Comments on Selected Investments

November 5, 2017 in Letters

This article by Matthew Sweeney is excerpted from a letter of Laughing Water Capital.

EZCorp (EZPW) – EZCorp has moved past the stock price weakness caused by the convertible bond offering which I detailed in our 1H’17 letter. More importantly, the company recently announced a major acquisition in the form of 112 Latin American stores. While operationally this appears to be a good use of cash, there are larger implications which I believe will play out in the months and years to come as the market digests the news. First, for the last few years the narrative surrounding EZPW has been somewhere between “it is a disaster” and “they have a lot of changes to make.” As the company enters the final year of their 3 year plan with a cleaned up balance sheet and incredible operational improvements, the narrative should shift to, “they are back on a growth track,” which should lead to increased interest from the investment community. Secondly, for the last few years while EZPW struggled, their largest competitor, FirstCash (FCFS) has been hoovering up large pawn operations throughout the western hemisphere without any competition. Now that EZPW has signaled they are back in the game, I believe it is likely that FCFS will realize that their best move would be to buy EZPW, even if it required a large premium. First, FCFS would be able to realize massive synergies by eliminating virtually all of EZPW’s infrastructure. Second, if they do not buy EZPW, FCFS will be living in a world where all of their substantial growth ambitions will lead them to competitive bidding processes, driving up prices. Simply stated, paying up for EZPW means they will be able to pay down for every other pawn group. EZPW remains a top 5 position.

Iteris (ITI) – In our last letter, I noted that curiously management created a new, separate legal entity to house the agriculture/weather business, which suggests that an eventual sale of this business may be somewhere on their radar. Adding to the intrigue, Iteris recently hired Jim Chambers to run the agriculture/weather business. A review of Mr. Chambers’ CV reveals that of the previous companies where he was employed, four (4!) of them were acquired. It seems clear that management has positioned the agriculture business for eventual sale, and hired an executive that knows a thing or two about selling businesses. However, the company has also registered a shelf which would allow them to raise capital in a secondary offering. If the agriculture business was sold in the near term it would be unlikely that the company would need to raise additional cash, so the tea leaves are muddled. This is just fine because the company continues to execute at a very high level, and the traffic management business remains an undiscovered gem at the forefront of the future of intelligent transportation and autonomous vehicles. ITI remains a top 5 position.

Now Inc (DNOW) – I have sold our shares in DNOW. The original thesis was that an investment in DNOW was an investment in the beaten-up oil space that would benefit independent of oil prices as management used their massively over-capitalized balance sheet and long track record of successful M&A to gain market share by buying struggling Mom and Pop players in the oil field distribution business. Shares rallied quite a bit from our purchase price as the price of oil recovered, but quickly gave back the gains. The price of oil was never germane to our thesis so we should have exited on this brief move, but we did not. Management has since signaled that the rally in oil prices has made M&A increasingly unlikely because bid-ask spreads between buyers and sellers are too wide. Absent the opportunity to take market share through M&A, in my view DNOW is a bet on oil prices, and I have no reason to think I am any good at predicting oil prices so we exited the position.

Revlon (REV) – Revlon’s wild ride continues, with shares having traded hands below $16 in mid September and above $27 in late September. Business value just doesn’t change that quickly absent catastrophic events, but as a stock Revlon is its own animal as controlling shareholder Ron Perelman and the largest independent shareholder, Mittleman Brothers, do battle through SEC filings that seek to influence the supposedly fiduciary minded board of directors. Notably, Mittleman asked for Perelman to agree to not squeeze out minority shareholders for a period of five years. Perelman agreed to not exceed 90% ownership for a (woefully short) one year period. From our perspective, it is of course frustrating that shares have traded down from ~$35 earlier this year, but they remain drastically under-valued if you are a long term, patient shareholder. Lower prices make Revlon an attractive candidate for tax loss selling, but Perelman’s 1 year standstill agreement had the curious side effect of emboldening short sellers (who are likely hedging debt investments) who no longer have any reason to fear a buyout deal at a premium. As a result, we are presently earning a ~15%+ yield lending our shares to those who are concerned with short term volatility while patiently waiting for long term value to develop. Getting paid 15%+ to wait for something that I believe may ultimately be worth multiples of its present price helps sooth the pain of our mark to market losses incurred this year.

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Disclaimer: This document, which is being provided on a confidential basis, shall not constitute an offer to sell or the solicitation of any offer to buy which may only be made at the time a qualified offeree receives a confidential private offering memorandum (“CPOM”) / confidential explanatory memorandum (“CEM”), which contains important information (including investment objective, policies, risk factors, fees, tax implications and relevant qualifications), and only in those jurisdictions where permitted by law. In the case of any inconsistency between the descriptions or terms in this document and the CPOM/CEM, the CPOM/CEM shall control. These securities shall not be offered or sold in any jurisdiction in which such offer, solicitation or sale would be unlawful until the requirements of the laws of such jurisdiction have been satisfied. This document is not intended for public use or distribution. While all the information prepared in this document is believed to be accurate, Laughing Water Capital, LP and LW Capital Management, LLC make no express warranty as to the completeness or accuracy, nor can they accept responsibility for errors appearing in the document. An investment in the fund/partnership is speculative and involves a high degree of risk. Opportunities for withdrawal/redemption and transferability of interests are restricted, so investors may not have access to capital when it is needed. There is no secondary market for the interests and none is expected to develop. The portfolio is under the sole trading authority of the general partner/investment manager. A portion of the trades executed may take place on non-U.S. exchanges. Leverage may be employed in the portfolio, which can make investment performance volatile. The portfolio is concentrated, which leads to increased volatility. An investor should not make an investment, unless it is prepared to lose all or a substantial portion of its investment. The fees and expenses charged in connection with this investment may be higher than the fees and expenses of other investment alternatives and may offset profits. There is no guarantee that the investment objective will be achieved. Moreover, the past performance of the investment team should not be construed as an indicator of future performance. Any projections, market outlooks or estimates in this document are forward-looking statements and are based upon certain assumptions. Other events which were not taken into account may occur and may significantly affect the returns or performance of the fund/partnership. Any projections, outlooks or assumptions should not be construed to be indicative of the actual events which will occur. The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of LW Capital Management, LLC. The information in this material is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Laughing Water Capital LP, which are subject to change and which Laughing Water Capital LP does not undertake to update. Due to, among other things, the volatile nature of the markets, an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment. The fund/partnership is not registered under the investment company act of 1940, as amended, in reliance on an exemption there under. Interests in the fund/partnership have not been registered under the securities act of 1933, as amended, or the securities laws of any state and are being offered and sold in reliance on exemptions from the registration requirements of said act and laws. The S&P 500 and Russell 2000 are indices of US equities. They are included for informational purposes only and may not be representative of the type of investments made by the fund.

