About Me

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Avram Fisher, Founder & Portfolio Manager of Long Cast Advisers, is a former equity analyst at CSFB and BMO covering industrials and business services. He has prior experience in private equity; as a corporate governance analyst; as a writer; reporter and private investigator; and as a lifeguard and busboy (I still clear plates when my kids don't). This blog is an open book of ideas about patient investing and about starting up a small-cap focused RIA. It is part decision-diary, part investment observations and part general musings. Nothing on this blog is a solicitation for business nor a recommendation to buy or sell securities. It is simply a way to organize and share thoughts with an expanding audience of independent, patient and talented small cap investors. www.longcastadvisers.com

Tuesday, July 24, 2018

Question sent from reader (QRHC)

I haven't posted in awhile. Companies I've written about and own haven't been operating as expected and their stocks aren't working either, which has lead to some combination of reflection (a good thing) and hiding under a rock (a less good thing). I've been struggling to sincerely articulate the experiences and painful lessons of "getting punched in the face" and hope to post something on that soon.

But I wanted to share my recent response to an email received from a reader on QRHC who asked questions around ...

executive comp ("Do you have any idea what the executive comp plan actually is?"),
commodity exposure ("I am trying to get a sense if it's possible that the recent increase in GM’s is related to commodity prices rather then fundamental profitability improvement"),
the Chairman selling ("it sure does look like Saltz is running for the exits as soon as the stock popped")
and finally about the lack of insider buying ("I can’t seem to find any evidence of Hatch buying stock on the open market even as it traded to $1.00.").

... I'll take the last one first.

On the lack of insider buying, I asked the CEO this exact question the last time I spoke with him, and it was the last time he spoke with me. Putting aside the slight frustration with getting ghosted by management over a layup question, all managers should be aware that avoiding questions is an "amateur hour" technique that's about as useful as a concrete life preserver. It doesn't make questions go away, it just means the askers have to find other sources.

Having poked around some, I don't know why the CEO hasn't been buying shares but I do feel comfortable that he is in his wheelhouse building a mid-market focused business, and that he is surrounded by good executives who know what they're doing.

I'm blind however to whether or not they have the right technology to grow the business, and that worries me, b/c this business needs good technology to scale.

I know that at Oakleaf, technology was key to the turnaround, but they had a CTO who was an MIT grad and is now CIO of XPO logistics. In contrast, it doesn't look like QRHC even has a CTO. A search on LinkedIn reveals two people who fit tech related roles but I'm not familiar enough with the technology departments at Fairfield University nor East Central University in Ada, Oklahoma to judge their pedigree.

According to the CF statement, in 2015 they spent $2M on capitalized software and that should be enough, if well spent, for a good system, but that's all I know. Growing revenues much faster than COGS would indicate a good tech system that obviates the need for more people touching invoices / receivables. Without that, this doesn't work.

In contrast to a management team that appears experienced and well-suited for a small mid-market focused business, the Board appears non-functioning. It is controlled by Mitch Saltz, the Chairman and majority shareholder, even as he sells shares into a guidance # I don't believe they will hit. Presuming he too wants a return on his investment, I wrote letters asking him they re-incorporate from NV to DE to better attract institutional investors and that they add an experienced industry expert to the Board to better monitor management, but he said no.

The exec comp - if that's what you want to call it - can be viewed as an example of the non-functioning Board, something that easily could be fixed if the Board wanted to, but they don't appear to care.

Want to see a vague exec comp plan?

"One or more of the following business criteria for our company, on a consolidated basis, and/or for Related Entities, or for business or geographical units of our company and/or a Related Entity (except with respect to the total stockholder return and earnings per share criteria), will be used by the committee in establishing performance goals for such awards:
(1) total stockholder return;
(2) such total stockholder return as compared to total return (on a comparable basis) of a publicly available index such as, but not limited to, the Standard & Poor’s 500 Stock Index or the S&P Specialty Retailer Index;
(3) net income;
(4) pretax earnings;
(5) earnings before all or some of the following items: interest, taxes, depreciation, amortization, stock-based compensation, ASC 718 expense, or any extraordinary or special items;
(6) pretax operating earnings after interest expense and before bonuses, service fees, and extraordinary or special items;
(7) operating margin;
(8) earnings per share;
(9) return on equity;
(10) return on capital;
(11) return on investment;
(12) operating earnings;
(13) working capital or inventory;
(14) operating earnings before the expense for share based awards; and
(15) ratio of debt to stockholders’ equity."

I think we'd all prefer to see a Board pick three of these and consistently pay on those parameters, at least so shareholders know the targets.

Getting to the last remaining question on commodity exposure, since the company doesn't own fixed assets, I don't believe commodity exposure on its own is a material driver of revenues or margins. A processor that owns fixed assets drives their business on the bill / pay spread of waste oil but here the broker only takes their margin on the total value.

