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This is written with serious investors in mind, though sometimes they're just drafts in progress. I'm a former reporter, private investigator and institutional equity analyst who digs deep to find niche undervalued and undiscovered securities. I manage money for individuals, institutions and family offices via my business Long Cast Advisers. This blog is part decision-diary, part investment observations and part general musings about Philadelphia sports. It should not be viewed as a solicitation for business or a recommendation to buy or sell securities.

Tuesday, January 26, 2016

when the process works, the patient investor sits on losses (FTLF, VRX)

Two forms of regret I most often hear when talking with investors are:

I sold too early (b/c it went up)
I held too long (b/c it went down)

Surprisingly, I rarely hear anyone say: "I wish never bought that .... ". Buying the wrong stock is like having an STD; nobody wants to admit it but if you're active as an investor (or otherwise), it's probably going to happen.

For investors who rely on research as the foundation of their work, having a checklist or process can help avoid mistakes and, when they happen, provide for an easy and effective post-mortem if the mistake is the result of a deviation from process.

However, a flawed process, or worse, a mistake that precedes process - both of which can compound mistakes - must be exceedingly hard to detect. I imagine that navigating the solution to a flawed process requires an intense degree of self-reflection and might potentially be crushing.

I'm thinking broadly of something like Valeant, where very smart investors were proven to be very wrong. I don't know Ackman or Cuniff's processes and what - if anything - went wrong with them, but as an outside observer, I think their mistake was accepting the prime fallacy that a pharma can sustain itself without R&D. In my opinion, once they accepted that, they were screwed no matter the proximate cause for the company's revaluation.

This post relates to my continuing fears of an error in process tied to a stock that - like many on the market - is underwater for the year.

Specifically this post is about Fitlife Brands (FTLF), which sells sports nutritional supplements, primarily to GNC franchise stores but also increasingly to GNC corporate stores and independent channels.

I've written about it previously and I own and like the company. The stock, like many that trade on public exchanges, is down and though we all should conduct constant due diligence on our holdings, one's focus can really narrow when sitting on steep losses.

It is the nature of capital that we should have an urge to not lose it, but if we trust our processes, it's important to fight that urge, dig down and do more research.

Keep asking that question: "What don't I know?" and then try to learn something new, because selling a stock when it's down for no other reason is sheer idiocy: If I liked it at 1x, I want more of it at 0.6x.

So the losses I'm sitting on with FTLF got me out the door for more channel checks and more due diligence and for better or worse, most of what I heard reinforced what I already knew: store mangers love the brand and it continues to sell well.

I visited five stores that were owned by various franchisees that among them own more than 20 stores, and the majority of managers I talked with all said the same things: The company is great at selling, they are great at coming up with new brands and new ideas, and their sales people are smart, personable and know the product.

Trends were mixed - some said volumes were down for the quarter other that they were up - but they all said the company was awesome and the long term trend / outlook was from their perspective positive.

I talked to two store managers who had each been in the industry for +10 years and they said the "industry" clouds felt no different than prior cycles. One said volumes were impacted by "the Dr. Oz thing" and seasonality but nothing dramatic.

Another store manager said he'd been carrying the product since they were "nothing" and that he'd seen them grow "like this" (45 degree angle with his arm) and he still sees that growth ahead.

A manager repeated something I'd heard elsewhere, that FTLF reminded him Cellucor when it was just starting out. (Cellucor is owned by Nutrabolt which rec'd a minority investment from MidOcean Partners in July 2014).

One new - marginally negative - thing I learned is that the most successful franchise in the area didn't even carry the product. 

That franchise, in a mall with predominantly Chinese stores, doesn't carry a lot of sports supplements in general and my sense was they don't have to; Chinese are big buyers of supplements. 

I didn't see that as a huge issue and it certainly made sense to me. As a side note, I had been previously informed - with some sense of awe by another store manager - that this Chinese store did $7M in annual sales, an astronomical figure compared to the $2M-$4M / year that would be expected from other stores of similar sizes. Just some color on what a GNC franchise brings in the door. 

But the short summary is the channel checks reinforced most of what I already knew. 

So I've revisited my model as well. 

iSatori (IFIT) at the time it was acquired by FTLF was more distressed than anticipated b/c of poor balance sheet management by the prior exec team (reinforcing the opportunities to be managed by FTLF's excellent management team) leading to a lower share ratio in the acquisition.

By my math, FTLF issued 1.8M shares to acquire IFIT then repurchased 600k shares (I'm guessing at $1.50 / share) back from Stephen Adele, IFIT's prior CEO. 

So I estimate post deal FTLF has 10M shares outstanding and a slight net cash position. I maintain they can continue to do $30M sales / $3M EBITDA year one as a combined company. At current prices its trading at 4x EBITDA, which I think is an incredibly attractive price for something that has no impact from China, commodities, energy, f/x, etc.

On top of the overall market turbulence, FTLF has one specific headwind also previously disclosed and also related to the deal: IFIT's largest shareholder Russell Cleveland has about 460k shares he wants to sell and the company has the right of first refusal on the price.

This could lead to some turbulence in the near term, b/c I would bet the seller wants to get the most money he can and the buyer wants to pay the lowest reasonable price and I can imagine the seller using some leverage ala "I will dump every share on the market at $0.90 before I sell you my shares below $1.40" and them telling him to go ahead (for some reason I imagine this dialogue taking place with french accents).

This is a temporary non-operating issue overhanging the stock that should be resolved in short order, is not a surprise and maybe it's an opportunity to lower my cost basis.

Big picture is the CFO and CEO have a history of running this business profitably and with cash flow generation - even when growth has slowed in the past - I see no reason my thesis should change. In short, the stewards whom I entrusted my capital with continue to run the business with the same strategic aplomb as they've done before and as I expected.

Yet, with Valeant in periphery, I can't help but wondering if - even as I check every check in my process - have I accepted a prime fallacy that obviates the process?

I have two thoughts on what that might be ...

1) The supplement industry has intrinsic value.

I accepted the hypothesis that this is a large mature industry with ~$3B in sales that isn't going away overnight. There's room for innovation such that new brands are accepted and in some ways, it isn't much different from other consumer products (ie pop soda, for example) that aren't really good for you but are consumed in mass.

2) The company's push model advantage is sustainable.

Most of FTLF sales go through GNC franchises. GNC makes it's money selling wholesale to franchises and is expanding its franchise system so on its face, this points to more doors for FTLF. But  it makes FTLF that much more reliant on the GNC channel.

I had initially thought to hedge FTLF with a short against GNC in order to offset the risk of this situation - in retrospect it would have been the right call - but it seemed absurd to hedge a microcap with a short against a midcap. Maybe next time it won't be so absurd.

More broadly, internet sales of sports nutritional supplements is the elephant in the room. FTLF's model is to save on sales / promotional spend and push at the store level. But that won't work where the internet disintermediates the push channel. And that means it might need to spend on S&M, which would impact profitability / cash flow / etc.

... These are the questions that make investing hard and their answers, or how I choose to answer, will help me succeed or fail quickly in my business and more broadly help define my process.

Even as I sit on losses, I have to rely on my process or the emotional toll of price signals will be overwhelming. I want to avoid that.

I think my process is working. I still think is a very well run business - run for profitability and cash flow - with future opportunities for growth and margin expansion, going though some very specific turbulence regarding post acquisition shares (a temporary issue), some industry overhang (as it has done before) as well as some systemic issues that rains on all stocks.

Relying on a process doesn't make sitting on losses any more fun but it makes it bearable and its something a patient investor needs to accept, even perhaps as an opportunity to lower their cost basis.

-- END --


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