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Adding to Sarine Technologies

Posted on April 12, 2018 by WertArt Posted in Current 4 Comments

Sarine Technologies provides machinery and software to the midstream diamond processing industry. The midstream sector is placed between the producers of rough stones (upstream) and the retailers of polished diamonds (downstream). There are about 5,000 manufacturers most of them located in India (1).

Sarine has played a major role in transforming the industry with the help of their automated solutions for every stage in the manufacturing process from the rough stone to the polished diamond. Sarine is mostly selling to the larger manufacturers providing them with a cost advantage over the smaller players in a very low margin business.

Sarine has a 70%+ market share and a monopoly position in some product segments. Their leading position in this relatively small market results in high returns on capital with profits reinvested in product development to strengthen the company’s competitive position.

But that’s not all: their growing installed base of machinery delivers recurring revenue streams that currently account for roughly half of revenue. In addition, Sarine recently started to market products for the downstream retail sector (2) and diamond grading. So far, contribution to total revenue from products targeting new sectors has been small. Management is targeting a 5% revenue contribution from these new products in 2018.

Currently, a number of risks and uncertainties weigh on the stock price:

Since its peak in September 2014 when the company was valued at SGD 1 bn, the share price has lost about 60%. This is partially due to two years (2015 and 2017) where industry headwinds weighted heavily on operating results. In the latest annual report, the company’s Chairman Mr. Glinert provides a good summary of the headwinds Sarine has been facing.

1) There has been substantial oversupply of polished diamonds due to the following reason:

“The normal production cycle of the diamond industry is driven by the fact that half of the annual retail sales worldwide are concentrated from November — China’s Singles’ Day, India’s Diwali and Black Friday in the U.S., through February — Chinese New Year and Valentine’s Day. Polishing is catalysed by the sell-off of inventories throughout the industry value-chain during this four-month period. As downstream wholesalers and retailers replenish their inventories, midstream manufacturers adjust their output accordingly and typically slow polishing activities when the downstream demand cools. However, as the industry is fragmented, and little, if any, information is shared, and as the cycle time from buying rough diamonds to finishing polished diamonds is at least three months, the midstream usually overshoots with production. There is a consistent cycle wherein in Q3 there evolves an oversupply of polished diamonds in the midstream. The degree of overstocking varies from year to year and is dependent on many factors – actual consumer demand, how aggressive the producers are at offering rough diamonds, how aggressive the manufacturers are at competing for said rough, at what point the manufacturers realise the demand for polished has slowed, relative prices of rough and polished stones, etc. This year, primarily due to the aggressive sale of rough by producers still working down their excessive inventories from 2015 (they sold more carats in 2017 than they mined), and correspondingly aggressive buying by the manufacturers, the build-up of inventory was significantly higher than the norm. This is evidenced by the very significant drop in rough stone sales by the producers in the second half of the year (e.g., the DeBeers sights from July onwards), after the manufacturers realised their situation. Consequently, the corresponding slowing of manufacturing activities in the second half of the year is the primary reason for our weaker results in the second half of the year.”

In summary, the midstream sector’s margins are squeezed by their suppliers (rough stone producers) and their customers (retailers and wholesalers). From time to time, supply of polished stones exceeds demand by a wide margin. This leads to an even weaker position of the midstream sector and therefore lower demand for Sarine’s products and services.

However, in February 2018, management reported that diamond sights have come down in 2018 and that retail sales were better than last year. In the annual report released at the beginning of April management confirmed this positive trend pointing out that they are expecting a relatively strong year for the industry (3).

Moreover, besides the up and downs of the midstream sector there seems to be a structural shift going on in the diamond cutting and manufacturing industry. A number of banks have reduced their borrowing activity to the midstream sector. And recently one of the biggest bank scams in Indian history was uncovered directly related the Nirav Modi who owns diamond manufacturing and retailing. Ultimately, I expect midstream segment consolidation to speed up as small manufacturers have to leave the market due to tight margins and more stringent regulation. A more transparent midstream sector consisting of fewer but larger players should benefit Sarine’s business activity in the future.

2) The other headwind results from Sarine’s technological leadership as intellectual property infringement saw a sharp increase in 2017. This is mostly the case in India, by far Sarine’s most important market. As Mr. Glinert explains in the annual report, management is taking all judicial measures to protect their intellectual property and is trying to increase awareness of these infringements with retailers and wholesalers of polished diamonds.

Moreover, they are also relying on technology to protect their property:

“The newest Advisor® 7.0, protected by proprietary home-grown cloud-based cyber protection, has many enhanced features. Comparative testing between Advisor® 7.0 and the older version hacked by the illicit competition shows the polished stones planned using the newer software have a significant tangible added value in actual dollar terms. Advisor® 7.0 also has functionality specifically aimed at enabling the manufacturer to better meet today’s retail trends for branding — optimising modified cuts, light performance enhancement, etc. These valuable add-ons, along with other commercial incentives noted below, motivate manufacturers to migrate upwards to the latest version…”

According to the company, out of twenty thousand systems sold, eleven thousand have so far transferred to the protected Advisor® 7.0 Software.

In addition, infringements can now be uncovered by various software control tools that have been implemented in Sarine software systems to prevent misuse.

Going forward, I expect that it will become more difficult to copy Sarine’s product and that the impact of patent infringements has reached its peak in 2017/2018. Encouragingly, management believes that Sarine managed to retain its market share in the midstream manufacturing segment of the diamond industry in 2017. Although the number of stones processed declined and product piracy took business away, Sarine was able to set a new record of 10 million scanned stones (4).

3) There are a number of additional risks that could affect Sarine’s operations including:

First, the technological advancement of man made diamonds has progressed over the last years. Consequently, there is a risk that synthetic diamonds substitute demand for natural diamonds at some point in the future (5).

Apart from that, the current geopolitical situation will affect the diamond industry, if US/EU lawmakers impose sanctions on Russian diamonds. With Russian state run Alrosa controlling 30% of annual diamond output any export restrictions would have a severe impact on market supply.

A brief look at management/shareholders and valuation:

The company’s directors have significant insider ownership holding about 12% of the company. David Block was appointed CEO in May 2017 after joining the company in 2001. Most managers have been working at the company for at least a decade. Mr. Block is currently holding 0.8 m shares and he will shortly be granted 1.2 m options at market price vesting over four years.

In December 2017, Mondrian Investment Partners and Shareholder Value Management exchanged their position, with Shareholder Value now being the largest outside shareholder holding 9.2% of the company.

Like many of my other investments, the company has a pristine balance sheet with USD 29 m of net cash. The current enterprise value is USD 277 m. I think that the company should be able to achieve normalized net profit of USD 20 m going forward valuing the company at a 13.8 times cash adjusted multiple.

Given the company’s

high earnings quality,
strong ROICs,
leading product development capacity in its industry,
recent product launches targeting new markets,
high recurring revenue stream,
a history of returning excess cash to shareholders,
and a low financial leverage,

I think shares of Sarine should trade at a significantly higher multiple.

After building an entry 2.5% portfolio position in September 2017, I have been increasing the position to 3.5% after the release of the annual report at an average price of SGD1.14 per share.

Disclaimer

The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!

(1) India is the largest diamond cutting and manufacturing centre with total rough diamond imports pegged at $17 billion per annum. Hence, India, especially Surat, processes around 90 per cent of diamonds mined around the world.

