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

Friday, April 29, 2016

"In a word: Good. In two words: Not good" Reviewing $FTLF and $FHCO

A friend of mine recently told me this terrific joke ...  

Two old mates run into each other.
"How are you?" says one
"In a word: good. In two words: not good." 

... incongruency, surprise and some revelation of truth are key sources of humor according to Freud - they certainly make the joke work.

They are all key elements of investing as well.

Responding to the inevitable surprises of investing with an even keel, without emotion, by revisiting assumptions and figuring out the important lessons to takeaway are among the essential elements of patient investing.

This post is about recent surprises regarding stocks I've written about: $FTLF in its recently filed 10K and $FHCO with its recently announced merger with Aspen Park Pharmaceutical.

***

There are many moving parts to $FTLF and the summary thesis, which I laid out in an earlier post, is as follows:

FTLF makes branded sports nutritional supplements
They sell primarily (+90% of revenues) brand exclusive products to GNC franchise stores
They are "in" ~900 of GNC's ~1,000 franchise stores.
Previously, they sold direct to these locations
At year end 2014 GNC notified them that they were no longer able to sell direct and would be required to sell through the GNC wholesale channel
Franchisees stocked up on inventory; sales expanded, then collapsed and 2015 was a year of slowly returning to prior levels.
The company just anniversaried the year's disruption from this channel change (a good thing; comps are easy), but the change brings with it the following negative issues ...
GNC is now an intermediary and has more control on price. Sales are discounted ~15%. Some of that is made up via lower shipping costs and the disappearance of transaction fees offset by higher DSO's. Furthermore, a primary benefit of direct sales to franchises was the opportunity to offer a copycat product at a lower price to the consumer and a higher margin to the franchisee. Franchisees we've spoken with said this remains true but at lower levels (ie its still a higher margin product, but not as much).
... the three big tailwinds for the company are 1) y/y comps are easy so we should dd organic growth all year, 2) they recently acquired a poorly run competitor but with a product that consumers and stores like so overall topline should be quite dramatic ~50% y/y and 3) best of all, over the next three years, GNC is transitioning 1,000 corporate stores to franchise stores meaning - at face value - shelf space for their core customer and core business is about to double. I say "at face value" b/c this is a brutal competitive business with incredible competition for shelf space. It is fought franchise by franchise and store by store by sales rep educating the local salesforce on the value of the product.

$FTLF filed its' 10K 4/15 and it came with good news and bad news. I'll start with the negative surprises ...

Inventory expanded to $4.8M meaning turns were below the 4-6 targeted range.
The sales discount through the GNC Corporate distribution model widened to 15% from 10%
The option to acquire 600,000 shares issued it IFIT's former CEO Stephen Adele expired unexercised.
After deducting one time merger costs, EBITDA margins for the year were 5%

... all of this raises doubts about my $30M sales / 10% EBITDA margin expectations that had been the foundational thesis to the stock.

It wasn't all bad news - organic sales growth was ~20% - and I had expected 4Q to be messy with management "kitchen sinking" all kinds of costs post merger, but the inventory figure had me concerned enough to wake up the next morning in a sweat.

I subsequently talked with the CFO and I got a pretty narrative along the lines of ... "the past was bad b/c of XYZ but the future is wonderful" ... which didn't answer anything about the inventory, nor the wider than expected sales discount, nor the margins, nor the possibility of management conflict since their largest shareholder is the former CEO of the company they just acquired and whose business was managed E.N.T.I.R.E.L.Y differently (and incredibly poorly, to boot).

If I had $1 for every time a mgmt team provided a narrative answer instead of a substantive one to simple business questions, I wouldn't have to work anymore and certainly I wouldn't wake up in a sweat thinking: "there's got to be better ways to make money than investing in nano-caps."

But patient investing is about navigating those surprises.

Are the inventory issues temporary or terminal? 

High inventory can mean stocking ahead of sales, the timing of shipments, acquiring raw materials before a cost increase or any number of things that aren't just "good" or "bad". Too soon to say.

Are these new risks or symptoms of risks I am already aware of? 

GNC is the price setter, no doubt, and now that FTLF must sell through the corp distribution system, they exist solely for GNC's interest in providing alternative product to its franchisees. This was known ahead of time.

Also, this is a brutally competitive business.

