revisiting ESWW so I can sleep better at night

I've written a few short pieces in the past on ESWW, a tiny US manufacturer of diesel particulate filters, and just wanted to take a pre-holiday opportunity to revisit what's going on and as usual am happy to share what I find here.

The lede is that the stock has been a bit more active than usual and there's a new CEO. I like the former CEO a lot and he'll remain on as Chairman and apparently still work closely with the company and this is great news.

The new hire, Patrick Barge, has great experiences on paper and - who knows - he could be the person who lifts the company from the gritty turnaround that's achieved operational excellence and cash flow on a shoe string budget to an innovative company focused on R&D and new product manufacturing in the transportation diesel emissions after market. If the Volkswagon scandal tells us anything its how ubiquitous these systems are even though few end-customers know about them and they are little valued until the penalties of non-compliance become onerous. And I'll get to that aspect later.

The bigger picture as an investor is how deep into the weeds is it worth going for a company with just a few hundred thousand shares outstanding and a highly concentrated ownership structure (80% owned by one group) that concurrently holds the company's expensive convertible debt. Going into the investment, I thought "what could go wrong investing alongside a titan of finance" and although the business seem to be going in the right direction, the uncertainty around ownership will remain an issue until the debt converts or is paid off or the owners do something else. Whether or not the risk and concern of that "something else" is worth the massive valuation discount when I bought it is too soon to tell, but either way, it's a lesson I've paid to learn.

Barge according to his self reported resume is a mechanical engineer who rec'd a masters at this now defunct graduate school for the french textiles industry, many of whose graduates work in engineering, sales or quality control in various industrial or technology companies (BASF, Suez, Johnsons Controls and Thuasne). He appears to have "grown up" - so to speak - at Cummins where he worked in air and liquid filtration systems - including diesel emissions - with increasing levels of responsibility, most recently running the European geography of Cummins Emissions Solutions where he ran a P&L north of $300M.

Prior to that - and for a longer period - he was at Cummins corp HQ in Indiana doing R&D and new technologies where his budget was $150M with "700 employees in 6 technical centers located in 5 global locations".

This all sounds like good news, but it's still his first go around in the C-suite and there's no getting around that. And then there are questions ...

Why does someone go from +$300M budget and multi-national management to $25M peak revenues and two facilities? How much will they have to invest in new machinery to build out the operations this guy is used to? In what direction does the business go in the hands of an engineer with R&D experience sitting in an under utilized but high tech emissions testing facility an hour's drive from Trenton? Are they moving from a mesh metal weave to fabrics and if so is there a local supplier of polymers / fabrics who might have more insight into the market? What does he know about cash flow generation? Will he be able to thrive like his predecessor on a shoe string budget? etc. etc.

... in the absence of a conversation with him, I'm left to grasp at quotes from the press release on the hire ...

Old CEO: "We are thrilled to have Patrick join us as CEO at this critical phase of growth for ESW Group ... I look forward to working closely with him to drive growth within our rapidly evolving diesel aftertreatment and emissions market"

New CEO: "I am excited to leverage my relevant experience and seasoned leadership to help the ESW team achieve the next level of success within the aftermarket and OEM channels, as well as in the development of other potential markets"

So it sounds to me like the former CEO will remain a hands on Chairman (yay!) hopefully managing the financial / cash flow strategies as he's done so excellently in the past and the new CEO who is an expert in the niche industry, will have a lot of room to position the company more deeply into existing markets and also into new as yet unnamed markets. And the focus is growth.

In short, it looks good on paper.

I originally bought the company b/c Mark Yung was turning around a poorly run business that was thinly traded and valued at 1x-2x EBITDA, (the calculation of enterprise value being dependent on how one looked at the convertible option derivative liabilities).

The company's management prior to 2010 had a colorful history (ie a bunch of crooks), but in 2010 Yung took over in and hit the cover off the ball in a market with terrible crosswinds including changing regulatory deadlines, intense competition and highly reluctant customers. From 2010 to 2014, while acquiring one troubled competitor out of bankruptcy, he more than doubled revenues, grew EBITDA margins from -40% to +20% and FCF from - $2M to +$4M. The last we heard, ESWW had a banner 2014 year, with $25M in revenues, $6M in EBITDA and ~$57 in EPS.

Unfortunately, we don't know much about the financials anymore since the company "went dark" in April 2015,  and there hasn't been any new financial information since.