In conclusion, with this investment, I've been focused almost exclusively on the three things that I think make this business work ...

right people
right market
right technology

... in short, management. I am confident on the first two. I have limited visibility into the latter. I've long said that as investors we need to hang our hats on facts that endure even when the market tells us we're wrong or when operations temporarily aren't performing as expected. I feel comfortable knowing what I know and hanging my hat on "this is a simple business with experienced people running it".

But I do think it might be time to elevate some Board and corporate governance issues in my investment weighing process. It certainly can be a more nuanced and potentially effective way of further separating the wheat from the chaff.

-- END --


Monday, April 30, 2018

IVTY Proxy: Board Compensation is Shameful

When Christopher Byron died last year, I was reminded of the years I knew him, my first two out of college, when I was an editorial assistant at the (old) New York Observer and he wrote a weekly column about executive compensation.

The obscenity of executive pay at the time was still relatively new and it was awesome to hear him talk about the issue. Now executive comp is an old obscenity, like a grandmother's curse. "Feh!"

Even in our topsy turvy world, it seems that the one thing everyone can agree on is paying themselves raises with other people's money. It is certainly the one issue on which all our government representatives tend to agree. All the more reason to continue to shed light on the practice.

For smaller companies, I typically see Board cash pay in the $10k-$25k range and a few thousand shares. Occasionally you see Boards putting skin in the game, though no examples come to mind at the moment.

Invuity's latest proxy demonstrates the wrong side of comp, a greedy, do nothing board paying itself an absurd fee justified by nothing. Here is the board comp for $75M market cap company trading at its 52-week lows, whose stock is down 65% over the last 52-weeks, 50% ytd and whose new CEO is trying to talk up better capital allocation to the street.

I'm sure Boards justify these things using comparables but the aspect of benchmarking everyone seems to forgets is adjusting plus / minus from the baseline depending on performance. So I'd be fine with them using a benchmark, just deduct 65%. Oh and by the way, granting oneself $125K worth of shares is not a form of alignment.

Here's the cash comp they intend to pay themselves next year, roughly the same as last year. That the Chairman takes a small cut infers he knows it's excessive, but the cutback isn't nearly sufficient.

The company reports quarterly earnings in a few days and based on the stock's recent performance, I guess the market expects 1Q18 sales below consensus $9.5M and / or management will lower already conservative guidance of 5% topline growth.

It would be pretty dramatic if this happens on top of plenty of drama year to date: The new CEO was announced in mid-February and there was an equity raise in March.

Whatever happens, the new CEO will have to articulate a lucid and reasonable plan, and I expect he will. As I see it, the reasons for owning the company haven't changed much: Great product, selling okay, scaling the marketing curve, with optionality to do much better under better management, and with the whole company selling for less than 2x sales.

Here we are under ostensibly better management and I have been trying to keep my head about even as the stock slides and the anonymous comments pile up on CafePharma. Obviously, I think investors will get paid or else why would I own this, but I think the aspects that I underweighted in my initial analysis, notably the prior CEO's spending ways and the excessive Board comp, takes on increasing weight under the new CEO, and I just keep thinking "The Board should contribute not detract from the new CEO's efforts by making material changes to their comp." I recommend a few changes in the letter I sent today.


Dear Chairman:

I was shocked and disappointed to open my Invuity proxy and observe continued excessive Board compensation.

What you pay yourselves even as you’ve overseen significant and material destruction of shareholder value should outrage Invuity’s employees and customers from whom you are effectively taking much needed resources. Furthermore, the extent at which you sell shares and the miserliness with which you personally buy them should outrage shareholders, the majority of whom have lost money on this investment to date.

No doubt, a compensation structure that exists only to enrich yourselves fit comfortably with the norms, cultures and behaviors of the prior CEO, but this has no place in the current strategy of managing capital more efficiently and effectively.

We have a new CEO who is working hard to improve so much prior mismanagement that occurred under your watch and that resulted in the evaporation of capital market credibility. The Board can help him re-establish credibility by following a sane and reasonable compensation structure.

I recommend the following two steps to show faith and confidence in his efforts and in the company in general:

Take no compensation until the firm starts earning money.

Buy shares with your own personal money until the Board effectively owns 20% of the company.

Lead by example. Stop this senseless self-enrichment. It will do right by your employees, customers and shareholders and it will materially and beneficially contribute to the company’s new efforts towards a wiser and smarter approach to capital allocation.


-- END --


Tuesday, April 17, 2018

LCA 1Q18 Letter: "On Testing An Investment Hypothesis"

I included this short piece as part of my 1Q18 letter posted on the Long Cast Advisers website.


I like to make as few decisions as possible and react as little as possible to short-term changes in price. However, as the largest single client in the firm, I definitely feel it when stock prices go down. And when they do, as they will inevitably, I increase my research to try to better test the hypothesis, because I want to make sure I’m not missing anything while taking advantage of the opportunity to buy more.