(2) A number of Asian retail chains including Soo Kee Group in Singapore, Shining House in China, Golden Dew in South Korea, K-Uno in Japan and Aurora in Thailand have already adopted Sarine’s retail solutions in 2016 and 2017.

(3) See also: http://www.paulzimnisky.com/global-diamond-supply-expected-to-decrease-3-4-to-147m-carats-in-2018

(4) Since its release into the market in 2009, the inclusion mapping technology / Galaxy® family of systems has provided inclusion mapping data for rough diamonds in major diamond processing centres wordwide. The company states that the system has “revolutionised planning and production processes by maximising polished diamond yield, while expediting the manufacturing cycle and reducing human error.” Over 30 million stones cumulatively have been scanned since the technology’s launch.

(5) See also: http://www.paulzimnisky.com/the-price-of-lab-created-diamonds-relative-to-natural-continues-to-fall

Selling Retail Holdings

Posted on March 28, 2018 by WertArt Posted in Sold 4 Comments

Back in November 2013, I invested in Retail Holdings (ReHo). At that time, the company was already in the process of selling its assets and returning net proceeds to shareholders with the ultimate goal of full liquidation.

At that time, I derived at the following valuation:

”ReHo has currently approx. 5.3 m shares outstanding. I came up with a market value for ReHo’s share in Singer Asia of USD 133.2 m or USD 25.16 per share. In addition, a value of USD 19.3 m for the SPV Notes translates into USD 3.64 per share. Last but not least the company has USD 6.5 m in cash or USD 1.23 per share. This leads to a NAV of USD 30.03 per share. At a current price of USD 19.25 the share is offering a 56% discount to NAV.”

While it turned out that the SPV notes were worthless, management was able to maximize Singer Asia’s asset value and sell many assets with almost perfect timing (e.g. sale of Singer Thailand). In addition, management repurchased 12% of shares outstanding at attractive prices. The good sales process was also a consequence of executives/insiders directly profiting from a smooth liquidation in the form of equity ownership and incentive fees.

After 4.5 years, I have so far received USD 19 per share in dividends. The stock is currently trading at USD 13 per share or a 30% discount to reported NAV.

During the first quarter 2018, I sold my position at 13 USD per share realizing a total return of 98.6% and an IRR of 21.2%. Total contribution to portfolio performance since inception was 2.9%.

The rationale for this transaction is that around 70% of the assets are in the form of shares held in Singer Bangladesh. Therefore, the remaining portfolio has become much more concentrated than it was the case in 2013. More than a third of the Singer Bangladesh shares are restricted as “to the remittance of dividends and the proceeds from the sale of these shares.” Management is seeking an elimination of this restriction, but currently a sale would only be possible at a material discount I assume. Apart from that, last year’s momentum of continuous sales activity has stopped for quite some time now. Therefore, I think that the investment has become more risky and that the current discount to NAV reflects a fair assessment by market participants.

Disclaimer

Pason Systems (TSE:PSI)

Posted on March 5, 2018 by WertArt Posted in Current Leave a comment

After my recent investment in Geospace Technologies, I am buying another service provider to the upstream sector of the oil and gas industry. Pason’s equipment is installed in over 1,000 onshore drilling rigs or 65% of all rigs in the Western hemisphere. Mid cycle operating margins reached 25% over the last cycle with ROCE in the 15%+range. Operations have been very volatile during periods of squeezing demand (like in 2009, 2014 to 2016), but Pason has been a steady compounder taking the last two decades of the company’s history into account.

I think that the company is well equipped to profit from an industry recovery due to (i) a strong competitive position, (ii) new product introductions and geographic expansion opportunities, (iii) high operating leverage and (iv) relatively low investment requirements going forward. On top of that, I get a pristine balance sheet and high historic earnings quality.

The key to Pason’s operational success is the application of technology to recording what is occurring at the well head. 20 years ago, this was an area where bigger companies were not paying attention to. Pason under the leadership of Jim Hill used this lack of attention to develop products that quickly covered the market before the competition could react.

Pason’s Electronic Driller Recorder (EDR) is the company’s primary product and generates 45% of total revenues. The EDR links the rig manager, rig crew, operator, geologist, mud logger, directional hand, and drilling operations technician, on a common data network. By providing secure communications via broadband satellite or wireless networks, the EDR system enables rigs to share drilling data, reports, and real-time well information with office-based personnel. The system can also provide Internet access for wellsite users. Additionally and very importantly, the EDR provides the platform for other Pason products like the Pit Volume Totalizer (15% of revenue), AutoDriller (6%), Gas Analyzer (7%).

In terms of new product development, the company has recently invested in data management solutions to help the customers to increase drilling data streams to the back office and provide analytical tools for these data streams. In addition, the company is improving its offerings with regard to so called drilling intelligence to further enhance drilling optimization and automation at the rig site (for instance Pason received the license for Exxon’s Drilling Advisory System). Lately, Management reported that these products are gaining traction based on first trials with customers. If these new product launches turn out to be successful, this will be a direct consequence of keeping investment activity in R&D stable during the current downturn. Pason is investing a healthy 10% to 15% of revenue in research occupying 25% of the workforce. New products will also have the potential to increase revenue per installed EDR.

Over the last three years, the company has been shifting its investment activity from the hardware side to software development and solutions. They spent CAD 192 m in 2013 and 2014 combined to invest in new hardware for rental equipment. Capex spending came down significantly from 2015 to 2017. Management expects annual capex to stay around CAD 25 m to CAD 30 m over the coming years (one fourth of 2014 spending) as the focus on software product development will require less capital expenditures going forward. This has already a positive effect on cash flows and will also provide support for income generation over the coming years as D&A continuously decreases.

During the latest downturn beginning in late 2014, management has reduced operating run rate costs by CAD 100 m (20% of 2014 peak revenue), helping the company to stay free cash flow postive.

Management summarized the effect of cost reduction in the Q2 2017 conference call:

“The impact of previously implemented cost reduction programs is highlighted by comparing this quarter’s results with the second quarter of 2015. While revenue was essentially at the same level, EBITDA increased from $7.5 million the second quarter of 2015 to $21.1 million in the second quarter of 2017. Our recorded net income was also much improved. We expect to continue to reap the benefits of our lower fixed cost structure into the foreseeable future.”

In addition and according to management, PSI was able to defend market share in all key markets with limited price concessions.

Speaking of market share, PSI serves close to 90% of its home market in Canada and 50%+ of the US market. They also have a leading position in LATAM and Australia and are currently gaining traction in the Middle East. According to management, the company is now operating in a stable duopoly with a third player operating an inhouse system in the US. At the moment, there is strong investment activity in the US (mostly Permian basin), while Canada is behind due to the reasons discussed in this article.

Over the long term, Pason has shown terrific growth rates being one of the best performing E&P servicers listed on the stock market. At the same time, operating volatility has been high following the E&P industry cycle. For instance, in 2014 revenues reached an all time high of CAD 500 m and declined to only CAD 160 m in 2016. In 2017, revenues recovered to CAD 245 m. While management reduced the cost base over the last three years, there continues to be a large degree of operating leverage in this business. According to management, in 2017 incremental EBITDA margins were 79%. Management believes that incremental margins might be even higher by a couple of hundreds basis points going forward.