We know however that theirs is a lumpy business and that two major drivers of performance in 2014 - a municipal contract in Chicago and CARB compliance deadlines in California - are unlikely to repeat. The former b/c the contract was due to complete and the latter b/c of lack of enforcement by the CARB of regulations that require legacy trucks to retrofit with expensive diesel particulate filters as well as resistance from truck drivers against installing retrofit DPF's, fires supposedly caused by DPF's and a lawsuit from the California Alliance for Business against the CARB (and other parties - case # 13CV01232  - in Glenn County Court, CA).

This is where we circle back to VW. When CARB starts to enforce the regulations with costs more onerous than the retrofit investment, then we'll see a change in adoption. But so far they haven't and California distributors of DPF filters and their suppliers are suffering.

It's hard to be sure whether or not the groups opposed to CARB are gadflies, wackadoodle freedom fighters or have a legitimate claim, but they fight with an unusual zealotry and with a good social media presence, so that can't be overlooked. We're also in an environment where the regulations seem to fall heaviest on the smaller independent businesses who tend to be a sympathetic group even if they are rolling coal.

But as crazy as this fight appears, I'd be surprised to see environmental regulations rolled back. And by the way, there are a lot of these DPF's on the road, in all kinds of diesel cars and trucks, so there's a wide opportunity around testing, cleaning, OEM supplies, aftermarket replacements, etc. This is a wide space they can play.

Now that the company seems to have someone who can anticipate and manage the market and not just a financial and operating guru who got the ship on an even keel, then it seems like the business could be set up for a bright future even if 2015 is a down year.

About 700 shares traded hands this week, a large amount relative to avg daily vol over the last three months of 40 shares. I don't know how one would assess the opportunity since they've gone dark except maybe using CDTi's "Heavy Duty Diesel Systems division" as a proxy though their product is a pos (I've been told) and their products have verification issues with CARB. Through 9-mos sales in that division are down 25% y/y weighed down by some of the similar issues facing ESWW. Except in my channel checks  with distributors, they love the ESWW product and speak less highly of CDTi's.

Taking everything together, a still difficult environment, slow rollout of penalties to motivate compliance for older fleets and a lack of large contracts I still think even if 2015 is a down 25% year, with the new CEO steeped in this world paired with a Chairman who can focus on the financial aspects the potential for a brighter (and cleaner) future remains high. We will remain patient investors.

-- END --

THIS IS NOT A SOLICITATION FOR BUSINESS OR A RECOMMENDATION TO BUY OR SELL STOCKS. DO YOUR OWN HOMEWORK. I OWN SHARES OF THIS COMPANY. IT IS THINLY TRADED AND NO LONGER DISCLOSES ITS FINANCIALS.

A few lovely surprises this earnings season (STRL, FTLF, EVI and ARIS)

There were a few lovely little surprises this earnings season but none brought a smile to my face more than hearing that STRL had hired Ron Ballschmiede as their CFO.

Ron was previously the CFO of CBI, including the six years that I was a sell side analyst covering the E&C industry, and he is great.

To be frank, he joined CBI when it was in a period of dire need after one of those ridiculous petite-scandals that corporate america engages in every so often. In this case, in 3Q 2005 the company delayed filing its 10Q b/c of alleged accounting issues and then in winter 2006, filed this statement paying an underling in the accounting office $1.7M in hush money. A few days later, the CEO and CFO were fired. Phil Asherman, a former FLR biz dev guy was elevated to CFO and Ron was hired six months later.

I recall, during his tenure as CFO, in no small detail and with plenty of professional regret on my part, when CBI was losing boatloads of money on an LNG regas project in Wales (a project he inherited mind you), when much that could go wrong did including a labor force protesting work conditions daily and in 2008 the rainiest summer in UK history, when the company's balance sheet was so stressed it had $88M in cash compared to $1B in deferred revenue (ie cash collected from customers ahead of work to be completed), when it seemed to me the company was close to running out of money and I had a conversation with him where he calmly reiterated that construction companies - contrary to popular opinion - don't need a lot of cash on hand as long as the customers are willing to patiently accommodate temporary problems.

He was right, I was wrong, and the shame on my part was downgrading the stock in 4Q08 when shareholder equity was ~$600M vs $2.9B today.

I learned a number of lessons in that experience, as an analyst and as an investor, and also gained an enormous amount of admiration for a guy who is now the CFO of our wee +$90M mkt cap company that is also in need of an accomplished CFO who can lay the foundation of a professional organization. It should bring a smile to all the faces of STRL investors b/c he knows the construction business, the processes, the accounting and the institutional investors well in excess of what should be expected in that role and for a small company such as ours. We are lucky to have him. (He's also the person who hilariously once counselled me, "If you sit down at the airport, you've arrived too early").

