Rite Aid Post-Mortem

In my original post I said I’d take a flyer on RAD. Boy howdy do I wish I’d gone over my usual checklist! WBA and RAD announced new deal terms.

I assumed the following about any potential new deal:

  1. The FTC would be more spineless than it has been at the tail-end of an outgoing presidency.
    1. In the worst case a postponement would force RAD and WBA to push the merger out by 3-6 months.
      1. This did happen, but it could be pushed out even further with the new terms and need to find either a second buyer or a stronger lead than FRED.
    2. The CEO of Rite Aid would not suffer the indignity of further reducing the buyout price.
      1. It turns out RAD management was more desperate than I had thought to sell. I guess the CEO is still waiting on his $25m cash payday.
      2. Operationally RAD is on the ropes.
    3. At most WBA would reduce their offer price to $8.00.
      1. Instead they agreed to a range between $6.50-7.00 depending on how many stores needed to be sold. Kudos to WBA management for negotiating RAD down… twice..
    4. Valuation was irrelevant.

#4 was my most cardinal sin. These are some of rules which I broke by investing in RAD.

  1. M&A bets must be founded on attractive valuations.
    1. RAD failed this test.
  2. Agency risk – is management aligned with shareholders?
  3. No edge in pharmacy companies. No industry knowledge.
    1. This makes the importance of “stupid cheap” valuations even more important to the process.
  4. Short-term rent-seeking investment is generally not a good idea.

There is probably money to be made in RAD, but looking with fresh eyes, I simply don’t have comfort with the valuations for RAD as a standalone investment at $5.72. Furthermore, a 14-22% spread to the new deal price is not enough to warrant the downside risk to $4.

Special situations can be great, but they have to provide upside optionality founded upon attractive undervaluation. I still feel OK about TSL trading at 6x EV/EBITDA. However, I did sell a bit of TWX today.

Investors have been laboring under the notion that Trump was not to be taken literally. This no longer appears to be the case. The man has a long track record of childish score-settling, and so his commentary around AT&TTWX, which could be dismissed a week ago when we weren’t actually building a wall or detaining refugees as campaign rhetoric, deserves fresh eyes as well. Combined with some pushback from Democrats, I think AT&T-TWX could be a harder slog than investors currently expect. I still have a good-size position here, but took some gains since I am up 7% and slightly less confident in the deal post-weekend. A 7% return in two months is not great, but not terrible either and I have other places I can put the cash to work. I still think the deal gets done, but my confidence goes from 70% to 55%.

I also took gains on CHTR on the VZ acquisition rumors. I don’t know how that deal would get done or when, and I am skeptical that Charter is through the pain of integrating Time Warner Cable. Consequently I sold a bit of CHTR prior to earnings, but it is still a large position for me.

Valuation must serve as the foundation to any investment thesis.

Valuation must serve as the foundation to any investment thesis.

Valuation must serve as the foundation to any investment thesis.

^Consider these my chalkboard lines for today.

 

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Closed out of Cigna. Adding to DVMT, AOBC, and TMUS.

The Cigna deal looks like it will not be going through, so I sold at a minor gain. Valuations for Cigna look too rich relative to comps, and it seems more likely that CI management will attempt to acquire WellCare or Humana rather than try to sell CI again. By most accounts, Cigna and Anthem management were not on the friendliest of terms. This is just my sense of the matter. Humana on the other hand is still cheap and sitting on a lot of cash which could be returned to shareholders. Same story with WCG. I think both look compelling at these prices.

I doubled my T-Mobile position after news that Ajit Pai will likely be the new FCC head. Mr. Pai is about as free-market as it gets. From his previous comments, I believe he is fully captured by telecom and cable lobbyists. This should be really bad news for net neutrality, and good news for mega mergers in the telecom and cable space. So shed a tear for your cable and phone bills, and buy TMUS, DISH, and perhaps CHTR to offset your pending rate increases.

I would expect at least 2 buyout offers for TMUS in 2o17. DISH will probably be bought eventually, but the company is going to keep showing investors bad numbers in the earnings reports. I think better entry points will present themselves as rattled investors shake loose of the stock due to the legacy business’ declining trajectory. I could also be wrong about any selloff, so I have a small position in DISH at present. Sprint is probably spinning up for another TMUS effort as I type.