Thinking about this, I’m reminded of a wonderful article I recently read in my alumni magazine about the physicist Andrew Ewald’s work on metastasized cancers. I recommend the entire article but this paragraph alone blew me away. It speaks to the amount of time, effort and experimentation involved in simply tracking information that might be useful:

“He reconfigured his microscopes to image hundreds of positions in quick succession while staying in perfect focus. And he replaced the light filters. Microscope designers typically enhance their instruments' resolution by blasting a sample with as much light as possible. But light that bright kills cells. "Bringing in more light looks fantastic for a few images," Ewald says. "Then the sample dies." He took a different tack: He carefully guided the scope's light beams to make each photon do more work. He managed to supercharge his resolution while keeping light levels low enough for cells to survive indefinitely. He wrote software that made the microscope take a picture every 10 to 20 minutes for up to 100 hours. He calls the technique 4-D confocal microscopy—the fourth dimension being time. He calibrated his equipment to collect not just images but numbers—quantitative measures of cells' positions, velocities, and trajectories.”

What an intense and extraordinary amount of work first identifying a problem then testing different solutions. It got me thinking about how investors test a hypothesis related to an investment idea.

All public investors have access to self-reported financial information published quarterly; macro-economic information published regularly by the government (and supplemented by private sector service providers); and their own abilities to reason. These are good primary sources to help form a hypothesis.

We also have access through Seeking Alpha, Sumzero, VIC, et al. to other people’s views on a stock. And of course, the most expedient piece of information is the stock price, which is essentially the aggregate of what everyone thinks.

There is value to knowing what everyone else thinks, but it often serves more as a “bias creating machine” than a “hypothesis testing machine”.

I recently met a PhD psychology student at Stanford who told me: “There’s lots of human error out there, that’s for sure,” which is a nice way of saying something a lot of us probably wonder from time to time. It gets to the heart of my belief that the markets, theorized as an efficient method of price discovery just as often amplifies human error.

If you want to do better than the crowd, you have to do different. With nearly two decades of investment experience, and a foundation of healthy skepticism, a little irreverence and a lot of humility, I think it is possible to sustainably and repeatedly do better than the crowd. The question is: How?

Part of my work, which was informed by my brief experience in 1996 working as a PI for BackTrack Reports, involves interviewing people. Without care, interviews can lend towards biases (small sample sizes, weak connections, etc) but a good source (customers, executives’ former colleagues, competitors who always love to dish dirt, experts in certain fields) asked the right open-ended questions can add value that is not otherwise available elsewhere. It is a sharp relief from talking with other investors who more often than not don’t want to hear or haven’t considered the bad news. (The best ones do, and most likely already know it.)

I know I’m not the only investor who interviews people and I know that as a “hypothesis testing machine” it is imperfect. But I think marrying the quantitative analysis of financial statements with the qualitative aspects of “walking around and talking to people” helps reduce some errors.

Whatever the favored method is, the key is to first figure out what we’re looking for, then try to figure out how to find it. It’s hard and it’s time consuming and you never know if what you’re going to find will add value. I start with asking “where am I wrong” in order to seek out what I don’t know so I can find ways to disprove the hypothesis. Asking the right questions is one of the hardest parts to solving any problem, investing included.

There’s no one answer and we can all find our paths to success. But following a scientific method has tremendous value. I realize that comparing the humble and greedy aspects of business valuations and investing doesn’t hold a candle to cancer research, but in taking a professional and scientific approach to the work, at least we can match the integrity of it.

-- END --


Monday, March 26, 2018

"The Past is History, Tomorrow's a Mystery": On Paying Backup Prices for Starting Talent (CTEK, PSSR)

In a post-game interview after beating the Giants in a January 2007 playoff game, Jeff Garcia, then QB for my Philadelphia Eagles, said: "The past is history, tomorrow's a mystery, today's a gift" (sadly he didn't complete the aphorism: "that's why they call it the present.")

The premise of the comment was to "live in the moment" and it was made in response to a question about Garcia's unlikely rise from backup to playoff hero, a role I might add that was reprised and expanded on even more heroically by Nick Foles, 11 years later.

Investors, like athletes, should as much as possible "live in the moment" by putting their heads into their work of reading, learning and analyzing, and then making most of opportunities when offered by the occasionally mis-priced market.

Athletes are "talent" but investors are "talent evaluators". We look for managers and executives at a company, who themselves need to allocate their assets optimally. It is capital allocators all the way down.

And where a professional athlete's drive and focus directs them to only one outcome (with a focus on winning) the investor's world is by nature much more probabilistic. We need to consider the range of potential outcomes from success to failure, the inputs to those outcomes, and weigh the likelihood of each.