Second to that satisfaction is a little vanity on my part seeing the amended 10Q STRL just filed. Something about the initial Q struck me as weird when they reported a swing to losses in the the Myers JV. So after the earnings call I asked the interim CFO about it (he is wonderful in his own right and for many sound reasons has zero interest in being a full-time CFO) and I really liked his frankness: "those parenthesis you see, they don't belong there."

To avoid this mistake in the future, I offered to proofread their filings a few days before their release but I doubt that's something anyone will oblige.

Other good surprises for the quarter included ...

FTLF: Getting back on track with revenues up 14% y/y and now having lapped the worst of its channel disruption and with the IFIT acquisition under its belt on track for $30M revs and 10% EBITDA margins, still trading at just 6x proforma EV despite growth and profitability.

EVI: The quarter wasn't great b/c of a delayed equipment delivery but customer deposits were the highest ever at $5.8M and a special $0.20 dividend was declared. I also just attended my first shareholder meeting and got a firsthand account of plans / expectations for buy / build strategy and how they intend to consolidate their fragmented, regional and balkanized industry. While I fear equity dilution to fund future deals, the suggestion that they use rights offerings to raise money would allow investors to substantially maintain their ownership levels.

ARIS: Still flying under the radar despite top line growth, cash generation and margin expansion. Returns are expanding to low teen ROE and ROA and high S/D ROIC. With several acquisitions under its belt, and I believe a focus on customer retention and organic growth, I see a lot left in the tank for a company whose stock is trading at 11x EBITDA vs a peer group north of 15x.

... of my larger holdings sadly only STLY continues to underperform. My initial views on the company was that the furniture business sucks, that management destroys value, that there's no growth, no margin, no competitive advantage, and that it's not a business I want to own. Somehow I convinced myself that activist investors who own large chunks of it would push out the CEO and turn things around but in talking recently with a source in the business, as he put it: "there are always wall street folks who think they can turn it around. It has a great brand within the industry, but customers have no idea what it makes, their styles are out of fashion and the industry's distribution model is broken."

While STLY doesn't put a smile on my face, I was more right than wrong in the quarter and more importantly the lessons I learn today as I continue to grow in this business will, I believe, provide a framework for better decisions in the future.

-- END --

THIS IS NOT A SOLICITATION OR AN ENDORSEMENT OR A RECOMMENDATION  TO BUY OR SELL SECURITIES. DO YOUR OWN HOMEWORK BEFORE INVESTING.

One More Letter to $FHCO After they Blocked my Effort to Improve Exec Comp

A few weeks ago I sent a letter to the Chairman and Board of $FHCO asking for a proposal to be included in the proxy re: chg'd exec comp.

With a board that avgs 71 y/o and +13 years of svc I'm not surprised they responded with obstructions and not open arms. Since I am not a shareholder for the continuous year (thank goodness for my portfolio) they won't consider it.

But the thing is, the same people running the company are the same people who've been there since the product was approved by the FDA in 2009, and its still not on drugstore shelves, which means either the product sucks, they suck, or somewhere in between. I'm in the group that thinks its somewhere in between.

Yet, even if the product sucks (and I've been assured by some it does and others it doesn't) there are so many condoms on the shelves of every drugstore I've ever been to, at least one female condom can fit there as well, even if its just a novelty. If it ain't the FC2 it will be something else someday.

And thus this letter (see below). I cut the part where I pan their decisions to hire an ex-pharma exec and an ex-marketer of IUD's (who is also on the board), b/c it seemed appropriate to be nice. But I am dumbfounded, speechless, nonplussed in the true definition of the word, why they'd hire execs with those kinds of expertise for a product that's the anti-IUD and the anti-pharmaceutical. It's like hiring a vasectomy surgeon to sell condoms. They need brand strategy and consumer distribution expertise not ex-pharma folks.

In my view, at least if we can align comp structure, I know they won't be paid unless my capital is put to best use, which so far, it hasn't.

Here is the full letter going out to the board today and please remember this is not a solicitation to buy / sell / transact business just shared out loud thoughts and ideas.

-- END --

Dear OB:


I was disappointed by your response to my letter regarding my shareholder proposal for changing executive compensation. I had hoped you would welcome the proposal not put up roadblocks to cause its exclusion.

My goal in recommending an alternative comp structure is simple and threefold
• To find a system that is fair to executives
• To find a system that incentivizes good long term capital allocation not short term goals
• To find a system that aligns the interests of shareholders and management

The current compensation plan isn’t fair.
As your filings point out, you have no control over the timing of public sector purchasing patterns. Since the public sector remains your largest customer, one order, the timing of which you have no control over, can determine whether or not executives are compensated.

