Laughing Water Capital YE2017 Letter: ADES, GHL, TRC, FC

Smart Money

Laughing Water Capital Year-End 2017, January 2018

  • Returned 13.5% during 4Q17, bringing return for the full year to 40.0%
    • In the 2 years since inception, LWC returned 101.7% gross
  • SP500 and R2000 returned 6.6% and 3.3% in 4Q17, brining full year performance to 21.8% and 14.6% respectively

More on Saying “No”

  • We are not looking for sensible investments. We are looking for anomalies. In contrast to Wall Street, our typical investment thesis is, “this makes no sense”
  • When we bought EZPW and GAIA, we were buying companies that could be shut down and sold for scrap at prices significantly higher than the prices we were paying for the possibility of continued success; when we bought ITI, we were thinking that if management simply decided to shut down a money losing business, the stock would double or more; with FC, the thesis is that customers like getting more for the same price; with ADES, the thesis is that no one likes paying taxes
  • In no case are we attempting to predict how consumers will behave. Rather, we are just looking for situations that don’t make sense
  • Despite the simplicity of these theses, they are useless without a cheap purchase price. It is important to recognize that these theses never exist in a vacuum. There are always competing theses
    • In fact, we deliberately seek out situations where the prevailing thesis is widely recognized and suggests the company in question is at risk due to some sort of uncertainty tied to operational, optical, or structural problems
    • In almost all cases, this prevailing view has merit, and we say no to the investment. A few times a year, we find situations where we are able to develop a variant perception that comes down to simple common sense
  • We will surely make mistakes in our evaluation of management’s ability to solve their problems. A cheap price is essential

Advanced Emission Solutions (ADES)

  • At first glance, company appears to be in the coal industry, which broadly speaking is unattractive, and helps explain the current mispricing
  • In reality, ADES is in the tax avoidance business. Through a JV called Tinuum, company owns refined coal (RC) facilities that reduce the emissions generated by coal fired power plants
  • Reducing coal emissions is broadly better for the environment and broadly impossible to do profitably
  • Government developed a system whereby operators of RC facilities could generate tax credits to offset their economic losses. Tinuum partners with companies that want to lease or purchase access to the RC facilities in order to harvest the tax credits and thus reduce their own cash taxes
  • Tinuum has partners in 17 facilities and there are 11 more that it is actively seeking partners for
  • Under current tax law, RC facilities have a 10 year tax advantaged life, and there are 2 classes of facilities, those that lose their tax status in 2019, and those that lose their tax status in 2021
  • Company has been leasing their facilities in recent quarters and we expect them to be able to add at least one new facility per year through 2021
  • As ADES’ facilities are 2021 vintage, seems likely that 2020 should see a large surge in demand as those companies that are currently engaged with 2019 facilities roll into 2021 facilities
  • If this comes to pass, I believe we were able to purchase shares at prices that represent a 25-30% annual discount rate to the CF that will accrue to ADES – after corporate level expenses – from these facilities between now and 2021
  • A recent purchase of an RC facility by another public company suggests that ADES could theoretically be liquidated at a 20% premium to our purchase price
    • This valuation ascribes a value of $0 to an emissions control chemicals business and $0 to whatever value the RC facilities will have post 2021, and $0 to a patent portfolio that could be valuable as well
  • As cash comes in from the RC facilities, it is being aggressively returned to shareholders through share repurchases and dividends (present yield > 10%)

Greenhill & Co. (GHL)

  • Boutique investment that has struggled to keep up with the competition in recent years, leading shares to decline more than 70% from their 2013 high
  • Attempted to execute a levered recap, whereby they raised $350M in debt in order to repurchase more than 50% of their outstanding stock
    • CEO and Chairman both concurrently invested $10M personally in the company in support of the transaction and CEO volunteered to take a 90% pay cut in exchange for equity
  • Transaction did not go through as envisioned as there were not enough interested sellers. This creates a situation where we now know there are no sellers in the near term, and we know there is a large buyer, which is generally an attractive setup to step in front of
  • GHL is in a competitive business and face some challenges. However, we take comfort knowing that the 2 people who know the most about the firm’s future prospects have both voted with their wallets in support of brighter future
  • GHL has been aggressively recruiting new MDs, and their strong balance sheet and the levered upside of their equity has already strengthened their recruiting pipeline, which will drive revenue
  • We think GHL could more than double in the coming years and is unlikely to trade below the failed deal price in the near term

Tejon Ranch (TRC)