Charter or DISH could be targets for Verizon. Pretending to be Google is not working out well for VZ, and they have not focused on simply being a good carrier for so long that they risk losing a lot of customers. With net neutrality less of a threat there is less need to try to compete as a search and advertising company. VZ management should dump or renegotiate the Yahoo deal and start looking at carrier-related M&A instead. AT&T appears to have its hands full getting the TWX deal approved, and seems fairly well-positioned for the next few years. With AT&T and Comcast making MVNO moves, VZ will at some point have to get back to being a provider.

Michael Dell recently exercised DVMT options worth about $7.4 million. I added to my position last week. There still looks to be a good 15-20% left for the stock to squeeze upwards to approach parity with VMW.  It would make sense for Dell to eventually buyback the tracking stock entirely, simply to save them the nuisance of SEC filings. With VMW trading at $82, a fair value for DVMT would be around $65-70.

As Seeking Alpha authors have mentioned previously, American Outdoor Brands’ CEO purchased 55,000 shares (roughly $1.1m) in the open market from January 9th-17th using a 105b-1 trading plan. This is typically a passive monthly instruction to purchase a standard allotment of shares. I can’t think of a more bullish sign for the stock. Except of course, when a company’s CFO also makes open market stock purchases like Jeffrey Buchanan did around the same time for 10,000 shares using a similar plan.

So we can assume that AOBC management believes the stock is undervalued. Because of the plan type, we can also assume that they don’t believe the trading multiple will improve much this year. I added a little and plan add more over the year alongside management, but there doesn’t seem to be any rush, and RGR‘s late-February earnings report often drives AOBC in sympathy.

I’m still uncomfortably waiting to find out if the RAD deal goes through. We should get clarity by the end of the week. The negative reports so far have been unconfirmed rumors, but I haven’t added yet. At a >25% spread it’s getting very tempting to buy more though…

Switching to Call Options on GSAT

Globalstar has not performed as I anticipated post-approval, so I sold my recently GSAT stock at $1.68, and switched to $2 April 21st call options at a cost of $0.39/share. I may purchase more longer-dated call options in the future if no catalyst occurs by April 21st. The likelihood of bankruptcy is too high for me to sit comfortably on the stock itself.

With the FCC low-band spectrum auction set to end favorably for the telecom giants within a matter of months, I would expect potential partners to start sniffing around mid-band spectrum holders. The conference call was interesting, but I think the bull valuation thesis is pricing GSAT’s spectrum far too high. Rhetoric aside, management will have to keep the lights on for the next year. They have 4 options.

  1. Dilute the common stock now
  2. Issue something that is eventually dilutive
  3. Issue more debt
  4. Sell the company

I think option 2 is potentially the most likely outcome, followed by 1, 3, and finally 4.

I do still believe the spectrum has value per my initial post. However, spectrum can lay fallow for years and GSAT is going to have to dilute or take a painful loan at some point in the future.

Options for partners probably include VZ, Softbank, DISH. Alternatively we could see some sort of merger with another one of the odd-ball spectrum firms out there like PDV Wireless or Ligado Networks.  An important question right now is why would anyone mess around with GSAT right now with other options available, especially when potential buyers or partners can force better terms in a few months?

At a time when the FCC is looking a lot more relaxed than the old Wheeler regime, GSAT seems like small potatoes for Verizon, SoftBank, or Dish. Why dink around with a $2.2b company sitting on a sliver of spectrum when you could buy DISH, TMUS, or S?

Due to the technical aspects of the spectrum, SoftBank would seem to be the most likely partner/buyer. Globalstar’s spectrum footprint aligns with what SoftBank has both inside and outside the U.S. and should be conceptually appealing to an empire builder like Masayoshi Son. So what does or does not happen here could be a telegraph for Masa’s long-term Sprint plans.

I could absolutely be wrong here, and so I view long-date call options as the best way to invest in GSAT. If the company can announce progress in the U.S. within the next couple of months I would expect the stock to go gangbusters (2-3x within 1-2 years). So I regard rolling long-dated calls as a relatively cheap and safe way to take a position until we get clarity on the real interest level from telecom giants.

