Sunday, July 9, 2017

Following Buffett into STOR Capital

In the past few years I watched with confusion as Buffett bought up IBM, Apple, airlines stocks, and just last month a shady Canadian lender called Home Capital Group. There are definitely times I wonder if he's gone senile. But Berkshire's investment in STOR Capital makes a lot of sense and I'm following.

Trading at $22-23 range, STOR Capital (STOR) can offers 20% IRR over the next few years. This comes from mid-teens adjusted funds from operation (AFFO) growth plus dividend yield of ~5%. I assume Price/AFFO multiple stays constant since it’s already a reasonable ~14x.

Thesis Sketch
  • STOR’s sales-leaseback model has a long runway for growth, and the weak retail environment may actually help in that respect. 
  • Berkshire’s involvement strengthens the already solid balance sheet. There’s a possibility that STOR can turn into a platform to consolidate the industry. 
  • Just a well-run company. Prudent leverage levels means this is something I can double down on if stock goes south.

What They Do
STOR Capital buys retail locations from companies and leases back to them at negotiated rates. Unlike typical landlords who start by targeting desired locations then try to minimize vacancy, STOR starts with specific business customers and then figure out the lease terms they need.

In this way STOR is more like a financial service company than purely an asset owner. Another way to view the company is that STOR takes on credit risks of their clients, but that risk is collateralized by revenue generating real-estate.

There are inherent advantages with this business model. First, since these properties come with tenants, occupancy rates are high (~99.5%) and STOR don’t incur much costs to lease out the properties. Second, the leases are “triple-net”, meaning tenants are responsible for not only insurance and taxes, but also property maintenance costs. This means STOR has very little capex needs, so their AFFO is a good proxy for free cash flow. Finally, the customer service component allows STOR to stay away from auction situations, and historically they have been able to buy real estate at below replacement cost.

Growth Prospects

STOR has a track record of dividend growth, backed by mid-teens growth in cash flows. The growth is mostly through acquisition of real estates, which STOR has been investing about $1-1.2bn per year. Keeping up this pace would imply rental revenue growth of ~15% CAGR the next 3 years or so.

I think STOR can continue, if not accelerate, this pace of expansion. In the latest 10K they estimated an acquisition pipeline of $8.6bn at December 2016, compared to $5.2bn worth of properties on balance sheet. Furthermore, the U.S. is in a weak retail environment, and more companies will likely try to offload their real estate and optimize their capital structure. This would create opportunities for STOR to buy at attractive prices.

STOR is also now a strong hand in a weak industry. On 6/26/2017, Berkshire invested some $375mm into the company. These are newly issued shares so STOR further strengthened their capital base. STOR is now in a position to consolidate weaker players in the distressed retail REIT space.

There are other considerations. Let's quickly go through them in bullet points.

Just a really well run company
  • The basics all check out fine – geographic diversification, tenant diversification, inflation escalators…etc. 
  • Property investments require unit level profitability, not just corporate credit or property value
  • Great disclosure. Management collects abnormal amount of data.
  • Prudent debt levels with property asset covering debt by 2x. They use non-recourse asset backed funding.
  • No staggered board.
  • Unlike some of the REITs out there, STOR actually has good GAAP net margin.
  • 5% dividend yield is very sustainable and is well covered by AFFO (which closely tracks cash flow from operations before working capital)

Is The Market Wrong?
  • Retail REITs have been killed due to threats from Amazon. But STOR has differentiated exposure like health clubs, movie theatres, day care center...etc. They even have industrial/manufacturing exposure.
  • I’m not sure physical retail is dead just because of Amazon. Maybe physical retail still works but the business model needs to be tweaked. Amazon is actually moving to physical stores. If anything, Amazon’s recent purchase of Wholefood validates value of physical stores.
  • One of STOR’s clients, Gander Mountain, just entered bankruptcy, but that is only 2% of their rental income and another client is negotiating to buy them out. Gander Mountain’s troubles have been known for a while and I would be surprised if it’s not already priced in

Everything checks out great. Global bond yields have been going up the past week so dividend stocks have not done well. Once those bonds stabilize though, this should be a good one. 

Saturday, June 24, 2017

Musings: Cash on the Sidelines and the Illusion of Market Cap Calculations

Cash on the Sidelines

I read Zero Hedge regularly. It is not the most reputable publication, but once in a while it bring up interesting topics. Like this article: Destroying The Myth Of 'Cash On The Sidelines'.

Permabulls love to argue there are all these “cash on the sidelines” ready to buy stocks and jack up prices. The article disagrees with the very idea of it. It quotes Cliff Asness:

There are no sidelines. Those saying this seem to envision a seller of stocks moving her money to cash and awaiting a chance to return. But they always ignore that this seller sold to somebody, who presumably moved a precisely equal amount of cash off the sidelines.”

Asness is saying there are no sidelines because buy/sell transactions do not increase overall cash in the system, since for every buyer there’s a seller.

I used to think that, and it’s something clever to say. But it’s wrong.

We all know friends, relatives, or neighbors who, at one point or another, try to put their growing cash piles to work. These people clearly have cash and its growing. Where does that come from?

First, it’s called money creation. As people earn wages and deposit that in their bank account, their “cash on the sideline” grows. So you say, “but the employer who paid them now has less cash, so total cash level don’t change right??” Well, at least some of the employers borrowed money, the act of which is how our financial system expands money supply.

Second, there’s asset class rotation. Asness would be right in a world where it’s just cash and equities, (and no liquidity creation). But you know, there’s such a thing as fixed income and bonds and they get used as cash alternatives. You see all these balance sheets where companies list “cash and marketable securities”? That’s your T-bill/CP’s/notes/bonds…etc.

So to the extent bond prices start going down and people rotate into equities, that’s “cash (and marketable securities) on the sidelines” which can boost equity prices.

The Illusion of Market Caps

The big news last week was Amazon buying Wholefood. As CNBC reported here, Amazon is paying $13.7bn for Wholefood, yet AMZN’s market appreciated by $15.6bn when the news hit.

CNBC wrote: “So, you could argue, they are getting Whole Foods for free, and pocketing $1.9 billion as well.

How could this be? Are investors stupid? One explanation (which is the CNBC editor’s view) is that the market thinks Amazon will get so much synergy that it exceeds the entire cost of acquisition.

Maybe. But there’s another explanation - that the way we calculate market cap renders it a flawed concept.

