Scheid Vineyards (SVIN) - substantial upside potential

I first found about Scheid in a writeup from Aaron Edelheit. Scheid is the 33rd largest winery in the United States when measured by number of cases sold. Their vineyards cover approximately four thousand acres in Monterey county in CA, roughly half owned and half leased. They started as a wine grape grower in 1970s, then started making bulk wine in 1990s that other wineries could use to mix with their cased goods, and invested substantial money (~$75M) in 2000s to construct their own winery. In 2012, they started selling cased goods under their brands and under private labels, and quickly ramped to 500+ thousand cases by 2018.

The first thing that appealed to me about Scheid was the downside protection. 2018 appraised value of vineyards and winery (excluding inventory, Greenfield rezoned land, and vineyard equipment) was $190M. Add to it inventory for $60M (at cost), and Greenfield land re-zoned for residential / commercial use for $15M. Subtract out debt of $105M and we get value of $160M, compared to market cap of $60M.

Why such a big disconnect? For one, Scheid stock trades on OTC and is very illiquid. There are days when no shares trade. Second, the Scheid family owns 40%+ of the stock and hasn't been actively promoting the stock. None of this matters to me though due to the downside protection and significant upside potential. I'd be happy to own this for years without much movement in the stock price.

Before I talk about the upsides, it's useful to look at how wine business works. Sales follow 3-tier system with producers, wholesalers and retailers being different. Troy Carter of Motorcycle Wineries describes the distribution process - for a wine that sells for about $30 - as follows. Distributors buy cases of wine from the maker at $15 per bottle. They then sell it to restaurants and stores for $20. Restaurants’ markups vary, but stores consistently sell it for $29. Vacationers in Napa Valley will pay $30 to buy the bottle directly from the winery - it is something of a standard that bottles cost one dollar less at stores than at wineries, according to Troy. Supermarket chains like Costco, which is the largest provider of wine in the US, sell the bottle for around $22 - just above wholesale prices.

The first upside comes from selling more of finished goods, rather than bulk wine or grapes. Last year, according to Heidi Scheid (EVP of Marketing), the company sold 10% of what it grew as grapes, 60% as bulk wine to other wineries, and about 30% was bottled wine for Scheid’s brands. Scheid has crush capacity for 2 million cases, but currently sold only 517K as cased goods. If it sold all of the 2 million cases, revenue would be $100M per year assuming same price per case. That's probably $25M EBITDA per year and at 8X multiple, that's $200M.

What is needed to get there? First, Scheid has already done majority of the capex needed to sell 2 million cases. They now need to build a planned third bottling line, which has an estimated capacity of 1 million cases annually. Next, they need to continue to build their distribution network and their brands. There are similar California wineries outside of Napa valley that have ramped to 2 million + case sales: Bogle is one example, and there's no reason why Scheid can't repeat Bogle's playbook.

Scheid has already started making upgrades to their distribution network. They are switching to bigger distributors that will support the growth plans. For example, they switched to Young's Market (number 4 distribution in the US) for California in Jan 2018. Distribution is tricky - for a small winery a small distributor makes sense. But once a winery is at a substantial size like Scheid, it becomes important enough for big distributors to care about sales, and big distributors can provide the needed reach to expand sales. Scheid has also made progress on getting into big retailers and now has brands in 3 out of 4 top retailers of wine in the US -Albertsons/Safeway (#2), Kroger (#3), and Total Wine (#4). So one way to grow will be to start selling at the #1 wine retailer, Costco.

Scheid and retailers seem to be aligned on the move towards more private labels. They current sell the following private labels: Hive &Honey (Kroger), Ryder Estate (Bevmo)
and Mozaik at Benchmark Resorts. Private-label is a fast growing segment for wine in the U.S. has and has doubled since 2012, now making up 8 percent to 10 percent of domestic sales. But it has plenty of room for growth: private-label sector is approaching 30 percent in the U.K., and Brian Sharoff, the president of the Private Label Manufacturers Association, says it has reached 50 percent in some European markets. There are benefits for both retailers (higher margins, no competition with other retailers), and for Scheid (lower marketing spend).

Scheid is also ramping sales org to support higher revenues. The chart below shows the increasing G&A and Selling expenses going up over past 4 years. A lot of the spend is going towards hiring sales managers for different US regions (highlighted in yellow). These new hires will take time to ramp the sales, but it's the blocking and tackling work that will (hopefully) produce higher sales.

The second upside for Scheid comes from building their own national brands and getting higher revenue per case (vs. $50 per case assumed in earlier valuation case in this article). Currently only ~100K cases out of 500K total cases come from their own brands vs. private label. Expanding on their own brands can give them higher revenue per case. Among the current brands, Vivino has favorable ratings on District 7 (sold at Safeway, Total Wine & More) and Ranch32 (was Bevmo exclusive, but now sells also through other stores: Total Wine & More, liquor stores). We tasted these wines and they offer good quality and decent price. There is a low chance that one of these brands hits it really big, though big hits like Meiomi are rare. Meiomi sold just the brand for $315M to Constellation Brands at 24X future earnings multiple. But we don't need such a hit to be successful. Again, something like Bogle with multiple varietals and high total volumes works just great.