In our role as a "talent evaluator," I (and I'm sure many others) place a lot of emphasis on historical results as a reference for understanding what worked and why, and how in our assessment of future outcomes, these same managers are likely to behave given a set of changing circumstances.

But sometimes the near and / or distant past offers little guidance, b/c the product or company is new, or has an unremarkable - or even tarnished past - so the future opportunities aren't immediately apparent on form or financial statement. And since most people tend to repeat their behaviors, for better or worse, something significant needs to have changed for the trajectory to change, or one need be aware of the factors that lead to poor historical results. Getting back to the sports analogy, most viewed Foles' history with the Rams as sufficient to dismiss him as a potential starter, but they may not have understood how capable Jeff Fisher was at ruining QB's.

Companies with unremarkable histories are inherently lonely trades b/c understanding the opportunity requires some knowledge of what's changed / is changing, or requires some digging and / or comprehension of accounting, or simply requires the kind of patience that is unusual on Wall Street. And it usually takes time for these changes to filter through.

A simple example that comes to mind is PSSR, which I've written about previously and which I've patiently been accumulating even as the near history shows profits turning to losses, negative cash flow and evaporating BVPS.

This negative change of recent history is primarily a result of SG&A growth +21% CAGR 1Q15 to 1Q18 TTM while over the same period, revenues growth of +7% CAGR. The slowdown in sales growth was primarily due to a single customer not renewing a contract in 2017. (PSSR is a tiny $18M EV company; investors should consider the risks / consequences given the impact a single contract can have on the P&L.)

If you stopped at this unprofitable inversion, you'd miss the potential conclusion of that spend. When the "S" of SG&A is spent wisely and consistently, that "S"elling effort should result in a resumption of sales growth. It is the job of every investor under any scenario to assess for themselves the reasonableness and probability of "should" and where "should" elevates to opportunity.

This isn't an ideological "should" ("We should have ice cream for dinner every night") but one based on causality and reasonableness ("if you study hard you should do well on the test"). As a caveat, I warn those away from ever investing on the thesis of what Congress "should" do, b/c in my experience at least, it never does.

The nice thing in the case of PSSR (and other subscription-based companies like them), is that the balance sheet offers a peek into the future via deferred revenues, which has grown to new highs, indicating some traction (at long last) that "S"elling is converting into sales.

Therefore, there is a reasonable probability that revenues over the next 12-months should grow to new highs (back of the envelope assumes +$16M in 2018). This would infer some re-normalization of revenue growth > expense growth and a return to profitability.

And this is potentially just the start. Given the growth in demand for air travel concurrent with capacity constraints at airports, et al., one may anticipate that the airline industry should continue to want (and perhaps even rely upon) even in an ADS-B world, the type of technology solutions that PSSR offers (surface management, diversion management, fee management, etc), and that spending for that offering could be sustained by the strong positive economics experienced by the airline industry (provided fuel costs remain stable).

That PSSR has access to permanent capital sourced from their Chairman who is 76 years old, owns 55% of the company and has a long history of operating with an eye towards wise & capital allocation further aids my view. That his age creates a form of impatience makes it even more interesting b/c in a sale, this I believe could go for multiples of the current public market valuation.

Nobody knows the future ("tomorrow's a mystery") but with PSSR the probabilities seem attractive, at least to me.

All that said, it is actually not my endeavor here to write about PSSR but about another opportunity that seems like a lonely trade, where one can pay backup prices for starting talent, and where the past seems unremarkable but the future potentially rewarding.

In this case, I refer to Cynergistek (ticker: CTEK), which at the current price of $4.75 has a roughly $45M market cap company and by virtue of nearly $17M in net debt outstanding, an EV of $62M. At 8x EBITDA, and with foreseeable growth in its high margin cybersecurity business, it seems like an opportunity. And as we discuss later, the filings actually show some championship style historical financial statements, but an investor would need to dig to find them, an endeavor that would require more effort than trying to find pretty much any athletic statistic at the minor league, college or CFL level.

CTEK provides two niche service - cybersecurity and managed print services - to one niche type of customer - hospitals and healthcare institutions. 

About these services, in brief ...

1. Cybersecurity. This is the prize of the company. It is a consulting / staffing business, with low revenues, high margins and high cash flow. It is a service that utilizes highly skilled, trained, personable, customer service oriented folks with advanced knowledge of IT. The contact point with the customer tends to be the CIO or CTO.

2. Managed print services (MPS). This is a cash generator but an otherwise unattractive, low growth, low margin service for managing the purchases of printer supplies (toner / paper) and equipment (printers / copiers). It tends towards high and lumpy but low margin revenues (based on the timing of pass through equipment purchases). Traditionally it utilizes low skilled, personable customer service oriented folks with basic knowledge of IT. The contact with the client is the purchasing office.

... the company itself is the result of an acquisition where publicly traded pure play MPS company "Auxilio" acquired privately held cybersecurity company "Cynergistek", and then changed its name to Cynergistek.