The future opportunity remains driven by GNC's re-franchising strategy - converting 200 stores this year and 1,000 over the next three years from GNC corporate to GNC franchise stores - as well as getting iSatori products on more shelves in independent stores.

If there's one underlying thing FTLF does it's, it's good at getting product on shelves profitably and living on its own cash flow. I've seen no evidence (yet) to dispute that assumption.

What can I do to learn more so that I don't have to rely on a mgmt narrative with an obvious agenda? 

The only thing I can think of is to revisit the channel checks. When I was a kid we used to visit every home furnishings store b/t home and our destination b/c of the family curtain business. We'll be visiting a few GNC franchise stores enroute to Colonial Williamsburg on our next vacation. (I doubt they have NDS products in Ye Olde Farmacy).

The good news on FTLF is they report 1Q16 in less than a month, it's typically their strongest quarter and it will provide a better sense of performance than the kitchen sinked messy year end.

Part of patient investing is waiting, learning, researching, checking (and re-checking) assumptions and not throwing in the towel b/c of one bad quarter that you had a sense ahead of time would be bad. If they can penetrate the new franchise stores the way they penetrated the existing ones, core revenues would double over three years + the added benefit of the iSatori product = potential for significant upside.

***

In my +20 years as an investor, the bulk as a professional analyst, I have never had a "WTF!" moment like I had reading the $FHCO merger press release. Pairing a cash flow generating value company with a speculative pre-clinical phase pharmaceutical company is a deal that makes so little sense - it is so incongruous - that as Freud predicted, you almost have to laugh. And no doubt there are plenty of jokes to make.

I have written about $FHCO a few times on this blog. I bought the stock the first time in the ~$4 range after the dividend was cancelled. I sold it for a loss in the ~$2.50 range when I fully understood that the product was an irrelevant joke and then management was not much better.

I bought it back in the ~$1.35 range after the prior CEO was fired and OB Parrish resumed his leadership. The thinking then was that he'd lost so much money over the last two years, and the stock was so cheap, he would do the right thing to restore the value by simply using the copious cash flow to buy back shares and get the product on consumer shelves.

I sold a bunch of the shares north of $2 when Bares showed they'd unloaded their stock but I own enough to remain an active observer.

And I observe that FHCO, which manufactures and sells the female condom, and generates +95% of sales from developing world NGO's, will merge with Aspen Park Pharmaceuticals, a company run by two urologists / serial entrepreneurs with lousy records of value creation.

APP has new formulations of existing drugs in preclinical and clinical phases for prostate cancer and hypogonadism (ie low testosterone) and a consumer product called Preboost "a disposable, pre-moistened wipe that uses a safe, highly effective topical anesthetic ... Slightly desensitizing the penis slows down a man’s sexual response without interfering with pleasure or orgasm."

It is my belief - a product of my imagination based on many conversations with OB Parrish before and after the deal - that the entirety of the deal is OB Parrish's hope - no doubt sold to him - that the guy who got Preboost on the shelves can also get the FC2 on the shelves, and the oncology drugs are just icing on the cake, if they pan out (and in the development phase oncology world, who really knows?).

I came to this conclusion in this order ...

1. I wondered if OB Parrish lost his mind.
2. I wondered how many people thought OB had lost his mind when he invested in a small company that had acquired rights for the female condom
3. I reflected on his patience in refining and bringing his product to market
4. And on his unusual relationship with the product, which, for reasons that are unclear to me, he sort of withholds from the consumer market.
5. And finally it dawned on me that this guy is playing the "long game" and - while we don't know what's in his head - to him this must represent something "heroic"
6. However, it's not something someone does with a strong hand so maybe it's also a bit of an admission of what I've learned, that his product is a bit of joke, a novelty like preboost and he sees the writing on the wall, that at the end of the day the FDA will down-classify the female condom and he'll be left with nothing.

But who knows what will happen? The deal needs a super majority to pass and it seems possible he won't have the votes.

Unlike with $FTLF I have a very limited pathway to learning more. The key here is understanding the value of the development drugs at APP ...

delayed release Tamulosin
APP-111
MSS-722 for secondary hypogonadism
APP-944 for male hot flashes

... and I tend to avoid med-tech / pharma for the speculativeness of their products and b/c I don't have enough sources to make informed decisions. But I do have a few folks I can talk with and as I learn anything material from the urologists and other folks I intend to speak with, I will post it here.