The third upside comes from potential expansion of Direct to Consumer channel, though this is starting from a small base of $1.9M sales per year, and it's hard to grow direct sales fast. However, this is very lucrative because it helps to bypass the 3-tier system and allows Scheid to keep most of it's profits. The CEO Scott Scheid acknowledges the importance of direct sales in the latest annual letter. When we visited their wine tasting room at Carmel, it was packed with people and it was a fun experience. The hope is that they can convert more people into subscription wine club members with both high margins and repeat buying pattern. They could also expand their online sales and play a better social media marketing strategy to get direct customers and drive down marketing spend.

The risks are primarily illiquid stock, lack of clear timeline as to how value gets enhanced, and potential succession issues in family run businesses.

Quick update on Drive Shack

Drive Shack ($DS) is a golf entertainment company and an upcoming competitor to Topgolf. TopGolf has been expanding rapidly and Cowen analyst recently valued it at $6- $7 billion EV (likely inflated because they used 11-13 X EBITDA multiple, but even if we take 5X EBITDA multiple, it's still $3 Billion EV). Drive Shack could be the second player in this market and potentially enjoy long growth runway. However, $DS is still in startup phase with 1 location open, 9 sites in the pipeline, and they are funding this growth by selling traditional golf courses they own. I haven't written about Drive Shack ($DS) in over a year (you can see the detailed thesis here). These have been some significant developments since then, and this article provides a summary of where things stand.


People:

1. They brought on new CEO Kenneth May in Nov 2018, who was previously CEO at TopGolf. While at Topgolf, he grew number of locations from 7 to 34.
2.   Also brought on new CFO who was previously at Marriott and SBE.
2. The CEO has been busy and brought on many other TopGolf  alumni : VP of Real Estate Development, VP of New Store Openings, Corporate Chef, Head of Marketing,  and VP of Technology.

I like these changes because TopGolf has already figured out a lot of things on how to run golf entertainment sites efficiently, and getting people with those experiences into Drive Shack is the best way to accelerate the development of Drive Shack sites.


Significant progress on sale of golf courses:

Drive Shack's legacy business is in traditional golf courses (owned, leased or managed). The company's strategy is to sell all owned golf courses, get out of unfavorable leases, and focus on becoming an asset-lite, fee-only management company. An year ago, the company had not sold a single golf course it owned, but their Match 2018 estimate was that they could get between $200M to $325M by selling all of the 26 owned golf courses.

They have now sold 15 courses and have 6 in contract or LOI with total proceeds of $155M (See chart below). Their revised estimate is that the sale of all golf courses will give them between $220M to $240M, so on the lower end of their March 2018 estimate. But overall: good execution and this gives them liquidity to invest into Drive Shack sites.

They also retained management contracts on several of the courses they sold. This fee-only transition helps to get better cashflow. At the end of the sales, they expect that their traditional leased and managed golf business will do $10M of free cash flow per year.

Drive Shack eatertainment sites:

The first location at Lake Nona (Orlando), FL was opened in early Q218. $DS estimates that each location will give $25M to $25M annual revenue and  $3M to $5M annual EBITDA. But two quarters after opening, in Q418, sales at Lake None were only $1.6M. What's worse is that its only 1% higher than sales in Q318. The new CEO made swift changes after coming onboard. The changes include: putting more focus on social entertainment rather than golf (Topgalf has the same strategy), and increased online targeting and higher event sales. To execute on this strategy at Orlando, they replaced the General Manager with a Topgolf alumni in Q119.  In Orlando,  the CEO guided on earnings call that they expect to breakeven this year and generate substantial revenue and EBITDA by next year. It seems like a reasonable timeline for results to stabilize. We'll have to wait to see the results.

There are 9 additional sites in development: 3 to be opened in 2019 and 6 more in 2020. It's highly likely that with the Topgolf alumni on board that they won't be able to successfully copy TopGolf strategy and deliver on their revenue and 25% EBITDA margin target.

The anecdotal data from Topgolf suggests that there is scope for Drive Shack to execute on this strategy. For example, Yelp reviews suggest that Topgolf in Orlando sometimes has hour to 1.5 hour wait times and so that drives people to go to Drive Shack. Another example is that TopGolf has indicated that they see meaningful expansion opportunities across US cities. It's highly likely that TopGolf won't have the financial or operational bandwidth to execute on all of their grand plans on expansion, and Drive Shack can pick up a lot of wins.

Bottom line:

$DS has the cash from sales of traditional golf courses and has the team with the experience needed to launch new sites. I don't see any reason to update the valuation estimates done in the past and believe that the stock price may move up significantly in the next couple of years.