The Considerably Challenged

November 5, 2017 in Letters

This article is excerpted from a letter to partners of Boyles Asset Management.

Having already discussed our Mastermyne exit in relation to the capital cycle, we also wanted to discuss our experience with the company as it relates to one of our investment category mental models. Earlier in the year we presented our “Temporary Trudgers” model. Here we discuss a model we’ve come to refer to as “The Considerably Challenged.”

The “considerably challenged” investment category mental model can typify some of the most challenging business and investment operations. Companies meeting this model are navigating a battlefield dotted with landmines.

There are unique challenges with owning companies that fall into this category. As we’ve alluded to, these positions can ultimately become quite taxing before the ultimate prize is realized. As our quote highlights, investors have to be aware that they and the business are traversing a battlefield dotted with landmines. You have to realize that the landmines are there; you just don’t know where they are or when the company will hit one. These ideas require a type-specific investment approach and mental awareness.

When we refer to “The Considerably Challenged,” in the context of our operations at Boyles, this does not refer to balance sheet stress. We specifically avoid that particular challenge. We seek other challenges, including: severe cyclical downturns, poor operational decisions, significant customer issues, etc.—anything that is likely to severely depress, or even eliminate, current earnings.

Investment and Portfolio Management Considerations

Given our focus on little or no downside in these situations, the balance sheet must be quite strong, not just acceptable. Given the challenges being endured and the landmines likely to be triggered, the company must be in a position to absorb them, a fact that will likely weaken the balance sheet during one’s holding period. In addition to allowing for survival, a strong balance sheet, both absolutely and relatively, can be key to capitalizing on the upside envisioned.

You can be patient in share accumulation. After the company hits a landmine, you are likely to be presented with wonderful buying opportunities.

Purchasing well below book value is a good place to start. Given what may transpire, starting to get excited at book value or above is likely to prove less productive than it may seem at the time.

An ability to generate cash, if not earnings, is particularly important. This may come in the form of working capital release, ongoing operating cash flows, asset sales, tax recoveries, etc.

If such an idea presents itself in a small-cap name with limited liquidity, the changes in sentiment and stock prices can be quick and significant.

Mental Considerations

Owning such ideas can be mentally taxing. It may require you to show a large unrealized loss at some point during your holding period. Not only may you look silly for owning it, but also you must be prepared to avoid the behavioral challenges associated with such a situation, and make the appropriate decisions when something you own seems to go down in a straight line.

When it really hurts to buy more shares, it may very well be a good sign.

One must recognize that after owning such a company for a substantial period of challenging times, you may be in a better position than others in the marketplace to make significant sums on the idea.

When we exited Mastermyne, we earned a total return, including dividends, of 122% in U.S. Dollars during our approximate three-year holding period. The IRR on the capital deployed was 40%. In AUS Dollars, the total return was 127% and the IRR was 42%. While we made money on all share purchases based on our exit prices, developing the mental model outlined here allowed us to make significant returns on capital deployed after our initial purchase—when that initial purchase looked poorly made. While our initial small purchases would have produced a mid-to-upper-single-digit IRR during our holding period, our lower subsequent average cost produced a much more attractive outcome.

During the period we owned shares, the company hit plenty of landmines. Large long-term customers were lost, specific business expansion opportunities that looked promising failed to materialize, environmental challenges pressured the industry, commodity prices suffered even further, an acquisition didn’t perform to expectations in its first two years, cash flows deteriorated beyond our expectations, customer asset sales disrupted relationships, maintenance work was deferred beyond anyone’s expectations, and the list goes on. Despite all the landmines, with the right purchase price(s), and the right mental model, we achieved an acceptable return.

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The content of this website is not an offer to sell or the solicitation of an offer to buy any security. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this website. BeyondProxy’s officers, directors, employees, and/or contributing authors may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated herein.

Why We Invested in Redknee Solutions

November 4, 2017 in Equities, Ideas, Letters

This article by Matthew Sweeney is excerpted from a letter of Laughing Water Capital.

Redknee Solutions (RKN.TO) is a vertical market software company focused on selling billing software to telecom companies, that entered our portfolio as a top five position. In short, a year or so ago the company ran into problems with its balance sheet after being overly focused on growth, and making poor acquisitions. The company announced they were reviewing strategic alternatives, which led to a controlling investment from software turnaround specialist ESW Capital. I am generally wary of turnaround stories, but upon learning more about ESW, I think the odds are tilted very heavily in favor of success.

ESW has traditionally operated in the private markets, and has previously maximized profitability at ~40 small software companies by bringing the benefits of scale to these small software companies. This has been accomplished by partnering the target companies with ESW’s competitively advantaged platform, which includes internally controlled outsourcing capabilities, software development capabilities, and shared infrastructure.