With $FHCO, I don't yet have an opinion one way or the other and therefore see no reason to make a decision either way. But it is a strange situation. I have low expectations but plenty of patience.

-- END --

ALL RIGHTS RESERVED. THIS IS NOT A SOLICITATION FOR BUSINESS OR A RECOMMENDATION TO BUY OR SELL SECURITIES. 

Thursday, April 7, 2016

Hinkie's "Letter to Shareholders" and the Hubris of Intellect ($FHCO, $BRK)

Summary Bullets:


  • Sam Hinkie, the 76er's GM quit, leaving behind a 13-page resignation letter that reads like a shareholder letter. 


  • As an investor, Philly sports fan and former writer, it's an irritating read for a number of reasons: 1) its the kind of thing that smart people do trying to sound smart, which I call "the hubris of intellect"; 2) it's a totally derivative style, unoriginal and in someone else's voice; and 3) to storm off in a huff b/c he was asked to share power with "a basketball mind" is the kind of ego driven emotional behavior that all the great investors seek to avoid.


  • Hinkie's strategy to lose in order to accumulate assets was quite wild. His abrupt resignation means he'll never have a chance to allocate the bulk of the assets he collected from losing. Therefore we'll never be able to judge the success of his path. 
  • Instead we'll have to judge  him only on his record; they won 47 out of a total of 242 games under his leadership, a 0.24 winning percentage. The cognitive dissonance of his "smart sounding letter" is lost on someone who doesn't follow sports. 


Sam Hinkie, the 76er's GM resigned Wednesday with a 13-page resignation letter that reflects the convergence of my two great passions: Investing and Philly sports. The entire piece reads like a letter to shareholders, opening with a reference to Atul Gawande and an admission by the author that "Reading investor letters has long been one of my [guilty pleasures]."

Still on the first page, he quotes Warren Buffett.

By the second page he's quoting Seth Klarman as well as Charlie Munger's two step process for decision making:

1. First, what are the factors that really govern the interests involved, rationally considered?
2. Second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things—which by and large are useful, but which often malfunctions?"

A Buffett quote / reference shows up again on page 4: "Warren Buffett in the late 80s on this topic: “In any sort of a contest—financial, mental, or physical—it’s an enormous advantage to have opponents who have been taught that it's useless to even try.” Ask who wants to trade for an in-his-prime Kevin Garnett and 30 hands will go up. Ask who planned for it three or four years in advance and Danny Ainge is nearly alone."

Followed by Howard Marks:

"Howard Marks describes this as a necessary condition of great performance: you have to be nonconsensus and right. Both. That means you have to find some way to have a differentiated viewpoint from the masses. And it needs to be right. Anything less won’t work."

Let me remind you, this is the resignation letter of a basketball GM. Red Auerbach is barely mentioned.

On page six he quotes TED-talker Tim Urban ("one of tomorrow's polymaths").

By page 7 he's writing about disruption and quotes Max Planck: “A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die.”

He even throws in the word "zugzwang" somewhere towards the end.

The cognitive dissonance of this letter might be lost on someone who doesn't follow sports but the record shows that over the last three seasons the 76ers have won just 47 games out of a total of 242 played. That's a 0.24 winning percentage. They are dying, not their opponents.

So there's an inherent incongruity here that resolves itself to what I call "the nauseating hubris of intellect". Because even while Sam Hinkie quotes smart people, indicates a practice of and reverence for incredible investors, he built a team that has one of the worst three year records in the history of professional sports.

To his credit, and as Hinkie's letter points out, the team was successful at achieving its plan of losing in order to acquire assets. When Hinkie was named GM, he inherited a bad team with few good options and the goal was to acquire future assets for long term success by losing a lot in the short term, getting high draft picks and drafting good young players with "upside."

So the record doesn't tell the whole story and looking at it alone isn't fair to Hinkie.

But his resignation itself tells another story. Although changes in the executive suite resulted in his having to share power with more traditional basketball minds, his leaving now, near the moment when he'd harvest the results of his three years of tanking, sounds like ego and emotion acting over wisdom. That is distinctly un-Buffett, un-Klarman and un-Marks.