EVI Industries ($EVI) : buy and build strategy

Recently I've noticed lot of chatter on rollups on Reddit. But historically, rollups don't work in most cases. The problems in most cases are paying too much for acquisitions, and improvements to each business unit's economics by being under rollup structure are just not enough to offset high purchase price.


However, sometimes rollups make sense - when they deliver more value to customer, claim higher share of value in the supply chain, or when scaling up improves economics of each business unit. $EVI may be one such rollup. It's a rollup of laundry equipment distributors, led by Henry Nahmad who is a Watsco  (HVAC rollup) alumni, and I'm long EVI.

Long runway:

EVI has a big TAM of several billions and there are atleast 100+ distributors for laundry equipment in the US and those make for future acquisition targets. Here's a relevant quote from 2018 Chairman's letter:

Ultimately, these products and services represent multibillion dollar industries, which we believe are addressable markets with attractive fundamentals and long-term growth prospects for our businesses.

The second vector of growth is to enter adjacent markets such as material handling, power generation, and water heating, purification, and recycling equipment, parts, and related installation and maintenance services. And lastly, they can expand revenue from services which currently is 20% of total revenue (Source: Dec 2018 10-Q).

"Right" Setup:

The most important aspect of the setup is that EVI can potentially create value for both supplier (national scale for distribution) and customers (one stop shop, insights on how to solve customer problems). Manufacturers get a lot of benefit from having one distributor that can sell across the country and that can bring insights on customer.

The other aspect of the setup is that there is hardly any competition from other buyers in the space for acquisitions. There's no auction driving up prices while buying.

And third, owner - operator Henry Nahmad controls 60%+ of stock and has long term options which vest in 2040. And mom-and-pop owners of laundry distributors still stay on as after selling to EVI(see Chairman's letter blurb below):

To date, the owners of our ten acquired businesses accepted approximately 46% of the contractual consideration paid in EVI stock

Is buy and build strategy working?

This is the main question when evaluating EVI as an investment. The buy component is to acquire mom-and-pop distributors at decent price and the build component is to enhance the economics at each location level.

Let's start with the buy component. Table below shows all the acquisitions done till end of 2018.  In my estimate, EVI has done a good number of deals and is making acquisitions at a good price of mid single digit multiples of EBITDA.  (A bit more complicated take: they are paying half of the amount in stock - a stock that can potentially grow a lot in the future. But they are doing it to keep the owners interests aligned and using high EBITDA multiple stock to buy these businesses / locations)

How are these acquisitions performing once they are part of EVI? Let's start by looking at revenue picture. The table below shows the bridge from FY 2017 and FY 2018 revenue by estimating revenue contribution by looking at annual revenue prior to acquisitions. The actual revenue was about $3.9M lower than my estimate and most of the difference comes from Tri-State and Aadvantage. I don't think this is concerning because there can be timing reasons. For example, Tri-State was acquired end of October and it is likely that most revenue that quarter comes in October / November and less in December due to holiday season. Overall, I'd say that this estimate bridge matches actual quite closely and that revenue post acquisition has been inline with pre-acquisition revenues (And hasn't dropped off after the business sale). The buy strategy is working: in less than 3 years, EVI annual revenue run rate has gone up from $36M to ~$250M.

Now that we figured out the revenue picture, how about EBITDA/ profitability? Things don't look as good when looking at profitability (see table below).

But this table is not indicative of long term profitability. That's because just 2 years ago EVI had a single business (Envirostar) and they now need to spend money to build the corporate overhead groups first, before they can start growing earnings and profitability at each location. EVI 10-Q from December 2018 talks about these increased expenses:

As a percentage of revenues, selling, general, and administrative expenses for the six and three-month periods ended December 31, 2018 were 19.1% and 19.0%, respectively, compared to 17.7% and 16.7% during the six and three-month periods ended December 31, 2017, respectively.

Increases in selling, general and administrative expenses also reflect increases in expenses in connection with the growth of the Company’s market capitalization, which include but are not limited to greater accounting fees, legal fees, and insurance expenses. Further, in support of the Company’s buy and build growth strategy, the Company added key personnel, which contributed to increases in compensation expenses. Finally, the increase in selling, general and administrative expenses includes an increase in non-cash amortization expense related to the intangible assets the Company acquired in connection with its acquisitions and an increase in non-cash share-based compensation.

Net interest expense for the six-month period ended December 31, 2018 was $539,000 compared to $183,000 during the same period of the prior fiscal year. The increase in net interest expense is primarily due to an increase in average outstanding borrowings.

A summary of these increased expenses, excluding personnel, is shown in table below.

Regarding personnel hire, Nahmad had the following to say in 2018 Chairman's letter:

In connection with our growth efforts and the compliance standards applicable to us based on the increased size of our public company, our financial results also reflect investments at the corporate level, including costs related to adding experienced personnel and engaging national professional service firms to support our growing size and scale.