Our investment is rooted in the fact that in August, the company raised capital through a rights offering, which led to un-economic selling, and thus a very attractive purchase price for our shares. In sum, Redknee is an excellent opportunity to partner with a best in class management team that has invested well over $100M in the company in the belief that they can simply do what they have done dozens of times before: maximize revenue at a small software company with sticky revenue. A more thorough description of the mechanics of the rights offering and the business can be found at the end of this letter.

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Disclaimer: This document, which is being provided on a confidential basis, shall not constitute an offer to sell or the solicitation of any offer to buy which may only be made at the time a qualified offeree receives a confidential private offering memorandum (“CPOM”) / confidential explanatory memorandum (“CEM”), which contains important information (including investment objective, policies, risk factors, fees, tax implications and relevant qualifications), and only in those jurisdictions where permitted by law. In the case of any inconsistency between the descriptions or terms in this document and the CPOM/CEM, the CPOM/CEM shall control. These securities shall not be offered or sold in any jurisdiction in which such offer, solicitation or sale would be unlawful until the requirements of the laws of such jurisdiction have been satisfied. This document is not intended for public use or distribution. While all the information prepared in this document is believed to be accurate, Laughing Water Capital, LP and LW Capital Management, LLC make no express warranty as to the completeness or accuracy, nor can they accept responsibility for errors appearing in the document. An investment in the fund/partnership is speculative and involves a high degree of risk. Opportunities for withdrawal/redemption and transferability of interests are restricted, so investors may not have access to capital when it is needed. There is no secondary market for the interests and none is expected to develop. The portfolio is under the sole trading authority of the general partner/investment manager. A portion of the trades executed may take place on non-U.S. exchanges. Leverage may be employed in the portfolio, which can make investment performance volatile. The portfolio is concentrated, which leads to increased volatility. An investor should not make an investment, unless it is prepared to lose all or a substantial portion of its investment. The fees and expenses charged in connection with this investment may be higher than the fees and expenses of other investment alternatives and may offset profits. There is no guarantee that the investment objective will be achieved. Moreover, the past performance of the investment team should not be construed as an indicator of future performance. Any projections, market outlooks or estimates in this document are forward-looking statements and are based upon certain assumptions. Other events which were not taken into account may occur and may significantly affect the returns or performance of the fund/partnership. Any projections, outlooks or assumptions should not be construed to be indicative of the actual events which will occur. The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of LW Capital Management, LLC. The information in this material is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Laughing Water Capital LP, which are subject to change and which Laughing Water Capital LP does not undertake to update. Due to, among other things, the volatile nature of the markets, an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment. The fund/partnership is not registered under the investment company act of 1940, as amended, in reliance on an exemption there under. Interests in the fund/partnership have not been registered under the securities act of 1933, as amended, or the securities laws of any state and are being offered and sold in reliance on exemptions from the registration requirements of said act and laws. The S&P 500 and Russell 2000 are indices of US equities. They are included for informational purposes only and may not be representative of the type of investments made by the fund.

Classifying, Cataloguing, Collecting… and the Capital Cycle

November 4, 2017 in Letters

This article is excerpted from a letter to partners of Boyles Asset Management.

“The stamp collecting is important. ‘Even Darwin’s Journal was just a scientific travelogue, a pageant of colourful creatures and places, propounding no evolutionary theory,’ wrote David Quammen. ‘The theory would come later.’ Before that came a lot of hard graft. Classifying. Cataloguing. Collecting.”
–Ed Yong, “I Contain Multitudes: The Microbes Within Us and a Grander View of Life”

Warren Buffett has compared the investing process to investigative journalism, and it is that process of learning, collecting facts (and opinions), and trying to tie a story together into a theory about a business and its valuation that makes the effort an enjoyable one for us. The investing business is one in which the knowledge that a person learns on a given day may never be put to practical use; but it’s also one in which the lessons a person learns have the potential to be put to use continually throughout one’s career. Done correctly, the learning process is one of continuously classifying, cataloguing, and collecting information in a way that allows one to eventually connect the dots that lead to useful insights.

One of the things about which we continue to study and collect information is how the capital cycle has worked in various industries over time. The best treatments of the capital cycle that we’ve come across (though we’re open to other recommendations) are the letters of London-based investment firm Marathon Asset Management. There are two books containing the selection of letters we’ve read: 1) Capital Account, which covers the period leading up to and following the Technology, Media, and Telecom boom and bust of the late 1990s and early 2000s; and 2) Capital Returns, which covers the boom and bust leading up to and through the Great Financial Crisis that hit its apex in 2008. Ed Chancellor, editor of the collections of letters, provides a good summary to Marathon’s work:

“The key to the ‘capital cycle’ approach – the term Marathon uses to describe its investment analysis – is to understand how changes in the amount of capital employed within an industry are likely to impact upon future returns. Or put another way, capital cycle analysis looks at how the competitive position of a company is affected by changes in the industry’s supply side.”

So the key to capital cycle analysis is to focus heavily on the supply side within an industry, as opposed to the drivers of demand that normally get most of the attention. This dynamic is especially important in capital-intensive industries; and among companies that can be good businesses in the right part of a cycle, but that don’t have the wide-moat characteristics that are most desirable—and rare to find, especially at an attractive price.

While we enjoy the cataloguing and collecting of historical examples of things such as the capital cycle to help us navigate the future, the lessons that one experiences first-hand usually stick the best. And during the quarter, we exited our investment in Mastermyne Group Limited, which we have both followed and owned during the bottom portion of the current mining cycle. As we’ve followed it over the years, and had conversations with management—from the tough times on through the tougher “darkest before dawn” times—we’ve gained a vivid example of how the capital cycle can unfold in the real world.