Pason has a CAD 1.5 bn market cap, no debt outstanding and CAD 154 m in cash. Management has been focused on increasing the dividend over the years and mentioned that given current company’s excess cash on hand a further increase in the dividend is likely. Historically, the company’s acquisition paved the way to enter new markets. Recently they made a small purchase by acquiring visual analysis software company Verdazo. Managements remuneration is skewed to a relatively high equity component with more than 5 m stock options or 6% of total shares outstanding. Options vest over three to five years. Current average exercise prices are roughly 15% above the current share price. Management has generous change of control clauses in their contracts and will be rewarded in case of Pason being acquired. James Hill, who led the company for 25 years is now Chairman and still holds 10%+ of the company. He has been selling shares but this might be related to financing his interest in philanthropy and horse racing.

Valuation

In 2017, the company generated EBITDA of CAD 85 m. Accordingly, the company is valued at a 16 times trailing enterprise value to EBITDA multiple.

I think this is an attractive price for the following reasons.

I think it is likely that we are at the beginning of an industry recovery with demand increasing over the coming years. According to management, recent forecasts expect E&P spend to grow 5% internationally and 15% to 20% in US in 2018. If this expansion scenario comes true, there will be substantial top line growth potential and therefore margin enhancement due to operating leverage. Assuming that revenues will revert to a normalized level of 60% of peak levels (achieved in 2014) this results in a revenue potential of CAD 300 m. Based on 80% incremental margins, EBITDA can reach roughly CAD 130 m. This turns then into 10 times multiple.

In addition,

Pason’s earnings quality has been excellent. Cash conversion from EBITDA is usually very high. Return on invested capital and operating margins over the business cycle have been strong.
New product releases should help to foster the company’s competitive position and provide additional revenue upside.
Pason can grow internationally. For instance, they started to install on Saudi Aramco’s rigs in Q2 2017. As of Q3 2017, they already had a market share of 15% in Saudi Arabia with 30 of a total of 200 drilling rigs using Pason’s solutions. They are also starting activities in Oman, the United Arab Emirates, Qatar and Kuwait.

After the release of Q4 2017 numbers, I bought a 3% portfolio position at CAD 18.2 per share.

Disclaimer

Sell Francotyp Postalia

Posted on February 19, 2018 by WertArt Posted in Current 2 Comments

With the physical letter volume shrinking, the demand for franking machines is abating. Francotyp Postalia (FP) however is a good example for a company that can prosper in a declining industry. Only two other companies are offering franking machines including Pitney Bowes and Neopost. In addition, the distribution of franking machines is highly regulated. This provides for attractive industry characteristics. FP invested early in the technological enhancement of low volume franking machines. This is (so far) a stable segment and FP is the technological leader grabbing market share from the two other incumbents. While the competition focuses on the development of new services, FP is broadening the geographic footprint entering new markets and investing in new leasing equipment. With the replacement cycle of old franking machines in the US mostly completed, I was invested to participate in strong free cash flow generation from a highly predictable recurring revenue stream over the coming years.

In 2016, the management changed. The new CEO released a road map leading all the way to 2023. Ambitious goals were announced. So far however, there has been a high amount of “non-recurring” costs. Investment in efficiency and new product development have been made. For me it is difficult to quantify future cost efficiencies and to predict whether investments in new products will turn out to be successful.

Moreover, the company’s other business lines are weak. The mail services segment barely breaks even and suffers from intense competition and deteriorating economics. The software segment generates healthy margins but revenues are stagnating and they recently lost their largest client. More resources might be needed to restructure or reposition this part of the company.

From a valuation perspective a 3.5 times EBITDA multiple looks attractive. In my investment case, I assumed that required investments will go down leading to lower D&A and therefore higher EBIT over the years. Therefore, we would also see higher free cash flows and cash return to shareholders. Unfortunately, this has not been the case so far. Cost overruns and continued investment will cap EBIT at EUR 10 m in 2017. Consequently, the company is valued at ten times operating profit (For comparison, shares of competing Neopost can be bought at eight times EBIT). With EUR 4.5 m of free cash flow in 2017, FP trades at a 6% yield. As I do not see much improvement in 2018 as well, this turns out to be a high valuation for this type of company. FP is operating in a declining industry (although they are increasing their market share) and has to carry around the mail services business that might never be generating noteworthy profits in the future but requires substantial resources. I think it is time to move on and to sell the shares.

I started selling shares on February 15, 2018 with a limit of EUR 4.3 per share. At this sales price, this investment generated a 11.9% total return and a 3.8% IRR over a 3.5 year holding period.

Disclaimer

Geospace Technologies (NASDAQ:GEOS)

Posted on February 6, 2018 by WertArt Posted in Current 1 Comment

An investment in Geospace Technologies (GEOS) is a bet on an increase in seismic exploration activity in the oil and gas sector from current low levels. It implies that continued curtailment of seismic exploration activities cannot be sustained for an indefinite period of time and that seismic technologies will continue to be an important tool used by the oil and gas industry to find and exploit oil and gas reservoirs.

Management has managed this downturn decisively. They cut costs thoughtfully, kept their solid balance sheet and even achieved positive cash flow in 2017. At the same time, they invested in the future of the company by keeping R&D expenses steady. From an accounting perspective, I get the impression that the company is run conservatively. Adjusting for the large and ever-increasing amount of non-cash write downs that depressed accrual income over the last three years, there has been an upward trend in operating performance which might continue in 2018.

Excess inventory at customers’ hand will take some time to come down. Management is however confident that future demand will be supported coming from product replacement due to technological advances. In addition, two of the three major competitors are focused on regaining financial flexibility. GEOS might profit from the current weakness of competitors.

Doubts about GEOS technological leadership in permanent reservoir monitoring systems increase uncertainty on how the company will perform in a recovery. Based on my assessment, orders in the permanent reservoir segment are not needed to justify the investment case at current valuation. It rather provides optionality for further upside potential.

With the second largest shareholder recently sending a letter to the board and requesting a share buyback program, this provides a good reminder for the long tenured management to fully consider shareholder interests in capital allocation decision making.

Houston based GEOS designs and manufactures instruments and equipment used in the oil and gas industry to acquire seismic data in order to locate, characterize and monitor hydrocarbon producing reservoirs. The company also designs and manufactures non-seismic products, including industrial products, offshore cables and imaging equipment.

Horrendous performance over the last three years

From the following table you can see that the seismic segment is divided into three sub groups (including traditional exploration, wireless exploration and reservoir) and that the non-seismic segment has two sub groups (including Industrial and imaging). Following softening demand for seismic exploration activities GEOS posted a series of grim results over the last three years. The non-seismic segment although relatively small delivered healthy operating income over this period.

Let’s take a longer-term perspective at the income statement:

As a result of lack in demand and pricing pressure revenue fell by 79% from its peak in 2013, back to where it was in 2004/5. Since 2005, the company has evolved and increased capacity. For instance, between GEOS IPO in 1997 and through fiscal year 2014, the company expanded manufacturing, warehousing, engineering and office space from 99,000 square feet to 648,000 square feet with the number of employees increasing from 351 to 1,149 (707 at the end of FY 2017). Consequently, the cost base has increased requiring more revenue to generate profit.

