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Wolf Hill Capital Management – Kraton, Constellium, Archrock, Abercrombie & Fitch

Wolf Hill Capital Management Q3 2017 Letter

  • Since inception on March 9, 2017, posted net returns of 19.77%
  • In 2Q17, posted net gains of 11.73% versus 4.48% for S&P 500 and 3.51% for HFR Equity Hedge Fund Index

Review

  • Constellium: During the quarter, appreciated by ~50% as news reports indicated that the board of directors was weighing options after several companies expressed strategic interest in the company. Not surprising that there is strategic interest given the secular growth tailwinds in the company’s automotive end-markets and the still depressed valuation – we do not expect the board to sell at a price anywhere close to today’s valuation. If CSTM were to be valued at a similar valuation multiple to its closest peers, share price would be 60-70% higher. We believe that as the market recognizes the true earning power, valuation discount to competitors will abate
  • Abercrombie & Fitch: Initiated a position after the stock fell 30% in a matter of days in the wake of a failed auction for the company. In the weeks and months preceding this news, there had been multiple press reports indicating that ANF was close to announcing a transaction to be acquired by American Eagle Outfitters, with financing from Cerberus Capital, for $13/share. When this failed to materialize, arbitrageurs headed for exits and investors assumed the worst – that ANF would be another in a wave of teen-retail bankruptcies. Despite the obvious challenges related to merchandising missteps, declining mall traffic, and the persistent threat from e-commerce – there was considerable margin of safety and optionality in ANF at the price we initiated our position ($9/share). Company’s balance sheet remained strong with a net cash position of >$100 million and approximately 1/3 of company’s mall leases set to expire over the coming 12 months. Even despite depressed sales, company has remained FCF positive while guiding to over $100 million in cost savings in the coming year – primarily as a result of expiring leases at secondary and tertiary mall locations. At 2x EBITDA and with a 9% dividend yield, ANF offered a highly asymmetric investment opportunity. After a 50% rally, we have reduced our position yet remain enthusiastic given our belief that the upcoming earnings report will demonstrate a continuation of the positive trends we witnessed in Q2
  • Revlon: Initiated a short position in May. Revlon’s over-leveraged balance sheet, challenging industry backdrop, and C-suite turnover followed a fact pattern that I have born witness to many times over my career. Stock subsequently declined 25% from our entry price as our thesis played out. During September, borrow rate increased exponentially to 140%, causing the shares to rally 70% and we were forced to cover our short position. Ended up giving back most of our net gains on the position

Kraton

  • Specialty chemical company with strong franchises in engineered polymers and pine-based specialty chemicals. Engineered polymers are used in personal care and coating for the medical, industrial, and consumer end markets, and pine-based specialty chemicals are used in a wide variety of products for the construction materials, tire, and oilfield services end markets
  • Products are ubiquitous in everyday life in everything from condoms, plastic gloves, and tooth brushes, to asphalt and environmentally sustainable roofing materials. Demand for Kraton’s diverse portfolio of specialty chemicals are essentially a proxy for global GDP
  • Opportunity to invest in this terrific business presented itself while the stock was under pressure as the result of a temporary spike in their primary raw material, butadiene, as well as from growing pains after digesting a large, transformational acquisition completed in 2016
  • Kraton is what I refer to as a public LBO that offers three likely paths towards value realization (company with a small market cap relative to its total EV, ~<25%, that by the nature of its business generates a predictable stream of FCF with low capital intensity)
    • As the company de-levers via FCF generation, there will be a transfer of EV from debt to equity holders
    • As company de-levers, it is reasonable to assume that the EV should grow as business risk diminishes
  • In January 2016, closed on the acquisition of Arizona Chemicals for $1.4Bn, doubling the size of the business
  • As crude prices began to rise in early 2016, greater drilling activity ensued and rig counts rose, which in turn spurned more demand for TOFA (Tall Oil Fatty Acids) and TOFA derivatives. Increased demand for TOFA combined with a more rational competitive landscape that resulted from industry consolidation has provided an improving fundamental backdrop for the acquired Arizona business
  • In addition to the economic tailwinds the company should enjoy as a result of the expanding US economy, management has articulated and delivered on a cost savings plan that is expected to cut up to 10% off the organizations cost structure in the coming 12 months
  • CEO Kevin Fogarty now owns 1 million shares of restricted stock
  • Kraton should generate $350 million of EBITDA in 2017 and there is a credible path towards $500 million of EBITDA in 2019 as raw material costs mean-revert and company realizes the benefits of merger synergies. Even using a discounted 9x multiple and factoring in the de-leveraging that will take place over the next 2 years, believe that KRA offers greater than 100% total return potential to our $100 base case scenario

Archrock Partners

  • MLP and the largest player in the fragmented natural gas compression business. APLP’s compression fleet has 3x more horsepower than the next competitor, offering size, scale, and customer and geographic diversification that other competitors can’t match. Company offers gas compression services including gas lift and re-injection, processing, turbine fuel boosting, and carbon dioxide compression. In addition, also provides used equipment and aftermarket services
  • As energy prices plummeted in 2014 and 2015, oil and gas production and rig counts followed, causing devastation throughout the oil and gas industry
  • While APLP’s revenue model isn’t directly linked to commodity prices in the way a producer would be, APLP was not immune from the price declines either
  • Resulting decline in energy production caused the company to play defense by halving its distribution to a level that would allow meaningful de-leveraging to occur. Based on this defensive payout, company enjoys distribution coverage >2x distributable cash flow
  • Over the long-term, demand for compression services are directly linked to natural gas production growth – not energy prices
  • Management has discussed increasing distributions once there is a clear line of site to 4x leverage. We believe that by 1Q18, company will increase quarterly distribution to a sustainable 1.5x coverage ratio. This would imply a $0.40/unit quarterly distribution and assuming 8% yield, would yield a unit price of $20 (total return of >50% and a nice, tax-deferred 8.3% payout while we wait)

Image Source: Wolf Hill Capital Management

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