We bought shares of Mastermyne at various points from the middle of 2014 through December 2016, and sold the last of our shares in September. The average cost on our Mastermyne holding was approximately A$0.24 per share, and our average selling price was approximately A$0.53 per share, with dividends received pushing our average exit price up close to A$0.55 per share. Our initial interest in the company was driven largely by a valuation that had the company trading at a discount to book value, a business that was still profitable, high insider ownership, and the mining services industry (especially underground coal mining, in Mastermyne’s case) becoming unloved. Companies throughout the industry were trading at close to 52-week lows, with many down 50-75% from the highest share prices they had reached during the boom that had peaked a couple of years earlier. As an illustration of how boom can turn into bust, the market cap of Mastermyne at its low point during 2016 was below its net income achieved in each year from 2011 through 2013.

As is often the case with value investors, we likely bought too soon, and sold too soon. The lack of interest from the investment community was evident last year as the stock price was trading in the range of A$0.11-A$0.23 per share from January 2016 through the end of September 2016, and the volume of shares traded was quite low. But just more than a year later, as there was some improvement and a little light at the end of the tunnel, the company was able to increase its share count by about 11% by issuing 10 million new shares of stock at A$0.60 per share in a placement that “was heavily oversubscribed.”

Some new work, a better business pipeline, and some renewed interest in coal from China this year on the demand side helped lead to the improvement in the business. But the catalyst for the dramatic change in sentiment and stock price for Mastermyne has its roots in the capital cycle. While the company has a number of competitors in different areas of its business, it had four main competitors in underground coal mining services, which comprise its core. One of those competitors left the industry a couple of years ago early in the cycle due to problematic contracts; another started to shift away from underground work as conditions became difficult; and yet another is fairly small and has become less active in the tendering process for new work. But the last of the four competitors served as the key catalyst to Mastermyne’s improving fortunes, as that competitor, after a period of struggling, went into administration (Australia’s equivalent of bankruptcy) earlier this year. Besides the decrease in competition, Mastermyne was also able to take over the work that this bankrupt company had been performing for its key remaining project.

The word “compounders” is the term often used to describe the types of businesses we prefer to own: high-return-on-capital businesses with reinvestment prospects and competitive advantages that protect those high returns on capital. But, we firmly believe that almost everything can be a good value at one price and a bad value at another, and that the best opportunities often come by looking at things that are unwanted and unloved by most. So, we’re willing to venture into other areas and “non-compounder” types of businesses, especially when attractive prices are combined with well-incentivized management teams and conservative balance sheets to create situations in which significant upside might be available with little or no ultimate downside. We believe this mental flexibility can be an important advantage to us as investors. We hope that our experience with Mastermyne and observations about how the management team was able to navigate the extreme lows that followed an extreme boom will help us going forward. And while it would be nice to see the cycle starting to turn before investing in similar types of businesses, the market often re-prices things before one has a chance to see the turn. Or as Warren Buffett wrote in October 2008, about five months before the U.S. stock market hit its low, “…if you wait for the robins, spring will be over.”

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Macro Enterprises: Long Record Constructing Oil and Gas Pipelines

November 4, 2017 in Energy, Equities, Ideas, Micro Cap, North America

This article by Michael Melby is excerpted from a letter of Gate City Capital Management.

Macro Enterprises constructs oil and natural gas pipelines, provides maintenance and repair services on existing pipelines, and builds pipeline-related infrastructure. The Company’s customer base includes many of the largest pipeline companies and oil and gas producers in western Canada. Macro Enterprises is headquartered in Fort St. John, British Columbia which is strategically located within the natural gas-rich Montney Formation and between the oil sands of Alberta and the port cities of western British Columbia. The Company has 46 full-time employees and supplements its workforce with subcontractors and hourly unionized employees. Macro Enterprises was founded in 1994. All figures in this section are presented in Canadian dollars.

Fort St. John, British Columbia

Fort St. John and the Montney Formation

Source: GoogleMaps and British Columbia Ministry of Energy, Mines and Petroleum Resources.

Macro Enterprises is best known for constructing oil and natural gas pipelines. The Company has a 20-year track record and has completed projects for major energy companies including Talisman, Kinder Morgan, Encana, and TransCanada. Macro Enterprises has a clean safety record with 16 consecutive quarters and 3.2 million-man hours without a single lost time for injury. Macro Enterprises has also developed a strong reputation for delivering projects on-time and on-budget with a particular expertise in challenging areas such as mountainous terrain. The Company also builds other energy-related facilities including compressor stations, interconnect piping, and pumping equipment. Macro Enterprises also generates maintenance and service revenue through the Company’s three Master Service Agreements. Pipelines require regular maintenance and repairs to ensure the integrity of the pipeline. Many pipeline owners enter into Master Service Agreements with companies like Macro Enterprises to provide a framework for expected service work at pre-negotiated rates. Macro Enterprises currently has Master Service Agreements with TransCanada, Enbridge and Pembina. These contracts have historically provided the Company with an annual recurring revenue base of $80-120 million.

Macro Enterprises has made the strategic decision to own its equipment and has accumulated a valuable portfolio of construction equipment and real estate. The Company’s equipment base including 84 pipe-layers, 44 excavators, 30 bulldozers, 4 trenchers, 24 heavy duty trucks, and 68 trailers was recently appraised at over $80 million. This amount easily exceeds the Company’s market capitalization. Macro Enterprises also has a considerable amount of owned real estate in the Fort St. John area including a recently-constructed corporate headquarters, a mechanics shop, a truck station, and a storage facility. Collectively, Macro owns 27 acres of land and five buildings likely worth over $15 million. Our team visited the Company earlier in the quarter and came away impressed with the scale and condition of the Company’s assets.