EVI's actions have demonstrated success in buying businesses at decent price. They have also shown initial signs of building corporate infrastructure. Where will they go from here? My guess is they continue to build capabilities that will in the future enhance economics of each location. They'll build ERP systems, central accounting and finance groups, sales training, and analytics to enable sales of more products and services via each location. They will share best practices, and solve problems for under-performing locations. The advantages of scale will start showing up: mom-and-pop small distributors can't advertise as effectively, or publish as often in trade publications as EVI. EVI due to it's size will also be able to attract the right talent, something that mom-and-pop distributors can't attract. Also, EVI will become more important to laundry equipment manufacturers and they will be able to cut better commission or exclusivity on products.


Once EVI is further along with building these capabilities, they should be able to get EBITDA margins easily in excess of 10% and more closer to 20% at each location level, mainly by increasing "utilization" at each location by pushing more sales with same number of resources.  Such company building activities need time. See Watsco as an example: 30+ years later, they are still building some corporate capabilities with their tech accelerator program. EVI has the right setup to continue these "investments" on build strategy without having to worry about short term profitability.  The key thing I'll continue to monitor is how EVI continues to "build", and some operational leverage related metrics (eg: Revenue per employee or Gross profit $ per employee).




PS: Some rough valuation: Revenue run rate is $250M/year currently. Let's say they keep doing 2 acquisitions each year at $25M  Revenue per acquisition for next 5 years. They'll probably do more acquisitions, but let's assume only 2 per year. Let's also assume they add $20M per year revenue from sale for new products and services from existing locations. So 5 years from now, we get $600M annual revenue, and assuming 15% EBITDA margin gets us to $90M EBITDA. What type of multiple should we put on something growing at 15% CAGR? 10x? That will be $0.9B (vs. current $0.45B market cap).  This is rough and there can be more acquisitions and more organic growth, and better mix of products vs. services. I like the odds here!

Passur: tiny company investing in the future

Passur ($PSSR) is a tiny company with current market cap of just $10M, but had a market cap of ~$40M as recently as March 2017. I first invested in $PSSR after reading about it in Longcast Advisor's blog (here).  I recently added more to my holdings because of drop in stock price. This is not a story that can be explained just quantitatively by looking at balance sheet or cash flow statement because the company is spending a lot on Sales & Marketing to deploy SaaS to airports and airlines. This spend is expensed according to GAAP rules leading to accounting losses, but it is in reality similar to Capex because it generates revenues for long term. Increased spend has not yet resulted in higher revenue due to long sales cycles. So we need to look at it as a qualitative story about SaaS analytics business in a niche for a company with a strong backer in owner/operator - Chairman Beck Gilbert, incumbent position, and encouraging leading indicators. And this investment is essentially a bet that Mr Market is ignoring the asymmetric upside vs. downside scenario here.

Passur was a profitable company from 2006 to 2016 and derived it's revenue from these sources:
a. Hardware: selling passive radars - small but declining revenue source
b. Services: Consulting with airports, airlines or FAA
c. SaaS portion: Software sold to top 5 airlines and top 30 airports in the US.

Based on review of publicly available contract documents for airports, this SaaS portion is very sticky. Airports and airlines use Passur software to track arrival and departure plane positions, as a communicator tool and for landing fee billings (plugs into Oracle ERP for auto billing). Few examples: Denver airport has paid ~$100K/ year for last 14 years, Tampa airport has contracts from 2012 to 2023 and pays ~$50K/ year. Many of these contracts show the services are sole sourced.

To understand how Passur got to the revenue and earnings seen in 2016, we need to look at role of Chairman Gilbert who owns 53% of the stock. He loaned the company upto $10M in 2002-03 when the company had only $2M in revenue so that they could build their radar network and software. This was upfront cash spend to get to the sticky long term revenues which grew at a CAGR of 15% from 2002 to 2016 (see chart below). Also, the Chairman charged 6% - 9% interest rate and if we add in his salary, he made 15% return for 15+ years just from salary and debt. However, it's important to note that he won't have made this loan if he didn't think the opportunity was big enough. Also, it proved to be a compounding machine if we also consider stock price appreciation.

Fast forward to 2017:  Passur decided to invest on new products and to grow internationally. And these upfront investments meant net loss and taking on additional debt from the Chairman who has committed to finance capital needs till Jan 2020. The excerpt from their letter to shareholders below highlights their decision to prioritize long term at expense of short term loss:

During the year [2017], we hired 14 additional teammates and increased our spending by approximately $2 million, including additional investments in new products and infrastructure. The Company introduced several new and enhanced product offerings and launched PASSUR's international program

FY 2017 was clearly a transitional year. Our board of directors felt it was important for the Company to invest heavily, so that PASSUR could build on its position as a collaborative digital solutions innovator and thought leader. To that end, our board authorized the Company to prioritize making additional investments, even at the expense of near term profits

While increase of 14 employees might seem trivial, this is a tiny company and that represents an increase of almost 30% over number of employees in 2016. So this change represents a big ramp in investments starting in 2017. The company continued to hire highly paid executives in 2018 while trimming some other employees.