  • At 40% of the size of Rhode Island, Tejon Ranch owns the largest piece of contiguous real estate in California
  • Despite not hosting conference calls or having Wall Street research coverage, stock is fairly well known amongst value investors because any reasonable valuation produces an EV that is substantially negative
    • Stock has been disregarded due to the belief that, “it is cheap, it has been cheap for a long time, and it will likely remain cheap”
  • Properly assessing Tejon’s value requires a multi-decade view, which is impossible for almost all investors. However, in my estimation on an enterprise level, Tejon is now trading at the same price it traded at during the financial crisis
    • While the EV is the same as it was in 2009, the assets are not
    • It should be obvious that real estate in general has appreciated since that time, but when looking at Tejon specifically, it becomes clear that Tejon has over-indexed
  • Tejon owns a commercial center approximately 1 hour north of LA that houses an outlet mall as well as distribution centers occupied by the likes of Ikea and Caterpillar
    • Value of industrial real estate such as distribution centers in the Pacific zone has increased by almost 350% since the spring of 2009
    • Large warehouse space in close proximity to major urban markets has increased by more than 100% in value over the last 2 years alone
  • Tejon has made significant progress toward breaking ground on their residential communities. Specifically, Mountain Village, company’s exclusive resort-based community which was 50% owned and only a twinkle in management’s eye in 2009, is now 100% owned, and received tentative approval of their tract maps only days ago
  • Lastly, in October, TRC raised $90M through a rights offering, which I believe should carry them through the early phases of construction at Mountain Village, before this development becomes self-funding
    • Rights offering was oversubscribed by more than 100% – much of this demand likely came from existing shareholders
  • Tejon has completed rights offerings in the past, and in all cases the market took note that the company was making progress on their multi-decade plan and shares quickly appreciated

Franklin Covey (FC)

  • I have seen the 47 page short thesis on FC and the author is to be commended for the depth of his primary diligence in trying to tell a negative story
    • In my view, the author dropped 47 pages on a writeup that could have been 3 pages if it had focused on the right questions
  • While the company has faced some difficulties with their transition, our long thesis is based on the belief that 1) customers like getting more content for the same price, and the competition cannot match FC’s offering; 2) it is okay to have some flexibility to your pricing when incremental sales are extremely high margin; 3) childhood education is different than pharmaceuticals; if the company helps local school boards raise money to improve the local school, everyone wins – there is no parallel to Valeant or Philidor; 4) recurring revenue model is massively more valuable than the Wile E. Coyote model; more specifically, if successful, FC will have transitioned from a business that falls off a cliff at the first sign of economic weakness to a business that is built on contractual recurring revenue with very high incremental margins, which deserves a much higher multiple than legacy FC
  • Too early to declare victory on FC but we are off to a good start as recent results have been strong and management has recently clarified their vision for the future – shares are up 35% thus far but remain drastically undervalued

EZCORP (EZPW)

  • Management executed at an extremely high level in 2017, having improved store level performance, strengthened the balance sheet, and aggressively returned to acquisitive growth
  • Despite the impressive business performance, stock was a negative contributor until mid-November. This bodes well for our portfolio in 2018, as the market is slowly catching on to what is happening at EZPW
  • This is a recession proof business that will likely anchor our portfolio when the economy inevitably softens

Fiat Chrysler (FCAU)

  • I don’t love the auto industry but I do love FCAU’s management team, their collection of enormously valuable brands (most notably Jeep and RAM), and their parts division, which I believe will be monetized shortly
  • Despite FCAU’s impressive run in 2017, shares remained under-valued, theoretically trading hands at somewhere between 3 and 4x earnings if one gives them credit for achieving their 2018 goals
  • Fiat’s all-star CEO Sergio Marchionne has an incredible track record of squeezing real dollars out of theoretically undervalued situations and I am confident the same will hold true at Fiat

Gaia, Inc. (GAIA)

  • At the time of our purchase in 2016, we believed we were buying a niche Video-On-Demand business for less than free due to the value of the company’s cash and real estate
  • Shares have rallied ~100% since then as the market realized what was happening beneath the surface. This rapid appreciation narrowed the gap between price and value
  • Company is executing well against their long term plan which they believe will bring them to EPS of $2.50/share in 2021 and the sustainability of their model is becoming increasingly apparent, so we continue to hold a large position in GAIA

Iteris, Inc. (ITI)

  • Shares have come a long way but the company continues to execute well and remain materially undervalued as the market has not yet realized that Iteris is leading the effort to develop and deploy the smart infrastructure that will be vital to a future where autonomous cars rule the roads of smart cities
  • It seems likely that the company will seek to sell their agriculture business in the not too distant future
    • Difficult to put a value on this business but it is not difficult to imagine scenarios where this asset alone justifies more than half of the company’s market cap

Image Source: Laughing Water Capital

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