JDPI 2Q15 Letter To Investors – Value In NOLsVW Staff
JDPI letter to limited partners for the second quarter ended June 30, 2015.
For the second quarter we were up 1.83% net to limited partners versus 0.27% for the S&P 500. Year-to-date the fund was down 0.68% versus 1.23% for the S&P 500. Since inception in October 2011, we have earned 87.42% after all fees and expenses, or 18.24% annualized.
JDPI - Review and Outlook
The Partnership outperformed in the second quarter due to anticipated earnings and/or corporate actions within our largest holdings. These gains made up for declines earlier in the year stemming from negative macro sentiment.
In the first half-year we realized gains on 25% of the portfolio due to valuation and limited upside. Capital was recycled into a combination of: a) Our highest conviction ideas, b) Basket of small caps with asymmetric qualities and strong balance sheet protection, and c) Increased cash.
Our strategy is focused on ideas that we believe could double within three or four years, with a margin of safety appropriate for the business and price. When there is an opportunity we take it, and do not try to time the market. Wearing this hat often makes monthly price movements more of a distraction than value enhancing.
Looking ahead, the fundamentals of our collective portfolio advanced materially from the start of the year despite prices having not caught up yet. We are positioned to do well even in a low-growth environment for the indexes.
Our top four holdings continue to make progress from our entry at controversial inflexion points in their history. Strengthening competitive advantages and impressive capital allocation are creating long-term compounder characteristics for each. As of 6/30/2015 our largest positions were: ALJ Regional Holdings, CyrusOne, Carrols Restaurants and Bank of America.
We think of a “compounder” as a business with a very unique mix of assets and shareholder friendly management that cultivates a sustainable, low-risk ecosystem for earnings growth to compound faster than the broader market for a long period of time—easier said than done. Portfolio Update In the second quarter we sold Perry Ellis-PERY (38% IRR) and Liberty Global-LBTYA (33% IRR).
PERY was the subject of an activist campaign to narrow a wide valuation gap created by years of founder-family insider dealing and poor capital allocation. We made the investment with the thesis that there was a high probability the company would be sold. Ultimately the majority of the PERY board was voluntarily replaced with independent directors to avoid a proxy fight and near term sale of the company.
We sold LBYTA after the stock’s rapid appreciation largely due to an overly enthusiastic anticipation of the July spin-off of the Latin America division’s tracking stock (NASDAQ:
LILA/K). We felt there would be a better opportunity post-spin to buy LILA/K if we chose to do so. The decision proved timely.
Our experience with LBTYA over the last two years has been valuable and has led to a deeper understanding of the economics and opportunities within the cable internet/TV business. We also have developed a knowledge base around the public players globally and the consolidation opportunities that still exist. We remain excited about the sector and are evaluating other ideas that are less mature, less understood, cheaper, and have more upside than LBYTA.
In the second quarter we added to our holdings in CyrusOne and Bank of America “A” warrants.
JDPI - New positions
Based on our profitable experience with ALJ Holdings, we have been on the lookout for similar opportunities around cheap shell-like small capswith huge Net Operating Losses (NOLs) that have been taken over by experienced capital allocators to be used as acquisition platforms.
In the first half we initiated new positions in a basket of three small caps that have similar characteristics to ALJ circa 2012: WMIH Corporation, BFC Financial Corporation and ModusLink Global Solutions. Each company has more than $1 billion in NOLs generated from an original business that is dying on the vine, or was once partly or completely bankrupt. The remaining assets have been re-purposed as investment vehicles for proven deal maker teams. WMIH (formally Washington Mutual Bank) is controlled by KKR, BFC is controlled by Alan Levan and John Abdo, and ModusLink is controlled by Steel Partners.
Ideally, enormous value can be created for pubic shareholders when a NOL-heavy HoldCo acquires high free cash flow generative assets because the tax shielding affect provides more cash to pay down buyout debt than would be available to a traditional buyer.
Additional arbitrage value is created if the acquisition(s) is purchased well below average public company free cash flow multiple comps because of the buyer’s unique access to
proprietary deal flow—think ALJJ.
Our price for this basket was attractive based on low multiples of cash per share in the case of WMIH and MLNK, and in the case of BFC Financial, approximately 4x estimated EV/2015 EBITDA of the current operating businesses. The three holdings represent 7.5% of AUMand we are ready to add more capital if one or all can further demonstrate an ability to find and execute on meaningful transactions.
JDPI - Performance drivers
Largest contributors to our Q2 2015 performance measured in total dollar contribution:
JDPI - Notable portfolio development
ALJ Regional Holdings
On July 12th ALJJ announced the acquisition of Phoenix Color and the remaining minority interests in Faneuil and Carpets that was owned by the respective management teams.
Post-transaction annualized EBITDA will more than double to $42 million with net debt estimated to be ~$150m or 3.5x EBITDA. Phoenix is a market leader in specialty commercial printing of book covers, game boards, boxes, posters, displays, and packaging with 25% EBITDA margins. Phoenix was an orphaned division of Visant Corporation, an underperforming private equity roll-up created by KKR in 2004.
We are excited about the Phoenix acquisition for several reasons:
- Purchase price of sub 4x EBITDA is half ALJ’s public value of 8x EBITDA,
- 100% debt used to finance the transaction with no equity, convertible or preferred stock issued,
- ALJ’s ~$160m remaining NOLs will minimize taxable cash flow and allow a faster repayment of debt,
- 40% to 66% upside in ALJJ stock or $6 to $7 per share from the current price of $4.20. This implies a 10x to 12x FCF/equity multiple on post-acquisition after-tax annualized cash flow of $20m, or an EV/EBITDA multiple range of 8.5x – 9.5x and 35 million fully diluted shares outstanding.
- Our valuation is justified due to ALJ’s ability to rapidly build cash, unique low-cost corporate structure with aligned management incentives, and an ultra shareholder friendly board. We would not be surprised to see additional acquisitions in the future, as management remains focused on fully utilizing the NOLs before expiration.
- ALJ’s increased size now justifies an up-listing to a mainstream exchange such as NASDAQ, which could lead to multiple expansion and increased liquidity.
Thank you for your support.