The results show increased SG&A spend due to hiring of sales executives and building up Business Intelligence group. Passur is selling software with $100K+ annual costs and this type of sale needs a direct sales effort (see Peter Thiel's great analysis on annual revenue levels and distribution methods here). Having executives with deep contacts is needed even if the product is great. This is really Customer Acquisition Cost (CAC) - upfront spend for long term stable revenues. Airports are managed by government organizations which are slow to move. I'm not sure how fast airlines move when buying software. Till now, revenue hasn't gone up yet due to long sales cycle. One thing to note: 2016 to 2017 drop is mainly due to one time service contract in 2017.

Without big uplift in revenue, we have to look at leading indicators to understand if SG&A spend is working or it's a waste of money. There are few data points that indicate that the increased spend is working and Passur is getting bigger contracts in software for collaborative decision making:

1. Broward County / Fort Lauderdale airport contracted with Passur for optimizing surface traffic flows and gate capacity. This contract pays substantially more on surface traffic optimization as compared to Passur's traditional software on landing fees and communicator.

2. Passur co-created software with DFW to allow for efficient diversion in case of weather related disruption events. This article explains how it works. DFW was an existing Passur customer for landing fees and as a chat Communicator.  The key here is to understand how well Passur is embedded with the customers to co-create new solutions as seen by comments from DFW's VP of Operations Paul Sichko:

Sichko considers the new system a “living program” and leads an annual meeting of airport and airlines stakeholders to discover how they can improve it. They also have weekly teleconferences. Ideas generated in the meetings are often developed by PASSUR into program upgrades. 

3. Passur has recently signed on international customers: Air France (Sept 2017), TAP Portugal (Jan 2019), Toronto Pearson airport (Feb 2019, for weather related diversion app) and AeroMexico (Feb 2019). Recent hire of Niels Steenstrup, who previously expanded international business at Gogo, is likely to help Passur accelerate international business.

We can see that international Revenue is ramping up fast from a low base in the table below. I might even make a guess here: most of 2018 increase came from Air France.

4.  FAA is evaluating a Passur tool and whether to deploy it at busy airports (WSJ article).  Passur developed a trial tool in Newark and LaGuardia last year that maximized use of runaway in bad weather and resulted in one to two extra landings per hour.

What does all of this mean for revenue growth? Management says that 2017 to 2019 was 3 year investment period and big growth is expected in 2020:

This fiscal year, ending October 31, 2019, is expected to be a transitional year, with only moderate revenue growth, but we are cautiously optimistic that our ongoing investments in a market segment where we believe PASSUR has unique capabilities will pay off in accelerated revenue growth in the years ending October 31, 2020 and beyond

Risks:

1. Is Passur addressing too small of niche? Is the sales spending too high given the TAM? Are these wasted dollars? Hard to know, but given how well Passur understands the landscape and the quality of hires, I'd say that they know the TAM size well. Why else would senior people from the industry join them? Also, Passur can cut the investment if leading indicators don't show enough promise.

2. Why is the Chairman charging 15%, considering interest on debt + salary, to fund the growth of the company? Seems excessive. Is he signaling speculative nature of his investment, or just making money for himself along the way? If these investments did not have enough ROI, would he have committed to sink additional capital?

3. Some other software provider with bigger sales force and higher R&D spend adds these niche capabilities

Bottom-line: 

There are initial indicators that new investments are working. Mr. Market may be undervaluing Passur at $10M market cap given future possibilities. And there is a stable base business with sticky SaaS revenue. If the new investments don't work, management can cut the losses and continue with the base business.

2018 year end portfolio review

I ended 2018 with -8.5% loss compared to -6.2% loss for S&P500. I play mostly in microcap area which sustained steep losses in Q418. My own portfolio wasn't spared in Q4 either. This is a quick recap of 2018 yearly performance and some learnings. 

 I can't predict macro stuff for 2019, but I feel cautious mainly because of where we are in the cycle (10 year expansion, ultra low interest rates now going up, etc).  But as Howard Marks says - "we don't need to know where we are headed, just where we are in the cycle". So, I'm trying to be cautious and my strategy is to stick with financially strong companies and avoid excessive leverage.

Closed positions:

FRP Holdings (FRPH) -  This was a good winner in 2018 and I previously explained why this was a good investment here. They did resource conversion in the classic manner as described by Marty Whitman. They converted a concrete batch plant to apartment building besides Washington Nationals stadium, and sold off warehouse business that they created from scratch for high valuation. I might look to get back into this stock again in the future depending on price and the Baker family plans on further resource conversion opportunities.