With inventories already high at the end of 2014, factory activities have been running at a minimum and consequently, revenues have not been able to absorb fixed factory overhead costs. These costs combined with impairment charges depreciation expenses on underutilized rental equipment and reserves against inventories led to massive losses over the last three years.

A different perspective on earnings

Let’s have a look at cash operating income:

From this perspective there has been improvement since 2015. Cash earnings provide a healthier impression of the company’s recent state of operations than pure accrual numbers. In this context, GEOS has been able to regain control over operating losses and showed first signs of improvement in spite of an extremely difficult environment the company is currently confronted with.

In the following I provide a brief discussion of the adjustments I made to get to cash operating income:

Accrual operating income has been adjusted for non-cash items including depreciation and amortization (D&A), impairments, inventory obsolescence expenses, stock based compensation and profit from sale of rental equipment. In addition, cash items capital expenditures (capex) and proceeds from sale of rental equipment for each period have been included.

For instance, in 2017, GEOS reported an accrual operating loss of USD 54.3 m. Adjusting for USD 17.8 m of D&A, USD 5.3 m impairment of long lived assets, USD 21.5 m of inventory obsolescence expenses, USD 5.7 m of stock based compensation, USD 4.9 m proceeds from rental equipment and USD 1.6 m of capex and USD 9.1 m of profit from sale of rental equipment results into a cash operating loss of ~~USD 15.2 m~~ USD 9.8 m.

Is the company spending enough?

D&A of USD 17.8 m exceeds 2017 capex of USD 1.6 m by a wide margin. For comparison, capex reached USD 33.5 m in 2014. Consequently, the question arises whether GEOS’s current capital budget is underspent. However, please note that the company invested USD 26.7 m in rental equipment in 2014 compared to only USD 0.5 m in 2017 (with new leased equipment during the period mostly being transferred from existing inventory) and that USD 12.5 m of D&A were attributable to rental equipment depreciation. Therefore, over the last three years the company has been using existing inventories being transferred to rental equipment leading to almost nonexistent investment in new rental equipment and therefore lower capex.

Potential recovery of inventory write-downs

Inventory obsolescence expenses sum up to USD 36.5 m over the last three years. Starting from an inventory level of USD 145.9 m at the end of 2014, management tried to work down from these inventories levels since then. Due to the lack of demand for their products, they started to take reserves for an inventory obsolescence in 2015. However, management pointed out, that the equipment where they built reserves against, would be sellable in a good healthy market as well. Currently, inventories stand at USD 77.6 m.

Cost cutting yes, but not at the cost of product development

Management has reduced the cost base over the last years and recently announced another cost cutting program targeting cash savings of USD 6.0 m annually. However, despite the industry downturn management continued to invest in research and development (R&D)

This is an extract from the company’s 2017 10-K:

“Past periods of revenue growth were primarily driven through our internal development of new products for the seismic industry. In past years, our seismic product innovations included the introduction of borehole seismology tools, seabed PRM systems and wireless data acquisition systems for both land and marine applications. These innovative technologies are the result of our unceasing investment in research and development initiatives, even during difficult industry cycles when we experience a significant decline in customer demand for our products. A majority of our product research and development cost relates to our product engineers. Our engineering staff has been key to our past success, and we intend to continue our tradition of retaining and attracting quality engineering staff and providing appropriate compensation and benefits. Going forward, we intend to continue significant investments in product research and development of new seismic technologies as well as non-seismic products in order to diversify and grow our revenue base.”

Management keeps spending for innovation with new products and enhancement of existing products, such that when seismic exploration activities pick up, they are well positioned to deliver those products to the market.

Strong financial position provides back up for prolonged recession

GEOS generated positive free cash flow in 2017. From a pure cash flow perspective, GEOS generated free cash flow of USD 13.3 m in 2017, the first positive after two years of cash outflow in 2015 and 2016. The 2017 result was positively influenced by a USD 13.0 m tax refund, but is still an encouraging signal with regard to financial flexibility.

This brings me to the company’s balance sheet which is in excellent shape. At September, 30, 2017, GEOS had USD 51.2 m cash and short-term investments no long-term debt outstanding and borrowings buyable under their credit agreement were almost USD 24 m. In addition, all of the company’s various real estate holdings were owned free and clear and without any leverage. Real estate is booked at cost and besides the large cash pile presents another substantial cushion.

Customers, competitors and products

In the seismic segment, GEOS sells products to seismic service contractors. Based on company’s estimates there are fewer than 50 seismic contracting companies in the Western hemisphere and fewer than 20 seismic contractors who are engaged in marine seismic exploration. Consequently, a relatively small number of customers, some of whom are currently experiencing financial difficulties, account for most of the company’s revenue. Contractors have reduced the count of active seismic marine vessels and land crews from that of prior years and symptomatic of this shrinking market is an ongoing consolidation between GEOS’s customers. Consequently, the dependence on an even smaller number of customers is likely to increase in the future.

As a result of the drop in oil price, exploration and production companies reduced seismic exploration activities and therefore many of GEOS customers are currently utilizing only a fraction of their owned seismic equipment. This unutilized equipment is available for immediate deployment if future demand for seismic services were to increase. Therefore, any increase in seismic activity will first benefit GEOS customers, with contractors increasing orders for GEOS products once their backlog continuously recovers. So, the availability of excess customer-owned seismic equipment combined with substantially reduced capital budgets has curtailed the customer’s need to purchase or rent seismic equipment from GEOS over the last three years.

Nevertheless, management is confident that future demand will come from product replacement due to technological advances. For instance, existing legacy cable systems eventually will be replaced with cable free /wireless systems which offer a number of advantages. Management sees the company well positioned to profit from customers switching from traditional seismic equipment to wireless equipment where the company is in a good position.

The company’s land-based wireless seismic data acquisition system is called GSX/GCX. According to the company, the GSX system requires less maintenance than traditional seismic data acquisition systems leading to less environmental impact and ease of operation. Since its introduction in 2008 and through September 2017, GEOS sold 403,000 GSX channels (67,000 in 2017, 4,600 in 2016 and 7,000 in 2015) and they currently have 73,000 GSX channels in their rental fleet.

Competition for land based acquisition systems comes from Sercel (an affiliate of CGG), ION Geophysics and FairfieldNodal. CGG and ION Geophysics are both listed companies. CGG is currently undergoing a financial restructuring. It does not look much better for ION Geophysics with USD 115.1 of net debt on its balance sheet as of September 2017 and USD 12.7 m of interest expense for the first nine months of 2017 compared to a market cap of USD 216.5 m and revenue for the first nine months of USD 139.6 m and negative free cash flow of USD 7.6 m. During periods of financial distress management and employees get distracted from day to day operations and customers who depend on ongoing service support will think twice before they buy from close to insolvent suppliers. GEOS could profit from this situation.

GEOS also has a strong position in the ocean bottom segment. GEOS marine-based wireless seismic data acquisition system is called OBX. Similar to the GSX land-based wireless system, the marine OBX system can be deployed in virtually unlimited channel configurations and does not require interconnecting cables between each station. GEOS’s deep water versions of the OBX system can be deployed in depths of up to 3,450 meters and for up to 50 days. Through September 2017, GEOS sold approximately 600 OBX stations and has 6,700 OBX stations in its rental fleet. According to management, OBX systems make up the majority of rental revenues.