The CNBC article wrote: “Amazon's stock was up $32 and change mid-morning. There are 478 million shares outstanding, so Amazon's market cap has appreciated by about $15.6 billion today.

The flaw is one of extrapolation. The deal was announced on June 16th, 2017. That day 11.47mm shares of AMZN traded.

That tells us the market was willing to pay $32 more for 11.47mm shares. That’s it. It does not mean the market was willing to pay $32 more for all 478mm shares outstanding. In fact, if all 478mm shares were for sale, I’m sure AMZN stock price would crash!

But that’s what our market cap calculation does. We take the increased price for 11.47mm shares, and then extrapolate that to say every single share, to the tune of 478mm shares, gets the increased valuation. We take one single point in the stock’s demand curve, which tells us there’s demand for x # of shares at y price, and extrapolate that to total shares outstanding.

And we do this all the time. We do this whenever we calculate market cap, which goes into enterprise value, EV/EBIT, EV/sales, and so on. 

It get's dangerous when we apply this false logic to value investing. How many times have you heard this type of argument: "This company had one little bad news, and its market capitalization declined by $7bn! How can the worth of the company change that much!?  It's irrational! Misunderstood! Buy buy buy!"

Again, it's extrapolation. We take one single point on the demand curve and assume all shares will clear at that price. Then we make claims about what the whole company is worth.  

This should make you think twice about using these metrics to make buy/sell decisions! Our “fundamental” valuation isn’t just subjective based on our view of the future - it is fundamentally and precisely wrong!

Sunday, June 11, 2017

Notes on Wachenheim’s “Common Stocks and Common Sense”

Ed Wachenheim runs Greenhaven Associates, a $6 billion value fund. He piled up an enviable track record over the past 20+ years, regularly making 20%+ a year. And he does this by investing in large caps like IBM and Lowe’s. I’ve been resorting to nanocaps to in my quest for returns, so I wanted to read his book and see how he did it.

The book, "Common Stocks & Common Sense" has an excellent format. It is a series of case studies, each about a particular company Wachenheim invested in.

He would typically start with some historical backgrounds for the industry and the company in question. Then he shows how he develops a thesis, problems the company was having (to the extent there were any), and how the idea played out the next couple years. Throughout these passages Wachenheim would sprinkle in bite sized philosophy about how to use sell-side research, his view toward interviewing management…etc.

We need more books like this. This is a little like “Alchemy of Finance” where Soros documented his real time decision making. If anything, this book provides interesting snapshots of some industries from 1990's to now.

This book was helpful in confirming some of the ideas I have on how to approach research, on top of some great insights. I will first share my observations about Wachenheim’s style, then list out some general takeaways.

Observations of Wachenheim’s style

  • Buy large cap liquid securities. 15-25 stocks in the portfolio, try to be fully invested all the time. 
  • Targets 20% return. This means individual ideas need much higher upside (say 60%+), because there will be losers also.
  • Ignore broad market moves, focus on fundamentals.
  • Not a buy and hold forever type of guy. Willing to hold for 2-3 years and sell when the thesis is played out.
  • In general stay away from growth stocks with high multiples. But also try to stay away from severely distressed companies. 
  • Typical type of plays:
    • Turnarounds/ leadership changes: e.g. IBM, Interstate Bakeries
    • Cyclicals: e.g. U.S. Home Corp, Centex, Southwest, Lowes, Whirlpool
    • Good companies with temporary issues: Union Pacific, Lowes, Boeing, Goldman Sachs 

Miscellaneous Notes and Takeaways

1) Focus on the upside first. Creativity is key in target identification.

Before doing a big deep dive, do a simple model and project 2-5 years out to see if there's enough upside to justify further work. Try to be creative in generating thesis - what can make revenue and margins go up? Can management cut cost here and there? What happens if input cost goes down…etc.

A lot of people say “focus on the downside and the upside will take care of itself”. But at least in the idea generation/filtering stage, you have to demand the upside - else you’re just wasting your time. The focus on downside can come after an idea passes the initial filtering and you’re doing deep dives and running scenarios.

2) Know the long term history of the business and industry. This helps you appreciate the structural difficulties and what it takes to fix them. 

IBM was an example in the book. In the 1990’s the company’s business model of selling, leasing, and servicing mainframes became outdated due to emergence of the PC. That left IBM with a bloated cost structure which old management was not willing to address. The buying opportunity came when Lou Gerstner became the new CEO and showed “the courage to take tough steps”.

Knowing the long term history also helped Wachenheim invest in cyclical companies. He bought Southwest Airlines in 2012, understanding that the decade of 2000's were miserable for airlines and forced them to cut capacity.

3) True insight comes from understand the unit economics of the business well.

Knowing the economics of Union Pacific helped Wachenheim differentiate between a temporary problem and a structural one. In UNP's case, congestions led to train delays, which hurt margins because revenue is a function of volume, while much of the expenses like labor are a function of time. When congestions were fixed, UNP’s margins improved and stock went along with it.

Another example is when he talked about Southwest Airline's capacity utilization. 83.1% utilization might seem like there's some excess capacity. But that is the average. Since unpopular flights (bad hours, remote locations...etc) are going to have many empty seats, the more popular flights are probably operating at full capacity and having wait lists.

4) Historical average P/E of the market is a little less than 16x. When valuing companies Wachenheim would use the 16x as a benchmark and adjust up and down based on business quality.

This is a better approach than using comparable multiples, which may be the most over-rated valuation methodology of all. “Peer comps” is an easy way for unscrupulous bankers and analysts to justify over-valuation in bubbly markets (“hey Alibaba trades at 56x PE so let me value this other shitty e-commerce stock with 45x PE! Look I’m really conservative here!”)

5) Use sell side analysts mostly as a gauge of market consensus, and think “do I see an upside here that consensus is not pricing in?” 

That makes sense because sell side guys get their feedback from buy side community, so these analyst reports in some way reflects prevailing opinions.

6) In my humble opinion, Wachenheim can screen stocks more effectively. He seems to run a lot of screens based on low valuation ratios, which he himself admitted is rarely productive, since these “cheap” stocks are usually cheap for a reason. 

I think you’re better off screening with charts and basic technical analysis. For example if you're looking for out of favor stocks, don't screen for low P/Es, low EV/EBIT...etc. Rather, find some price charts that dropped like a rock more than a year ago, underwent heavy capitulation selling, and have since showed price stabilization along with low volume (a sign of investor disinterest). What I typically do is screen for some minimum quality (low debt, high ROIC...etc) then run them through charts.