Yatra (YTRA) - This was the biggest mistake of 2018 for me and I took 35% loss on this 5% position. I got suckered into $YTRA and the thesis was an unforced error. It was focused too much on the upside and not enough on the downside (torched marketing $s). Again, this is one case that will always remind me to never use price to sales ratio ever again. Yatra is growing, but their marketing spend is just not efficient relative to revenue added. And they are in race to bottom to acquire users with MakeMyTrip. This was also a good wakeup call to not touch SPACs and just have error of omission. The problem with SPACs is similar to that of IPOs - prior owners find opportune time to cash out and find other (bag)holders. Yatra was the same story. 

Keryx (KERX) - This was my first biotech investment, but was relatively lower risk since Keryx already had a FDA approved drug.  So the only question was whether they can sell enough of the drug. I kept position size low at 2%. I entered into this position when Keryx had manufacturing yield problem at a contract manufacturer and supply for disrupted for a month. However, Keryx could never ramp up sales fast enough and announced sale to Akebia. I exited it with a minor loss and probably won't be back in biotech since it's not worth the effort.

PBF Energy (PBF) - This was another winner in 2018. They bought refining assets for cheap and were turning around operations in PE style. As Whitman says, when there are resources with good quality and quantity, eventually earnings come around. There's natural ebb and flow in demand, but no new refining capability is being added.  So earnings went up for a short period in 2018 and stock price shot up. I sold it when it seemed fairly valued in mid 2018 and the price has come down by ~30% since then. Might be worth another look if price keeps dropping to mid 20s.

Open positions:

Resolute Forest Products (RFP) - I bought most of my stake in $4 - $6 range. The basic thesis was that they have high quality assets and were severely undervalued due to making operating losses in 2015 - 17 period. But earnings typically follow when there are good assets. And 2018 saw lumber, pulp and paper prices all rise up due to high demand. Supply can't be created fast enough and RFP stock price shot up to close to $13. I sold off 1/2 of my stake at that price, and still hold the rest. The stock has done a round trip and is now at $7 where I believe it's very undervalued. Much of the drop seems related to softwood lumber prices dropping down from 2018 heights and back to level to Jan 2017. But the selling seems overdone since pulp and paper prices are still high. Also, RFP did some asset sales which will reduce debt, and is doing close to 50% FCF currently. Finally, if their tissue segment starts producing earnings (a big IF), this will look a completely different company.

Drive Shack (DS) - When I first bought Drive Shack, they had cancelled REIT status and there was indiscriminate selling. They are doing resource conversion - selling golf courses and investing proceeds into Topgolf like eatertainment arenas (detailed thesis is here).  My purchase price is in $3 range and $DS shot up to > $6 on news that Wes Edens bought a big stake at $6. The stock has dropped back to < $4, though they have executed well on golf course sale (12 sold out of 26 courses for $89M). They are also retained management of these sold courses which means they will get to keep fixed fee earnings. They recently hired Topgolf ex CEO as $DS CEO. It's too early to tell if the Drive Shack concept will be as profitable as Topgolf, but atleast there's existence proof.

Cheniere (LNG) - I've held it for past to 2 - 3 years. The basic thesis is that they are toll road operators for LNG. They have high leverage but long term contracts reduce the risk. And their earnings keep going up as additional trains come online.

Antero Resources (AR)  - Biggest paper loss came from Antero. I did a long write up here, but the stock slid almost 50% just in Q4. I've re-looked at the thesis and don't see anything majorly wrong with it. Yes, the paper loss is painful, but this is an undervalued company. Management has announced corp structure simplification, and share buyback. No time like now to buy back some shares when they are so undervalued. 

Ashford Inc (AINC) - No change in the thesis written here. This has the same setup as RMR, and the Bennett family has converts at $140/ share. They have the incentives to do transactions to raise stock price and get those converts in the money.

Fiat Chrysler (FCAU) - There's still lot of value left to be unlocked as they continue to ramp Jeep and Ram, divest parts business (Magneti Marelli), and extract value for luxury brands - Alfa Romeo and Maserati.

Gaia (GAIA) - Detailed thesis is here and nothing has changed except drop in price. Very niche business, but potential to be a multi bagger. The stock price did a round trip and is now roughly close to average price I bought it.

TripAdvisor (TRIP) - Great assets that need to be monetized better. Either they will do it, or will be sold to another company that can monetize it better. This contributed to a gain in 2018.

Envirostar (EVI) - Rollup story with Watsco alumni management owning > 50% of the stock. It has great potential to be multi bagger similar to Watso and $POOL. They can continue making acquisitions since there's not much competition. And they can increase profitability by cross selling and focusing more on services.

Passur (PSSR) -  It's a tiny data analytics company that provides services to airlines and airports. They have ramped spend on sales and marketing, but revenue hasn't gone up. This is a bet that either revenue goes up, or spending is cut. Either way, earnings will follow.