One of the pioneers in ocean bottom systems is FairfieldNodal. However, the choice of OBN systems is limited because most systems are proprietary to their operators who use their own vessel fleet. Magseis ASA and inApril are two smaller upcoming players in this field and less established than FairfieldNodal and GEOS.

Customer concentration gets even more pronounced with permanent reservoir monitoring system products (PRM). GEOS markets PRM to large oil and gas companies. Since this product’s introduction in 2002, GEOS received system orders from only three offshore oil and gas operators (BP, Shell and Statoil). At the same time, there are not more than ten PRMs in use globally. GEOS has not delivered a system since 2014 nor has it received orders since 2012. However, when they receive an order the effect on total revenue will be massive. Statoil’s order in 2012 was worth NOK 900 m. Management considers their PRM product to provide “best performance and long-term functionality of any PRM system ever deployed”. PRM systems are used for producing assets and reservoir monitoring has to be done on a regular basis. However, in most cases only temporal surveys are brought in to try to image those reserves.

Management continues in its Q4 2017 analyst call laying out that: “… there’s a lot more of a return when one examines the broader aspect of the financial side in having a permanent system. Where in that you get a reap of those capital expenses now versus operating expenses, but requiring investment that you will then get your return in anywhere from five to seven years or so. So, there’s a certain amount of a discerning need with respect to those operators to examine the financials and the benefits that they can reap in longer term.”

Consequently, PRM offers substantial return enhancement in the future but requires a capital expense now compared to periodic surveys that require a relative small expense with lower return on investment.

However, doubts about GEOS technological leadership in this field have come along with a lost bid on two offshore fields operated by an existing PRM client to a competing technology. This is relevant, because obviously there are not that many potential bids in the current environment. As a result, management charged a USD 5.3 m impairment against factory equipment used in the production of PRM. In the end, the question is whether GEOS electric sensor technology is superior or inferior to the competing fibre optic technology. This is currently unknown. At the same time however, a scenario where a PRM order suddenly arrives is not reflected in GEOS current market valuation at all.

Most of the traditional seismic products (in contrast to GSX, OBX and PRM) are characterized as low margin commodity or consumable products with intense competition. Management believes the level of industry demand for these products to be a good barometer of seismic crew activities since these products are consumed, damaged or lost while being utilized in seismic field operations. As GEOS focuses future product development at higher margin specialty products and new technologies, they expect future sales of these lower margin traditional seismic products to decline.

The following table summarizes revenue from each seismic segment for the last eight years:

In contrast to the seismic segment, operating income from the non-seismic business line increased each year over the last three consecutive years. The company has been successful in transferring sensor technology to non-seismic applications. For instance, the company’s automated water meters have been exhibiting fast growth as they got accepted by many municipalities. According to management further growth can be expected and with operating margins of 15%+ this is a highly attractive business segment.

A capable management team and first signs of shareholder activism

Walter Wheeler became CEO in January 2014. He has been with the company since 1997 and has an engineering background. Many members of the board including the current CEO used to work for ION Geophysical before joining GEOS. There has not been much fluctuation in the board since GEOS becoming a public company 20 years ago. In line with this, the former CEO became Chairman of the board in 2013. In spite of the current leadership’s long tenure and a relatively high equity compensation component, insiders are holding less than 4% of the shares outstanding.

There is no doubt that management has done a better job than most competitors in navigating the company through the downturn. Nevertheless, there is a risk that management teams become complacent when they stick together for such a long time.

Recently, Lemelson Capital Management, a small fund from the US, and an investor in GEOS for at least three years announced it is holding 10% of the company. This makes Lemelson the second largest shareholder. Lemelson started an activist campaign by sending a letter to the board urging for an immediate share repurchase program. So far this has been unnoticed.

Management emphasized in the past, that they see the company’s cash pile as strategic asset to make GEOS a “survivor through this difficult time”.

I think it is good to see that large shareholders are showing more commitment now and are offering more options. Management does a good job, but some assistance from owners in capital allocation should be useful.

Valuation

GEOS is currently trading at 14 USD a share leading to an equity value of USD 188.1 m. The tangible book value stands at USD 195.1 m with USD 51.2 m in cash and roughly USD 40 m of real estate at cost and no debt outstanding. Inventories, already reflecting large write-downs, add another USD 76.6 m. Historically, GEOS compounded equity by 6.4% since the IPO in 1997. This includes a 40.7% drop in book value from its peak in 2014. Before the crash in oil prices, GEOS traded at two to three times book value.

From an earnings perspective, I would be comfortable to buy this company at ten times operating income. At an enterprise value of USD 136.9 m this requires roughly USD 14 m of normalized operating income. Assuming that corporate overheads stay flat (roughly USD 12.0 m) and operating profit contribution from non-seismic increases to USD 5.0 m, this leaves USD 21 m of operating income for the seismic segment. This requires revenue to rebound quite a bit, but the required level of profitability is far away from the heydays in 2013/2014 and should be achievable once demand stabilizes. With the help of a recovery and additional demand for wireless systems and slow continuous growth in non-seismic products this scenario should be achievable. Any product orders for PRM systems would then provide further upside. Once, the company will have returned to such numbers, the market should apply a higher multiple. Historically, shares traded between 15to 17 times operating income.

Over the last trading days, I bought a 3% position at an average price of USD 13.8 per share. Depending on the quarterly results, which will be released after market close today, I plan to adjust the weight of this investment in the portfolio.

Disclaimer

2017 Annual Performance Review

Posted on February 5, 2018 by WertArt Posted in Reporting Leave a comment

In 2017, WertArt returned 4.3% underperforming the market with the benchmark increasing by 16.1%.

What are some of the reasons for this significant underperformance? I think there are four which had the largest impact on last year’s result:

1.) My portfolio is heavily weighted towards contrarian bets. Market valuations of portfolio companies like DFS Furniture, Houston Wire & Cable and Sarine Technologies reflect strong skepticism about future earnings streams due to uncertainty with regard to customer demand. While it may take some time until demand for their products will recover, they are fostering their competitive position and should profit even stronger in the next upswing in their respective industries. Investments like Pershing Square Holdings, Dundee Corp., and Francotyp-Postalia are disliked by market participants. They failed to meet expectations in the past and it will take time until market participants return with confidence to these names.

2) An underweight in large technology names. Changing industry dynamics have always been an important factor in the investment process, but disruptive trends are now the major concern for most investors. Almost all the long term businesses that have existed for such a long time are standing at the edge of a cliff today it seems. I believe that I own companies that can adapt to these dynamics by investing in new technology and transforming the business. However, I missed to take part in the disruptive process itself meaning that I had no exposure to US and Chinese large tech companies.