The Canadian pipeline construction market underwent a sharp contraction in 2016, as many energy companies reduced spending following the decline in energy prices in 2014 and 2015. The Company’s financial results suffered in 2016 as service and maintenance work was cut dramatically and project work was almost non-existent. Despite the setback in 2016, we expect the long-term outlook for Macro Enterprises and the Canadian pipeline market to remain robust. Canada exports most of its energy production, with virtually all of Canada’s energy exports now destined for the United States. Historically, Canadian oil and natural gas prices have traded at a sharp discount to U.S. benchmark prices due to the additional transportation costs. The construction of additional pipelines would allow more oil and natural gas to be exported to overseas markets and would also likely reduce the discount Canadian energy producers receive for their products. Importantly, Canada currently has 16 LNG facilities under consideration on the Pacific Coast and the construction of any of these LNG facilities would require a large amount of pipeline infrastructure.

Several major pipeline construction projects in western Canada are scheduled to begin construction in 2017 and 2018. We have identified nearly $15 billion in potential Canadian pipeline construction projects from the Company’s three Master Service Agreement partners alone. Macro Enterprises also recently announced that the Company is a partner in a 50/50 joint venture that was recently awarded a $375 million contract from Kinder Morgan to construct an 85- kilometer section of the Trans Mountain pipeline expansion. The award is structured as a time and materials contract and could have a significant impact on the Company’s financial results should the project proceed as expected. In addition to new pipeline construction, Macro Enterprises has already seen a noticeable increase in maintenance and services work as MSA clients catch up on maintenance spending that may have been delayed during the downturn.

When evaluating any potential investment, Gate City Capital Management considers the price we would pay for the entire company. Macro Enterprises currently has a market capitalization of $70 million. The Company has $28 million of cash and only $1 million of debt resulting in an enterprise value of $43 million. We expect Macro Enterprises to generate nearly $200 million of revenue in 2018 and approximately $20 million of EBITDA. We value Macro Enterprises using a discounted cash flow analysis to arrive at a target enterprise value of $105 million. We added $27 million of net cash to obtain our target market capitalization of $133 million or $4.00/share, representing potential upside of over 75%. In addition, the Company’s cash balance and large owned asset base provide a significant margin of safety in the event our financial forecasts prove overly optimistic.

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Disclaimer: Performance for the period from September 2011 through August 2014 has undergone an Examination by Spicer Jeffries LLP. Performance for the period from September 2014 through December 2016 has undergone an Audit by Spicer Jeffries LLP. Performance for 2017 is unaudited. The performance results presented above reflect the reinvestment of interest, dividends and capital gains. The Fund did not charge any fees prior to September 2014.The results shown prior to September 2014 do not reflect the deduction of costs, including management fees, that would have been payable to manage the portfolio and that would have reduced the portfolio’s returns. Actual performance results will be reduced by fees including, but not limited to, investment management fees and other costs such as custodial, reporting, evaluation and advisory services. The net compounded impact of the deduction of such fees over time will be affected by the amount of the fees, the time period and investment performance. Specific calculations of net of fees performance can be provided upon request.

An Update on Rolfes Holdings

November 3, 2017 in Ideas

This article is excerpted from a letter to partners of Boyles Asset Management.

Rolfes Holdings was a significant negative contributor to the quarterly performance.

In September, the company first reported a trading update that revealed a somewhat weak H2 and, more alarmingly, an accounting restatement for fiscal 2016 and H1 2017. Approximately 10 days later, the company reported the full amended results. After peaking briefly at R5.09 per share in July, the shares were soft throughout the quarter, and following the accounting restatement, closed Q3 at R3.08, down 39.4%.

Obviously, we are disappointed in the earnings restatement, which we would classify as material, especially as it relates to H1 2017. To put the restatement in perspective, full-year adjusted earnings, which were also pressured by ongoing soft business conditions, came in approximately 27% below where we envisioned.

In mid-October the CEO resigned, and a number of directly responsible parties have left the company. The company’s interim CFO and new auditor, KPMG, discovered the issues; and the interim CFO was recently named full-time CEO.

The most egregious accounting issues were in one of the company’s majority-owned foreign subsidiaries, where local management fabricated results. Importantly, there were no accounting issues at the company’s two most critical units: agriculture and food.

While we continue to evaluate the restatement and current performance, we believe the margin of safety we originally demanded of the shares will protect our ultimate downside. The current episode may very well provide a remarkable opportunity to acquire shares, as they trade at approximately 5.5x the restated figures. The company has announced a share repurchase program, and we are comforted by the fact that three large board member shareholders are actively working to restore shareholder value. In recent days, multiple large shareholders have purchased sizable numbers of shares in the open market.

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The content of this website is not an offer to sell or the solicitation of an offer to buy any security. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this website. BeyondProxy’s officers, directors, employees, and/or contributing authors may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated herein.

Why We Invested in Franklin Covey

November 3, 2017 in Equities, Ideas, Letters

This article by Matthew Sweeney is excerpted from a letter of Laughing Water Capital.

I have been following Franklin Covey (FC) off and on since 2014 when I first met the management team, and it recently entered our portfolio as a smaller position. FC is in the business of performance improvement, with a strategy based on the ideas first laid out in the best-selling book, “The 7 Habits of Highly Effective People.”

Insiders own 33% of the company, and check Charlie Munger’s “cannibal” box, having repurchased almost 20% of outstanding shares since I first met with them.

The crux of the thesis is based on stepping over what should be a very low hurdle: customers like getting more value for the same price.

In short, historically customers have been able to order FC’s training materials a la carte, paying one price (~$200 per employee) for training materials on a specific topic. The materials are considered best in breed, and renewal rates are high. However, recently the company has shifted gears and began offering access to training materials across all topics for one price via their “All Access Pass.” While this should represent incredible value to existing customers and has already opened doors to new customers, there are a few wrinkles that have impaired recent results and caused the stock to trade down.