Rubicon (RBCN) - They have lot of NOLs but have sold off their loss making operations. I am confident that Bandera Partners and CEO Tim Brog will repeat their prior performance and unlock value here in next 2-3 years.

iStar (STAR) - They have a hodge podge of real estate assets, and they seem hell bent on being a developer instead of simplifying their balance sheet and staying only as a lender. In the two years I've held this stock, they haven't made much progress to unlock value, and it might stay the same for another 2-3 years.

Antero Resources ($AR): undervalued Marcellus shale play

Antero resources is a natural gas and liquids exploration and production (E&P) company with acreage in Marcellus and Utica shales. It's shares have under-performed since going public in Oct 2013 ($60/share at time of IPO, $18/share in Sept 2018). Shale E&P's remain an unpopular area of the markets, and some of it is deserved due to capital destruction by many of the firms. In this article, I'll give a brief summary of my initial thesis on Antero, what's the bad side for this investment, and whether Antero is creating or destroying value with their drilling program.

Antero differs from the other stocks I typically write about or invest in, because:
1. It's not a small / micro cap stock, and is covered by several Wall Street firms,
2. It's in the commodity segment. And I have no special forecasting capability on the price of natural gas (But does anyone else, really?)

Yet I still invested in Antero because I believe it's undervalued. I first bought small position in $AR in mid 2016. The thesis was simple: the market was valuing Antero only for the drilled acreage, and was valuing undrilled acreage at zero. Plus, Antero owns contiguous acreage in the prolific Marcellus shale which allows for longer laterals. Recently, SailingStone Capital which owns 11% of $AR stock gave the same thesis on Antero in a letter to the Board:  "The shares of Antero Resources trade at a discount to the value of the company’s proved reserves using the futures strip and a 10% discount rate, and reflect no value for the company’s vast acreage position and liquids-rich drilling inventory in the Marcellus Shale."

Since 2016, the stock moved slightly down. Despite this, I've recently added substantially more to this investment to make it a mid-sized position (5%), and this post will provide an updated thesis.  I can't predict when AR stock price will move up, but what I know is that Antero is undervalued and value is being created, and it will be realized someday.


Let's start the thesis by looking the "bad" side of Antero

There are two frequently cited items here:
1.  Complicated corporate structure,
2.  Abundant natural gas in US, with potential impact of low natural gas pricing for long period

The corporate structure is complicated and major investors have written letters asking the Board to simplify the structure. Chapter IV sent a letter to the Board explaining why they exited the investment due to complex corporate structure.  SailingStone Capital also wrote a letter (Exhibit D in this filing)  asking the Board to evaluate options such as share buybacks, reducing debt and simplifying corporate structure.  The Board is currently doing a strategic review, but my overall thesis does not depend on the outcome of that review.

The complex organization structure is shown in the figure below. The Sponsors are PE firms (Warburg Pincus, Yorktown) and management (Rady and Warren). A common criticism with this complex structure is that Sponsors profit from being owners of the GP, and profits for GP ($AMGP) increase faster than those for LP.  This leads investors to suspect that the drilling program is driven mainly for the purpose of increasing GP profits.  Another angle here is to look at how much money Sponsors have tied up in each of the companies in the structure. Sponsors own $1.8B of $AMGP stock and $1.5B of $AR stock. I'd argue that Sponsors have put roughly the same amount of money into AR and AMGP, and I don't think their interests are heavily skewed towards the GP at the expense of AR, especially when considering that AR is quite undervalued (more on this later).

I don't believe that rising GP profits are the main motive for the drilling program. Instead,  I believe the major reasons are:

1. Management (which owns 9% of the stock) believes that it is a good investment to keep drilling,

2. AR has higher firm transportation capacity than current production, which means they are taking a loss due to take-or-pay agreements with pipelines. They are losing about $0.16 per Mcfe due to excess capacity.

3. AR can lose their lease on acreage if there's no production by a certain date, see table below for example.

The big questions are: 
What is the economic reality at AR? Are they spending cash today to create wealth, or are they sinking cash (i.e. destroying wealth) with their drilling program?

The full cycle rate of return is 28% (source: 2018 Analyst day) which is lot higher than cost of capital, and so drilling program is creating wealth. Of course, Antero could slow down the drilling program, and sell their finite reserves of natural gas at higher prices in the future. This needs to be balanced with not losing acreage due to no production. I don't know what the sweet spot is for not losing acreage vs not selling too much gas at low prices.

Unit economics is another useful way to look at E&P companies. Antero has cash margins of $1.13 per Mcfe for 2018. However, they are losing $0.16 per Mcfe due to take-or-pay on firm transportation. As Antero grows production, there will be two upsides: a. loss on transportation will go away, pushing cash margins upto $1.4 per Mcfe, b. G&A costs will be spread over larger revenue.


Valuation:

If we subtract $AM holding from $AR's market cap, the market is pricing stand alone E&P at $2.8 Billion. 2018 Operating Cash Flow is estimated to be $1.5 Billion , and maintenance capex is ~$580 Million (source: 2018 Analyst day). So excluding growth capex, cash flow is $0.9 Billion. $AR has net operating loss of $3 Billion at federal level and won't be paying taxes for a long time. That's yield of 32%. Even after using up or expiring NOLs, they'll have $0.7 Billion of cash flow (Excluding growth capex) which is 25% yield.