Monday, May 29, 2017

Recent Exits: NBIX, VIPS, SLM

Thoughts on three recent exits/position reductions. I would consider buying back at lower prices.

Neurocrine Bioscience (NBIX)

Ingrezza failed its phase 2 trial for Tourette’s syndrome; and the stock dropped from $53.5 to now $46.2.

I came away with a small profit and actually bigger confidence. The results were not good, but the decision procedure was sound – it gave me a shot at high upside while preserving capital. Had the trial results came out good this could have easily been up 30% with long term upside of 100%.

Going into the phase 2 results, NBIX was 8-9% of my total net worth with average cost of ~$47.4. I was sitting on a 13% gain. That gave me the cushion to sit through the event, knowing that a failure would probably result in a small hit to principal. The idea was to be aggressive with profits but conservative with capital. After the bad news came out I quickly cut NBIX down to a immaterial position with average exit price of more than $48, retaining a small profit for the entire trade.

Buying well is truly half the battle. That requires knowing a situation well, anticipating the scenarios, and going big when opportunities present themselves.

The episode also illustrated one of the advantages of individual investors. I highly doubt an institution could have went from 0% position to a 9% position and then down to < 1% position as quickly as I did - and come out unscathed.

The stock is now undervalued, but with no clear catalyst. If NBIX gets to low 40’s I’d strongly consider loading up again.

Vipshop (VIPS)
I exited the position before the company’s latest earnings. I had been accumulating JD and Alibaba and prefer their competitive positions.

Originally I saw Vipshop as a niche strategy (discount retailer), but the more I look at JD and Alibaba, the more I wonder if that’s even a valid category. For example, Vipshop sells excess inventory for brands – a lot of which are typically available after China’s November 11th “singles day”. Now, obviously Alibaba is the king of Single’s Day – so why can’t Alibaba just run some discount/flash sales to get rid of those exact same items, which is already listed on Tmall/Taobao?

The other thing I wonder about is the integration of warehouse and inventory systems. Let's say some apparels were listed on and was already in JD’s warehouse. Why not just let JD run its own flash sales? Why bother with moving inventory from JD’s warehouse to Vipshop’s warehouses?

As e-commerce matures and inventories get more integrated into JD or Alibaba affiliates warehouses, whoever list the items originally will also be the best candidate to get rid of that same (now excess) inventory. So is the “online discount retailer” even valid as a separate model?

Another thing that bothers me about Vipshop is its build out in last mile delivery. It seems to me they are aping JD, but with less resources. Logistics in China is becoming a crowded space, and a capital intensive one. Alibaba’s Cainiao allies are mostly publicly listed now, so they will be able to access capital and pour money into logistics. It’s not clear to me how Vipshop has a competitive advantage there.

This is another one where I bought so cheaply that I booked a nice gain. The stock actually looks like it has bottomed, but I'm in no hurry to get back in.

Sallie Mae (SLM)

I cut this down after the stock started dropping. As much as I like the growth prospects, I never felt comfortable with the political risk. SLM would have been a huge beneficiary of Trump's tax cut but it doesn't look like it will happen anytime soon.

Everyday, major news outlets report on America’s "student loan crisis". Read through the comment sections and I get the sense that people think if they can sue the hell out of Sallie Mae, cause it to go bankrupt, then they don’t have to pay back their loans.

Borrowers (a big and growing portion of society nowadays) have incentives to hurt Sallie Mae. That means politicians have great incentives to hurt Sallie Mae. That’s a dangerous place to be for shareholders.

Saturday, May 13, 2017

Common Quotes and (Maybe Not so Common) Thoughts on Investing

1. Investment vs Speculation - the classical definition

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” - Ben Graham, from “Security Analysis”

By this definition “investments” are exceedingly rare in today’s equity market. Good companies don’t trade at <17x earnings. Great companies could be 30x-50x earnings. Justifying those prices often require extrapolating growth out for 5-10 years, then assuming 1) margins and earnings don’t get destroyed by a recession during the forecast period, and 2) multiples don’t decline due to higher risk-free rates (as if there’s such a thing).

Thus, at today’s prices, much of “investing” (certainly much of growth oriented investing) contains implicit macro bets on the direction of economy and interest rates. A high percentage of these same investors would consider questions of interest rates and macroeconomics to be rank speculation. By that logic then, one can only conclude these "investors" are really "speculators".

Given the majority of "investing" today is really speculation, Graham's distinction kind of loses its meaning and usefulness. Perhaps it's time to redefine the two. Personally, I think of investment versus speculation as follows:
  • Investment = I'm betting on real world fundamentals playing out as I figured. 
  • Speculation = I'm betting on shifting expectations. It doesn’t matter how things actually play out, as long as people think it will go well, they will buy the stock and push prices up.

2. You are NOT the owner

“You are not buying a stock, you are buying part ownership in a business” – Warren Buffett (not sure, really every value investor)

Ok, I get the point, but let’s face it - most of us are not REALLY owners in the business. Understand this is key to avoid getting ripped off by unscrupulous management and insiders. 

To me, ownership means I have access and control. If I own a coffee shop, I would be able to access the shop’s profit and loss data any given day. I would have the power to fire under-performing workers, change the marketing and advertising strategy when it’s not working…etc. 

I own GOOGL stock. But If I call up Google today, I’d be lucky if investor relations call me back in a week, let alone have access to management. I certainly don’t get to tell Sundar Pichai what to do. I’m not really an owner of Google.

When Warren Buffett buys a stock, he’s an owner. He has great access, and has at least some influence on the board. He can influence the companies’ capital allocation decisions and extract cash flows if he needs to.

I think a lot of Buffett’s ability to bet big with conviction comes from having access and control. It also explains why entrepreneurs and business owners are willing to risk their life savings on one idea – essentially take leveraged, super-concentrated bets, while most investment manager consider a 15% position a big position.

3. Bet you didn’t know Ben Graham said this!

"It would be extremely unwise - and hypocritical - for anybody to buy a list of common stocks and say that he was interested only in his dividend return and cared nothing at all about price changes…the problem is not whether price changes should be disregarded - because clearly they should not be - but rather in what way can the investor and the security analyst deal intelligently with price changes which take place." - Ben Graham, from Current Problems in Security Analysis

In recent years the so called "dividend growth investing" crowd blindly chased yield without regard to valuation. They would pull up some old Benjamin Graham quote about ignoring "Mr. Market", and babble on about "long term investing" to justify their pavlovian "buy the dip" strategy.