Last year, executives did not receive bonuses. This year, because of the Brazil tender, they likely will (including yourself). The key point is that your current executive compensation system doesn’t reward decisions from the FHCO C-suite, but rather decisions made in developing world health departments thousands of miles away.

Executives should be compensated for the decisions and efforts they make, not someone else’s.

The system doesn’t motivate long term planning or capital allocation.
Your current plan is based on one year sales and margins over which – as you’ve long established - executives have limited control. As a result, spending on marketing campaigns or strategies with long term payoffs negatively impacts the compensation for executives, disincentivizing long term planning.

Executives should not be compensated solely on short term results as your current policy now holds.

The system doesn’t align interests of shareholders and management.
Ending the dividend to invest in your business is an equivalent indication that you can allocate capital better than your shareholders can. The system I recommended in my proposal rewards good capital allocation and ensures that the capital you’ve taken from shareholders is put to the best and highest use, as your shareholders themselves likely would have done with their dividends.

A plan that promotes good capital allocation would incent better decisions and might improve outcomes.

I hope you and the board will address the shortcoming of your current executive compensation plan and consider implementing one – perhaps along the lines of the ones I recommended in my earlier letter - that is forward thinking and rewards good long term capital planning.

Above all, I want to see evidence of a management team that makes sound long-term high-return capital decisions while providing safe, low cost and accessible choices in women’s reproductive health. I imagine we stand on common ground with respect to that goal.

A few additional comments.
As you are aware, I previously recommended in prior communications with you and Ms. King two low cost ideas to help expand your product reach.

1. Explore a partnership with SHE Sustainable Health Enterprises.

SHE, as you know, has created a program to locally manufacture and distribute affordable menstrual pads in Africa (Saathi does a similar program in India). They have a partnership with J&J and their founder, Elizabeth Scharpf, is an advocate for expanded use of the female condom.

In fact, in an interview I read online, she is asked: “You’re going to a desert island, and you’re allowed one food, one drink and one feminist. What do you take?” and she answers: “Cherry pie, champagne and whoever invented the female condom.”

It is easy to imagine a wealth of opportunities available through a partnership with SHE to reach a shared customer base in Africa, your largest market. I previously recommended you reach out to her and I've emailed with her several times. In response to my suggestion, both you and Ms. King replied: “She didn’t return a phone call”. That is not leadership regarding a potential partnership with an influential advocate of your product.

2. Expand your creative / brand development.

I have also suggested that you hire a creative / brand team from one or two “innovator cities” (perhaps offering equity as a form of long term alignment) to test creative programs and get your product on shelves. This suggestion was simply ignored and I see no evidence to support your statements that you have already initiated a successful brand building strategy.

I think we both agree that bending the consumer sales curve will require smart long-term investments in sales, marketing and distribution today, with the benefits in years 2, 3 and beyond. I also think we both agree that getting the right consumer brand strategy is the key to fixing recent cash flow degradation, stagnant shareholder equity, rising competition, and risks associated with a being one-product company.

So please consider changing your incentives to align them towards the long term investments required to bend the sales curve. Doing so will help provide shareholders more faith and trust that decisions from management and the board are made with optimal long-term capital allocation in mind.

Another year, another attempt to improve exec comp at $FHCO

A few weeks ago, I submitted the following letter to the board of FHCO and its CEO / Chairman OB Parrish regarding executive compensation. Alas, I haven't been a shareholder for the last continuous 12-months, a good thing for my portfolio  since the stock is down more than 50% y/y but a bad thing for myself as shareholder since comp is a strong way to align goals, and they are prejudiced against short-term shareholders.

My effort is to comp execs on ROIC. My reasoning is that once they stopped paying shareholders a dividend to invest in the business their capital allocation decisions should have become paramount.
They haven't, and shareholders suffer.

They SHOULD invest in their business no doubt. The industry has changed - the product is no longer a monopoly - and the company has spent considerable money and efforts to broaden its consumer appeal, but without articulating or explaining the strategy and with no improvement in the goals they seek to attain.

I believe they are going about it all wrong - old fashioned ex-pharma marketing - versus just getting it on shelves, and I've suggested low cost creative and strategic partnerships to no avail. I think they are afraid to make fun of themselves and therefore try something risky (the consumer product is risque).

Whatever ... since I can't effect how they are going to spend their money at least I can try to make sure they understand that cost of money and try to ensure compliance with a return.