3) An underweight in eurozone small caps. European small cap equities increased 18.6% in 2017 (based on EMIX Smaller European Companies ex UK Total Return Index). At year-end, only a quarter of the portfolio was invested in the euro zone and a large part of this portion was allocated to special situations including Italian REIFs, Renk and Kanam Grundinvest. So instead of increasing my exposure to Italian, Spanish and French equities during the year to participate in this bull market, I added new small cap investments from the US, UK and Singapore. So far this was clearly the wrong decision. In addition, currency exposure to the US, UK and Canada had also a negative effect on performance as the euro strengthened against these currencies throughout the year (costing 300 bps of portfolio performance). The current portfolio allocation in terms of currencies looks as follows:

4) One investment that stands out is System1 Group (Brainjuicer). The share price almost doubled within a couple of months at the beginning of 2017. After that, the company began to release one trading update after the other indicating that the operating performance has deteriorated. When the share price peaked, the company was trading at an elevated multiple of future earnings potential. However, I liked the way management was incentivized for a continuation of the growth path over the next couple of years. At the same time, I ignored upcoming cutbacks of System1’s largest clients’ marketing budgets as consumer staples companies reassessed their marketing approach as big retailers (like Walmart and Amazon) put pressure on suppliers to cut prices. Throughout the remainder of the year the share price declined by 60%. The retreat in System1‘s equity value decreased 2017 portfolio performance by 400 bps.

You can see the attribution of each investment to portfolio performance in 2017 in the following table:

In 2017, A&O Johansen was again the largest contributor to performance. Management has proceeded very well in digitizing the sales channel. Recent construction activity in Denmark has picked up substantially and I expect the company to present good annual results at the end of February. Trading below ten times earnings the stock is still cheap. At the bottom of the attribution table, Dundee Corp had a horrific year from a share performance perspective, but management has progressed in streamlining the portfolio and positive news should finally be reported in 2018.

An overview of the portfolio’s largest ten positions can be found in the following table:

Over the last twelve months, the portfolio has become more concentrated with the largest ten investments representing 55.4% at the end of 2017 compared to 50.2% at the end of 2016.

In addition to Bellevue Group, I exited two small portfolio positions during the fourth quarter.

The first United Medical Services (UMS) is a liquidating special situation where I first invested in September 2014. The liquidation process went well and I was able to realize a 6.0% total return and an 8.4% IRR over a three year holding period with this relative low risk opportunity. Total contribution to portfolio performance was relatively small at 0.4%.

The second investment I exited was a restructuring case of the oldest German listed company. There were basically two reasons why the restructuring failed and therefore my investment went to zero. First, I was distracted by the company’s large asset base which seemed to be worth multiple times of the current market value. At the same time, I paid no attention to inadequate cash reserves and hidden liabilities. In addition to that, I misinterpreted the interests of the second largest shareholder (the local community) and misjudged the influence of the largest shareholder (a poorly organized coalition of pensioners) and the CEO. In the end, a capital increase to solve the liquidity constraint was prevented by the local community and the inability of the CEO to file a prospectus. Consequently, the company went bankrupt. This lesson is a very painful one. In this type of turnaround situation, I learned to focus on a company’s ability to pay the bills instead of spending to much time in valuing a company’s assets. Even more importantly, I learned to keep close attention to the interested parties. This sounds obvious but sometimes it takes a lot of effort to figure out what the different stakeholders plans are. I exited Aktiengesellschaft Bad Neuenahr at a 100% loss over a 2 and a half year holding period. Total detraction to portfolio performance was 0.8%.

To wrap things up, I am providing the quarterly portfolio cash streams in the table below:

Disclaimer

Year-end transactions in Italian REIFs

Posted on December 30, 2017 by WertArt Posted in Current 4 Comments

Over the last days and weeks, I made a number of add-on transactions in my Italian real estate fund sub portfolio:

After news spread that a fund has acquired a 30% share in Amundi Re Italia, I increased my position by 0.9% to 2.2% of the portfolio at an average price of EUR 845 per share from December 22 to December 29 2017. I expect the GWM Value Activist Fund to positively affect the liquidation process until the end of 2019.

Europa Immobiliare Uno sold its two remaining assets before year end. Consequently, the fund is left with cash and an undisclosed amount of liabilities and provisions. The final distribution will be announced at the beginning of March 2018. Management commented that they expect the final distribution to be in a range between EUR 420 to EUR 459 per share. This does not include potential pay offs from two pending law suits. I increased my position by 1.5% to 3% at an average price of EUR 431 per share from December 27 to December 29 2017. The potential upside from this transaction more than compensates for a 2% loss in a worst case scenario.

Immobilium 2001 sold its best asset in Rome above appraisal value. After completion the current market cap will be covered 68% by cash. With a remaining real estate portfolio that has already been written down substantially, I believe the fund offers a very attractive return potential. Given the low trading volume, I was only able to increase my position by 0.2% to 0.6% at an average price of EUR 1,782 from December 27 to December 29 2017.

After a sharp price increase in the share price of Unicredito Immobiliare Uno, I reduced my position by 1.0% to 3.7% of the portfolio at an average price of EUR 937 from December 22 to December 29 2017.

I also bought a 0.5% a new position in Securfondo at an average price of EUR 281 from September 1 to December 29 2017.

This brings the total weight of Italian REIFs in my portfolio to 11.2%. The following table provides an overview for each fund (click on table to enlarge):

Notes to the table:

1) Cumulative write down as a percentage of total historic costs (based on current real estate portfolio).

2) Cash available plus short term investments and current assets less current liabilities as a percentage of current market cap plus debt.

3) Expected 2017 free cash to unit holders (after all cash costs).

4) Total annual gross rent as a percentage of current total real estate portfolio appraisal value (including vacant space and excluding developments / refurbishments).

5) Weighted average lease term as of YE 2017, best estimate given that disclosure differs by asset manager.

6) As of 6/30/2017, based on total leaseable area.

7) From a location perspective; note that other assets in the portfolio might have better characteristics in terms of leasing or asset liquidity.

8) Assumptions: liquidation at current NAV. In the case of Europa Immobiliare this scenario also includes a positive outcome from two legal claims.

9) Assumptions: liquidation of property portfolio at 60% of current appraisal values except for the best asset. Best asset to be sold at current appraisal value.

10) Assumption: liquidation of total property portfolio at 30% of current appraisal value.

11) Equal weighting of each scenario.

Disclaimer

Adding to Dundee Corporation

Posted on December 14, 2017 by WertArt Posted in Current 6 Comments

Over the last two days, I increased my position in Dundee Corporation to 2.5% of the portfolio at a price of CAD 2.5 per share.

Since I have started the WertArt portfolio, Dundee Corporation has been by far the worst investment (contributing a 3.2% loss at portfolio level).

Dundee Corp is an investment holding in the midst of a restructuring process led by ~~Mark~~ David Goodman. His farther Ned Goodman looks back at a very successful investment career. Nevertheless, his last years as CEO of Dundee were full of capital misallocation. Unfortunately, I almost invested at the top of this process and did not see the results coming. In 2014, ~~Mark~~ David Goodman returned to Dundee and took over as CEO (from 1994 he had already worked at Dundee for more than ten years). Sooner or later, it became clear (i) that many of the investment holdings were facing substantial issues, (ii) that expenses were way too high and (iii) that ultimately liquidity became a constraint.

(Edit: Ned Goodman has four sons. Two of them David, as CEO, and Mark, as COO, are working for Dundee Corp)

To be fair, a large portion of the portfolio is allocated to the commodites sector putting external pressure on the portfolio. One of the largest investments is UHIC. It used to own oil exploration rights in the Republic of Chad. While this can be classified as speculative frontier market investment, it is noteworthy that Exxon is already producing oil next to UHIC’s site. This year Dundee managed to sell the rights to Delonex at a fraction of the original investment. At least, Dundee was able to outsource the development risk and additional cash needs to Delonex while keeping the option to participate in oil production from a milestone payment and royalty streams.