Yet Benjamin Graham himself would say stock prices clearly matter. After all, if you make 3% dividend and risk 10% on principal, what's so good with that?

This is all the more so if you’re not really an owner like Buffett, but rather an OPMI: outside passive minority investor.

Now, what are prices dependent on? Why, supply and demand, of course. That’s a function of 1) people’s ability to buy (liquidity on their hands), and 2) willingness to buy (based on their assessment of company’s future outlook and “intrinsic value”, versus their alternatives).

This leads me to the next point.

4. What is it worth? And to whom?

“Value investing is figuring out what something is worth and paying a lot less for it.” – Joel Greenblatt

This quote is helpful to the extent it points out “value investing” is not just low P/E, low EV/FCF, or some other valuation metric. Warren Buffet would agree: there's no "value" versus "growth" investing. You're always looking for value.

What’s not helpful though, are the discussions that typical follow. Typically, these discussions of “what something is worth” automatically jump to some sort of discounted cash flow analysis, complete with disclaimers on how estimating “intrinsic value” is more of an art than science.

I think there’s a lot of talk about “intrinsic value” and not enough about “intrinsic value to whom?” The latter question matters. A control investor looking to extract synergy sees a different set of cash flows versus a mutual fund investor. The Bank of Japan, which has been gobbling up local equities, sees a different set of “values” from what Warren Buffett sees.

An example of the “intrinsic value to whom?” question is Canadian real estates. Consider a very logical housing investor. He might value a house by projecting out rental income minus various expenses, capitalize that cash flow stream with some desired yield. He then arrives at an "intrinsic value" that's way lower than the market price, and declares the housing market a bubble.

A rich guy from China, however, may be willing to pay a multiple of the market price. Why? because he's not just buying a house. He’s buying fresh air, safe food, quality education for his kids…etc. Heck, even just freedom of using gmail without getting censored by the government. A few millions for a crappy Canadian house is a bargain for that guy. 

The "value to whom" question matters. Knowing who's the buyer and the seller matters.

5. Compounders? or just justification to buy high?

“Given the three ingredients of a) optimistic assumptions as to the rate of earnings growth, b) a sufficiently long projection of this growth into the future, and c) the miraculous workings of compound interest - and the security analyst is supplied with a new kind of philosopher's stone which can produce or justify any desired valuation for a really good stock” - Ben Graham, from The New Speculation in Common Stocks

Nowadays, a typical “compounder” thesis goes something like this. This company is run by management with great integrity. The company has such and such competitive advantage: low cost structure, differentiated business model, this and that. The company is awesome. This company trades at some expensive looking valuation. But hey, if you project revenue out 5 years at 30% growth rate, put some 30x terminal EV/EBIT on it (all justified by qualitative discussion of competitive advantage), then we can get to 15% IRR.

Is this really margin of safety? Or are we just stretching ourselves to justify buying a good company? 

I have no problem against paying up for compounders. In fact I have lots of these: GOOGL, BABA, JD, EW...etc. But I'm under no illusion of what will happen to these stock when investors decide they will only look 3 years ahead instead of 7 years ahead.

Wednesday, April 12, 2017

Backing Up the Truck on NBIX below $50

update 4/12/2015 - added a quick sentence about Mitsubishi Tanabe agreement and minor formatting edits.

Notes on NBIX (Neurocrine Biosciences)

INGREZZA for Tardive Dyskinesia got approved after market.  Stock jumped from low 40's to almost $50 after market.

I kept buying after market. Literally bought until Interactive Brokers wont let me by anymore.

The big surprise is the approval came with clean label. I had anticipated 50/50 chance of FDA approval, but most likely with some sort of black box warning. More upside surprises (for me): management decline to give price guidance, but pointed out that even the high end of their $20-60k estimated annual price range will be well below Teva's rival drug Austedo (which comes with black box warning).

That's a game changer. Market share and pricing assumptions that people used a week ago will likely prove conservative.


  • INGREZZA for Tardive Dyskinesia (TD) - worth $40-60
    • US only peak sales - $1.5-$2bn, use 2-3x EV/revenue.  Get you to roughly $40-$60
    • That's just US.  
  • Elagolix for Endometriosis - 800mm-1bn peak sales, assume NBIX takes 20% royalty get you $150mm ballpark revenue. This is an NDA filing 3Q17, which has about 85% probability of success.  works out to $3-4/share.  
  • Opicapone - 150mm peak sales, NBIX takes 63%, 2x EV/revenue.  thats another $2/share

This gets to $45/share floor price already. Could be $65

What am I not counting?

1) Not counting 300mm of cash - I just assume they'll be burned near term for development and bridging to commercialization.

2) They have an agreement with Mitsubishi Tanabe Pharma to commercialize INGREZZA for TD in Japan & Asia. I'm assigned 0 value for now but it's certainly something.

3) Elagolix for Uterine Fibroids  - this is in Phase 3, which empirically have 55-65% probability of success. This is a bigger market than Elagolix for Endometriosis. Could be $2-5/share. 

4) and finally, the big one:

INGREZZA for Tourette Syndrome (TS), in Phase 2.  This is a bigger market than TD!.  If Ingrezza for TD is worth $40 conservatively, then TS indication could be worth $50/share.  That could doubles the stock price right there.

At anything < $50/share there's zero or very limited downside.  You're getting a free option on INGREZZA for TS - 100% upside. The Phase 2 results come out for that next month. 

Other Notes

CEO is loaded with stocks. This is an R&D focused company. Management team is full of PhD and MD's with decades of industry experience.

Obvious acquisition target with attractive pipeline/assets/catalysts. Great R&D capability, But I'm not sure they're willing to sell. NBIX is building out its sales force/commercialization capabilities. We could see them transform from a small biotech to the next great pharma.

There's almost 4mm shares short interest and those will get squeezed.

Sunday, April 9, 2017

R1 RCM (RCM) Has a Long Way to Go Up

R1 RCM (formerly Accretive Health) is a high probability trade with >2:1 upside/downside. The stock is trading at ~$3.3/share and I can easily see this going to $5 if not more. This is an idea that’s been on the radar for years. Here are just a few write-ups that helped along the way.