Energy Services of America – Energy and Infrastructure Upside at a Firesale Price

  • Trading below tangible book value with decent operational and growth trends.
  • Positioned for additional energy and infrastructure spending in the Mid-Atlantic region.
  • Undervalued due to minuscule ~$20m market cap, which makes it “uninvestable” for institutional firms.
  • Management has a large stake and a history of being shareholder friendly.
  • High potential for margin expansion, revenue growth, and increased shareholder returns.

Business Overview

Energy Services of America is a dirt cheap holding company with exposure to two different types of infrastructure. Based in Huntington, West Virginia ESOA operates two service companies, CJ Hughes for pipeline construction and maintenance and another, Nitro Electric which handles electrical and mechanical services. Revenue split is about 50/50.

From the 10-K issued in December:

Wholly owned subsidiary C.J. Hughes is a general contractor primarily engaged in pipeline construction for utility companies. C.J. Hughes operates primarily in the mid-Atlantic region of the United States. Nitro Electric, Inc. (“Nitro Electric”), a wholly owned subsidiary of C. J. Hughes, is an electrical and mechanical contractor that provides its services to the power, chemical and automotive industries. Nitro Electric operates primarily in the mid-Atlantic region of the United States.

CJ Hughes builds and maintains but does not own intrastate pipelines and sewer systems in the vicinity of the Marcellus Shale. So we’re looking at a relatively asset-light, regionally focused subsidiary, which services some pretty big corporate energy, chemical, and utility names, as well as some (probably more predictable) municipal and state customers.

cj001

Energy Services’ customers include many of the leading companies in the industries it serves, including:

EQT Corporation

Columbia Gas Distribution

Marathon Petroleum

American Electric Power

Toyota Motor Manufacturing

Bayer Chemical

Dow Chemical

Kentucky American Water

Various state, county and municipal public service districts.

Nitro Electric primarily services utility companies and municipalities.

nitropiechart
Nitro Electric Revenue Mix

ESOA overpaid for a pipeline company which it has since sold at a loss. In December of 2012, the company emerged from a forbearance agreement, and the company has executed nicely since then, with very high asset turnover >200%, growing EBITDA margins, and annual ROIs >20%.

Valuation 

Price to Tangible Book Value: 0.87

EV/EBITDA: 4x

Price to FCF: 7x

TTM Dividend Yield: 3.6%

The dividend is new as of this year, and is higher than all of the profitable energy service comps I could find. These metrics all indicate an undervalued stock relative to the oil services industry as a whole.

Energy Industry Outlook

I am not an expert on oil or natural gas fields, which is why I prefer to buy an energy services company with significant utility and municipal exposure rather than a pure-play owner of well or pipeline assets. From the research I have done it seems that while energy prices will likely be lower than the past decade, we may be near the bottom of the industry trough. Marcellus/Utica specifically is established and has cheaper cost of production than other shale fields.

Over the past several years, companies operating within the U.S. energy sector, and in shale particularly, have continuously lowered operating costs. OPEC’s recent agreement could further bolster the industry.

Management

ESOA is headed by Douglas Reynolds, the representative of District 17 in the West Virginia House of Delegates, and son of local Huntington business magnate Marshall T. Reynolds.

Since taking the helm at ESOA in December of 2012, Douglas Reynolds has increased tangible book value per share of the company from $0.43 to $1.43/share, a more than 3x increase. ESOA’s share price has grown by 150% over the past 4 years, vs the S&P500 at 50% and the Russell 2000 at 64%. The CEO has also been modestly buying the stock, and issued this letter to shareholders explaining why he felt shares were presently undervalued.

“I am extremely pleased with the improvements that have been made over the last four years with one exception: the under-valued price of our stock. In December of 2012, our stock value fluctuated wildly between $0.50 and $1.00 per share, and rightfully so, as we were under a forbearance agreement and were restructuring our balance sheet. On December 28, 2016, our last trade was at $1.38. This value represents less than the tangible book value per share of $1.58 at September 30, 2016. Our price to earnings ratio is 6.57 at December 28, 2016, and our backlog was $78.5 million at September 30, 2016 compared to $71.3 million at September 30, 2015. Members of the Board and management have been consistent insider buyers of the stock and hope that you will continue supporting us in what is poised to be a great fiscal year 2017.”

