost and Two and a Half Men. Consumer habits have dramatically shifted. Consumers prefer to watch live content when tuning to linear television and turn to streaming apps to watch their favorite television shows and movies on their own schedule. Disney knows these trends will continue to accelerate and began to implement a two pronged strategy: 1) Maintain ESPN’s place in the cable bundle, as the premier destination for live sports; and 2) shift the majority of its scripted entertainment to a new Disney direct-to-consumer streaming product to be introduced next year.

ESPN

The traditional cable bundle is still the best mechanism to distribute ESPN’s live sports content rights. Live sports are very expensive and therefore ESPN needs to be distributed as widely as possible. Television advertisements for sports events are the most valuable due to the live nature of the content, and sports transmission on cable has less technical issues relative to online live streaming. Given that the most watched programming on television is live and the most valuable portfolio of live sports is licensed by ESPN3, we expect ESPN’s ability to extract value from the cable bundle to continue.

Recognizing the decline in U.S. pay television households, ESPN launched a new branded direct-to-consumer streaming service called “ESPN+.” The focus for ESPN+ is on niche sports, daily MLB and NHL games, and ESPN’s original programming, including the award-winning 30 for 30 series. We expect ESPN to acquire more significant sports rights for ESPN+ over the next few years, which could serve as a hedge to ESPN’s cable bundle risk. In our view, the risks to ESPN’s long-term business model are vastly overstated.

Disney Direct-to-Consumer

Disney’s studio business was built on movie theatres selling tickets, retailers selling home movies, and other media companies licensing Disney’s content library. These third parties mark-up Disney’s products considerably and do not provide Disney with significant data on its customers. Disney does not know who watched Frozen in theatres, purchased Frozen merchandise, or bought Frozen Blu-Ray for home viewing. To position Disney for the future, the company has announced a Disney branded direct-to-consumer streaming service that will launch next year. Disney will cease to license its content to Netflix (and other streaming providers) and go “all-in” on its new service.

We believe the larger goal of the Disney streaming service will be to create a sustained Disney experience for consumers. With the new service, Disney will know what movies and television shows consumers watch most and will be able to adjust its content spend accordingly. The service could eventually offer exclusive deals for Disney merchandise, theme park discounts, cruise line discounts, and/or exclusive Disney Broadway tickets. Shifting the content monetization from primarily third party revenue streams (individual movie tickets and home movie purchases) to a subscription model will create enormous value for Disney over the long-term. Owning the most valuable family-oriented content in the world has its perks!

Twenty-First Century Fox Transaction

The above description does not include the assets Disney is acquiring from 21CF, but it is worth commenting on, given the size of the transaction. We believe the 21CF acquisition materially enhances Disney’s long-term opportunities. On the Media Networks side, Disney will be adding a large portfolio of regional sports networks (“RSNs”) that matches well with ESPN and could provide valuable content for ESPN+. Disney will also be acquiring FX Networks and the National Geographic Channel. Both channels own noteworthy content that Disney will be able to monetize through its own streaming services, including Hulu.

The 21CF deal will raise Disney’s ownership in Hulu to a controlling 60% stake. Disney will be able to supply Hulu with quality adult-oriented content that does not fit well with the Disney branded streaming service. With over 20 million subscribers, Hulu is a growing force in content streaming and will fit perfectly with Disney.

The Twentieth Century Fox Film and Television studios add enormous content and content-making capabilities for Disney, including the Avatar, X-Men, Fantastic Four, Deadpool, and Planet of the Apes franchises. Monetizing franchises has been Disney’s “bread and butter”.

21CF’s Marvel film franchises (X-Men, Fantastic Four and Deadpool) will integrate seamlessly into Disney, but the Avatar franchise is also a great fit4. Lastly, Disney agreed to acquire 21CF’s 39% stake in Sky Plc and Fox’s international television businesses, which provide additional direct-to-consumer services and increases Disney’s international scale. Growing internationally has been one of Disney’s long-time goals; 21CF provides the perfect assets to grow Disney’s content awareness globally.

It is important to note that Comcast is trying to disrupt Disney’s 21CF deal. Comcast announced a formal bid to buy Sky Plc, and is currently outbidding 21CF5. The Wall Street Journal also reported that Comcast may be interested in publicly bidding for the 21CF assets Disney agreed to acquire. We believe Disney will still manage to close its 21CF deal with Sky Plc, however, if the deal does not happen, Disney remains an attractive investment.