I'll discuss more about this acquisition in a moment, but for now, here's a slide from their investor deck showing services offered. These are primarily consulting type offerings with some staffing and some MPS.

Why in brief this investment works ...
  • This is primarily a services business that makes money (broadly speaking) on the bill / pay spread of a utilized employee or contractor. 
  • The company has access to talent though a strong military connection that helps provide a quality labor supply, which is often a constraint in services businesses. More importantly, it is a constraint for customers who cannot otherwise access this talent.  
  • The company also owns technology that can be utilized for remote / automated engagements, which enables some scaling.
  • The risks of a cybersecurity breach means spending on it should no longer be discretionary. 
  • Customer spending supports growth in contracts = Grow sales. Leverage O/H. Generate cash. Pay off the debt. Value accrues to shareholders + potential multiple expansion.
  • Publicly traded staffing comps trade 10-15x FORWARD EBITDA. This is trading at 8x trailing.   
Why in brief this investment fails ... 
  • Customers don't have fat wallets. Post ACA, healthcare institutions have fragile income statements. That means long sales cycles and competition. 
  • A corollary to stressed financials is that it can lead to consolidation, which would shrink CTEK's market. 
The optionality of end market expansion beyond the thin-walleted healthcare market into education and academia offsets what I believe to be the biggest risks of the investment.

Since the company recently reported 4Q17 results, let's look at the present through this brief peak into the financials ...

... the contribution of the lower revenue / higher margin cybersecurity business means OpInc + EBITDA growth much faster than revenue growth. Investors who just look at topline growth are missing the picture entirely.

My view is that over time, mix shift towards faster growth / higher margin cybersecurity business justifies a higher multiple even if overall revenue growth slows. If this plays out over time, I'd say at current prices, the present really is a gift to investors.

"The Past is History" (ie a brief look at how we got here)

Going back to early 2000's, Auxilio (as this publicly traded company was previously known) was a pure play MPS business. It was managed capably under prior CEO Joe Flynn, except for the period '06-'09 when he left to pursue other opportunities and the company was incapably managed by someone else (Flynn returned in 2009).

Like everyone, Flynn has positive and negatives. One of this strengths was anticipating that the MPS business wouldn't offer enough growth or profitability for the long term so as far back as 2014, he started pursuing a cybersecurity offering.

He made two small acquisitions to implement the change: Delphiis for $2.7M in mid-2014 and RedSpin for $2.6M in early '15. His weakness however was making / integrating acquisitions. By the end of '16, the goodwill on both those deals was written down.

Then in January 2017, he cracked open his wallet to acquire Cynergistek for $34M. That acquisition cost $27M upfront, consisting of ...

$15M in cash (borrowed from a bank)
$2.8M in stock (1.2M shares valued at $2.40 / share)
and $9M seller's note

... with the potential earnout of an additional $7.5M to the two founders of Cynergistek, Michael "Mac" McMillan and Dr. Michael Mathews. (All the proceeds of the deal went to them).

At the time of the deal, core Auxilio was a $3M EBITDA company. As per deal press release: "CynergisTek generated approximately $15 million in revenues and $5.0 million of EBITDA in 2016." Thus, the acquisition was valued at 7x EBITDA fully loaded.

The two entities together offered a company with 2017 EBITDA of $3M + $5M = $8M, though by the end of this year, despite some cancelled contracts, it got pretty darn close.

Early into the acquisition, the company did a few things that had been anticipated ...

changed its name from Auxilio to Cynergistek to reflect the emphasis on CyberSecurity
moved its state domicile from NV to DE, a shareholder friendly move

... BUT financial results for 1H17 did not set the trajectory of an $8M EBITDA company.

Turns out, both the acquired company and the core company were experiencing contract churn + delays to new contracts. This Q/A b/t Jeff Bash (an investment analyst) and Paul Anthony (CFO) on the 2Q17 conference call sums up the issue ...

... the two key issues with the 1H EBITDA shortfall were ...

1. negative surprises aren't welcome in the investment world.
2. the difficulty the company could have funding the debt, with about 60% owed to a bank and 40% owed to the prior owners of Cynergistek

... then, more surprises post the deal ...

In October 2017, Flynn left, replaced by "Mac" McMillan, founder of the original Cynergistek. (Flynn went to a small private MPS business).
In March 2018, the COO of Cynergistek left, took his earnout with him, and the company refinanced the debt in order to pay off the bank and prior Cynergistek management ahead of schedule

... obviously, not everything went according to plan. It's a bit screwy and a bit weird and for investors who acquired this at the time of the acquisition, a bit frustrating. But, "the past is history" and at the end of all these changes, Michael "Mac" McMillan is like a QB that catches their own pass; he sold his company, pocketed $15M and now runs the company again along with it much larger acquirer.