His father Marshall Reynolds also happens to be the chairman of ESOA and CEO of Champion Industries, a printing company which has not had a great couple of years, but keeps the lights on. Mr. Reynolds also sits on the boards of several banks financing the debt portion of ESOA’s capital.

Neither Douglas nor Marshall Reynolds appear to have significant experience in the energy services business. What they do both have is a significant personal stake. Insiders own >30% of the shares and Douglas Reynolds takes a modest salary around $100k/year. I would expect that both Doug and Marshall bring valuable Rolodexes to the business as well, both from local government and business connections. Additionally, they appear to be smart enough to leave the general management of both companies to experienced industry veterans.

Biggest Risks 

Customer concentration risk varies by year and project with such a small company, but Marathon Petroleum (Ticker:MRO) and EQT Corporation (Ticker:EQT) represented >10% of revenue for ESOA in 2016.

“The two customers, Marathon Petroleum and EQT, represented 18.2% and 17.6% of revenues and 40.6% and 11.3% of receivables net of retention, respectively. The Company had two customers that exceeded 10.0% of revenues for the year ended September 30, 2015. These two customers, Marathon Petroleum and Rice Energy, represented 14.6% and 22.8% of revenues and 14.5% and 32.6% of receivables net of retention, respectively.”

In a sector as wild as energy, accounts receivable write-offs are one way to look for issues with customer payments. Rising write-offs indicate that customers cannot afford to pay their bills. A/R write-offs have been negligible for the past two years. The company wrote-off ~$11k in A/R in 2015, which increased slightly to $14k in 2016, on roughly $100m in revenue.

Days Sales Receivables is a metric which gauges credit risk from customers as well as project completion, with a lower number of days being better. Days Sales Receivables in the energy services industry ranges between 65-90 days for the largest energy services companies. We should expect a company this small to have higher DSR. Days Sales Receivables have declined slightly from 112 to 106 days for 2016 and are on-track to decline further in 2017 due to sizable project completions in 1Q17.

The biggest A/R customer currently, Marathon, is highly levered, but does not appear to be in danger of bankruptcy in the near-future. MRO bonds are trading at or around $100+, signaling that creditors are not worried about Marathon’s ability to pay its bills. I could not find much on MRO’s break-even cost in the areas which ESOA services, but according to this EQT is one of the lowest cost natural gas producers in the Marcellus field. EQT actually seems well-positioned to roll-up other operators, which could be a good thing for ESOA’s backlog. Marathon’s outlook seems a bit murkier, but neither EQT nor MRO show signs of serious financial distress.

All employees of CJ Hughes are union members, which means some collective bargaining risk is baked-in. In total, ESOA employs 920 people. I would expect some pressure on SG&A in the form of wages. Additionally the company contributes to a few multicompany pension funds which are currently underfunded. I could not find any indication that ESOA itself is not paying it’s allotted portion.

The company’s debt schedule shows $9.1m coming due in 2017, which could result in lower FCF compared to 2016. I expect some of the additional debt repayment to be offset by about $1m less in CAPEX; the company purchased a building which Nitro Electric had been leasing in early 2016. The 10-K also mentions that management expects to renew the current line of credit. Given the strong local banking ties and solid balance sheet, I would expect some revolver debt to be rolled over to 2018.

Outlook for 2017 and Beyond

Energy Services of America is well-positioned to benefit from any increase in energy or infrastructure investments in the Mid-Atlantic region. The company reported a backlog of $78.5m as of the end of September vs $71.3m in September of 2015. First quarter is typically when you can get a good idea of the expected annual revenue, but 10% higher y/y backlog sounds encouraging.

Year over year the company grew revenue by 25.8% in 2015, and 32.5% in 2016, while at the same time improving operating margins and asset turnover. These improvements occurred in-spite of a tough 2-year stretch for energy service companies due to the global collapse in oil prices. The company is trading slightly below net tangible book value, and looks cheap relative to cash flow and EBITDA, which are both under 5x. The company also maintains a modest debt/leverage ratio of 2x. I’m not betting on lower tax rates, but ESOA also pays a current effective tax rate >40%. Tax reform would be yuuuuge for this company.