Another important holding is a trophy real estate development in Vancouver. The property was recently completed and comprises two hotels, a casino, parking lots, restaurants and event space. Total development costs were approx. CAD 800 m with 70% debt financed. After a ramp up phase of twelve months, management expects the property to generate CAD 75 m to CAD 100 m in EBITDA (with 60% coming from the casino). Currently, interest expenses are roughly at 9%, but with the stabilization of the asset, a lower interest burden seems achievable in the future. Dundee Corp. holds 40% of the asset. After another cash injection of CAD 12 m from Dundee Corp. at the end of this year, management expects Parq Vancouver to stay self-sufficient.

Whether Blue Goose will ever reach profitability remains questionable. The acquisition of Tender Choice last year should have brought the turnaround. However, a recent shut down of the Tender Choice production site initiated by government authorities was followed by a fire taking place at the same site. This creates another headache for shareholders. Blue Goose has assets of CAD 150 m mostly comprising of cattle and land, but also CAD 90 m in debt non-recourse to Dundee Corp. Over the next months, I expect management to communicate how much cash will be needed to keep this investment going. In my valuation of the company, I have entirely written off this investment.

Overall, management has made progress in going through the portfolio from top to bottom reducing capital needs and disposing non-core assets. However, it is of importance that operational results improve according to the management plan and therefore the misstep at Blue Goose is unfortunate.

Expenses have been reduced significantly and corporate bank debt was repaid this year. Still, holding costs sum up to CAD 30 m per annum. CAD 16 m are overhead expenses and CAD 13.7 m comprise of interest payments for CAD 220 m preference shares outstanding (to be reduced to CAD 205 m in January 2018). As of Q3 2017, Dundee Corp had CAD 68 53 m cash available at corporate level and roughly CAD 200 m of listed securities on its balance sheet. In addition, some of the subsidiaries have cash available to the company. Bank debt outstanding fully belongs to Dundee’s subsidiaries and is non-recourse. I think that the company is in a position to sustain this multiyear turnaround from a liquidity perspective provided that capital will be used efficiently (i.e. the Tender Choice acquisition was an exemption).

The Goodman family has a 25% economic interest in Dundee Corp and Ned Goodman is still in control of the voting shares. The value of their stake dropped from more than CAD 200 m in 2014 to slightly more than CAD 30 m as of today. David Goodman, CEO, is holding 5% and his brother Mark Goodman, COO, 4% of the shares outstanding. Of course, they might have substantial net worth outside of Dundee Corp.

I think that management compensation has been aligned to the current situation to a larger degree than before. In 2016, David Goodman received CAD1 m in cash including a CAD 0.3 m bonus payment. His base salary will be reduced by CAD 0.2 m in 2017. In 2016, the whole executive management team received for the first time CAD 3.7 m of share based awards. Cash payments for all five executive directors were CAD 3.6 m.

In addition to that, the number of board seats was reduced to seven and new members joined. The reporting has been improved and quarterly earnings calls have been introduced.

Notwithstanding the improvement in corporate governance over the last two years, the Goodman family is in full control of the company. To some extent, interests with minority shareholders are not fully aligned given the divergence between voting rights and the economic interest.

The share price has lost 85% since I have first bought invested in the company. The current net asset value (NAV) as provided by Dundee Corp is CAD 11.8 per share. The share price is currently trading at an 80% discount to the official NAV.

I think that the company is worth roughly CAD 4 per share taking into account

a 34% hair cut on asset value (CAD 554m vs CAD 845 m);
CAD 220 m in preference shares;
CAD 53 m in cash available;
CAD 160 m of capitalized holding costs;

Leading to net assets of CAD 227 m or CAD 3.90 per share. This scenario implies a potential upside for the share price of 56%.

Disclaimer

Sell Bellevue Group

Posted on December 7, 2017 by WertArt Posted in Sold Leave a comment

Over the last two weeks, I sold my position in Bellevue Group at an average price of CHF 24.5 per share realizing a total profit of 80.1% and an IRR of 31.7% over a 30 months holding period.

My original investment thesis to be found here and here mostly materialized. Assets under management grew not only through the acquisition of StarCapital but also organically. The loss making banking segment has been restructured and is now on its way to become a profitable wealth manager. Consequently, Bellevue’s true earnings potential came to light over the last two years.

Nevertheless, Bellevue Group is still depending to a large extent on its BB Biotech mandate representing more than 50% of annual fee income. Given the relatively high volatility in biotech stocks (e.g. the recent 30% drop in the share price of Celgene), I anticipate results to fluctuate with the performance of the biotech/health sector. For 2017, I expect net profit to reach CHF 21 m turning into a price earnings multiple of 16 times. The company has roughly CHF 40 m in seed capital and other investments on its balance sheet and there is potential for additional profit coming from the banking segment in 2018. Consequently, the stock does not look overpriced at the moment.

However, any sharp contraction of the health/biotech sector will have a significant effect on earnings. As the company’s full earnings potential is now largely reflected in the stock price, I decided to sell my position.

Disclaimer

Pershing Square Holdings (ISIN: GG00BPFJTF46)

Posted on December 4, 2017 by WertArt Posted in Current 9 Comments

Pershing Square Holdings is burdened by the Ackman Malus. After a disastrous performance over the last three years the investment community is turning its back on former activist star investor Bill Ackman. Pershing Square Holdings, managed by Ackman and his team, offers access to a hedge fund charging relatively low fees, trading at a large discount to NAV with the benefit of permanent capital. In addition to that, some downside protection comes from a potential liquidation of Pershing Square Holdings.

An Introduction:

Pershing Square Holdings (PSH) is a closed end investment scheme trading on the stock exchanges in Amsterdam and London and as ADR in the US. PSH has USD 5.3 bn in total investable capital consisting of USD 4.2 bn in net assets attributable to public shareholders, USD 0.2 m of management shares and USD 1.0 bn in outstanding 5.5% senior notes due in 2022. Pershing Square Capital Management (PSCM) is responsible for the investment management of PSH and other investment vehicles. PSCM has a total of USD 9.4 bn assets under management (excluding PSH’s senior notes):

PSCM AUM as of October 31, 2017

Total Strategy AUM includes PSH and other vehicles (i.e. Pershing Square International, Pershing Square and Pershing Square II). They have a similar allocation to investments. The difference between “Total Firm AUM” and “Total Strategy AUM” stems from Pershing Square Master VI that is primarily holding securities of Automatic Data Processing.

Bill Ackman is the founder of PSCM. As an investor it is hard to ignore him, because of his regular media appearance be it on Bloomberg, CNBC or one of his marathon conference call sessions. He is taking an activist approach on most of the companies he is buying a share in (most recently Automatic Data Processing) trying to get on the board, hence getting access to private information and influencing decision making in the way he thinks the company should be run. Ackman makes use of the media and public to either put pressure on the management of companies that deny his demands or to promote his investment cases. Over the last years, he also tends to take a more passive approach with some investments (i.e. Valeant at the beginning, Mondelez, Air Products)

With PSCM’s semi-activist approach comes a concentrated portfolio. If you look at the performance attribution below, you will see what significant effect single investments had on total performance:

Investments like Valeant and Herbalife are prime examples for PSCM’s slump over the last three years. In October 2015, Ackman made the following statement in a Bloomberg interview:

“If I had to pick one stock out of the ten stocks we own that is perhaps the most undervalued I would say it is Valeant today. It is probably the most attractive from a risk reward perspective over the next year or so.”