Everyone wants to compare themselves to the greats but when we look in the mirror, unless we have the record to show a comparison, we can't. The best we can do without such a record is humbly ask ourselves what we are doing to pursue and reveal truths, first about ourselves and then about the world around us. "To seek the truth and knowing it give the light" is the one thread that binds all great minds, people and art.

I'm not sure what truth if any Hinkie has revealed in his tenure or his departure except that it's unlikely anyone will try this extreme case of tanking again.

Outside of the "future assets" it remains unclear how well Hinkie did as a talent evaluator - drafting "good young players with upside" - since it takes at least three years to evaluate talent and none of the first round players they've drafted or acquired over the least three years have played for that long or are still on the team. (An example of Hinkie's work is with Michael Carter Williams, drafted in 2013 #11, named Rookie of the Year, and then traded for future draft picks that they will harvest this year).

And although they have successfully acquired draft picks, what is done with the picks, how they are coached, how the practice is implemented, etc. all factors into the equation. Hinkie won't be around to conclude what he started.

If he had any success at all, it's in setting the team up for the future. As he states in the letter, and I include his underlines for emphasis:

"In the upcoming May draft lottery, we have what will likely be the best ever odds to get the #1 overall pick (nearly 30%), a roughly 50/50 chance at a top-2 pick (the highest ever), and a roughly 50/50 chance at two top-5 picks, which would be the best lottery night haul ever. That same bounce of a ping pong ball (almost a flip of a coin) will determine if we have three first round picks this year (unusual) or four (unprecedented). That's this year. Or this quarter, if you will.

If you were to estimate the value of those firsts and the ones to follow, from this point forward we have essentially two NBA teams’ worth of first round pick value plus the third most second round picks in the league."

The whole thing is funny to me almost in the way it would be funny to be a passenger on a jet plane flown by someone who says "I studied from the great pilots, except I never learned how to land."

***

It's also funny to me in context of yesterday's merger announcement by $FHCO.

It is one of the strangest, surprising-est and most bizarre capital allocation decisions I've ever seen in that it combines a one-product company owned primarily by value investors who are attracted to a balance sheet and cash flow, with Aspen Park Pharmaceuticals, a bio-tech company that owns patents / has rights to some prostate-cancer drugs, new formulations of existing drugs and also has a consumer product "Preboost" that uses a topical anesthetic wipe to alleviate premature ejaculation.

I reckon the pairing makes sense in that it combines an unusual and irrelevant male consumer product with an unusual and irrelevant female consumer product.

I can further imagine the CEO of FHCO being sold on the merger idea simply with the promise that as a combined company, the marketing genius behind Preboost would bring the FC2 to consumers.

I've written about $FHCO in the past and have long thought that its CEO and Chairman OB Parrish has too much of a beloved view of his product, and in an unconsciously patronizing way. As I've learned talking to social workers and other professionals in the sex work community, the FC2 is a joke with likely no consumer market outside of novelties, but even the novelty market at a certain price has an investment thesis (eg $BRK owns Oriental Trading).

Why a product that received FDA approval in 2009 isn't already on the shelves has been a mystery to me for years, particularly if the company fumbles its market lead if FDA re-classifies the device. Parrish told me once - with no irony - of seeing the FC2 on the shelf of a corner store in an upmarket section of San Francisco selling for $15 / pack  (nearly 5x retail price) and the grocer telling him that its used by gay men off label for anal sex.

Yet, he didn't seem to appreciate what that meant about supply / demand and what could happen to sales if only they would get their product on the shelves in a variety of cities with large gay populations.

Needless to say, I should have stopped trusting the CEO, himself sitting on losses, to make wise and sound capital allocation decisions with the belief that I could go along for the ride, which has now taken a very strange and unusual turn.

I read the current move as a hail mary by someone near retirement age and sees this as his best way to turn a weak hand into a potential high return.

When I asked him why he didn't just sell half the company and buy powerball tickets and he laughed. I presume he thinks a bio-tech has greater opportunity for success than a lottery ticket. Time will tell. If there's a lesson in both these stories it's to invest with managers who can fly the plane and also land it.

-- END --

ALL RIGHTS RESERVED THIS IS NOT A SOLICITATION FOR BUSINESS OR A RECOMMENDATION TO BUY OR SELL SECURITIES DO YOUR OWN HOMEWORK