While the company is not the sort to provide detailed guidance, I found the recent 10k management commentary to be interesting:

“We were awarded several major projects in fiscal year 2016 that will be completed in the first quarter of fiscal year 2017. We will need to replace those projects in fiscal year 2017, but we feel the opportunities we are already seeing and our strong relationships with our customers will allow us to do so.”

The atypical shareholders letter issued on January 4th, and recent insider purchases seem to indicate that management is confident that recent growth and operational trends will continue.

Conclusion

I like nano and micro-cap stocks lately for several reasons.

  1. They tend to be much harder for big investors to buy put meaningful cash into without significantly moving the share price.
  2. They generally don’t have the same tax expertise as Apple or GE, so they stand to benefit inordinately from lower tax rates.
  3. They are often under-followed and consequently mispriced.

Due to an incredibly small market capitalization, ESOA is a difficult company for institutional investors to buy at any scale. The company has shown impressive operation improvements and has strong growth prospects. I believe ESOA is undervalued relative to the business prospects and to peers. The business fundamentals warrant another 2-3x turns in EV/EBITDA, which would put the stock price above $2/share in the short-term. A nano-cap penny stock like this should continue to maintain a valuation discount relative to larger names, but I expect management to continue to return capital to shareholders or to achieve an eventual sale of the company. To me this stock seems like a good long-term buy-and-hold prospect.

2016 Year-End Summary and 2017 Rankings

2016 was a pretty crazy year for me both personally and professionally. Professionally, I walked away from a couple of corporate fast-track opportunities in pursuit of a smaller company with more ownership opportunities and personality.

I also (finally) got to start living with my wife and kid, and now we have another one on the way! These confluence of events had me doing really weird stuff with my money. At one point I was something like 50% in cash in my 401k alone, aside from pulling all of my individual trading account cash out of the market as well.

I put most of my excess cash into Lending Club notes where I could earn a 2-5% annualized return (pretax) and not have to worry about a market downturn. As this money comes back out of the notes, I am building up my cash again.

asset-allocation-snapshot-12302016
Asset Allocations End of 2016

I’ve been stepping back into the market over the past 6 months in a mix of value, growth at reasonable price, and special situations or “workouts” as Warren Buffett used to call them, and a fourplex apartment complex as well (not captured in the above graph due to no significant equity stake at this point)!

I have only recently gotten back to blogging, so the closest thing I have to a 2016 ranking is from 3Q. Keep in mind that the results do not fully reflect my actual portfolio weightings.

3q-to-2016-end-performance
Performance from October 14th to December 30th

Crossed out tickers represent stocks which were either not owned or sold. I failed to anticipate a Trumpictory on November 8th, and I bought CSAL too richly. I expect the 9.5% dividend and growing appreciation for the business to improve the stock’s performance in 2017. A 5.8% gain in a single quarter is pretty fantastic, but is overshadowed by the market’s 8% return over the same time frame. The market usually returns 6-8% annually, so I think expectations could cool down in the next month or two, and the likelihood of a mini-selloff is high.  Consequently I’m attempting to position myself to hold onto my existing gains rather than stretch for more. I sold INTC recently because I bought it on March 9th at a lower price and after a 20% gain I do not believe there is a strong catalyst to justify continuing to own at this valuation. I am also considering liquidating my investment in VTI if I can find more attractive investments elsewhere.

allocation-2
Current Allocation

I also plan to add WellCare (Ticker: WCG), as part of my recent interest in healthcare stocks, which seem to have been inordinately beaten down over the past year. I am sort of astounded that defensible sectors like telecom and healthcare aren’t doing better this late in the cycle, and I’m pretty happy to jump in.

I am still developing my strategy, but I don’t believe the M&A spreads which I have been seeing will persist over the next couple of years. With greater regulatory clarity post-election, I expect more traditional players to start sniffing around again. So I’m looking to rotate into small stocks which are more likely than mid or large cap stocks to be severely undervalued. A $16 million market cap liquidating trust like my most recent investment ENZN, is much harder for an institutional investor to step into, and I’d rather look for solid returns of capital than lots of greater fools after 7 years of strong stock market returns in 2017.