2014: From Buyside Notes

Also late 2014: write up by Sententia Capital

2016: mentions by Reminiscences of a Stockblogger

So why another write-up? This is now a material position for me and I owe myself a write-up for documentation. Also, given the recent run up, it would be helpful to explain why the stock can go a lot further, as well as provide some valuation ranges.

R1 RCM (formerly Accretive Health) does revenue cycle management for hospitals. I won’t bore you with what that means - that’s covered by the various write-ups I cited above. In any case I’m not enamored by the business. Basically I’m investing in the stock, not the business.

A few years back company had accounting/customer issues which caused delisting. They fixed those problems and just re-listed. The ugly history, customer concentration, combined with (still) ugly accounting and capital structure all combined to discourage investors and create this opportunity. I know that because for the last 3 years every time I looked at the company I thought “yuck” and skipped, until recently the opportunity simply became too good to resist.

Cheap Valuation Relative to High Probability of Delivery Next 3-4 years.

Management has a 2020 plan for free cash flows of $75-105mm by 2020. They expect to be free cash flow positive by 2H17.

Notably, management stated that currently contracted business alone would deliver 90%+ of the low end of that 2020 projection.

Capital structure is messy but not crazy once you work it out. Here are the basics.
  • $181mm of cash, but ~16mm of that is “customer float”. So excess cash is about $165mm
  • $0 debt. 
  • $214mm of Convertible Preferred’s that Pay-In-Kind (PIK) at 8%, convertible at $2.5/share. 
  • 60mm shares of warrants convertible at $3.5. 

The best way to value RCM is to roll the capital structure forward to 2020 and factoring in all the dilutions.
  • Cash and debt. The company will be cash flow positive by 2H17, so I give them credit for the full $165m cash at 2020, and still no debt.
  • Convertible Prefs. $214mm at 8% quarterly compounding get you to ~$295mm by 2020, which at $2.5 conversion price get you about 118mm dilutive shares at 2020.
  • Warrants: I used treasury stock method, assuming warrant holders exercise at $3.5/share, and then company buy it back at higher average price of $4/share (just to have some conservatism built in). This gets us 7.5mm dilutive shares.

All in, there should be ~125mm of total dilutive shares from convertible preferreds + warrants, getting to total share count of 239mm by 2020.

So here’s what valuation looks like. Using conservative EV/FCF multiples of 10-12x, RCM should be worth $3.8-$6.0 per share by 2020.

R1 RCM valuation

Given today’s stock price of about $3.3, there is no downside, while the mid-point of that valuation range provide almost 60% upside and ~20% IRR

This is almost too good to be true. At what point would I say “I may be wrong, let’s cut out and re-evaluate”? There appears to be some support around $2.4. Using that as a stop loss, downside is about 30%. Compare that to 60% upside that’s a 2:1 reward to risk ratio.

Again, this is a high probability given that currently contracted business delivers 90% of the low end projection. God forbid they actually win new contracts, the shares could go through the roof.


1) The recent listing has brought increased volume and the stock is already trending higher.

2) Company will go through an accounting change 1Q17 to simplify the story.  

Right now the accounting is a mess: GAAP revenue is completely meaningless, so investors have to rely on management’s non-GAAP measures. I remember spending lots of time reconciling GAAP revenue and EBITDA to management's corresponding gross and net "cash generated from customers", and then from that to GAAP cash flow from operations and management's free cash flow measure. It was a super pain in the ass. A simpler GAAP accounting profile would go a long way to remove the “yick” factor and bring in investors.

3) If they win a contract outside of Ascension and Intermountain, that could "prove" their capability and help the story. 

I think they can do it. The company offers a fully outsourced model where they effectively take the risk of cost overrun and reap the rewards of cost savings. I think that makes a lot of sense in today's hospital landscape where margin is tight, and where payers pushing "value based care" are pushing risk into hospitals.

Other notes

Dr. Rizk served as the Chief Executive Officer of Accretive Health, Inc. from July 21, 2014 to May 26, 2016.  It’s likely he left voluntarily because 1) he became CEO of Verisk Health (now Verscend) in Aug 2016, like 3 months later 2) they groomed Flanagan as COO for a while.

Wednesday, March 22, 2017

Transcat Can Double in 3-5 Years

Transcat (TRNS) distributes, services, and calibrates equipment for a variety of industries, particularly highly regulated industries such as life sciences. Transcat serves as a one stop shop to make sure the equipment are working properly, without customers having to schedule with each and every OEM. The link here shows the instrument types they can calibrate.

I will try to provide the outline of a long thesis as succinctly as I can. Someone has a more thorough write-up here (paywall).

Thesis Sketch

Transcat can double its EBITDA in 3-5 years, and the stock can double as well. The reasons are below:

  • The company has 2 segments, one growing and one declining/stabilizing. Revenue growth is set to accelerate because the growing segment is now outpacing the declining one.
  • Growth is further enhanced by a roll-up strategy in its services segment (in addition to organic growth) 
  • Margins will benefit from mix (Services segment has higher margin), as well as operating leverage.

As a bonus - I'm not counting on this - the company pays 30-40% tax. A corporate tax cut to 20% would immediately boost earnings by 14-33%

Mix Shift Toward Higher Growth and Higher Margin Segment

The company has 2 segments: Services and Distribution. Right now they contribute about 50/50 in terms of revenue. The Services segment has been a steady grower (both organic and via acquisition). Distribution segment revenue declined the past few years due to the oil and gas industry downturn, but seems to have stabilized in the past few quarters.

Going forward, the growth in Services will outpace the decline in Distribution. Since Services enjoys a higher EBITDA margin (low double digits vs mid-single digits), EBITDA will grow faster than revenue.

The slide below shows the revenue and profitability crossover.

Transcat revenue and operating income

Roll-Up Strategy

The Services segment is also a rollup story, supported by reasonable debt levels (~2x Debt/EBITDA). The company is a disciplined acquirer, typically paying 4-6x EBITDA with IRR hurdle of 15%.

Calibration services is an $1bn market, split 40%/35%/25% between 3rd party services providers, in-house labs, and OEMs. Within ~the $400mm market for the 3rd party services provider, Transcat is the 2nd largest with behind Tektronix (18% share versus 22% share).