First, under the old model FC was selling to HR managers who could make purchase decisions out of their existing budget, leading to a short sales cycle. Under the All Access Pass, customers must sign a 1 year contract, which typically requires legal review, and thus a longer sales cycle.

Second, under the new model, GAAP accounting requires that revenue be recognized ratably over the course of the contract, while expenses are recognized during the period that they are incurred. In other words, if FC sells a one year subscription, in the first quarter they must recognize all of the expenses associated with that subscription, but they can only recognize one quarter worth of revenue.

These two items combined have been a drag on recent results, but over time they should lead to higher revenues and lower expenses: a potent combination. In the near term, as the launch of All Access Pass is lapped, deferred revenue will be recognized, which should catalyze shares by mid 2018.

Longer term, the company’s addressable market is enormous, the combination of secular growth and a management team with a proven affinity for rewarding shareholders through repurchasing shares is attractive, and there is potential to separate the company’s education business from its corporate business, which the market would likely reward.

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Disclaimer: This document, which is being provided on a confidential basis, shall not constitute an offer to sell or the solicitation of any offer to buy which may only be made at the time a qualified offeree receives a confidential private offering memorandum (“CPOM”) / confidential explanatory memorandum (“CEM”), which contains important information (including investment objective, policies, risk factors, fees, tax implications and relevant qualifications), and only in those jurisdictions where permitted by law. In the case of any inconsistency between the descriptions or terms in this document and the CPOM/CEM, the CPOM/CEM shall control. These securities shall not be offered or sold in any jurisdiction in which such offer, solicitation or sale would be unlawful until the requirements of the laws of such jurisdiction have been satisfied. This document is not intended for public use or distribution. While all the information prepared in this document is believed to be accurate, Laughing Water Capital, LP and LW Capital Management, LLC make no express warranty as to the completeness or accuracy, nor can they accept responsibility for errors appearing in the document. An investment in the fund/partnership is speculative and involves a high degree of risk. Opportunities for withdrawal/redemption and transferability of interests are restricted, so investors may not have access to capital when it is needed. There is no secondary market for the interests and none is expected to develop. The portfolio is under the sole trading authority of the general partner/investment manager. A portion of the trades executed may take place on non-U.S. exchanges. Leverage may be employed in the portfolio, which can make investment performance volatile. The portfolio is concentrated, which leads to increased volatility. An investor should not make an investment, unless it is prepared to lose all or a substantial portion of its investment. The fees and expenses charged in connection with this investment may be higher than the fees and expenses of other investment alternatives and may offset profits. There is no guarantee that the investment objective will be achieved. Moreover, the past performance of the investment team should not be construed as an indicator of future performance. Any projections, market outlooks or estimates in this document are forward-looking statements and are based upon certain assumptions. Other events which were not taken into account may occur and may significantly affect the returns or performance of the fund/partnership. Any projections, outlooks or assumptions should not be construed to be indicative of the actual events which will occur. The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of LW Capital Management, LLC. The information in this material is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Laughing Water Capital LP, which are subject to change and which Laughing Water Capital LP does not undertake to update. Due to, among other things, the volatile nature of the markets, an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment. The fund/partnership is not registered under the investment company act of 1940, as amended, in reliance on an exemption there under. Interests in the fund/partnership have not been registered under the securities act of 1933, as amended, or the securities laws of any state and are being offered and sold in reliance on exemptions from the registration requirements of said act and laws. The S&P 500 and Russell 2000 are indices of US equities. They are included for informational purposes only and may not be representative of the type of investments made by the fund.

Portfolio Commentary

November 3, 2017 in Letters

This article by Michael Melby is excerpted from a letter of Gate City Capital Management.

The Fund generated an attractive absolute return for investors in the third quarter while underperforming the small- and large-cap indices.

TheStreet (TST), Dawson Geophysical (DWSN), and Canterbury Park (CPHC) were the Fund’s top performers. TheStreet (TST) reported strong Q2 2017 results that were well-received by the market. Dawson Geophysical advanced as sentiment surrounding the energy services sector improved. Canterbury Park moved higher as the company continued to progress on plans to repurpose a portion of the company’s excess land holdings. PICO Holdings (PICO) and Scott’s Liquid Gold (SLGD) detracted from performance during the quarter. Of note, after quarter-end PICO Holdings announced that the company was reviewing strategic alternatives including a potential sale of the company.

The Fund ended the quarter with 18 companies in the portfolio. The largest position was 15% of the portfolio and the top five positions represented 50% of the portfolio. The Fund added three new companies during the quarter and effectively exited our position in Precision Auto Care (PACI) after the company was acquired by an affiliate of Icahn Enterprises. By sector, 24% of the Fund is in real estate (primarily land), 16% of the portfolio is invested in water assets, 16% in energy, 8% in consumer products, 6% in media, 5% in industrials, 5% in gaming, 3% in defense, and 18% in cash.

The average portfolio company has a Price/Book ratio of 1.1x and trades at 7.5x trailing EBITDA. These valuation metrics compare favorably to the S&P 500 which has a Price/Book ratio of over 3.0x and an Enterprise Value/EBITDA ratio of over 13.0x. The portfolio has a weighted-average market capitalization of $135 million and an average enterprise value of $110 million. As of quarter-end, all but one of our portfolio companies had more cash than debt on the balance sheet.

In our Q2 letter, we highlighted how we had recently spent more time researching companies in the energy sector. Even in a market where we consider many companies to be overvalued, we found several companies in the energy sector that had many of the qualities we look for including large cash balances, owned assets, and the potential to generate strong free cash flow. In this letter, we provide our investment thesis on Macro Enterprises Inc. (“Macro Enterprises”, “MCR”, or the “Company”), a Canadian pipeline construction company that we expect to benefit from increased infrastructure spending in Alberta and British Columbia.