It's a small sample size and not the easiest data point to find, but the filings from the acquisition show financial information for then privately held Cynergistek that perhaps indicates "major league" talent.

From 2014 to 2016, McMillan's company generated topline growth, margin expansion and strong cash flow generation ...

... that the cash on the b/s doesn't grow is simply a function of an annual "draw" by the business owners of $2M, $4M and $7M in 2014-2016. Even before the acquisitions, this business created a lot of wealth for its owners. Over the two year period, adding back the "draw" they grew BV +80% CAGR

That's where tomorrow's mystery comes in. Is it reasonable that he can continue to create value for owners today? Certainly there are reasons to consider either way.

One can blame prior management for overpaying for Cynergistek (and other acquisitions), for not doing enough due diligence to see that core and acquired contracts were at risk, that perhaps levering up in the near term might create risk.

One could argue, (as I do) that we should see more insider buying by the board and by the newly enriched management team of much more stock at current prices. (I'd also like to see more alignment of incentives towards lower DSO's for line managers and cash earnings for upper mgmt.)

The company has recently cleaned up its debt situation, but one should acknowledge that "putting the pieces into place" is not equal to value creation; rather its the performance of those pieces that creates value for shareholders. They need to continue to show results.

But even as the company digests these changes, it has transformed into a higher value business, though its not necessarily evident right off the bat. You won't see incredible topline growth with the cybersecurity business but rather margins and cash flow generation. And to see evidence that they've done this before, you'd have to dig to find it.

For the patient investor, with the past as history, and today's valuation a gift, tomorrow's mystery does not need to be a complete thriller to experience the opportunity. It could actually be boring, and investors can still win. Just the way I like it.

-- END --


Thursday, February 15, 2018

Investment Diary: Reflecting on IVTY ( + / - ) and why buying more despite frustration might be the right step

Asked recently what my thoughts were on IVTY, after meeting management at the Leerink Conference, my reflections belong in this investment diary:

Competition isn’t the issue.  The issue is the way the company is run: I observe that investors are attracted to the company's product, but the big spend is on developing a sales organization. It is difficult and expensive to do this from scratch. What frustrates me as well is that a native sales force seems so outdated but everyone says "that's the way its done".

Since I just had the science fair experience with my 5th grader it very much feels like we shareholders are the kids with the science fair project (cool product!!) and dad (Phil) has taken it over to force a costly & time consuming sales org down our throats, while also taking all our babysitting and snow shoveling money.

So what do we do from here?

As always I like to look at history. Sawyer's last company was Fusion, which was acquired by Baxter in 2002. The story I've heard a lot from two sell side analysts who cover this industry is that "Phil sold Fusion too early and doesn't want to make the same mistake with IVTY" 

A few screenshots tell us something that offers perspective, a potentially different narrative and certainly a cautionary tale.

First, look at FSON's volatility / awful stock market returns!!! When it comes to the pain of stock ownership, Invuity shareholders have nothing on FSON shareholders.

Consider that the company was eventually sold for $10 / share. What a tremendous destruction of shareholder capital by Mr. Sawyer. And it begs the questions: Did he really sell too soon or was he forced to sell from frustrated investors?

Concurrently, look at how much stock Phil was taking on top of his salary compared to everyone else. It sort of looks comparatively the same relative to the colleagues but still a fraction of the +$1M he paid himself last year.

(it's a bit interesting / weird / tidbit to note that no one from the board or the executive team from FSON appears to be involved in IVTY. this could be totally meaningless and arbitrary but if you asked me to start a company tomorrow I'd hire people I've worked with in the past.)

and finally, look at how much they spent on sales / marketing relative to flat R&D and consider that IVTY doesn't even have a head of R&D anymore

All of it reinforces what's really going on here: they're building a sales force and the early steps are costly and is not going at the expected trajectory. but is it failed? 

A few things to keep in mind ... 

if history is a guide, stock market volatility should be expected  
there is value in a good sales force, even if they haven't built it yet. and maybe they are learning / adapting as they go? 
we originally bought this company b/c they were narrowing the gap between sales / marketing, here they have finally bridged it while growing (more slowly than expected) accounts and procedures. 

... at less than 2x sales, why shouldn't we buy more? 

two things have changed 

our frustration
the balance sheet. and this is where I erred months ago. i should have re-evaluated (and maybe sold) when they levered up, b/c that changed the valuation

... but standing here today the reasons for initially owning this have only improved 

Investing is a very hard business. And let me stress it is preferable to become part owners of companies with master capital allocators at the helm. But I have found myself in certain frustrating situations and this is one. This is where research and due diligence come in. Information provides a reference point no matter what the market tells you day to day. For me, it's these three charts and a low valuation that of course could get cheaper still. 

