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Laughing Water Capital 1H18 Letter: EZPW; FCAU; CDMO; RMNI

  • Returned 2.9% during the 2nd quarter, bringing net returns for the first half of 2018 to 10.8%

EZ Corp (EZPW)

  • Management has executed very well having almost doubled store count in Latin America and more than doubled EBITDA over the last year
  • This growth has been financed through the use of low coupon convertible debt, which introduces a number of new variables to the equation
  • Convertible debt will result in dilution to our equity position, which necessitates a lowering of our long term price target
  • EZPW is a bit of an orphan at the moment in the sense that there is not a natural shareholder base; vanilla institutions are turned off by the dual class equity structure, growth focused investors may be interested, but EZPW is not really sexy enough for them, and value investors are likely concerned by management’s reliance on converts to finance the company, despite the undemanding multiple
  • On the positive side, using low coupon convertible debt has the effect of increasing near term cash flow, and it is highly likely that this cash will be used to continue to accretively grow the business
  • Unfortunately, this will likely lead to a Catch 22 in 2024 when the convertible debt begins to mature. By 2024, the company should be gushing cash, and this cash will likely be used to repurchase at least the face value of the convertible debt, minimizing dilution; if the company and stock perform as I expect, the convert will effectively have caused the company to issue stock at a low price and repurchase it at a high price, which is of course not very attractive
  • For now, these are high class problems that do not deserve much attention, because the near term setup is very attractive
  • Convertible bond offerings are typically purchased by arbitrageurs who sell short common stock against the bond; this is of course non-economic selling due to the arbitrage opportunity
  • More acquisitions are likely in the near future; these acquisitions come with operating leverage, and management has proven they are capable of driving margins in Latin America
  • Buying stock from non-economic sellers while the company is making accretive acquisitions is generally good practice

Fiat Chrysler (FCAU)

  • Management has been executing at a very high level, and recently released a 5-year plan that should continue to drive intrinsic value for years to come
  • Company plans to launch a financial arm in the US that could be worth 40% of current enterprise value and 60% of current adjusted enterprise value within a few years
  • Company has announced they will be spinning off their parts division into a standalone company
  • If the company hits their year-end guidance, the balance sheet will be in a net cash position
  • Adjusting the enterprise value for these two factors reveals that core FCAU is trading close to 1.6x EBIT
  • Bears will of course note that this is a cyclical stock, and 1.6x EBIT may not appear cheap if the economy goes off a cliff
    • Bears are still applying historical multiple ranges to the auto makers, despite the fact that following the structural and operating changes that were made in the wake of the great recession these are much better businesses that will be much more resilient during downturns than they had been historically

Avid Bioservices (CDMO)

  • Shares remain materially undervalued
  • Crux of the investment is “good co / bad co” whereby the cash flow profile of one business had been obscuring the quality of the other business
  • Often in good co / bad co setups the damage from the bad co is limited to the reported financials of the combined company, but in the case of CDMO, I believe that the existence of the drug development company extended beyond the financials and negatively impacted the ability of the contract manufacturing business to generate revenue; we purchased shares shortly after the bad co was sold off
  • The remaining contract manufacturing business is involved with the production of biologic drugs, which are extraordinarily complex; this complexity combines with regulatory oversight to create a business with high barriers to entry and high switching costs; it would be costly and time consuming for any customer of the contract manufacturing business to move to another manufacturer
  • Given that CDMO was also working on developing their own drugs, any potential customer was thus wary that if CDMO were successful in developing a new drug, they may need to reclaim their manufacturing capacity for their own use
  • Now that the development business is out of the picture, this eminent domain overhang has been removed, and it should be much easier for the manufacturing business to land new customers; this is important as the business is currently only operating at 50% capacity
  • If the business gets to scale, the cash flow generated by its recession resistant, recurring revenues will deserve a high multiple, and it is not hard to imagine scenarios where CDMO doubles or triples a few years down the road

Rimini (RMNI/RMNIW)

  • Rimini is in the business of providing third party maintenance for enterprise software
  • Defensive, countercyclical business with high normalized margins that has been growing very fast
  • At the moment and for the foreseeable future RMNI is subject to uncertainty tied to litigation brought by Oracle, who RMNI is effectively undercutting on price
  • Digging past the headlines and viewing the accounting through the lens of common sense rather than GAAP suggests that Rimini is markedly undervalued even considering adverse legal outcomes
  • RMNI reported earnings on May 10th, and the window for employee stock trading opened at that time. While there has been small buying by insiders, rank and file employees – many of whom have been with the company for 10+ years without an opportunity to monetize their stock – began to sell en masse
  • Timing is important here, because May 11th was the date of record for the rebalancing of the Russell indexes, which are market cap weighted, meaning that the indexes will need to buy more shares of bigger companies
  • Following the Russell record date, shares continued to trade down more than 25%, at which point we began buying, knowing that 6 weeks after the record date, the index and its followers would be buyers of shares in an amount that was determined when the price of shares was 30+% higher
  • Rimini is illiquid, and since the window for employees to sell would be closing just as brainless index funds would be buying, there was an exploitable imbalance in supply and demand of which we were able to take advantage
  • We own both common stock and SPAC warrants, both of which have appreciated by more than 30% in little more than a month. SPAC warrants which are essentially long dated options are especially attractive; if one were to assume a 95% chance that the company goes to zero, and only a 5% chance that our upside target is met, mathematically, this would still be the right bet to make
    • In actuality, the chance that this company goes to zero is very small, and there are multiple ways that the warrants could return between 10x and 30x our invested capital in a few years

Laughing Water Capital 1H18 Letter, July 2018

Image Source: RMNI Company Presentation

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