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Disclaimer: Performance for the period from September 2011 through August 2014 has undergone an Examination by Spicer Jeffries LLP. Performance for the period from September 2014 through December 2016 has undergone an Audit by Spicer Jeffries LLP. Performance for 2017 is unaudited. The performance results presented above reflect the reinvestment of interest, dividends and capital gains. The Fund did not charge any fees prior to September 2014.The results shown prior to September 2014 do not reflect the deduction of costs, including management fees, that would have been payable to manage the portfolio and that would have reduced the portfolio’s returns. Actual performance results will be reduced by fees including, but not limited to, investment management fees and other costs such as custodial, reporting, evaluation and advisory services. The net compounded impact of the deduction of such fees over time will be affected by the amount of the fees, the time period and investment performance. Specific calculations of net of fees performance can be provided upon request.

GEM’s Advice for Aspiring Superinvestors

November 3, 2017 in Building a Great Investment Firm, Featured, The Manual of Ideas

We had the pleasure of interviewing the investment team of Global Endowment Management, based in Charlotte, North Carolina for The Manual of Ideas, the flagship publication of MOI Global, in 2015.

The GEM team’s perspective and advice are timeless and truly invaluable for emerging managers looking to build a great investment firm. Enjoy!

The Manual of Ideas: Please tell us about the genesis of Global Endowment Management and the principles that have guided you since the firm’s founding.

Mike Smith, Chief Investment Officer: Global Endowment was founded in early 2007 by Thruston Morton, the former CIO of Duke University’s investment office. The original idea and what we continue to do today is to manage a fully-discretionary pool of long-term capital primarily from US endowments and foundations. Our ultimate goal is to generate at least a 5% real return so that our investors can continue to fund their operating expenses and grants in perpetuity (since US endowments and foundations typically spend around 5% of their endowment capital each year).

MOI: How do you typically partner with clients that have an existing in-house investment team?

The majority of our endowment and foundation investors outsource 100% of their capital to us.

Campbell Wilson, Head of Public Investment Team: The majority of our endowment and foundation investors outsource 100% of their capital to us, so most of our interactions are with their board members, investment committees, and/or operations staff. However, we have some family office and sovereign wealth fund investors who only invest a portion of their assets with us, and we often do have a dialogue with those groups’ in-house teams: where we are finding interesting opportunities, potential co-investments, best practices, etc. (Operational reviews of managers are one topic that has come up recently, for example). Additionally, we’ve had some of those investors join us on research trips, such as our annual public investment team trip to the Berkshire Hathaway meeting in Omaha.

MOI: Please describe your underlying investment philosophy.

James Ferguson, Associate, Public Investment Team: Like most value investors, our investment team was introduced to investing through reading some combination of Graham, Buffett, Klarman, Schloss and Fisher. Buffett’s quote, “Price is what you pay. Value is what you get,” succinctly captures our investment thinking. We spend the majority of our time identifying and investing with value-oriented managers around the world. We’re focused less on fulfilling a search in a particular country or region than we are on finding great investors with whom we can partner, wherever they happen to be located. In an ideal world, we’d find 20 Buffetts from the 1960s dispersed across the globe, and spend all of our time building relationships and investing with them. If we could identify and invest with such a group, the best thing we could do is get out of their way and let them compound. Easier said than done, but it’s what we focus on constantly.

Campbell Wilson: We also focus on markets where truly mispriced securities are more likely to be found—where we’re not as likely to find thousands of smart, hardworking, highly paid investors competing with us every day. One of our favorite quotes is from Julian Robertson, who said “With hedge fund investing, you get paid on your batting average irrespective of the ‘league’ in which you’re playing. So go where the pitching is the worst.” (Graham and Doddsville, April 2012). We agree with that completely so we spend a lot of time trying to find great investors who focus on less efficient markets, and have small enough asset bases to take advantage of the inefficiencies that exist.

MOI: How does your investment philosophy shape your target asset allocation and manager selection criteria?

Campbell Wilson: “Invest bottoms up, worry top down” sums up our asset allocation vs manager selection philosophy. We believe manager selection is the key to sustainable outperformance, and our bottom up, value-oriented approach since inception has definitely explained most of our outperformance of relevant benchmarks. We deal with asset allocation concerns top down—at the overall pool level, addressing concentrations in particular factor exposures and portfolio risk through hedges and overlays. One of the nice things about having Mike focus on the portfolio from a top down perspective is that it allows our public and private investment teams to concentrate on finding great investments.

MOI: You seek to deliver a minimum 5% real return over the long term. How do you think about inflation and how are inflation considerations incorporated into your investment process?

We are biased towards investing in higher quality businesses that have the ability to increase price, somewhat independent of the overall inflation level.

Mike Smith: The history of most fiat currencies, and certainly the US dollar, is one of consistently eroding value over time. Consequently, we want to build a portfolio that preserves the purchasing power of our investors’ capital, regardless of the type of macro environment we encounter. We are thus biased towards investing in higher quality businesses that have the ability to increase price, somewhat independent of the overall inflation level. We’re not confident in our ability to predict a single macro variable like inflation. But by constructing a portfolio across asset classes and geographies, focusing on businesses that have pricing power; we’ll have a better chance of achieving our ultimate goal. We’re quite aware that there are no absolute certainties in investing, but we believe that this approach is not only the most prudent, it also increases the probability of success.

MOI: You seek to “capture illiquidity premia when they exceed the opportunity cost.” Could you provide an example of a situation in which you judged an illiquidity premium to exceed your hurdle.