Notably, almost 40% of 3rd party providers market is serviced by smaller regional and local players. That’s a ~$160mm space that Transcat has been, and will continue to be consolidating.

I believe the company can improve its share of that 3rd party market from 18% to low 20%’s, providing a tailwind for revenue and margins.


With TRNS stock trading at $12.4/share, the company has $89mm of market cap and ~$115mm of enterprise value.

Management is targeting $175-200mm of revenue and double digit EBITDA margin in 4-5 years. Using the midpoint of $187.5mm revenue and a 12% margin gets you to $22.5mm EBITDA. With a 10x EV/EBITDA and you have $225mm of enterprise value – almost a double from the current $115mm EV.

That is in 4-5 years. But as markets are forward looking, I expect the stock to double sooner.

Here’s my rough model on 1) how revenue and EBITDA might progress over the next few years to FY2021, and 2) what they look like if management’s goals are met.

The 2 are fairly close so I think management’s goals are reasonable. Recent financial results suggest they are well on their way.

Transcat model

Friday, March 10, 2017

Week ending 3/10/2017: Losing Streak

From red hot to ice cold. My major stock holdings have drifted lower. My small, speculative positions have blown up and given back their gains. In the past months I twice sold stocks (Fortress and Nimble Storage) days before they get acquired at huge premiums. Even currency trades, a barometer with which I judge my understanding of the world, went from positive to negative.

It’s a combination of bad shots and bad luck. What do you do when you keep shooting bricks and air balls? Do you keep shooting? Or do you bench yourself?

For now it’s the latter. I have cut back on losers and winners alike. Despite having a plethora of stock ideas, I’m putting them on hold until I can figure out what’s going on.

Major Stock Positions

Fidelity National Financial (FNF). Spinoffs coming 2H16 to unlock value. The core title insurance business is cheap at about 10-12x PE. This is a great business and we may be on the cusp of a wave of millennials buying their first homes.

Beijing Enterprises Holdings (0392.HK). Just too cheap.

Sallie Mae (SLM). A play on deregulation, tax cut, and higher interest rates.

Aetna (AET) and United Health (UNH). Insurers have the best bargaining power in healthcare.

Medtronics (MDT). SURTAVI trial results coming March 17th. A good read could boost the market size of TAVR heart valves and MDT’s market share.

Vipshop (VIPS). Incredibly cheap for a company with 20%+ revenue growth. The market should come around to it one day.

Most of these have done well the past 2 months but are now showing weakness. I’m actually praying for FNF, SLM, and VIPS to go lower so I can buy more. Beijing Enterprises had a nice run the past month but looks about to be beaten down again. The negative sentiment in Chinese stocks persists (this applies to Beijing Enterprises as well as VIPS) and I think part of it is the market assigning a steady decline in Chinese Yuan.

Inotek and Negative Enterprise Value Situations

2017 will be an interesting year in biotech. When “clinical stage” biotechs fail their trials and still have cash left, what do they do? These stocks can trade at below value of cash on balance sheet, so the market is basically saying management will entrench themselves and burn away cash. There’s a bunch of these companies in the market right now. Ovascience, Inotek, Ophthotech…etc. Merrimack is another one that could have negative EV soon.

I replaced my OvaScience position with another negative EV play, Inotek. This company develops eye drugs. It has one more phase 3 trial result coming up, and no more pipelines after that.

In this way Inotek is superior to OvaScience, which has multiple years of pipeline (thus excuses to burn cash and destroy shareholder value). If the trial fails, Inotek would still be sitting on cash of $2-2.5/share and no debt. The company trades at 1.6 when I bought (up to 1.8 today).

It’s hard to say what management will do. Ideally they just return cash to shareholders. But they could try to acquire some product pipeline. Or they could refuse to admit defeat and do another phase 3 trial on the same failed molecule. In short, anything to keep paying themselves.

So this is potentially an activist situation. But I’m not sure how much good that can do. The board has no investor representation and only one director is up for election in 2017.

Ophthotech is another eye drug company with negative enterprise value. They have already said they will not return cash, but will look to acquire. So Inotek could be a target.

On “M&A Valuation”

What are these “plethora of ideas” that I’m holding back from? I have one general observation about the whole IT/medtech space.

I’m seeing lots of companies like this: revenue growing fast – say 20%+ or even 100%+ a year. Stock trades at 2-4 times EV/revenue. Big net cash positions. GAAP losses but approaching cash flows break even (because of stock based comp and D&A). High gross margins. The biggest expenses tend to be sales/marketing /G&A.

From the perspective of a strategic acquirer, you can synergize and cut down SG&A by half or even more. If you do that, most of these companies are essentially valued at <10x EV/forward EBIT, maybe lower.

So if you start modeling “acquirer perspective”, they all look like slam dunks. On a standalone basis though, most of them will never be profitable (unless you literally project growth like 10 years out).

Off the top of my head, Novocure (NVCR), Atricure (ATRC), Nutanix (NTNX) are just a few that fits in this category. The list is long.

The megacaps are sitting on huge cash piles. Tax reform could add to that by allowing big tech companies to repatriate cash. This all bodes well for M&A. Of course, not every company will be bought out, but increasingly market valuations are based on perceived M&A potential.

Monday, February 13, 2017

Leaning on Currency Trades

In a bull market everyone is a genius. In the month or so I enjoyed profits in all directions – equities, currencies and commodities. The problem is that idiosyncratic contributions are wearing thin and the gains are more and more dependent on market wide movements. So I decided to do another macroeconomic review, starting with currencies.

A quick disclaimer: anytime someone tells you about a “macro trade”, it’s got a lifespan of about 3 months or less. The reason is market moves feedback to real world fundamentals and no one knows how that will play out with any certainty. The trick is to anticipate a sort of decision tree, and ride the trend when real life plays out as you expected, and be ready to do an 180 when events go down a different path. This is why macro guys like Druckenmiller can flip flop all day yet still make money.

With that out of the way, I’m long Russian ruble, Danish krone and USD, short euro, and anxiously watching the USD.JPY pair. I will explain each below.

The Ruble

I've been riding this trend since late November/early December. I actually have no great conviction on the ruble, but I love Russia’s situation –their geopolitical and economic outlooks are clearly improving.

In the 1970’s and 80’s, the U.S. and its allies opened up to China to counter the Russian threat. Now in the 2010’s it’s the reverse. The U.S. will warm up to Russia to balance against China. Trump clearly wants to work with Russia and France could elect Le Pen, who views Russia more favorably. Shinzo Abe in Japan is getting closer to Russia as well.

