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Greenhaven Road Capital 4Q16 Letter: Outlook, Fiat, RMG Networks

Greenhaven Road Capital 4Q16 Letter, January 24, 2017

Performance Review:

  • During 4Q16, generated positive returns of more than 5%, bringing the full-year 2016 gross return to 18.7%
    • This compares to 12% for S&P 500 and 21.3% for Russell 2000 over the same period
    • Outperformed S&P 500 in each of the last four years; consider it more meaningful that, over the last three years, five years, and since inception, outperformed major indices
  • Several prescient investment decisions which led to appreciating more than 50%, including RMR Group, IDW Media, Diamond Resorts, and Iteris

Outlook:

  • Outlook for the economy is rather benign; our portfolio is a mix of high-quality companies that should compound earnings over years, despite market gyrations, and ultimately be worth more than our cost
  • Special situations investments should work regardless of the overall market
  • Skeptical of the “Trump Rally”
    • Understand the euphoria around the potential for changes to the corporate tax code
    • Our process of checks and balances is unwieldy and the influence of special interests has not abated with the new administration; inertia is a powerful force and legislation by a committee of 600+ people has the ability to stall or bastardize the magnitude of tax reform
    • Volatility is our friend – will continue to invest with a long term horizon

Where are the backhoes? Buy more Fiat:

  • Came across a 1996 column by venture capitalist Bill Gurley, “Backhoes Don’t Obey Moore’s Law: A Story of Convergence”
    • Gurley effectively diagnosed that the bottleneck to realizing the utopia of computers connected with broadband would not be computers but rather the ability to lay the pipes which would enable the connections
    • Unfortunately, backhoes only improve at 12% per year, far more slowly than computers
    • As I look at new and existing investments, I now try and understand what might be the metaphorical “backhoe” for the given situation that will delay convergence or demise of an existing product
      • Common narrative of our times is that virtual reality, 3D printing, self-driving cars, blockchains, and drone delivery will transform industries
      • Often the mispricings we exploit exist because the market is over-emphasizing the speed at which change will happen and underestimating the earnings power of the incumbent business
    • Fiat: situation where the market is/was forgetting about the backhoes; substantially added to our position in 4Q16 for two reasons
      • First is “backhoe” related: Fiat has underinvested in self-driving cars; if that is not “bad” enough, there is a vision of the future in which the model of individually-owned cars will go away as Uber and self-driving cars converge
        • For a futurist, Fiat is one of the most disadvantaged auto manufacturers
        • As a value investor, I don’t think it matters, there are “backhoes”
      • Futuristic vision of car ownership being replaced by an Uber-like fleet of self-driving cars has several likely backhoes
        • Massive leap that has to be made from today’s assisted driving cars, which have advanced cruise control and can parallel park, to a fully autonomous car that does not even have a steering wheel and will never be driven by a human
        • Self-driving car that works 99% of the time but still relies on occasional human intervention is not the real game changer; 100% reliability is necessary to change the paradigm
        • Other challenges include contextual challenges of programming a car to drive alongside other humans
        • Ultimately, regulatory hurdle will be challenging; even after all of the technical challenges are overcome, regulators and legislators may still take the “wait and see” approach
        • There will be early adopter cities and even states but a self-driving car that only works in San Jose on sunny days is not that valuable and hardly a death blow to Fiat
      • Another common argument against owning any auto manufacturer is that auto sales in the US has reached “peak SAAR”
        • Clearly, a low margin and high fixed cost business will see earnings decline as volumes decline
        • Current volumes are 18M per year and during Recession, saw SAAR fall to as low as 9M units per year
        • Think the most likely scenario is a plateau
        • US auto fleet is as old as it has ever been at 11.6 years and with 264 million cars registered, even at 18M units per year, the fleet is still aging; when adjusted for population growth and fleet aging, current SAAR looks sustainable
        • Barring a very large shock to the economy, skeptical that SAAR will decline rapidly

“I am not believing” – Actually, I am:

  • If we posit that peak SAAR may actually be plateau SAAR and autonomous car threats as substantially outside of our invest time horizon, what do we have?
    • CEO Sergio Marchionne laid out an ambitious 5-yr plan in 2013 that outlined substantial improvements in margins and volumes
      • Market reaction in 2014, 2015, and 2016 has been not believing of the plan
      • Plan has been dismissed despite dozens of changes at the auto manufacturer, including spinning off Ferrari, gaining access to Chrysler cash, improving margins, changing the vehicle mix to emphasize more profitable SUVs, and China JV
    • Fiat was trading at less than 1.5x 2018 plan numbers last fall
      • Something had to give; real companies that are debt-free don’t trade for 1.5x earnings even if the earnings are a year away
    • If Marchionne and team continue to execute and the new car market does not fall off a cliff, think we can earn multiples on investment and made Fiat a 10+% position

Top 5 Positions:

  • Top 5 holdings as of 12/31/16 were Fiat, Fortress Investment Group, Videocon, IDW Media, and Gaia
  • Thesis on Fortress remains the same: quality business with 45% insider ownership trading for a modest premium to cash and investments giving very little credit to future incentive fees; share price did nothing in 2016 but we did collect almost 10% in dividends; getting paid to wait
  • Details on other top five holdings:
    • IDW Media (IDWM)
      • Continues to execute on its plan to use the cash flow from its stable advertising business to fund its entertainment business
      • Long-term economics and share price will be determined by number of TV shows the company gets on the air (currently have 2 with a path to 5 or more in 2018)
      • If IDW has 5 shows on air in 18, EBITDA could be $30+ million
    • Gaia (GAIA)
      • CEO owns 38% of the company and did not sell a single share during a tender offer over the summer
      • Fully funded business plan to grow subscribers to the video streaming business over the next 5 years
      • Landscape may change, raising customer acquisition costs and increasing churn to make it a less attractive business – but the CEO has sold 4 previous businesses so there is reason to believe he would sell again if business deteriorates
    • Videocon DTH (VDTH)
      • Indian satellite TV provider we invested in since 2015
      • Fundamentally healthy business with revenue growing 20% y/y, rising prices, realizing operating leverage, and lowering churn
      • Bought more shares after merger with DishTV India was announced
      • Benefits of the merger: reduced threat of a price war as there are 3 players now instead of 4; 5% or more of costs can be taken out; reduced leverage
      • VDTH is covered by 2 sell-side analysts and yet, neither has felt compelled to publish research covering the merger deal even though it was announced in November (not completely invisible but clearly not focused)

Shorts:

  • Remain a very modest portion of our overall portfolio with individual shorts being 1-2% and index hedges being only modestly larger
  • Lands’ End short moderately profitable: company’s management situation may be stabilizing as the company announced a new CEO; short-term operating results likely to be bad but stronger CEO; easy money shorting the shares has likely been made
  • Remain short Tesla:
    • Poor unit economics
    • Convoluted Solar City deal
    • Increasing crowding in the EV market
    • Need for additional cash
    • Flawed economics of the Model 3

New Holdings:

  • RMG Networks:
    • Business in transition; historically sold screens that digital advertising is shown on which is a bad business with little differentiation, low margins, and little recurring revenue
    • Since Bob Michaelson became the CEO, sold the money-losing media business, restructured the digital screen business, invested in new products and improved distribution; de-emphasizing low-margin hardware and emphasizing higher-margin recurring revenue software and services; partnered with a public company 100x their size
    • In December, there appeared to be an indiscriminate seller – PM at the 2nd largest stockholder had turned over and whoever inherited the position wanted out of what effectively amounted to a rounding error in their overall portfolio
    • Company raised $4 million in additional capital by offering every existing shareholder the right to buy shares at $0.62 – largest shareholder indicated that he would participate on his pro rata basis and would backstop the offering by taking additional shares to sell the full $4 million
    • Stock trading at a depressed valuation and is at an inflection point where the product investments and partnerships will begin showing up in the financials

Investors are bad at math & New investments in boring businesses – Envirostar & Limbach:

Detailed summary of this section of the letter: Best Ideas Conf 2017 (Greenhaven Road Capital) – Envirostar, Limbach, and Watsco Case Study

Greenhaven Road Capital is a long-biased hedge fund, founded by Scott Miller.

Image Source: Twitter @GreenhavenRoad

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2 Comments on Greenhaven Road Capital 4Q16 Letter: Outlook, Fiat, RMG Networks

  1. $RMGN is worth 0$. Company making no profits and there products are outdated. CEO only cares about his salary and bonuses.

  2. When you short Tesla, you ruined your whole credibility. I don’t even need to read the rest. Good luck! You made onto my permanent ignore list.

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