Over the following year Valeant’s share price lost more than 90% with Ackman describing the investment in Valeant as an “anomaly” due to a deviation from Pershing’s intrinsic investment style by taking a large passive stake of a fully priced company. There have been other significant failures throughout Ackman’s career like the almost full wipe out of an investment in Target in 2008 and the forced wind down of his partnership with Bruce Berkowitz in 2002.

Edit: as a follow up to the investment in Valeant / Allergan, PSCM is currently fighting a class action lawsuit in a California court accusing Ackman of insider trading. PSCM has set aside USD 75m split between USD 29 m at PSH, and the remainder from its other funds. In an agreement with Valeant made in February 2017, the drugmaker would cover 60% of any costs from the class action suit. Whether the costs will be higher than the current provision in place remains unclear.

As a consequence of recent events, Ackman has been described as “un-investable” by a number of fellow investors and redemption requests from his ex-PSH funds started to increase. Three years ago, PSCM had assets under management of USD18.0 bn declining by 48% to USD 9.4 bn until the end of October 2017. Given the generous lock up periods, PSCM was able to negotiate with investors during the company’s heydays, more redemption can still be expected. Further redemption put pressure on PSCM’s existing investments given the need to liquidate large ownership to fulfill demands by existing investors.

Since inception of Pershing Square Holdings performance has been disastrous:

Taking a longer-term view since the inception of Pershing Square L.P. in 2004 however, the PSCM managed fund with the longest track record, provides a more pleasant picture:

In summary,

PSH is an investment vehicle managed by an asset manager who has a mixed track record: At Pershing Square he significantly underperformed from 2015 to 2017 and outperformed from 2004 to 2014. His partnership Gotham performed reasonably well from 1993 to 1999 but had to be liquidated due to large exposure to illiquid investments followed by redemptions (Edit: the term “mixed track record” is referring to Ackman’s investment career starting in 1993);

PSCM / Ackman lost almost half of his assets under management over the last three years;

PSCM /Ackman run a highly concentrated portfolio mostly invested in large cap companies;

PSCM / Bill Ackman is an activist investor who does not shy away from attacking the leaders of target companies publicly;

Indeed, Ackman eagerly pursues public appearance to defend his investment cases.

Why I invest in Pershing Square Holdings:

PSH provides access to a classic hedge fund vehicle. PSH faces minimal investment restrictions compared to most institutional investors. They can go long/short, can invest in derivatives and have access to over the counter transactions (OTC). The usage of derivative instruments increases the inherent leverage of an investment. For instance, based on the August 7, 2017 and August 31, 2017 filings with the SEC, PSH invested USD 1.2 bn in Automatic Data Processing buying OTC and listed call options, trading OTC equity forwards, and exercising a small part of the options later on. Consequently, PSH as of the last filing has an economic interest in 21.6 m shares or 4.9% of the company, while PSH owns 3.0 m common shares only.

The use of derivatives can produce/increase many types of risk. At the same time, derivatives can offer a great way to build large exposure to underlying investments without moving prices too much. In the right hands the usage of derivatives provides significant potential for return enhancement and can also reduce risk. For instance, Ackman recently switched his short exposure in Herbalife from selling shares short to buying deep in the money put options. I think this was a good move. So far, with Carl Icahn betting against him and the Herbalife management eagerly reducing the free float it was hard to imagine that the share price could fall significantly. I think now the likelihood for Ackman’s thesis being reflected in Herbalife’s share price is much higher. This flexibility in using the right instrument provides value to an investor in PSH.

According to the third quarter 2017 reporting, PSH’s largest position is in Automatic Data Processing (ADP) followed by Mondelez (MDLZ), Restaurant Brands (QSR) Howard Hughes (HHC), Chipotle (CMG), Fannie Mae (FNMA) / Freddie Mac (FMCC), Platform Specialty (PAH) and an undisclosed investment. On the short side PSH owns a 3% to 5% position in Herbalife put options. Based on my information, currently all investments include the usage of derivatives except from Restaurant Brands (QSR), Chipotle (CMG) and Platform Specialty (PAH). Based on PSH’s SEC filings and latest financials, I estimate the effect on PSH’s total performance from the largest three investments (ADP, MDLZ and QSR) to be up to 70%. At the same time, the investment in terms of total assets allocated to these three investments is much lower at 30% to 40%.

PSH will charge relatively modest fees before reaching the historic high-water mark. PSH charges a management fee of 1.5% of net assets. A 16% incentive fee will not be charged before the NAV reaches USD 26.4 per share. Hence, from its current level of USD 17.7, the NAV needs to increase by 51% before PSCM will be able to charge a performance fee. This provides for an attractive fee structure compared to most other alternative investment funds charging up to 2% asset management fee plus a 20% performance fee.

PSH’s unit price is trading at a 23% discount to NAV. While this is a reflection of missing investor confidence in Ackman’s ability to produce attractive risk adjusted returns in the future, it is detrimental to the fact that PSH is offering a more economical way to participate in a PSCM managed asset than in the past. Until the beginning of 2016, unit prices traded closer to NAV with the discount reaching a maximum of roughly 10%. So even assuming Ackman’s returns are random, PSH’s value proposition now is much better than in the past given the lower fee structure. In addition, PSH started to repurchase shares in April 2017. Obviously, this has an accretive effect on NAV per share.

PSH is a pool of permanent capital getting more important for PSCM. With increasing redemptions in PSCM’s other funds, PSH becomes more important to Ackman and his team. In hindsight, PSH might turn out as Ackman’s safety net which he might have established as insurance for his career as investor? Anyway, with less than half of assets under management compared to three years ago and a larger proportion of permanent capital (in addition to that a large part of Ackman’s personal wealth is invested in Pershing funds), Ackman will face a broader investment universe in the future (i.e. he can invest in lower capitalization names where activist investors face less opposition from management).

PSH has access to relatively cheap financing. PSH has USD 1 bn in 5.5% senior notes maturing in 2022. Unlike margin debt, the bonds do not have mark-to-market covenants which could require forced sales when equity prices decline. Right now, market participants would be reluctant to provide PSH with debt based on the same conditions, but the senior notes were issued before the Valeant debacle in 2015. With 4.5 years to go the notes provide additional access to permanent capital.

PSH liquidation as downside protection scenario. In case, PSCM continues to underperform and/or the discount to NAV widens and/or Bill Ackman needs access to his funds invested in Pershing Square vehicles, a wind down of PSH could follow. Given that most funds are allocated to liquid investments an investor could expect a liquidation close to NAV. There will be costs most noteworthy related to the early redemption of the outstanding senior notes. Overall, I expect shareholder returns will reach roughly 20%, if PSCM decides to unwind PSH tomorrow. (Note: A supermajority voting share is held by a special entity “with the sole objective to vote in the best interest of the Company’s shareholders as a whole” and “no affiliation to the investment manager”).

Over the last two days I accumulated a 4.5% portfolio position at 13.7 USD per share.

Disclaimer