So while the board has discretion to consider this proposal it is unlikely hey will oblige. With an average age of 71 years and an average length of service of 14 years this is not a group that invites new ideas.

Dear Mr. Secretary

Last year I wrote a letter to the Board regarding a proposal on executive compensation that I had hoped would be addressed at the annual meeting. However, the letter was sent too late for the deadline.

I am writing a similar letter with substantially the same proposal for inclusion in the proxy materials for the 2016 shareholder meeting (see below).

In the year since I wrote the initial letter, the stock has lost 65% of its value. Concurrently, year-to-date unit sales are up 44% and year-to-date revenues and operating income have grown 33%. So management is likely to receive its bonuses even after a year of shareholder suffering and negative cash flow generation. There is clearly a misalignment.

A compensation system that incentivizes principles of good capital allocation will re-align interests between owners and managers, ensure optimal investments in the business and re-instill confidence that management is making wise, capable and thoughtful decisions that will reward shareholders over the long term. I sincerely hope the Board allows shareholders to consider this proposal at its next meeting.

Sincerely
Long Cast Advisers, LLC

CC:
O.B. Parrish, CEO & Chairman
Brian Bares, Institutional Shareholder

 
A PROPOSAL TO CHANGE EXECUTIVE COMPENSATION

The current executive compensation system is based on unit sales and operating margin targets. It has as its greatest virtue, simplicity. It is not ideal but neither is it inappropriate for a single product company in an industry characterized as a monopoly.

However, recent issues have arisen that require exploration of a new executive compensation plan:

• The industry is no longer a monopoly.
• The company has cancelled its dividend.
• The company is seeking to use capital once reserved for shareholders in the form of dividends for internal growth and / or acquisitions.
• The company, once a great cash flow generator, is currently a cash flow user.

With these changes, especially the cancellation of the dividend and the recent cash “burn”, it is obvious that the role of management has expanded from one of maintaining market share to one of capital allocation.

I therefore propose that the board terminate the current compensation plan and adopt one based on capital allocation and cash flow. I suggest one of three options: Returns on Incremental Invested Capital (ROIIC) targets, Economic Value Add, or Cash EPS. Any of these would be better choices for a company that diverts capital from its shareholders to fund internal and acquired growth.

A compensation structure that rewards wise, capable and thoughtful capital allocation would be the best way to ensure that the owners of the company, who no longer have access to the company’s capital via dividends, are getting the greatest value for their shares.

$FTLF: Positive reflections on an initial (small sample) channel check

I have been looking at $FTLF as an investment idea and posted my initial thoughts here >> http://goo.gl/UnuzIs << but i've been struggling with an internal conflict b/t the investment thesis, which looks good to me on paper, and the product, which makes me feel uneasy.

So I recently visited two corporate GNC stores and three local franchise stores to check in and hear what they had to say about $FTLF and $IFIT products. This is an insanely irrelevant sample size. GNC has ~3,500 domestic corporate owned stores and ~1,100 domestic franchise stores and I've visited 0.10% of them.

Still, with the risk of spreading the contagion of availability bias, here's what I learned from visiting 0.10% of GNC stores in a small sample channel check.

Corporate stores (2): 
Both stores had a small section of iSatori bio-gro and hyper-gro on hand.

At one store, a bit run-down and poorly lit, the dipshit kid who helped me said they wouldn't recommend the iSatori product "... b/c nobody buys it".  uh ...

He couldn't tell me anything about it.

The other store was clean and well lighted and the dude working there was insanely nice, very knowledgeable and totally jazzed about the iSatori bio-gro. "I'm a biology major so i try to understand how these products work ... it's an IGF4 stimulator ... the only product like it on the market ... the only way to get the same effect is with a much more expensive growth hormone."

He says he was not trained or paid to say that.

My takeaway is that IFIT's bio-gro has a good product, but they pay way too much to market it through the "traditional" advertising channels of meathead spokespeople (ie CT Fletcher's "I COMMAND YOU TO GRO!").

IFIT pays $0.24 / dollar of revenue on sales & marketing and generates the same 2x sales / total assets as FTLF, which spends only spends $0.12 / dollar in revenue. No wonder FTLF has ~20% ROA. Now imagine for a minute the same product sold through FTLF's channels at 2x the margin.

It was a little disappointing that the MetisNutrition line hadn't yet reached the GNC corporate stores, but the product just launched.

Franchise stores 
I happened to arrive at a franchise store while the owner was there and he owns three of them in the area, so these comments refer to all three stores.