-- END --


Wednesday, February 14, 2018

A Few Quick Tidbits on PSSR's 10K

Fiscal year 2017 was the first year since fiscal year 2005 in which the Company did not generate positive income from operations. While the Company fully anticipates returning to positive income from operations in fiscal year 2018, future liquidity and capital requirements are difficult to predict, as they depend on numerous factors, including the maintenance and growth of existing product lines and service offerings, as well as the ability to develop, provide, and sell new products and services in an industry for which liquidity and resources are already adversely affected.


The Company relies on a small number of customer contracts for a large percentage of its revenues and expects that a significant percentage of its revenues will continue to be derived from a limited number of customer contracts. The Company's top five customers accounted for 58% of its revenue in fiscal year 2017. The Company's business plan is to obtain additional customers, but the Company anticipates that near-term revenues and operating results will continue to depend on large contracts from a small number of customers. One of the Company's customers, who accounted for 11% of total revenues during fiscal year 2016, did not renew a contract that expired on December 31, 2016.  However, notwithstanding the $1,400,000 loss resulting from the non-renewal of this contract in fiscal year 2017, the decline in subscription revenue in fiscal year 2017 totaled $538,000. The Company anticipates that the $538,000 decline in subscription revenue will be more than offset in fiscal year 2018.


they are really ramping up >> The Company has a sales office in Bloomington, Minnesota and McLean, Virginia.  The Company entered into a new five-year lease in December 2017 for a regional office in Irving, Texas, at an average annual rental rate of $60,000.

vs last year >> The Company has a sales office in Bloomington, Minnesota.


They called out a new product with heightened relevance >> A new product scheduled to be released Winter/Spring 2018: Regional Diversion Manager ("RDM") addresses the problem of highly disruptive large diversion events when a small set of airports get overwhelmed with diversions, while other airports have unused capacity. The result is extended delays, cancellations, and disrupted schedule recovery. Airlines need to know where everyone is diverting (not just their own flights) as well as the "capability status" of potential diversion airports (gates, fuel, deicing fluid, hardstands), airports, Customs and Border Patrol, and Ground Handlers. Airports need to know how many diversions are headed to them, what type of aircraft, which airlines, and whether crews are likely to time-out. PASSUR RDM addresses these challenges by creating the first-ever platform that ensures real-time information exchange and coordination between airports, airlines, and other key stakeholders during large-scale diversion events. It is designed to reduce cancellations related to diversions, and accelerate the recovery to normal operations.

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Thursday, February 1, 2018

Letter to Invuity Management ($IVTY)

There is no lacking for investment ideas, or the newsletters pitching them. Most of it is "noise" and it is enough to give anyone brain damage.

"Noise" not b/c they are bad ideas - who am I to say what is a good idea or bad idea - but b/c we all have limited capital and therefore must choose our investments wisely so as to get a return that compounds faster than the rate of inflation, perhaps even in excess of market returns over time and while still permitting a sound night of sleep.

So when I've already made a decision to become a part owner of a company, unless something materially changes, I intend to own that company indefinitely. I don't want to churn ideas. I certainly don't want brain damage, though this business can cause it for sure.

Safe to say, it is easiest to own companies whose values only go up. When their values go down, investors have three choices: Sell, buy more or do nothing. That decision should be based on a reassessment: Was I right or wrong with my initial consideration? And where are we now?

A good guide is the simple question: "What have I missed?" A most poor (though frequent) option is to seek out fellow investors who only reassert an initial thesis without comprehension or curiosity of what they're all doing wrong or what has changed for the worse. Better to focus on "what are we missing" than the company of misery.

I am writing this with Invuity in mind. It is now back to trading with a $4 handle and I am reassessing what to do.

I do not believe there is an intrinsic flaw with the product but I do believe management is entirely culpable. They have acted with the kind of behavior that I regard as "stupid". Short term focused. Capital destructive. I've written them a letter which I include below.

When I consider what to do, I reflect on the following:

A year ago, when I initially wrote about the company and started acquiring it, the stock traded with a $4 handle. However, back then, the company had $34M in net cash and therefore an EV substantially below its market cap.

As we revisit the same $4 handle today, it is important to keep in mind that the balance sheet is entirely different now. Currently, the company has $5M in net debt. Thus, despite a similar stock price, the EV is about 2x what it was a year ago.

I initially bought this a year ago at ~2x EV / GP when it had $21M in trailing GP. A price I considered a steal. Today they have $28M in trailing GP

Thus, for the stock to revisit my initial valuation - a potential scenario (what isn't a potential scenario?) - the stock would have to get to $3 on the nose. I expect it has the potential to get there when they report 4Q17 / year end earnings ... and miss guidance. I have no particular insight into whether or not they will miss guidance, but they have done so fairly consistently for quite sometime, so why shouldn't they again?

I continue to believe they have a winning product and evidence suggests as much. The letter below is intended to express my hope that they will get righteous for the customers first and foremost and then enrich themselves on their success, and not focus on the latter without due consideration for the former.