This all improves the probability that the current sanctions against Russia will be removed. On top of that, Russia is coming out of a recession and oil prices have stabilized. Inflation will likely subside, which can lead to the central bank cutting rates. Russia is also looking to lower its budget deficit.

The combination of lower expected rates, budget consolidation and improving sovereign credit is the best possible set up for bonds and has mixed outlook for the ruble. Unfortunately I have no access to Russian bonds, but I will settle for going long the ruble and Russian equities (which I also have positions in).

Even if the Central Bank of Russia starts cutting rates, the ruble should still be supported by a relatively high rates and portfolio inflows into the country. Once ruble strength start fading, Russian equities could be the next bull market.

Euro: short EUR/USD and EUR/DKK. Get ready to buy French companies

The dissolution of EU is on everyone’s mind but what happens to the euro is anyone’s guess. The euro could strengthen because weak countries like France and Spain would exit, leaving euro as the currency of a very strong Germany. The euro could also weaken because any dissolution requires a long transition period and the ECB will go on a quantitative easing binge while they’re at it.

At least in the next few months, I think the latter is more likely. So I’m shorting the EUR against the U.S. dollar and the Russian ruble.

I’m also shorting the euro to go long the Danish Krone. The downside is low here as I’m shorting a currency that is pegged, yet undervalued.

Denmark has one of the highest current account surpluses as percent of GDP in the world. If you think Germany has undervalued currency because it uses the euro, then the Danish krone is just as undervalued because of the peg to euro. Denmark also has zero interest rates and an overheating housing market. Does that sounds like an economy that needs more QE? If the ECB unleashes another round of QE, I doubt Denmark will want to follow suit, so they have to unpeg and let the DKK float upward.

Finally, a full dissolution of EU would be great for France. Upon completion, I expect French companies to be big beneficiaries as France would have much needed flexibility on fiscal and monetary policies. French companies will also enjoy great operating leverage with that 10% unemployment rate.

Yen: USD/JPY short in the next month could be the next pain trade

We are heading into European elections and there’s a high probability that populism will win out in Netherland and France. This could trigger a global risk-off with international funds pouring into JPY.

On the USD side, Trump's tax/trade/infrastructure plans (it’s all tied together now as you can’t have one without others and not blow up the budget) would certainly not be passed the next few months. So we can see deterioration in USD as expectations are pushed toward later dates.

Any JPY strength would catch the market by surprise. The market is still very long USD. As for yen positioning, “large specs” went from very long JPY to net short to less short (but still net short) in the past few months. This suggests more room for JPY to the upside.

I'm not going to short USD/JPY however. At the time of this writing, USD/JPY is at ~114. More likely I will wait for the pair to drop to 109.5 or even 106 and resume a long USD.JPY position.

Monday, January 30, 2017

Buying OvaScience at Negative Enterprise Value

OvaScience (OVAS) aims to improve chances of fertility. It has two products in early stage development, and one that’s already in the market outside of U.S.

I have some notes in the next section about what the company does, but the thesis is really quite simple - extreme cheapness presents attractive risk and reward.

At $1.6/share, this company has $56mm market cap, yet it has $130mm of cash and securities and no debt. There are no off-balance sheet arrangements either. Stock options are mostly way out of the money, so there’s minimal dilution risk. Taken together, the company has enterprise value of negative 70mm+.

Put another way, the market is pricing in 100% chance of OvaScience burning $70+mm of cash (more than the market cap!) and get nothing in return. Implicitly, the market judges the science behind OvaScience to be worse than worthless.

Now that’s harsh.

Let’s go through some hypothetical scenarios.

First, it goes without saying that this is a multi-bagger if the pipeline in development actually works out. Even if the pipeline doesn’t ultimately work in the long term, the stock can go higher with any positive results from clinical trials. Also, keep in mind we’re in a new era of deregulation – the FDA approval process can conceivably get easier.

But how if it does not work? What’s OvaScience without the science? Is it “game ova”?

No. On the contrary, the stock offers multiple options: a) as a target of acquisition and/or liquidation, 2) as an acquirer of another company.

The company is not majority controlled by insiders. So this is not a situation where management can destroy shareholder value with impunity. Various types of potential acquirers can take control and monetize the discount here.

Management did say they will burn cash in 2017, but not nearly as much as the stock price would imply. If clinical trials start showing bad results, an activist fund can step in, liquidate the company and realize the remaining cash hoard. A pharmaceutical/biotech company can likewise do the same. IVF clinic like Virtus Health could also be natural buyers.

OVAS can also act as an acquirer. This would remove the threat of management running cash down to 0, and thus a boon to valuation. The stock would be worth more even if management buys some snake oil with that $130mm of cash. If they buy anything worthwhile this could be a quick double.

Obviously, things have not gone well with the company thus far. But at this price the downside is minimal.

What the company does

Women are starting families later, which means their eggs are older and have lower chances of conceiving. OvaScience plans to improve fertility via operations on EggPC cells, defined as “immature egg cells found in the outer lining of the ovary, which have the potential to mature into new healthy eggs, thereby replenishing egg supply”. Here’s a picture from the company’s presentations.

Their 3 products in development represent 3 different ways of utilizing these immature egg cells.
  • AUGMENT - enhances egg health by extracting mitochondria from EggPC cells and injecting them into normal eggs.
  • Ovaprime - increase egg reserves by taking a woman’s own EggPC cells and injecting them into her ovaries. 
  • Ovature - A woman’s own EggPC cells are matured into healthy, young fertilizable eggs outside the body.

The company currently has minimal revenue because the AUGMENT treatment has not been a commercial success.

On December 2016, OVAS stock dropped to as low as $1.3, in response to an announced restructuring, summaries of which are below:

  • The company will stop expansion of AUGMENT and reduce its workforce by ~30%.
  • CEO and COO both stepped down. Founder Michelle Dipp took over the firm.
  • As a result of its corporate restructuring, the Company anticipates that operating cash burn will be between $45 million and $50 million in 2017, excluding one-time cash items of approximately $7 million to $8 million related to the restructuring. The Company may also incur further restructuring charges related to the restructuring plan. 
  • These changes will enable the Company to extend its cash position into the first quarter of 2019 and increase its focus on the development of OvaPrimeSM and OvaTureSM. The restructuring is expected to be completed in the first half of 2017.