I was told that musclepharm, BSN, Optimum and Cellucor all pay for their wall space and are in corporate and franchise stores equally.

FitLife products (NDS, PMD and SirenLabs) were all in the middle aisle, facing the wall, a less prominent position. (I think they called it a camel shelf, or something?)

The manager at the store raved about the product. He loved it for a variety of reasons:

1. it sells well and there are "zero returns, none!" apparently returns are a huge hassle.
2. the brands are consistent and have longevity. they don't change around the ingredients and they don't continually introduce new brands that are confusing to the sales people.
3. the product works, he said.

a few other tidbits ...

1. he said the brands reminded him of cellucor from a few years ago when cellucor was called nutrabolt, started out as a small business, grew through product development and word of mouth, and now is a GNC anchor product. but today's cellucor is different than the past, with too many new brand intros and a lot of returns.
2. he of alluded to musclepharm being a joke
3. on the distribution transition, they used to order direct from FTLF maybe a pallet every quarter. Now that they order via corporate GNC every two weeks and since they don't have to stock up, the orders are about 5%-10% less volume. but its steadier.
4. the product is now more expensive to them since they buy from GNC with a markup.

this final point highlights a negative aspects of the change in distribution channel and also a risk for $FTLF

• the product price to the franchise has increased and could cut into the franchise owner's margins. the owner I spoke said it is still a high margin product, but that's narrowed. FTLF mgmt says the higher prices are offset by a termination of shipping costs and credit card fees, so on their end the impact is a wash. 
• the risk is that GNC can pretty much do whatever it wants. while i'd assume there is a contract b/t GNC and FTLF on frequency and size of price increases let's face it, GNC controls the distribution channel ... and therefore can do whatever it wants. 

5. post summer is the slowest seasonal period for the business. everyone met their summer goals. it picks up again in January.

... my takeaway, from the franchise stores is that FTLF is punching above its weight, outperforming other products in the sports nutrition business without wall access space or end caps or expensive advertising.

Again, small sample, but exciting for me to hear and its developing some trust in the product. I called it "snake oil" in the prior post and I think that was overly harsh. I will amend that. 

Finally, "Sudbury Capital Fund" recently filed a 13G on the stock, representing a 5% position (432k shares) >> http://goo.gl/G8osCL << The fund has another disclosed position in RLJ Entertainment, so I'd guess this fund is going after small value.

Not sure how they acquired so many shares without moving the stock so probably acquired from another large holder. The fund is run by Dayton Judd >> http://goo.gl/s6bW7n << I google mapped his office in Texas just to get a sense of where it is. It's located - the cliche of Texas - roughly equidistant from a gospel church, a gun store, a bbq pit and a DQ.

All this is to conclude that I'm getting over my fear of the product and there will be more store visits in the future.

-- END --

ALL RIGHTS RESERVED THIS IS NOT A SOLICITATION NOR A RECOMMENDATION TO BUY OR SELL SECURITIES LCALLC MAY OWN SHARES OF STOCKS MENTIONED.

Rubbing My Nose in My Own Mistakes

As I transitioned in 2014 from sell side research (ie analyzing companies, industries, valuations, etc on behalf of hedge fund and mutual clients) to investing professionally with mine and other people's money, I made a handful of mistakes.

That will happen.

The important thing is burying my noses in them so I understand where my process failed and they don't happen again.

Here are some observations from rubbing my nose in my own mistakes with brief mentions of $OLED, $FHCO and $STLY. (Adding $CCJ, which I totally forgot to mention). All of this happened in the fall of 2014.

1) Overcoming the sense that "I need to be doing something." 

ALL mistakes I've made this past-year ultimately flowed from this one.

On the sell side analysts are not allowed to own the companies they cover and know best. So the stocks I bought for myself had to be super interesting and well researched for me to squeeze the extra work into a 60 hour / week day job.

There was enforced patience. I only bought things that were the most interesting and highest conviction and then I simply waited. A lot of great returns were generated this way.

Fast forward to professional investing and there was this initial compulsion to be "doing something". It's an unusual experience to sit around and read, talk to people, follow leads, learn new markets and industries, read some more, and then ... do nothing

But the source of my success in the past was - slightly tongue in cheek - doing as little as possible, finding, researching and waiting only for the most interesting ideas. Hewing to this model will help avoid this simple mistake in the future.

2) Buying before completing my research.