Valuation

Disney currently trades at approximately 15x LTM earnings6, a very cheap multiple when considering Disney’s future growth opportunities and earnings accretion from the 21CF deal. Disney has also committed to repurchasing $10 billion worth of its own stock by the time the 21CF deal closes and an additional $10 billion within two years post-closing. At today’s cheap stock price, Disney would create additional value by repurchasing shares.

______

1 Earlier this year, Disney announced a reorganization of its business segments to align the company with its future growth opportunities, such as its direct-to-consumer streaming services. Given that Disney does not yet report its financial statements under the new reorganization, we did not discuss the reorganized segments in this letter.
2 Includes both broadcast and cable television shows.
3 ESPN’s live sports portfolio includes, NFL’s Monday Night Football, NBA (including playoff games and the NBA finals), college football (including playoffs), college basketball, MLB, Grand Slam tennis and Formula 1.
4 Last year, Disney opened the Pandora – The World of Avatar “land” at Animal Kingdom.
5 21CF is in the middle of receiving regulatory approval to acquire the 61% of Sky it does not own. Upon receiving regulatory approval, 21CF is expected to raise its bid for Sky to prevent Comcast from acquiring the company.
6 LTM = last twelve months. We adjusted earnings for the impact of tax reform.

download printable version

Why We Invested in Smart Sand

May 2, 2018 in Equities, Ideas, Letters

This article by Matthew Haynes is excerpted from a letter of 1949 Value Advisors, an absolute return-oriented global value investment firm based in Mahwah, New Jersey. Matt is a valued contributor to The Zurich Project.

Matt will share his thesis on Smart Sand at Best Ideas Omaha 2018.

Smart Sand, Inc. (SND) is a leading supplier of industrial sand primarily serving customers in the oil & gas industry. Headquartered in The Woodlands, TX, Smart Sand is a pure play, low-cost producer of high-quality Northern White raw frac sand (NWS). Raw frac sand is a proppant, “designed to keep an induced hydraulic fracture open, during or following a fracturing treatment”. (Wikipedia) It is added to water to create a fracturing fluid which is then blasted down the well bore at very high pressure to “prop open” the fracture once the pumps are shut down, allowing release and capture of hydrocarbons.

Smart Sand is one of only five publicly traded pure play frac sand producers (in aggregate, representing ~50% of industry capacity). The company has one producing mine in Oakdale, WI adjacent to the Canadian Pacific railroad, well situated to supply its Northern White sand to any of the shale plays in North America. Logistics is one of the most important considerations in this industry, as transportation costs are a significant component of production costs (~40%) and contracts are typically priced on a delivered basis.

Recent plans to initiate frac sand production within the Permian basin, thus dramatically reducing the transportation cost element, has worried frac sand investors that NWS producers will be priced out of the market. Permian brown sand is considered to be of lower quality than NWS and uncompetitive without a logistical advantage.

In addition, Permian frac sand is a captive market, with no alternative homes outside the Permian basin. These imply that supply growth will likely undershoot announced nameplate capacity plans, limiting the negative impact to NWS pricing.

With a market cap of $225 million and net cash of $34 million, shares traded near $5.50 at the time of our purchase, down from $20 a year ago. Representing ~5.5x current year EPS and 4x EBIT (4.7x and 3.7x 2019 estimates, respectively), we believe that we have a margin of safety against permanent loss.

The sector has seen consolidation activity, with EV/ton of productive capacity being the most relevant metric in frac sand transactions. Deals have been in the range of $100-120/ton, versus the current valuation of Smart Sand closer to $40/ton.

We believe that SND could be an attractive target for larger frac sand companies, oil field services companies looking to vertically integrate, or a larger shale oil & gas producer looking to secure reliable supply of its higher quality NWS.

The reversion to a more appropriate trading multiple over time is likely to be our surest path, with takeover interest potentially catalyzing its higher private market value.

download printable version

Disclaimer: This summary does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Any such offer or solicitation may only be made to qualified investors and only by means of an approved confidential private offering memorandum or investment advisory agreement and only in those jurisdictions where permitted by law. This summary reflects select positions of the current portfolio of a managed account advised by 1949 Value Advisors. There is no guarantee that a commingled investment vehicle or another investment account managed by 1949 Value Advisors will invest in the same investments set forth in this summary. The investment approach and portfolio construction set forth herein may be modified at any time in any manner believed to be consistent with the managed account’s overall investment objectives. While all information herein is believed to be accurate, 1949 Value Advisors makes no express warranty as to the completeness or accuracy nor does it accept responsibility for errors appearing in the summary. This summary is strictly confidential and may not be distributed

MOI Global