Dear Chairman:

It is my belief that a product that solves a long-standing problem for its customers, sold at a reasonable price, and at a margin that generates profits for its manufacturer is generally a good starting point for a winning investment, especially when that investment can be purchased at a low multiple.

At ~2x sales, I believe Invuity has these initial ingredients, which is why I and my clients are holders of roughly 35,000 shares.

But good products alone are not enough to weigh the odds favorably for long term success. The investment world is littered with the detritus of mismanaged companies that HAD terrific products. Rather, long term investment success requires executives and managers who make sound capital allocation decisions to generate growth and cash flow, towards the eventual goal of self-funding operations.

[I included here a footnote ... "I urge you strongly to read Amazon’s shareholder letter from 1997 to fully understand and internalize what it means to invest for the long term so you can reflect on the many ways Invuity can improve in this regard."]

I am writing because I want our company to avoid the fate of detritus that plagues so many other promising small companies simply on account of poor decisions by its executives and managers. With your public equity returns down nearly 70% since the IPO concurrent with a nearly +70% return for the IHI Medical Device ETF, I am certainly not alone in my concerns.

Fortunately, I do not believe there are many issues that need resolving. Unfortunately, the issues seem to emanate from the core and culture of the wrong ways of doing business: Short term-ism, impatience, “Wall Street” pandering, and disregard for customers and shareholders concurrent with overly generous compensation for executives and directors.

This must change.

You and the Board and the Executives must engage your full facilities of good capital allocation. Reverse the trends of short-term decision making and focus instead on the long-term growth of the company, for benefit of the company’s customers first and foremost. When your customers knock down the doors to get your product, you, your employees and your shareholders will all benefit.

The issues I observe that lead me to write this letter all reflect an absence of clear, simple thinking on the long-term development of the company and its markets:

1. Location. The decision to locate product assembly in one of the highest-cost regions in one of the highest cost cities in the country is inexplicable. This is not a tech company vying for high skilled talent.
2. Executive comp. Phil is wildly overpaid, both in comparison to similarly sized companies in the same industry and on an absolute basis. A company this size should not be paying $1.5M to its CEO, nor should it be compensating its Directors as generously as it does. I’m sure you could point to many small successes that you believe justifies this compensation, but until Invuity is on a path towards funding its own growth, you are not successful.
3. Sales strategy. In the last year, and despite the company’s infancy, Invuity has had two different heads of sales and embarked on two different sales strategies. I appreciate that the new sales strategy is intended to create a more durable selling-culture for the company. But if this is true, why did the company initially pursue a strategy of stuffing channels through experienced mercenary hires? I imagine you were trying to show a “fast start”, which leads one to wonder, for whose benefit? It appears like a decision driven by short term-ism.
4. Guidance. Personally, I see no reason to provide guidance at all but I accept that those without imagination cling to “business as usual”. That you consistently miss your own guidance however … what is there to say about that?

Were these failings simply examples of growing pains, this letter would not be warranted, for the patient investor endures these knowing that smart, self-reflective and adaptable management turns early missteps into future strides. Unfortunately, our management appears to be missing opportunities to adapt and improve. Rather it seems intent on continuing to promote its decisions as sound despite ample evidence to the contrary.

I am a shareholder of this company because the product solves a long-standing problem. Doctors I’ve talked with who have used the product overwhelmingly approve. Those who haven’t overwhelmingly respond: “If it does what they say it can do, that would be amazing.” (The two criticisms I most often hear from customers of your lighted yankauers and bovies are that they are too expensive or that the disposability creates unnecessary waste.)

I am also attracted to the optionality in this investment. First, despite so-called “obvious problems” such as …

The product is too expensive for cost conscious customers
The equipment doesn’t have a CPT code so it is not reimbursable
The environment is not ripe for hospitals to spend money on discretionary products

… you’ve grown sales from $7M / year in 2013 to $32M / year in 2016, or 65% CAGR, and over the same period, gross profits have grown 95% CAGR. Something is working.

Furthermore …

If you can generate +70% gross profit margins in Potrero Hill, I imagine what you can generate assembling in a low cost region and when you actually achieve scale.
If you’re doing 31k procedures / quarter selling an expensive item to just a few verticals, I imagine what you could be doing if you sought ubiquity, selling at a lower price but across many more procedures, and helping so many more patients as well.
Finally, I consider what $30M in gross profits and a novel new product portfolio might be worth to a company with an existent sales force, run by a management focused on wise capital allocation.

In short, I own this because I look beyond yesterday’s and today’s poor decisions, with the expectation that in the future, better stewardship of capital – by you or someone else - will unlock the value.

At the current rate, a new capital raise will be required in 12-18 months. I simply want to ensure that the allocation of current and future capital is put to its best and highest use, through a reorientation of goals and expectations towards a more long term focus, a more customer-centric focus and bounded by patient and wise capital allocation,


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