My equity research relies heavily on the work I did as a reporter and private investigator many years ago bridged with more traditional financial analysis. So in addition to the basic equity research of ...

reading into the company
the competitors
the industry
building a historical model and thinking about drivers of the business
making assumptions on growth rates
flexing the valuation

... there's also a lot of researching the CEO and CFO to get a sense of what makes them tick, what motivates their roles, what are their strengths and weaknesses, capital allocation capabilities, and any other tidbits I can find.

And then there's also thinking about two additional points
i) what needs to go right for the stock to work
ii) and especially what are the risks to owning it

there are no short cuts to any of these areas. Three mistakes I've made in the past year were made from buying a stock before completing my research.

3) Going against my gut. 

I have a pretty good sense of what interests me and what doesn't. Not everything that interests me is a good investment and not everything that's a good investment interests me, but I only want to spend my time on businesses I understand that appear undervalued and / or mis-priced.

When I go outside my circle of competence, it's an uncomfortable feeling.

These three case studies converged all around the same time and combine all three mistakes. 

Case study: OLED. I wrote about it here >> http://thepatientinvestors.blogspot.com/2014/06/oled-my-gut-says-overlooked-value-but.html << Everything about it looked interesting but I didn't understand the business and I didn't have the stomach for the volatility. So I avoided it ... but then emotion got the better of me and bought it on the way up and sold it on the way down. Then the stock took off. Absolute amateur hour. I rub my nose in it everyday.

Case study: STLY. My first impression was this is a shitty business with god-awful management. And nothing has changed. But a value investor friend owns it and I allowed myself to be talked into it even though it's a shitty business with god-awful management. I've come to learn that value recognition is possible from an engaged activist investor who is likely to take over the company at some point in the not too distant future, so I continue to own it. But I bought it feeling the need to be doing something, going against my gut and without finishing all my research.

Case study: FHCO. It's the kind of interesting and weird business I like. I bought it after it cratered to ~$4 / share when they cancelled their dividend. I'd seen that Brian Bares owned it, and I've read his book and like his style. I didn't mind that the product is essentially irrelevant in the US, b/c most of the business is in Africa and S. America. I could deal with the fact that their monopoly was broken b/c they average EBITDA of ~$0.15 / unit and they are still profitable at $0.10 / unit. Plus if there's a competitor it only affirms the market.

But it did not take too many conversations to lose trust, faith and confidence in [prior] management. I won't go into all the details of their ineptitude but had I talked with them more substantively ahead of time I would have seen it quickly. So I sold it at a loss. Interestingly, prior management is now gone and I've revisited the stock at ~$1.40 / share. It is a cash flow machine.

Case study: CCJ. Again, this was around the time I'd just decided to start my own firm and felt the need to be doing something. It's just absolute insanity. I was thinking about uranium, china's desire to build 120 nuclear power plants, the collapse of mining markets in general, my expectation that the decline in mining markets / oil sands production might improve labor rates at the Cigar Lake mine and in general just had uranium and CCJ on my mind when I saw a Barron's article that mentioned a fund buying the stock and I bought some before I'd even cracked a filing.

Then only after buying it, I read about it, learned about the Canadian tax revenue issue, the incredible capital intensity of the refining operations, the trading operations, etc. etc. etc. I'm reminded of a lesson I learned a long time ago; "think before you speak". Do some research before you buy a stock!

***

It's painful to recollect all this stupidity / absence of judgement / willful avoidance of the simple processes I'd used with prior successes. But the lesson was to reflect on what's worked in the past - I've fortunately had a lot of experience with successful investments - and to not change what's worked simply by virtue of transitioning from a hobby to a profession.

So it's been a short but steep learning curve.

Looking ahead, all patient investors should realize that investing is deeply personal and one of the most differentiated enterprises out there. No one does what you do. Your intellectual capital is your edge. There is no comfort in crowds. In the absence of "consensus" you have to find your own evidence. Understanding this has been a big step in the learning process for me, and I hope to always be learning. That's one of the big draws of this business.

Finally, of course I will make mistakes in the future. Anyone whose not afraid to own them, acknowledge them, honestly assess what went wrong and learn from them should do well. Rubbing ones nose in them isn't such a bad idea either, at least to make sure you don't do them again.

-- END --

ALL RIGHTS RESERVED. THIS IS NOT A SOLICITATION FOR BUSINESS OR A RECOMMENDATION TO BUY OR SELL SECURITIES. STOCKS MENTIONED IN THE POST MAY BE OWNED BY LCALLC

$ARIS: Response from CEO on letter sent earlier this summer

Earlier this summer I sent a letter to the CEO and board of $ARIS regarding my optimism with the forward outlook for the company, tempered with my concerns about continued share dilution.

http://goo.gl/FYzx89

As the letter indicated, the company had grown substantially over the last seven years but on a per share basis - the only metric that matters to shareholders - growth was negligible and I'd hoped they would stop the dilution going forward.

