Laughing Water Capital 1Q18 Letter: Bluelinx, Ocwen, Iteris

Smart Money
  • Returned 7.7% net in 1Q18, compared to S&P 500 and R2000 of -0.8% and -0.1%, respectively

Bluelinx Holdings (BXC)

  • Wholesale distributor of building products with 39 distribution centers, primarily in the Eastern US and Mississippi River Valley; originally, captive distribution arm of Georgia Pacific (GP) but was carved out of GP by a private equity buyer in 2004
  • First purchased shares in late 2017 shortly after the PE sponsor dumped their shares on the market at a large discount
  • While buying from a buyer that is not concerned with price is a good place to start, we were further attracted to the business because of its misleading GAAP balance sheet, which we believed understated the value of the company’s real estate by almost $200 million
  • Company had been monetizing their real estate through sale-leaseback transactions, which allowed the company to pay down debt
  • While the mechanical screeners that rule the markets were viewing the company as levered ~8x, we believe the company had already reduced its leverage to ~6x, and could theoretically almost debt free if they simply continued to monetize their real estate
  • The reality is that they just don’t need all of the land they have; because the company started as part of GP, their footprints were designed to accommodate storage of plywood and other sheet goods; storing plywood requires a lot of space for a small amount of margin, and is thus not a good business to be in
  • Significant room for margin expansion through moving into more value-added aspects of the building supply distribution business
  • What I did not consider was that BXC would announce a merger with a competitor that has a highly complementary business and footprint only months after our purchases; shares more than doubled on the news, driving BXC into a top 5 position for us
  • This is a business where scale matters, and the opportunity to take costs out of the combined business and drive revenue through consolidating the footprint to more fully utilize square footage, leveraging purchasing power, leveraging administrative resources, and cross-selling complementary products is very real
  • Not difficult to envision a scenarios where the combined company can generate $8 to $12 in FCF/share looking out a few years

Ocwen Financial (OCN)

  • Mortgage servicing company that can best be summed up as a hated stock in a hated industry, due to a disastrous decade of mismanagement, and intense regulatory scrutiny
  • However, 10 years after the housing crisis threatened to collapse the global economic system and following a ~90+% decline in price, the company has developed a clear path past its past sins, is about to move past the last remnants of its regulatory problems, and has strong tailwinds from a rising interest rate environment
  • Headlines have painted Ocwen as a villainous entity taking pleasure in kicking people out of their homes; yet, at present a large % of OCN’s equity is owned by investors who specialize in mortgage bonds; in fact, more than 70 mortgage bond investors wrote to the bond ratings agencies expressing their support for Ocwen’s ability to effectively service their mortgages
  • Looking back several years Ocwen did in fact fail in their duty to homeowners in more than a few instances as they struggled under the burden of their own rapid growth; however, company has made great strides over the last few years, and was not malicious in its previous shortcomings
  • Valuation of the company was based on the assumption that any fines tied to this latest regulatory action would be on par with fines levied against the company by NY regulators in 2014 on a per total in state mortgage basis (i.e. total NY fine / total # of OCN mortgages in NY)
  • At the time of our purchase, there were non-economic factors adding additional pressures to shares; Ocwen’s founder and former Chairman was essentially banned from the industry by NY regulators in 2014, which coincided with the implosion of OCN’s stock, meaning that a man who was once a billionaire lost much of his wealth, at the same time as he lost his income; as such, he began writing call options against his shares in OCN in order to generate income
    • In May 2017, he wrote calls against 10,000,000 of his shares at $2.50 and $3.00 per share that expired in January 2018
    • An option trade of this size virtually guarantees that it is an investment bank on the other side of the trade, and with the stock approaching $4 in late 2017, the bank could lock in their profit by selling short shares of OCN, and then covering the short by exercising the call options
  • Despite all of the regulatory noise, I believe the quality is significantly higher that most realize; at their core, non-bank mortgage servicers are an important part of the mortgage ecosystem; they increase availability of credit for homeowners, aid banks and other originators with their liquidity, and are generally better at high touch servicing than banks
  • Once sufficient scale is reached, mortgage servicing is a platform business with very high incremental margins; additionally, the value of mortgage servicing rights goes up in a rising rate environment, because when rates are rising, fewer people refinance their mortgages, which has the effect of lengthening the cashflows that the servicer is entitled to
  • Following the PHH transaction, they are likely to pursue more transactions; perhaps the next target will be Ditech Holdings (DHCP) which recently emerged from bankruptcy; OCN’s 2nd largest shareholder, Leon Cooperman’s Omega Advisors, owns more than 10% of OCN, and almost 50% of DHCP; these are complementary businesses and a combined OCN-PHH-DHCP would be on par with NSM in terms of scale, and likely trade somewhere in the $8-12 range based on comps today
  • 10 years after the housing bubble popped, I believe OCN has paid for its past sins, and will begin generating substantial cash flows shortly
  • There are multiple ways to win as OCN is well positioned as an acquirer, target, and to transition its business to a less risky, lower capital intensity business in the years to come
  • With the downside theoretically protected by liquidation value, and multi-bagger potential on the upside, the odds are heavily skewed in our favor

Iteris (ITI)

  • Traded down 30% in the first quarter, and an additional 10% in the early days of the 2nd quarter, and has been a significant drag on our results
  • There are 4 reasons for the weakness, 2 of which are legitimate, but short term, one of which is unfortunate, but exciting for the long term, and one of which is just part of life when pedaling in small cap stocks
  • Company got bumped down to a subcontractor position with the Virginia DOT; this effort caused the original contract to be rolled into a larger contract that includes less attractive elements such as providing road side assistance and rest stop maintenance; this is business that ITI rightly does not want to compete for as they are focused on building a software centric platform, not clearing toilets
  • A mix shift to Texas, where there is a middle man in the sales process has weighed on gross margin recently; the company is investing in a centralized procurement team so that they can pursue bigger contracts; willingness to take short term margin pain in pursuit of long term gain tied to larger projects and the operating leverage that come with them is a sign of a thoughtful management team
  • Lloyd Miller, owner of 15% of the company and perhaps the world’s greatest investor that most people have never heard of passed away, and his estate has sold shares
  • A fair amount of ITI’s shares are owned by quantitative investors, and slowing revenue and declining margins will typically cause quantitative investors to head for the exits
  • The transportation businesses alone more than justify current market prices, and have the potential to be worth multiples in the years to come as the move toward smart cities accelerates

Laughing Water Capital 1Q18 Letter, April 2018