Additional considerations that enhance value:

1.  E&Ps get tax shelter through expensing of Intangible drilling costs.  I find this example of tax shelter at work interesting: though Antero received cash proceeds from derivative monetizations of $750 million in 2017, their NOLs increased by $1.6 Billion.

2. Antero has liquids rich portfolio. So there's potential upside if oil prices go up.

3. Antero has a large hedge book that will help them through periods of low natural gas prices.


Additional Reading:

1. My twitter thread on shale oil vs shale gas

2. Excellent VIC writeup on Antero

3. Antero Analyst day 2018 slides

4. Full cycle vs half cycle rate of returns for oil and gas

5. David Einhorn presentation on shale gas

6. Brief explanation on Intangible Drilling Cost and tax breaks

$GAIA - what the numbers mean

I previously wrote about Marty Whitman's insights on Value Investing. One key insight is to focus on what the numbers mean and not just what the numbers are. I cited several examples to highlight this point, and one of them was $GAIA. I got many questions on why $GAIA makes sense as an investment and I am attempting to answer some of them here.


I bought $GAIA when it had just sold off its yoga apparel business. The story was quite simple  at the time- Jirka Rysavy, an owner / operator with history of creating wealth,  was choosing to focus on streaming business and chose not to participate in tender offer. Most of the value came from cash and building near Boulder, CO. And if the streaming business didn't take off as expected, there was downside protection. $GAIA management also said that they could be profitable at any time with 90 day notice.

So $GAIA at first was the type of investments I am most comfortable with -- where things are so clear that its just simple sum of parts type of math and no complicated model is needed.

Since then, the subscription biz has grown (66% growth in subscribers from Q217 to Q218), and cash has dwindled (now $41M after recent equity raise).  So, now we need to look at whether the growth spend is good investment or torched cash.

Subscription type businesses cannot be valued based on earnings. This is because marketing spend to acquire customers is more like growth capex, but is expensed according to GAAP rules. So its cash outlay at the beginning, and it gets recouped (hopefully) over time. Customer Acquisition Cost (CAC) and churn are two important metrics here. I recommend this and this article from Tren Griffin ,and this Bill Gurley article to get deeper understanding beyond just mathematical model. Particularly relevant is the following quote from Tren: A business can start out with very high CAC and then have it drop over time (Sirius XM or Netflix) or have relatively low CAC and watch it rise over time (Blue Apron).  The case of Blue Apron is particularly illuminating as seen in this excellent twitter thread by @modestproposal1

Blue Apron didn't give churn, so here's a rough cut at GP$/Cost Per Gross Add with 3%/4%/5% churn. Bunch of simplifying assumptions. pic.twitter.com/sT63SNBaPV

— modest proposal (@modestproposal1) June 2, 2017

Two key concepts here:

1. Is CAC increasing or decreasing? If company is chasing customers who don't care enough about the product, CAC is likely to increase. CAC is also increasing when many competitors try to bid up the same Google adwords.
2. ARPU, LTV, CAC, churn are all related rather than independent variables. The LTV model is simply a tool to measure how "good" are the investments made by management.


The chart below shows sensitivity analysis based on range of churn rates for $GAIA. My guess is that the churn is closer to 5% because management keeps saying that they keep customer acquisition cost below 50% of LTV. The Marketing expense numbers are from different earning calls.

What's working for GAIA:
1. Cost per Gross Addition (CPGA) is flat to slightly down.
2. Even with close to 5% churn,  management statement that they are not spending more than 50% of LTV seems to be correct.
3. They have plans to increase ARPU from the more loyal subscribers by doing live events at their Colorado office space
4. They own the 80% of their content and content production costs are low.
5. They don't have competition in the Truth Seeker area to acquire customers (compared to Yoga where there's other competing apps, and free stuff on Youtube)
6. They will working on getting more organic growth via friend referral (share a video for free with a friend).


There's still lots we don't know. We don't know the churn by type of customer (Truth Seeker, Yoga) and acquisition channel, and if the churn is going up for each cohort or going down. And we don't know the CAC by different customer types. The comments from Management indicate that the Truth Seeker area has lower churn than Yoga area, and so management if focusing on growing Truth Seeker community. Perhaps the best way to understand what's going on is to focus on management's role as investor of capital (Whitman says that this role is not emphasized as much as it should be). To gain new subscribers, they are making investment decisions in the form of marketing spend - Which customers to target? How much to spend for acquiring these customers?  Its re-assuring that the people making these decisions have long track record of creating wealth and their own money is tied into it in form of stock ownership. Management even bought more stock in the recent equity raise. This leads me to believe that the management is making good investment decisions.  And I am happy to ride along as a stockholder.