Post the restructuring, the new goals/milestones are shown in the below slide (from company presentation)

Monday, January 9, 2017

Don’t Know Much About VIPS, But I Do Know It’s a Buy

At this price, Vipshop (VIPS) is a situation where a short term trading approach can turn into a longer term investment. I bought at $11.1 last week. The stock is at $11.5 now but the logic still holds.

I did not spend a lot of time researching VIPS– altogether no more than 8 hours. More research will be not be productive. I already have enough information to know that:

1) Stock priced in lots of negatives already, and the upside is big if things go right.

2) The technical set up provides a high probability of a short term trading win with minimal downside.

3) I’m not ready to assess VIPS’s longer term growth prospects, at least not until revenue growth stabilizes. But the likely short term trading gains could tide me over until then, and provide the cushion to turn this into a longer term bet.

Brief Background

VIPS is an online discount retailer for apparel brands in China. Apparel brands/manufacturers often end up have excess inventory to get rid of, but they don’t want to flood their stores with big discounts. VIPS is one of the ways that manufacturers can offload inventory. VIPS would organize “flash sales” on its website, selling these items at 30% to 70% off the original retail price. Most of their inventory for now is based on consignment, meaning VIPS bear little inventory risk.

VIPSHop came from a friend who compared it to the online TJ Maxx of China. It didn’t really appeal to me at first - I’m just not much into shopping for clothes. While I was away for Christmas vacation, I watched to stock drift lower and lower, and I finally decided to take a look.

What Is The Market Saying?

Revenue has been growing more than 50%+ per year, it has slowed recently but sell-side analysts still expect revenue to grow 26% in 2017E. 2017E P/E ratio is just a little under 18x. For this type of growth VIPS is incredibly cheap.

Just to put this in context, VIPS is expected to earn about USD $0.48/share for 2016. If EPS grows at 25% CAGR for next 3 years it will earn about $0.94/share in 2019. A consumer stock growing double digits in China should easily command an 18x multiple, justifying a $17 stock price.

Clearly, the market thinks that’s not going to happen.

With VIPS trading <$12, the market is basically saying a) growth will decelerate drastically or even decline 3-5 years out, or b) there are concerns of fraud.

There were in fact accusations of fraud, but that was over a year ago and GeoInvesting actually came out defending the company. At this point I think it’s got to be a small and diminishing factor in the stock price.

So it’s more about the sustainability of growth, and by extension VIPS’s business model itself (footnote 1). You can argue both sides. I lean toward the optimistic side but honestly– anything can happen. I’m certainly not one to claim any sort of conviction here.

On the bear side, one can easily think of some risk/concerns for VIPS. The discount retailer model is far from a sure thing – the success of TJ Maxx is an exception, not the rule. There are also questions as to how the discount model can carry online. Retailers can show deep discounts on their websites directly (like some already do in the U.S.), so the need for something like VIPS is questionable.

Competition will surely be tough. The fact that revenue has decelerated in recent quarters would seem to suggest other players are taking share. It puzzles me that VIPS is expanding into the financing business (for consumers, suppliers, and even selling private wealth management). Is that really the most effective way to juice growth? If you need to finance apparel purchases to increase growth, isn’t that a sign of desperation?

On the other hand, a bull would say yes, there are many ways for manufacturers to offload inventory, but this is China we’re talking about there. The market is big enough to have all these different channels. The company’s revenue may be slowing as percentage, but it’s growing off a larger base and that growth is actually larger in dollar terms. The upside is huge if and when the negative sentiments are lifted. If VIPS could sustain double digits CAGR for a few years and then not fall off a cliff, that business could trade closer to 20x P/E

I’m not smart enough to predict how the future will play out, or even assign probabilities. But I do know that IF it works, the stock can be up 50% or even double. How if it does not work? Well the stock already reflect much of the “not work” scenario.

What’s the floor value of VIPS in the next 3 years? Again, I don’t know. In the next month or so though, the downside is low and that’s a good starting point.

Where to Cap My Downside?

Here’s a chart showing 2 year stock prices against volume moving averages. The black line is the price (left axis), the blue and green lines (right axis) are the volume moving averages. I do this to smooth out volume fluctuations and get a better sense of volume trends.

VIPS price and volume moving average

The blue line (1 month moving average of volume) shows signs of capitulation selling with volume spike during late 2015 and early 2016. This was followed by a period of lowering volumes, signaling investor disinterest. It seems that growth/momentum investors have abandoned the stock, leaving value investors with lower expectations. 

I would also note the historical demand around the $10-11 area. Each time the stock dropped to $10.3 the buyers showed up. Even after the disappointment in 3Q16, the stock seems to bottom around $11.

Finally, this stock can run up between earning releases. This happened prior to the 8/15/2016 earning, as the stock rallied some 50% from its June lows. Serious resistance doesn’t show up until ~$15-$16 range.

Game Plan – Buy the Stock < $12

There’s not going to be an earnings release for at least a month or so. In the meantime there’s unlikely any catalyst to shock the stock below its $10-11 support zone. So both the probability and severity of downside is low in the next month or so.

If the stock falls below $10 then I'm probably wrong and I'll take a small loss. If the stock doesn’t move I could cut down before earning release. I might have limited losses, or limited gains – it’s a coin toss.

There's a good chance I might even get 15-20% upswing given the low price – there’s precedent for more. In that case, those gains would allow me to hold through the earnings, as the gains will serve as a cushion for any drops from earning disappointment. If 4Q16 turn out to be good, the stock could roar higher, giving me even more cushion to hold longer term – for the real bet - that the business is sustainable after all. 

Taken altogether - my downside is 10-15%, short term upside some 15-20%, long term upside could be 50% or even double. Regardless of my doubts about the company, I have to take the trade.

1. VIPS may not be cheap if there’s not a “mature phase” of this company. The multiple seems absurdly cheap if you think the company will grow double digits for a few years then revenue stabilizes at some level – a theoretical “steady state” for valuation purposes if you will.

That works for most companies, but an internet company? I’m not sure. It could be either you’re gaining share and growing, or your losing and dying – maybe there’s not this “steady state”. In a DCF model, revenue/cash flows would grow to some peak, slow down, then decline precipitously. That would justify the apparently low multiple. The market seems to price in some probability of this.