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Laughing Water Capital 1H17 Letter – EZ Corp, Gaia, Now, Revlon, Iteris, Points International

Laughing Water Capital 1H17 Letter, July 2017

  • Returned 10.9% during 1H17 vs S&P 500 of 9.3%

Alternative to What?

  • Market action in the first half has been unusually calm, with the market doing a good job of ignoring the negative headlines and drifting upwards almost without interruption
    • This environment has made it unusually easy for investors to stick with passive strategies, much to the detriment of active or alternative strategies
  • SP500 is market cap weighted and float adjusted
    • Market cap weighted means that if there were 2 companies that were completely identical except that one was more expensive than the other, SP500 would own more of the expensive company: if you are keeping score, this is equivalent to “buying high”
    • Float adjusted means that if there were 2 companies that were completely identical except that at one company, the management team owned a lot of shares, SP500 would own less of this company: this means that the more confidence the management team has, the less stock the SP500 owns
  • At present, SP500 is trading at LTM P/E of 25x with margins above their normal level and its growth will ultimately be linked to inflation
    • Even Jack Bogle (founder of Vanguard) has opined that SP500 returns over the next decade are likely to be 4%/year
  • Over longer periods of time, our results will be predicated on the ability of our incentivized management partners to unlock the value we see in their temporary hindered companies, and by our ability to remain rationally focused on fundamentals in a world that is irrationally obsessed with headlines

A Word on Volatility

  • Over the last 6 months, every one of our starting top 5 investments declined by at least 15% from high to low at one time or another, and 2 of those investments are no longer in our top 5
  • Any sizeable divergences are decision points, and we faced several in the first half
  • Even the best businesses in the world like Berkshire Hathaway have seen their stocks suffer short term declines in excess of 50% as they continued their march forward
  • Our investment in Iteris which suffered five declines of 15% or more during the last 6 months – if we had tried to avoid them, likely would have missed out on owning a very good business that is executing at a very high level

Comments on Selected Investments

  • EZ Corp (EZPW): traded off substantially in the first half, despite executing at a very high level and continuing to drive improving fundamentals
    • On 6/28, company announced they would be refinancing their debt and potentially acquiring a LatAm operation, as we had hoped
    • News led to sell-off in the market as refinancing is taking the form of a convertible bond
    • Equity capital is precious, and should not be used lightly, and have adjusted down our upside price targets as well as our faith in management’s ability to steward our capital
    • Despite our general disagreement with dilutive capital raises during a period when equity is undervalued, case can be made that it makes sense to sell cheap equity to purchase cheaper assets and we are withholding final judgment on the convert until we learn more about company’s acquisition plans
    • EZPW is under-scaled in Mexico and LatAm and it is possible that inclusive of synergies we will be able to buy LatAm pawn assets at an absurdly low multiple
    • Longer term, EZPW has multi-bagger potential through a return to growth and the eventual dissolution of the dual share structure and we are happy to own a defensive business that should benefit if the economy softens as the economic recovery continues to age
  • Gaia (GAIA): has impressed the market by growing faster than expected and spending less money on growth than forecast
    • Only recently started to expand its foreign language offerings and management has indicated they have received inbound interest from potential foreign customers, eager to gain access to GAIA’s offering
    • Given that Netflix recently made headlines as international subscribers became a larger % of the total than domestic subscribers, foreign language offerings should aid Gaia in their continued pursuit of new customers
    • Recently organized a social gathering for some of its “Truth Seeking” customers which was an enormous success
    • Continues to march toward 1.6M subscribers, and $2.50/share in earnings which would likely lead to upside of several hundred percent
  • Iteris (ITI): despite its considerable appreciation over the last 1.5 years, remains under-valued
    • Extrapolation suggests that transportation businesses are now producing in excess of $12M in FCF
    • If the transportation businesses are viewed as a simple consulting business, absent corporate expenses they would deserve a valuation in excess of current market prices, meaning that the fast-growing agricultural business is currently free to investors
    • In the coming decades, intelligent transportation market and autonomous vehicles could be worth trillions of dollars
    • To date, market attention has been focused almost exclusively on autonomous vehicles and their ability to communicate with each other
    • Iteris is not only the leading player in the sensor market, they are literally leading the development of the Architecture Reference for Cooperative and Intelligent Transportation under the US DOT
    • Continued to make progress with several notable customer wins in recent months in agriculture business
    • Management has also created a new, separate legal entity to house the agriculture/weather business, which suggests that an eventual sale of this business is somewhere on their radar
  • Now Inc (DNOW): been a laggard during the first half as the market is worried that increasing Western oil production is more than offsetting production cuts from OPEC
    • Day to day, DNOW treated as a proxy for oil prices – but the reality is more complex
    • In the intermediate and longer term, DNOW is dependent on oil volumes, not price
    • Investment has been predicated on the belief that as a dominant player in the distribution of parts for energy-end-users with a rock solid balance sheet and ample liquidity, any difficult times would allow DNOW to gain market share as they acquired struggling independent operators
  • Revlon (REV): started the year with gains of 20% but later sold off as domestic sales suffered, largely due to a channel shift from mass to specialty
    • Much of our thesis has been focused on the successful integration of Elizabeth Arden and international growth, but success in these areas have been over-shadowed by the domestic difficulties which I failed to fully appreciate
    • As inventory overhangs in the mass channel clear, pricing will come back, and controlling shareholder Ron Perelman has been aggressively buying shares of late, seemingly putting a floor beneath them
    • Open market purchase has increased the likelihood that the business will be taken private before ultimately being sold to a strategic buyer
  • Points International (PCOM): Canadian company focused on consumer loyalty market which entered our portfolio as a mid-sized position
    • Main business is providing the software and know-how to airlines and hotels to allow consumers to “buy, gift, transfer” loyalty points
    • Few short years ago, PCOM was a growth-crowd darling and traded at 100x EPS – however, a series of bumps in the road and a re-focusing of their business toward lower margin, longer term contracts, as well as investments in 2 not-yet-profitable business lines led to a ~75% decline in share price
    • Asset light nature and long-term contracts – attracted to the investment by its misleading GAAP financials, a pending change to the way the company reports segment earnings, and the complete turnover in the shareholder base as panicked growth investors threw in the towel
    • With 75% of revenue-partners locked in for 3 years, 3 growing business units, a management team that conceded they would likely be better served outside of public markets, strategic value that could be quite high, and a noted activist likely to push for a sale, it is unlikely that the 10 year future will matter in this case
    • A sale is not necessary for a successful investment as the company continues to strengthen its offering and the core business produces plentiful cash flow, which the market should recognize as the newer businesses reach break-even levels in 2018

Image Source: Laughing Water Capital

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