I received the reply just below. Talk is cheap of course and no commitments were made, but if mgmt and the board are aware of and equally burdened by the dilution, then there's potential for behavioral change going forward. My takeaway is that access to less expensive debt is more likely to provide growth capital going forward, nothing that hasn't already been publicly disclosed.

As a small investor with a nascent investment management firm, I enjoy focusing on smaller companies for three primary reasons ...

1) offers opportunities to compound growth faster, not available with larger companies due to "the law of large numbers"
2) offers opportunities to engage with mgmt, which due to scale is not available with larger companies
3) tends to be less efficient. since size and liquidity govern AUM causing otherwise intelligent investors to seek alternative markets. a patient investor can benefit from inefficiency on the purchase and reap rewards on the eventual harvest, or simply own great businesses forever.

... I believe $ARIS exemplifies all three attributes of smaller market companies and I hope to own it for a long time.

***

Thank you for your letter of August 11th. We have forwarded your letter to the Board of Directors and appreciate you taking the time to share your perspective.

When I became CEO of ARI in 2008 it was clear to me that ARI’s lack of “scale” was a driver of the then share price of under $0.50 and a market cap of under $5M. We recognized that we needed to grow the business and that our overall objective of growing shareholder value could not be obtained in the markets we served, with the two products we offered. As a result, we began executing a plan to grow the total addressable market we served both organically and through acquisitions. We also undertook an initiative to increase the number of recurring revenue products that we could offer to those markets while also looking for products that had a higher price point. In summary, our plan was to increase the total addressable market, increase the number of products we offered into those markets, and increase the average recurring revenue per dealer for those offerings organically and via acquisitions.

From a financial perspective, early on it was difficult to drive acquisitive growth using debt as our overall EBITDA levels were low and our lending relationships were such that to increase our debt levels would come with a significantly higher interest rate and more restrictive loan covenants. In addition, we took advantage of a unique opportunity to purchase 50 Below out of bankruptcy and had to finance that acquisition knowing it would take some time to generate positive EBITDA. As you know, we have completed several acquisitions and two capital raises in recent years. In addition, in the last 15 months we have experienced a significant increase in our EBITDA. I believe that these events have put the company in a much better position to finance acquisitions with debt than we were just a few years ago. Our ability to obtain that debt is primarily tied to our ability to generate EBITDA. Our current banking relationship has expressed comfort in allowing us to borrow up to three times our adjusted EBITDA with an interest rate that caps out under 5%. We are now realistically within striking distance of $50M in sales and have seen EBITDA improve by over 50% on a trailing twelve months basis compared to our prior fiscal year. With our scale, we are now generating more EBITDA than we have in the past and this dramatically improves our ability to complete acquisitions using senior debt. For example, if ARI generated $7.5M in EBITDA we could then borrow up to $22.5M in addition to 3x the target's EBITDA. This gives us a great deal of capacity to complete acquisitions without raising equity capital and it is our intention to take advantage of this capacity in the future. We have also adjusted our acquisition criteria to look for businesses that are immediately, or in a short time, accretive to the company’s EBITDA results. As the business scales and we continue to improve our operating results I believe the EPS will also improve. I do agree that the key to this is scaling the business from here without significant dilution.

We do plan on improving our subscriber reporting, starting with our Q1 FY16 results and appreciate your feedback on that item.

We continue to promote buying to our board and executive team and we will continue to encourage our management team and board to invest in the company using their own funds. As you know we did have 3 board members purchase another 49,000 shares on the open market in our last trading window (July 15). While I did not purchase in July I own over 150,000 shares the majority of which I purchased on the open market (these are outside the stock options or the restricted stock I have).

Again, thank you for taking the time to share your views with the board and me. We take your feedback seriously and we will carefully consider your comments as we grow ARI to the next level. We all agree, it is an exciting time to be an ARIS shareholder!

If you have any questions please feel free to contact me anytime. 

-- END -- 

ALL RIGHTS RESERVED BY LONG CAST ADVISERS LLC. THIS IS NOT A RECOMMENDATION TO BUY OR SELL SECURITIES NOR AN ADVERTISEMENT OR SOLICITATION. LCALLC / ITS FOUNDER OWNS SHARES OF $ARIS IN ITS BUSINESS AND/OR PERSONAL ACCOUNT