Mike Smith: This is basically dense language for the opportunity cost question, i.e., does the return justify the illiquidity. Unlike most endowment investors, we don’t have a target allocation to private investments. Instead, we think about overall equity risk and, at any given time, in what forms are we being best compensated to accept it. Our private investment commitments ebb and flow based on expected return premiums relative to public investment opportunities. That being said, there are specific situations where the private market tends to be more appropriate than public markets. An example would be turnaround situations requiring significant operational change where reported numbers can get significantly worse before they get better.

MOI: What is the typical process you go through with an investment manager prior to entrusting the manager with your capital?

It’s a common bromide in our business to say you’re a long term investor. Reality is that career risk and human psychology often intervene in the short term to derail that long term focus.

James Ferguson: In an ideal world, we would be able to spend several years building a relationship with a prospective manager, to underwrite both their process and their temperament. In our humble opinion, the former is much easier than the latter. We would like to see an investor work through a variety of market environments, and in particular how they react to adversity . If you look at challenging market environments throughout history, going back to the early 1920s, it’s amazing how many “great” investors did not have the emotional fortitude to withstand severe market drawdowns.

While we have spent years getting to know some of our managers before investing with them, it is often impractical to do so. Consequently, our ability to speak with people who have known the individual for a long time and have seen them in a variety of situations is a key part of our process. Besides personal vetting, we spend a significant amount of time going through individual portfolio companies to understand how the manager developed their thesis and identified areas of concern. The more in-depth the discussion we can have around the manager’s thinking about a company’s competitive dynamics, industry characteristics, and overall moat, the easier it is to underwrite the substance and sustainability of his or her process.

The second step of our approach is that we think it’s important for a prospective manager to know how we will behave in challenging environments. Given the inherent fragility of an investment partnership, a manger’s confidence in their investor base could help reinforce their ability to withstand a significant drawdown. We encourage prospective managers to speak with our current managers in order to get a sense of how we respond. It’s a common bromide in our business to say you’re a long term investor. Reality is that career risk and human psychology often intervene in the short term to derail that long term focus. We think we are good long term partners, and that we do what we say we’re going to do. We want prospective managers to get a sense of that. Time and talking with others can go a long way in building that trust. Once we have conviction in a manager as an investor, we then conduct a thorough operational review in order to get comfortable with the controls and protections that are in place.

MOI: What characteristics make an emerging investment manager appealing to you as a long-term partner?

Campbell Wilson: What we’re ultimately looking for is a skilled investment analyst with the discipline and temperament to succeed in different environments. Importantly, they must be able to transition from analyst to portfolio manager—we have seen many who cannot. Creativity, persistence and humility are key traits—people who are confident in their abilities but clear-headed and forthright about their weaknesses. Seth Klarmann described it well when he said “You need to balance arrogance and humility”. And maybe more than anything else, we’re looking for fanatics who are extremely passionate about the pursuit of investing. Given the monetary benefits of working in the financial industry, it is often difficult to discern “passion for investing” from “passion for making money”, but understanding a manager’s motivation is a key requirement for us.

MOI: What are some common mistakes managers make early on that make it more difficult for you to partner with them down the road?

A behavior that typically turns into a mistake is a fund hiring a big team early on. While this is inevitably sold as a reflection of seriousness and commitment, it forces the fund to raise more assets to support the operating costs of the team, fancy office space, etc.

Campbell Wilson: At a high level we often see young managers compromise their investment ideals or approach in order to raise assets. They might, for example, agree to hold more positions than they would prefer. At the end of the day, we want our managers to manage our funds like it was their own money and they didn’t have a client base to worry about. Decisions made for the sake of the business or client base are often detrimental to long term returns in our opinion, and it’s very difficult for small, young managers to say no to someone who wants to give them money. Our advice is to give yourself as long of a runway as possible to stick to your guns.

More specifically, there can be structural elements that make it difficult for us to invest. The first is a fund with co-portfolio managers. This isn’t an absolute ‘no’ for us but for managers with multiple senior team members we prefer when there’s a clear driver and a clear passenger vs. a 50/50 partnership. Investing is a personal endeavour with decisions based on imperfect information – two smart people trained by the same person and armed with the same set of facts will frequently come to different conclusions. We’re all wired differently, and the best investors tailor their portfolio to match their own psychology – but that also makes it important to have one person ultimately responsible for pulling the trigger.

A second structural impediment is a particularly challenging seed investment arrangement. We’re not opposed to firms that have seeds —we have made a few select seed investments ourselves. However, we’ve seen funds where the benefits brought by the seeder are de minimis and the costs are high. A particularly challenging form of seed is one where the seeder is in business to benefit from the seed itself, rather than as an investor in the fund. It’s tough for us to invest in partnerships with seeds from big asset managers or financial institutions simply because the incentive to grow can overwhelm the incentive to create a great track record. Given our focus on investing in less competitive markets, it’s important that our managers stay small enough to retain their ability to invest in less efficient situations.

The third categorical mistake is a partnership that is not selective on the types of investors that they allow into the fund. This may sound a bit arrogant but it’s really important that there are similarly-minded investors in a partnership, as any sort of hot money can be a detriment to the entire partnership. We’ve seen it happen that a manager loses money and, while our conviction in the manager hasn’t changed, enough other investors submit for redemption and then the entire fund goes into wind-down.

Another behavior that typically turns into a mistake is a fund hiring a big team early on. While this is inevitably sold as a reflection of seriousness and commitment, it forces the fund to raise more assets to support the operating costs of the team, fancy office space, etc. We would rather invest with a manager that runs a lean start-up in order to focus on investing, and then slowly raises money (a) over time and (b) appropriate for the strategy.

MOI: What are some of the ways in which you have sought to improve alignment of incentives between your firm and the investment managers to whom you entrust capital?

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